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Publication date: 09 Jun 2020
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Banking and capital markets
Spotlight on IFRS 9 - Assessing Islamic

Financing arrangements for classification and
measurement
Spotlight on IFRS 9 - Assessing Islamic Financing arrangements for classification and measurement
Islamic Financing arrangements are common in many territories, some of which operate under Islamic law. Transactions are
not structured as conventional banking products and, where such financing arrangements are within the scope of IFRS 9, the
assessment of solely payments of principal and interest (‘SPPI’) criterion for classification and measurement purposes may
be complex. The assessment of whether any arrangement meets SPPI is a matter of judgement, where specific
circumstances will need to be taken into consideration. This spotlight publication highlights a number of common
considerations that will help management to perform the SPPI assessment.
Overview
Islamic financing arrangements are common in many territories. Such arrangements are not structured as conventional
banking products and, where they are within the scope of IFRS 9, the assessment of the solely payments of principal and
interest (‘SPPI’) criterion for classification and measurement purposes might be complex. The assessment of whether a
particular arrangement meets the SPPI criterion is a matter of judgement that will depend on the specific facts and
circumstances. However, there are a number of common considerations that will help management to perform the SPPI
assessment.
What are the key features of Islamic financing arrangements?
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Under Islamic financing arrangements, the Shari’ah law requires adherence to specific principles:
prohibition of interest/time value of money (‘riba’);

prohibition of activities with elements of uncertainty, such as gambling or
derivatives (‘gharar’);
prohibition of investing in certain sectors (‘haram’ items such as alcohol, drugs,
conventional financial services etc); and
transactions should generally be backed by or linked to a tangible asset.

The most common Islamic financing products are either structured as asset-based or asset-backed financing transactions
(‘murabaha’, ‘ijara’ or ‘sukuk’), or profit- and loss-sharing models which might also be asset-based. Typically, the profit and
loss models might be structured in the form of investment contracts (‘mudarabah’ or ‘musharakah’), whereby the transaction
is merely a form of investment into a structure. However, in the contracts, there is no specific mention of interest in the
contractual terms of the Islamic financing arrangements; rather, mention is made of profit share, special commission or
return on investments which, in substance, is designed to mimic interest. Some arrangements might, as an example, refer to
LIBOR-based payments as a profit share.
The legal form of the contract might complicate the assessment of how to account for such arrangements. Consideration
might need to be given to a variety of accounting standards, such as IFRS 11, ‘Joint Arrangements’, IFRS 15, ‘Revenue from
Contracts with Customers’, IAS 17, ‘Leases’ (replaced by IFRS 16, ‘Leases’), and IFRS 9, ‘Financial Instruments’, to
determine which standard applies to the financing arrangement.
The technical requirements
Under IFRS 9, a necessary condition for classifying loans and receivables at amortised cost or at fair value though OCI is that
the contractual payments give rise to cash flows that are SPPI.
The overriding principle in paragraphs B4.1.7 and B4.1.7A of IFRS 9 is for contractual cash flow characteristics to be
consistent with a basic lending arrangement whereby the principal and interest cash flows under the contract are collected.
Furthermore, interest comprises consideration for the time value of money, credit risk, other basic lending risks and costs, as
well as a profit margin. [IFRS 9 para 4.1.3]. Contractual terms that introduce exposure to other risks unrelated to the basic
lending arrangement might not meet the requirements of a basic lending arrangement, and so some loans and receivables
arising from Islamic financing arrangements cannot be accounted for at amortised cost.
There are two steps in performing the SPPI assessment: 1) determining the characteristics of the contractual cash flows; and
2) determining if the contractual cash flow characteristics represent SPPI.
Step 1 – How to determine the characteristics of the contractual cash flows?
In this first step, the contractual cash flows need to be understood. Due to the unique nature of the Islamic financing
arrangements, the assessment is not as simple as in a conventional banking financing arrangement. The return on the
principal payment is not referred to as interest, but it might make mention of share of profit payment which, in substance,
might be interest. The repayment of principal might be structured as a sale transaction with deferred payment terms, a lease
transaction with a purchase undertaking, or an investment in a project, all of which provide the financial institution with initial
principal and a return akin to interest. For the purposes of this assessment, it might be necessary to use a legal expert to
interpret the contractual rights and obligations, as established by the relevant competent authorities having jurisdiction over
the agreements.
As such, the following factors might need to be considered when determining the contractual cash flow characteristics for
the SPPI assessment in IFRS 9:
Substance of the contractual rights and obligations: In terms of IFRS 9, Islamic

financing arrangements should be accounted for based on the contractual
substance and not merely the legal form. The Conceptual Framework for Financial
Reporting issued in 2018 (‘Framework’), in paragraphs 2.12 and 4.59–4.62,
specifically requires the consideration of the substance of the contractual rights
and obligations. The Framework elaborates as to when contractual rights and
obligations should be excluded from assessing the substance of contractual rights
and obligations. Paragraph 15 of IAS 32, ‘Financial Instruments: Presentation’, also
requires a financial instrument to be classified in accordance with the substance of
the contractual arrangement. However, this does not mean that contractual rights
and obligations can be disregarded just because, in practice, they frequently do not
result in changes in actual cash flows. Also, see ‘not genuine or de minimis terms’
below.
Enforceable rights and obligations: For the purposes of understanding the rights
and obligations of the contractual terms, paragraph 13 of IAS 32 refers to a
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contract and contractual as an agreement which has clear economic

consequences that the parties have little (if any) discretion to avoid, usually
because the agreement is enforceable by law. Contracts can take a variety of forms
and need not be in writing. Consideration should be given to the enforceable rights
of the contract, and whether any actions by either of the parties to the contract
demonstrate that contractual terms exist which might not necessarily be in writing.
Many of the Islamic financing arrangements require settlement of the full deferred
settlement amount on early repayment. Consideration might need to be given to
whether such terms are enforceable, because the banking regulator might not allow
such settlement terms, or past practice has demonstrated that the full deferred
settlement amount is not enforced by the financial institution. On early settlement,
the bank might merely provide a discount on the settlement amount. Whilst such
practice might not be written in the contract, it should be considered whether this
creates an enforceable right for the customer.
Legal framework: When considering the contractual rights and obligations,
consideration should be given to the legal framework and jurisdiction which apply
to the contract. For example, contracts might have different enforceable rights and
obligations in an English court from those which are under jurisdiction of the
Shari’ah courts. The determination of which court jurisdiction is appropriate might
also differ between regions.
As noted above, musharakah arrangements require the sharing of profits and
losses. Under certain legal jurisdictions, the financial institution might be required
to absorb such losses.
Not genuine or de minimis terms: In terms of paragraph B4.1.18 of IFRS 9,
contractual cash flows do not affect the classification of financial assets if such
contractual cash flow characteristics are considered not genuine or de minimis.
What are examples of contracts where the substance is similar to that of a conventional financing transaction?
In some instances, a murabaha contract is based on a commodity, which is traded in a liquid market. The financial institution
would buy a commodity and simultaneously sell the commodity to a counterparty, at a mark-up, but on a deferred payment
basis. The underlying commodity might never be physically delivered, but the counterparty would have an obligation to the
financial institution for the sale price of the commodity. In such cases, the purchase of the commodity and simultaneous sale
of the commodity do not have substance and should not be considered in the assessment. The substance of the sale and
purchase transaction is similar to that of a conventional financing transaction, whereby the mark-up is similar to interest
accrued over the deferred payment term.
Similarly, a musharakah contract might be structured as a co-investment between the financial institution and customer. The
financial institution might provide a portion of the capital investment, and the customer might invest capital, skills and
manpower. The agreement stipulates that the investment will generate profits periodically, at pre-agreed scheduled rates,
and profits will be distributed in a fixed proportion between the customer and the financial institution. This profit share might
provide the financial institution with returns similar to interest. At the end of the arrangement, there is a purchase undertaking
by the customer to purchase the asset, enabling the financial institution to recover the principal. Whilst the agreement
stipulates that all profits and losses are shared in accordance with the terms of the contract, if it is the case that the losses
might never be shared and were never intended to be shared, they might have no substance.
Sukuk represents undivided shares in the ownership of tangible assets relating to particular projects or special investment
activities. Sukuk are the Islamic equivalent of bonds issued. Sukuk could be either financial liabilities or, in some cases,
equity instruments from the issuer’s perspective. Classification of the sukuk from the issuer’s perspective should be
considered in the scope of IAS 32. Furthermore, some sukuk might be asset-based, but the cash flows from such assets are
unrelated to the profit share on the sukuk or the principal on the sukuk. Other sukuk might be asset-backed, where cash
flows might expose the sukuk holder to risk of the underlying assets. Again, the substance of the sukuk might not be that of
an undivided interest in a tangible asset, but instead it provides the investor with cash flows similar to other conventional
bonds.
Step 2 – How to determine if the contractual cash flow characteristics represent SPPI?
In this second step, it should be determined whether the cash flows represent SPPI. All of the guidance in IFRS 9 applies,
just as for any other contract; however, the following features will often be particularly relevant to Islamic financing
arrangements and might result in failure to meet the SPPI requirements:
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Prepayment options: On early settlement of an instrument, the contractual terms

might require payment of the full deferred settlement amount or other
compensation. The financial institution might therefore be entitled to receive
interest for the full period of the loan. If the term is enforceable, this prepayment
amount is unlikely to represent reasonable compensation. Paragraph B4.1.12 of
IFRS 9 provides guidance on assessing prepayment options.
Non-recourse loans: Islamic financing arrangements are either asset-based or
asset-backed and, as such, the requirements for non-recourse loans would need to
be considered. This would require a ‘look through’ approach to be applied in
accordance with paragraphs B4.1.5–B4.1.19 of IFRS 9.
Profit-sharing arrangements: If the instrument’s cash flow characteristics contain
profit- and loss-sharing features, understanding what the profit share represents
will be important in such arrangements. Some profit-sharing arrangements might
represent interest, and others might represent sharing in profit and losses. [IFRS 9
paras B4.1.13, B4.1.14].
Contractually linked guidance: In some Islamic financing structures, such as sukuk,
multiple series might be issued and, if there is a prioritisation of payments,
consideration needs to be given to the contractually linked guidance. [IFRS 9 paras
B4.1.20–B4.1.26].
Refinancing options: On maturity, in some instances the financial institution might
have the ability to extend the maturity date. The ability to refinance might be
possible in Islamic financing structures and might still result in an instrument
meeting the SPPI requirements, but consideration would need to be given to the
contractual terms and conditions.
Appendix 1 – Example of assessment of Islamic financing arrangements: Murabaha
The following example sets out the process in assessing a murabaha under IFRS 9. The murabaha arrangements might differ
from, and be more complex than, what has been illustrated below:
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Additional information:
The contract is under a legal system, which would require repayment of the
deferred price. The deferred price is the purchase price of the asset plus a mark-up
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– in other words, payment of principal and interest, regardless of the value of the
underlying car value.
On early settlement, whilst the contract stipulates that the deferred price is due, the
bank must provide discounts on early settlement. In the region in which the
financial institution operates, the regulator only allows the financial institution to
charge three months’ deferred mark-up on early settlement. This is not included in
the contractual terms of the agreement between the financial institution and the
customer.
Step 1: Determine the contractual cash flow characteristics
The substance of the contractual rights and obligations is that this is not a sale
transaction but merely a financing transaction. Paragraphs B66–B68 of Appendix B
to IFRS 15 deal specifically with such transactions.
The early settlement feature would not be considered the full deferred price,
because the regulator only allows for three months of the mark-up whilst the
contract might allow for the full mark-up to be charged. Therefore, the enforceable
rights and obligations would only consider those permitted to be enforced by the
regulator.
Step 2: Determine if the contractual cash flow characteristics represent SPPI
From the above terms, it would need to be determined whether the deferred price
represent SPPI. In other words, the contractual cash flows need to be consistent
with a basic lending arrangement.
On early settlement, it would need to be determined what amount is due to be
paid. Any amounts in excess of the principal and interest to date would need to
represent reasonable compensation. If amounts were in excess of reasonable
compensation, this would be contrary to a basic lending arrangement, and the
instrument would fail the SPPI criterion.
Appendix 2 – Example of assessment of Islamic financing arrangements: Sukuk
The following example sets out the process in assessing a sukuk transaction under IFRS 9. There are many different forms of
sukuk structures, and the example demonstrates one of the common examples. Terms and conditions of each sukuk might
vary.
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There is currently only one series of sukuk issued.

Ijara is structured as a lease transaction but is considered a financing arrangement.
It should first be determined whether the sukuk instrument held by the investor is
classified as an equity instrument or debt instrument under IAS 32 from the
perspective of the SPV. The classification of whether this is an equity or debt
instrument is always performed from the issuer’s perspective. If the instrument is
classified as an equity instrument for the issuer, the analysis of SPPI would not be
relevant for the investors. Such an instrument might qualify as an equity instrument
designated at fair value through OCI by the investors.
If the instrument is a debt instrument, the contractual cash flows need to be
understood. In assessing the substance of the contractual rights and obligations, it
should be determined whether the contractual rights and obligations merely
represent the underlying cash flows from the asset.
Consideration should be given to the guidance in IFRS 9 on whether the terms are
not genuine or de minimis.
Since the repayment of the financing is dependent on the cash flows of the
underlying assets, the nonrecourse guidance would need to be considered.
It should be considered whether the return from lease income is representative of a
basic lending arrangement.
If more than one series of sukuk are issued, consideration should be given to
whether the contractually linked guidance applies.
Appendix 3 – Example of assessment of Islamic financing arrangements: Musharakah
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The following example sets out the process in assessing a musharakah transaction under IFRS 9. The example below is
merely an illustration of some of the terms that might be inherent in a musharakah:
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Financial institution would only be entitled to principal and a return on investment if

the underlying asset generates sufficient cash flows. If the profit from the joint
investment exceeds the pre-determined return, the excess profit amounts are
moved to the reserve account. If the reserve account does not have sufficient funds
on default, termination or maturity, losses would be borne by the financial
institution.
The contract is under a legal system which would enforce the contractual
obligation for the financial institution to absorb losses.
The contracts do not provide the financial institution with a sharing of control,
because decisions about the relevant activities do not require unanimous consent.
As such, joint control does not exist and the investment would not be considered a
joint arrangement under IFRS 11.
The substance of the contractual rights and obligations does not represent that of a
joint investment under IFRS 11, ‘Joint Arrangements’, because there is no joint
control. The joint investment should be considered in the scope of IFRS 9.
The contractual rights and obligations for the financial institution to absorb losses is
enforceable under the legal framework used in the contract. Therefore, such rights
and obligations have substance and cannot be ignored in assessing SPPI.
It was determined that the terms are genuine and not de minimis.
Since the repayment of the financing is dependent on the cash flows of the
underlying assets, the nonrecourse guidance would need to be considered. The
financial institution is subject to risk related to underlying assets in the
arrangement.
If returns are based on profit and losses of the joint investment, this might be
inconsistent with the basic lending arrangement.
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In the Spotlight: Changing criteria for a

significant increase in credit risk - Banking
In the Spotlight - Changing criteria for a significant increase in credit risk - Banking
At a glance
As time elapses, there is an increasing likelihood that banks will want to update and change their criteria for determining
when a significant increase in credit risk (SICR) has occurred, with the consequent impact on which loans move from 12-
month expected credit losses (ECL) to lifetime ECL. This could be for a variety of reasons. However, such changes could
attract scrutiny from analysts, regulators and other stakeholders, who might be concerned about the risk of ‘moving the
goalposts’ to avoid the adverse profit or loss impact of more loans moving to stage 2.
This publication considers the relevant IFRS requirements, drivers for change, factors to consider when making such
changes to SICR criteria, and the need for good disclosures and governance. The key messages are:
IFRS 9 contains no specific guidance on whether or when to revise SICR criteria. However, it requires regular
review of the methodologies and assumptions used for estimating ECL. So, banks should have specific
procedures for reviewing, monitoring and reassessing the SICR criteria on a regular basis, no different to other
components of the ECL process such as probability of default (PD) and loss given default (LGD).
Determining what is a ‘significant’ increase in credit risk is highly judgemental and is not defined in IFRS 9. In this
context, small changes or changes that are not sustained over a period of time would not typically be expected
to result in changes to the SICR criteria.
Changes to SICR criteria are therefore generally not expected to occur frequently, and there should be a clear
rationale when they are made. However, they might be more frequent in the period following initial adoption of
IFRS 9, as banks gain valuable experience of how the criteria work in practice.
Financial statement disclosures should be clear and transparent about the reasons for any changes made to the SICR
criteria during a period, what the changes were, and their impact.
Background
The concept of ‘significant increase in credit risk’ is fundamental to IFRS 9 and banks’ reported profits, given that it
determines whether or not lifetime ECL needs to be recognised on loans and other debt financial instruments measured at
amortised cost or fair value through other comprehensive income (FVOCI). On applying IFRS 9, banks set criteria, typically
on a portfolio basis, for determining whether a financial instrument has had a SICR since initial recognition. Those criteria
typically consist of:
quantitative thresholds (for example, a specified percentage increase in PD);
qualitative factors (for example, put on a watchlist, or enter forbearance); and

the 30 days past due (DPD) backstop.
As time elapses, in particular as more information and experience are gathered, banks might update and change their SICR
criteria. This could be for a variety of reasons. However, to protect against the risk of inappropriate changes being made and
to pre-empt challenge by regulators, analysts and other stakeholders, banks will need to have robust and rational reasons for
any change in this highly judgemental area. In particular, banks need processes and controls to mitigate any risk of
‘manipulating’ ECL (for example, by unnecessarily making changes to SICR criteria that reduce loss allowances as economic
conditions worsen or using changes to SICR criteria to ‘store up’ loss allowances in better economic times).
This publication considers the relevant IFRS requirements, drivers for change, factors to consider before doing so, and
associated disclosures.
What does IFRS say?
When assessing a SICR since initial recognition, IFRS 9 requires an entity to compare the risk of a default occurring at the
reporting date with that at the date of initial recognition, considering reasonable and supportable information that is available
without undue cost or effort. As time goes on, a bank’s ability to collect reasonable and supportable information might
change (for example, more historical data will be built up over time).
As noted in paragraph B5.5.18 of IFRS 9, an entity might use qualitative and non-statistical quantitative information,
statistical models or credit-rating processes to assess SICR, depending on the facts and circumstances. The key building
blocks of a typical SICR or ‘staging’ assessment by a bank can be represented diagrammatically as follows:
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IFRS 9 contains no specific guidance on whether or when to revise SICR criteria. However, paragraph B5.5.52of IFRS 9
notes that an entity should regularly review the methodology and assumptions used for estimating ECLs to reduce any
differences between estimates and actual credit loss experience.
Practically, because SICR is an accounting concept only, it is at greater risk of falling outside the suite of model monitoring
that is normally applied to other aspects of the ECL process, such as PDs, LGDs etc, which are more core to day-to-day
credit risk management. However, banks should also have specific procedures for reviewing, monitoring and reassessing the
SICR criteria, as well as credit losses. Such reviews and monitoring might result in revisions and refinements to
methodologies and assumptions – in that respect, the SICR criteria are no different from other aspects of ECL measurement.
ECL is a highly judgemental estimate; so, as a change of a component within that estimate, any change in the SICR criteria is
also a change in estimate. In accordance with paragraph 34 of IAS 8, an estimate might need revision if changes occur in the
circumstances on which the estimate was based or as a result of new information or more experience. The impact of a
change in SICR criteria will therefore be reported in the income statement in the period when the change occurs, with no
restatement of previously reported amounts. See FAQ 45.24.6 How do changes in impairment methodology (for example,
change in Definition of Default) impact the assessment of whether a significant increase in credit risk has occurred? in the
Appendix for further considerations, in particular whether the credit risk assessment at initial recognition should also be
adjusted to reflect the changes to methodology and assumptions.
Furthermore, paragraph 35G(c) of IFRS 7 requires disclosure of any changes in the estimation techniques or significant
assumptions used to measure ECL, which includes SICR criteria.
Drivers for change
There are three main triggers that could identify the need to amend the SICR criteria:
1. Standard ongoing monitoring of the outputs (namely, which financial instruments are in stage 2 under the existing criteria)
identifies anomalous outcomes. This is a ‘detective’ control: that is, it will help detect an issue with the existing criteria.
2. Changes are made to the inputs (along with their underlying methodologies and assumptions) that are used by the SICR criteria.
This could result in ‘preventative’ updates: that is, to ensure that the SICR criteria remain aligned with how the entity manages
and measures credit risk.
3. Greater experience and new information, which indicates that the existing SICR criteria should be reassessed.
The three main drivers for change noted above are often interrelated.
Factors to consider
Changes made to SICR criteria should be supported and justified. It is therefore important to understand exactly what has
changed, and why, to determine whether it might be appropriate to make a change to the SICR criteria.
In addition, factors such as the impact of changing SICR criteria (both at the current reporting date and in the future, at
different points in the economic cycle) and the frequency of change should be considered before making any change. There
is a balance to be struck between (i) more frequent and smaller refinements to SICR criteria, particularly as more information
and experience becomes available, and (ii) the need for consistency and comparability from period to period.
Judging what is a ‘significant’ increase is not defined and is highly judgemental, and there will inevitably be an acceptable
range of SICR criteria. In this context, small changes (for example, identified by regular monitoring, or changes that are not
sustained over a period of time) would not typically be expected to result in changes to the SICR criteria. Rather, systemic
factors over time would indicate a need to change SICR criteria.
Accordingly, good governance and appropriate oversight is needed to ensure that the criteria are changed appropriately and
only for valid reasons.
In addition to these general considerations, factors to consider that are relevant to each of the drivers for change are set out
below:
1. Monitoring and review of outputs.
Monitoring. It would generally be expected that the monitoring required by

IFRS 9 is performed based on at least the criteria originally used to select
the SICR criteria. This is consistent with the view of the UK banking
regulator (the PRA) that clear validation criteria and thresholds should be
1
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set, against which the performance of SICR criteria is regularly monitored1 .
For example, a bank might have selected its SICR criteria to optimise key
performance indicators (KPIs), such as:
the proportion of assets moving to stage 2 due to a change in PD;
the proportion of assets moving to stage 2 due solely to backstop or
qualitative criteria;
the proportion of assets in stage 3 that spent less than a small number of
months in stage 2;
the difference in PD for assets in stage 2 compared to that for assets in
stage 1; or
the difference in PD between assets in stage 2 and assets that are between
1 and 30 DPD or on a watchlist.
Ongoing performance would then be expected to be monitored against these same KPIs, unless there was sufficient
justification for changing them.
In addition, some portfolios might be more susceptible to changes in SICR criteria and so be subject to closer
monitoring. For instance, a bank might more closely monitor i) portfolios with less history and so smaller data sets on
which to base the initial selection of SICR criteria, or ii) portfolios initially reliant on proxies or approximations for the
PD at initial recognition on the adoption of IFRS 9, whose behaviour might change as those assets mature and newer
assets originated with more accurate initial PDs increasingly dominate the portfolio. As a further example, the PRA
cites sensitivity analysis as an integral part of ongoing SICR validation, to identify portfolios that should be subject to
closer monitoring.
1
See paragraph 61 of https://www.bankofengland.co.uk/prudential-regulation/letter/2019/written-auditor-reporting-
update-and-main-thematic-findings.
Review. A review of actual outcomes against those expected might identify

that the SICR criteria, including PD thresholds, are not giving the results
expected. There should be a clear escalation process for when monitoring
thresholds or KPIs are breached, including a process to determine when
and how SICR criteria should be adjusted. However, judgement will often
be required, because the SICR criteria have to balance including assets in
stage 2 early enough (before they might become credit-impaired) against
including too many assets in stage 2, such that they move back and forth
between stages 1 and 2 without a significant increase in credit risk.
Such monitoring might identify that the specified increase in PD needs
revising, or that the SICR criteria do not take into account all forward-
looking information. Any apparent anomalies identified from the monitoring
should be analysed, to make sure that only the SICR criteria for the relevant
sub-portfolios are changed and to avoid taking too ‘broad brush’ an
approach.
Qualitative criteria. Monitoring should include qualitative as well as
quantitative criteria. Such monitoring should consider qualitative indicators
that, on initial setting of the SICR criteria, were considered for inclusion but
which at that time were not sufficiently discriminating. If that changes and
they become relevant, they should be added to the SICR criteria. For
example, such a review might identify that some qualitative identifiers (such
as pre-watchlist items that are not being proactively managed) that were
not previously considered to be key identifiers (, might need to be included
in the SICR criteria.
2. Changes to the methodology and basis for inputs. This could arise from a variety of reasons, including the review and
monitoring process discussed above and from changes in credit risk management practices and the metrics used.
Change in PD methodology. For example, an entity might change its

definition of default to align with regulatory changes. If the KPIs first used
to select the quantitative SICR criteria involved default (such as relative
increases in PDs), the KPIs should be re-run when the definition of default
changes. Hence, changes in PD methodologies could result in a need to
recalibrate the relevant SICR criteria to result in broadly the same financial
assets being captured as stage 2 as immediately before the change
(assuming that no other factors come into play). However, care should be
taken, because, if origination PDs are also updated for such a change, little
or no change might be necessary to the SICR criteria.
Changes to credit risk management. Changes in credit risk management
could be due to many different reasons, for example:
changes in credit risk characteristics of portfolios;
changes to the economic environment;
new information;
changes in bank risk appetite.
It is necessary to understand the reason for the changes to credit risk management and the impact that those
changes have on the quantitative and qualitative inputs to the SICR assessment. For example, the wholesale loan
watchlist process might be updated to focus on higher-risk loans and exclude lower-risk loans that were previously
included. If this is due to a deterioration in the economic environment or because the bank’s risk appetite has
changed, it might be that more pre-watchlist items should be included in the SICR criteria to maintain a similar SICR
threshold as previously, if the bank still judges that to be an appropriate measure of a significant increase in credit
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risk. That is, if the fundamental view of what is a SICR has not changed, but changes are made to the credit risk
management process leveraged by the SICR assessment, corresponding changes might need to be made to the
SICR process to compensate.
An inherent risk arises when different departments within a bank are involved – for example, if the credit risk
department starts using a new qualitative factor in its day-to-day credit risk management, but the finance
department is responsible for the SICR criteria and is not aware of this, so it does not consider whether the new
factor needs to be added to the SICR criteria. Continued effective communication between risk and finance will
therefore be an important part of ensuring that SICR criteria remain appropriate.
3. New information and learning experience. This is particularly relevant as more experience and data are accumulated in the
initial years of applying IFRS 9 or following the origination of new types of loan or loans to different types of borrower. For
example:
A bank might compare its SICR thresholds or the outcomes of its SICR assessment
with peers and identify significant differences, for example, in the percentage of
loans in stage 2. In considering the appropriateness of its own SICR criteria, the
bank would need to understand the specific facts and circumstances as to why this
might be the case, because there might be valid reasons for differences, such as a
different mix of portfolios or different underlying risk profiles. Where the portfolios
are similar and have the same underlying risk profiles, a bank might consider this
peer comparison as part of its wider determination of whether a change to its SICR
criteria is warranted.
A bank might have built up more historical data with which to better calibrate its
SICR criteria than previously. SICR criteria should be appropriate throughout the
economic cycle. However, for example, a bank might not initially have had enough
historical data for certain portfolios to identify key indicators in an economic
downturn, which could necessitate revising SICR criteria as more data becomes
available.
A bank might change the terms of the suite of products that it offers to customers
and whether or how it moves customers between those products, depending on
their circumstances. As the bank gains experience of the impacts that this has on
customer behaviour and risk, it might need to evolve what it considers indicates a
SICR.
A bank could gain new insight into how its SICR criteria behave in stressed
economic conditions from the results of regulatory stress-testing exercises
incorporating IFRS 9. This might show that SICR criteria do not have the initially
intended results in more extreme downside scenarios.
Disclosure
The financial statements should be transparent about any changes made to SICR criteria during the period. Disclosure
should include:
the new criteria used at the reporting date [IFRS 7 para 35G(a)(ii)];
an explanation of:
i. the changes to the estimation techniques or significant assumptions made to determine whether the credit risk of
financial assets has increased significantly since initial recognition; and
ii. the reasons for those changes [IFRS 7 para 35G(c)]; and
as a change in estimate, the amount of the impact of the change in SICR criteria on
profit in the period of change, and also its expected effect on future periods (if
practical to estimate), as required by paragraph 39 of IAS 8.
For example, the change in SICR criteria might not have a significant impact in the current economic environment, but it
could have in future periods if there is an economic downturn. In practice, it might be impossible to determine the expected
effect in future periods. However, there could be a link with any sensitivity disclosures presented (for example, changes in
sensitivities of ECL to more adverse macro-economic conditions), in which case a bank could consider explaining this.
Where do I get more details?
For more information, please contact Marie Kling (marie.kling@pwc.com) or Mark Randall (mark.b.randall@pwc.com).
Appendix
FAQ 45.24.6 – How do changes in impairment methodology (for example, change in Definition of Default) impact the
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assessment of whether a significant increase in credit risk has occurred?
Question
How do changes in impairment methodology, such as a change in definition of default (DoD), impact the assessment of
whether a significant increase in credit risk (SICR) has occurred?
Background
An entity changes the DoD that it uses in estimating IFRS 9 expected credit losses (ECL). This change could occur for a
number of different reasons (for example, changes in regulatory requirements or in internal risk management policies and
procedures).
The entity uses probability of default (PD), loss given default (LGD) and exposure at default (EAD) as inputs to its model used
to estimate ECL. The DoD is one of the key inputs to this model. Moreover, the entity uses an increase in an instrument’s
lifetime probability of default as one of the criteria to determine whether an SICR has occurred.
Does the change meet the definition of a change in estimate or change in policy as defined under IAS 8?
How should the entity consider the change in DoD for the purpose of assessing whether an SICR has occurred?
NB This FAQ assumes that the change is not the correction of a prior period error under IAS 8.
Solution
Question 1: Change in policy versus change in estimate
A change in ECL resulting from using an updated DoD, which is an input into the ECL estimation methodology, is a change in
an estimate under the definition in IAS 8 and not a change in accounting policy.
Paragraph 5 of IAS 8 defines a change in accounting estimate as “an adjustment of the carrying amount of an asset or a
liability … that results from new information or new developments and, accordingly, are not corrections of errors”.
In contrast, accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in
preparing and presenting financial statements.
The DoD is an element of the ECL estimation methodology and the updated DoD reflects a change in the circumstances on
which the estimate is based. In other words, it is a component of the measurement technique used to calculate ECL. It
follows that changes to the ECL estimate that result from revising the DoD are accounted for as changes in accounting
estimates under IAS 8. This is similar to revisions resulting from a change in a valuation technique or its application that IFRS
13 requires to be accounted for as a change in accounting estimate. [IFRS 13 para 66].
The effect of a change in an accounting estimate does not result in the restatement of prior year comparative amounts. [IAS
8 para 34]. [IAS 8 para 36].
Question 2: How to consider the change in estimate when assessing whether an SICR has occurred
The assessment of whether an SICR has occurred under paragraph 5.5.9 of IFRS 9 is a relative test that compares the risk of
a default occurring as at the reporting date to the risk of a default occurring as at the date of initial recognition of the financial
instrument. However, IFRS 9 has no explicit guidance on how to implement such a relative test when the DoD is changed,
and in particular when the entity could continue to measure the risk of default at the date of initial recognition using the
previous DoD and when it would need to recalculate the risk of default at the date of initial recognition using the changed
DoD. Therefore, judgement will be required, considering the specific facts and circumstances and bearing in mind the overall
objective of the SICR assessment as a relative test.
When making this judgement, relevant factors to consider include the following:
Impact on the impairment methodology

Some changes to the impairment methodology will be more pervasive than others. The greater the impact that a specific
change has on the overall methodology, the more likely it might have a material impact on the outcome of the SICR
assessment without adjusting the origination PD on a ‘like for like’ basis.
Impact on current and future reporting periods

An entity should consider the impact of the approach taken on the stage allocation of financial assets at both the date of
implementing the change in DoD and the potential impact on future reporting periods, taking into consideration the
requirement of paragraph 5.5.17of IFRS 9 that ECL should be measured in a way that is unbiased. In particular, an entity
should consider the risk that, if the staging assessment does not compare ‘like for like’ information, an instrument could
change staging without there being a significant increase (or decrease, in the case of a change from stage 2 to stage 1) in the
borrower’s default risk since initial recognition. Depending on the remaining expected life of the financial assets, there could
be different periods of time over which the selected approach could have an impact on the financial statements, which
should all be taken into consideration.
Cost or effort
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Paragraph 5.5.9 of IFRS 9 states that an entity should consider reasonable and supportable information, that is available
without undue cost or effort, that is indicative of significant increases in credit risk since initial recognition. Therefore, if
determining the origination lifetime PDs using the new modelling methodology would require undue cost or effort, this would
not be required. For example, this might be the case for origination PDs determined on transition to IFRS 9 that, as permitted
by paragraph B7.2.2, only approximated the credit risk at initial recognition. However, depending on the impact of the
change, an entity should nonetheless explore other simpler approaches that would not require undue cost and effort (for
example, by adjusting the SICR threshold when performing the relative test).
Use of hindsight
If using the new DoD at initial recognition would require information that was unavailable at the time of initial recognition, an
entity should consider the principle set out in IAS 8 regarding not using hindsight. Judgement will be needed to assess the
impact on it of any hindsight, when considering whether this precludes a recalculation of origination lifetime PDs.
Offsetting financial instruments for financial

institutions
Key points
Offsetting financial instruments for accounting purposes is a complex area of accounting for many financial institutions.
Understanding which financial balances should be considered for offset under IAS 32 and the operational and contractual
arrangements underlying those balances is key to arriving at the right accounting conclusion. This industry guide sets out our
views on the main questions seen in practice.
What’s inside:
1. Introduction
2. Balances that should be considered for offsetting
3. Currently enforceable right of set-off
4. Intention either to settle on a net basis or to realise the asset and settle the liability simultaneously
5. Disclosure of offsetting financial assets and financial liabilities
Appendix A – Bank acting as clearing member for derivative contracts
Appendix B – Industry FAQs

PwC Contacts
Mark Randall (UK); Marie-Claude Kling (US)
1. Introduction
Applying the offsetting requirements of IAS 32 to financial assets and financial liabilities with the same counterparty can be
complex, particularly for financial institutions.
Where the offsetting criteria in paragraph 42 of IAS 32 are met, applying offsetting accounting to the relevant financial
assets and liabilities is required; it is not merely an option. The two basic requirements of IAS 32 are that offsetting is
applied if, and only if, an entity:
currently has a legally enforceable right to set-off the recognised amounts; and
intends either to settle on a net basis, or to realise the asset and settle the liability
simultaneously.
In many instances, it will be clear with little or no analysis that the offsetting criteria are not met. In other cases, more
analysis might be required.
Understanding the underlying operational and contractual arrangements is often the greatest challenge, so care should be
taken to ensure the accuracy of this understanding, including any recent developments, before forming accounting
conclusions. Where the entity has multiple transactions with the same counterparty, such as a central counterparty (‘CCP’)
clearing house, consideration should be given to each separate type of contract, because details can vary between them,
with certain rules applying only to some, but not all, types of financial instruments with that counterparty. In addition,
accounting conclusions might vary between different countries due to the different legal frameworks.
As an overview, a common arrangement is where a CCP or broker requires cash collateral to be posted with them for
derivative contracts held by the entity. This cash collateral amount is based on the contract rules or, if it is an exchange or
clearing house, the exchange and/or clearing house rule book. Typically, on a daily basis, cash payments are made of an
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amount equal to the change in fair value in the underlying derivative contract to meet the contractual terms or
exchange/clearing house rules.
The industry-specific questions discussed in this publication are set out below, along with the major types of financial
instrument to which they will typically be relevant.
Typically relevant to:

Question OTC Listed Repos
derivatives derivatives
IND Does daily posting of cash X X

FAQ margin result in daily
2.1 extinguishment through legal
settlement of the contract,
leaving no recognised cash
collateral balances to be
offset?
3. Currently enforceable right of set off
IND Can cash collateral posted X X

FAQ in respect of a portfolio of
3.1 derivatives be offset against
the balance sheet derivative
positions?
IND What impact does the ability X X

FAQ to post non-cash collateral
3.2 (for example, securities)
have on offsetting a
derivative against collateral?
IND What impact does the X X

FAQ existence of a physical
3.3 settlement option have on
offsetting a derivative
against cash collateral?
IND What impact might a ‘one X X

FAQ way’ collateral posting
3.4 arrangement have on
applying offsetting?
IND Where daily cash X X

FAQ settlements contractually
3.5 have to be made on a net
basis for all derivatives with
a particular counterparty, is
it possible to offset
an uncollateralised derivative
asset and
an uncollateralised derivative
liability held with that
counterparty?
IND Do financial assets and X

FAQ liabilities that are subject to
3.6 a legally enforceable
arrangement for
simultaneous settlement
qualify for offsetting?
IND Can repos and reverse X

FAQ repos with different bond
3.7 CUSIPs/ISINs be offset?
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Typically relevant to:

Question OTC Listed Repos
derivatives derivatives
IND If a clearing house/exchange X X X

FAQ has a right to change the
3.8 rules applicable to
settlement processes, does
this prevent offsetting from
being applied?
4. Intention either to settle on a net basis or to realise the asset and settle the liability simultaneously
IND In what circumstances will X

FAQ the requirement in
4.1 paragraph 42(b) of IAS 32 ‘to
realise the asset and settle
the liability simultaneously’
be met?
IND What evidence is required to X X X

FAQ demonstrate an intention to
4.2 settle a financial asset and a
financial liability with the
same counterparty net or
simultaneously?
See Appendix A for further guidance where the entity is a member of a clearing house.
Further more general guidance on offsetting financial assets and financial liabilities is provided in paragraphs 47.15 to
47.28 of the Manual of accounting.

Financial instruments where offsetting might be achieved, and where analysis is typically required, include collateralised
over-the-counter (OTC) derivatives, repo and reverse repo transactions, futures, and listed derivatives, and these are the
focus of this publication. However, it is necessary to first ensure that the appropriate balances are being considered for
offsetting, since there can be complexities.
Offsetting might also be applicable in other situations, such as cash pooling arrangements and where payables and
receivables are settled net with the same counterparty, but these transactions are not addressed in this guidance.
Consideration should first be given as to which balances meet the derecognition requirements in IFRS 9 and, for those
balances that continue to be recognised, which groups of balances the reporting entity can contractually settle at the
same time to be considered for offsetting.
Industry-specific FAQs
IND FAQ 2.1 - Does daily posting of cash margin result in daily extinguishment through legal settlement of the contract,
leaving no recognised cash collateral balances to be offset?
General FAQs of particular relevance to the industry
FAQ 42.5.2 – How should a bank recognise centrally cleared derivative contracts where the bank acts solely as a clearing
member?
3. Currently enforceable right of set-off

An entity`s right of set off must be currently available (not contingent on a future event) and must be legally enforceable in
all of the normal course of business, in the event of default, and in the event of insolvency or bankruptcy of the entity and
all of the counterparties.
[IAS 32 para AG38B].
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IND FAQ 3.1 – Can cash collateral posted in respect of a portfolio of derivatives be offset against the balance sheet
derivative positions?
IND FAQ 3.2 – What impact does the ability to post non-cash collateral (for example, securities) have on offsetting a
derivative against collateral?
IND FAQ 3.3 – What impact does the existence of a physical settlement option have on offsetting a derivative against cash
collateral?
IND FAQ 3.4 – What impact might a ‘one way’ collateral posting arrangement have on applying offsetting?
IND FAQ 3.5 – Where daily cash settlements contractually have to be made on a net basis for all derivatives with a
particular counterparty, is it possible to offset an uncollateralised derivative asset and an uncollateralised derivative liability
held with that counterparty?
IND FAQ 3.6 – Do financial assets and liabilities that are subject to a legally enforceable arrangement for simultaneous
settlement qualify for offsetting?
IND FAQ 3.7 – Can repos and reverse repos with different bond CUSIPs/ISINs be offset?
IND FAQ 3.8 – If a clearing house/exchange has a right to change the rules applicable to settlement processes, does this
prevent offsetting from being applied?
4. Intention either to settle on a net basis or to realise the asset and

settle the liability simultaneously
An entity might have a legal right to settle net, but it might still realise the financial asset and settle the financial liability
separately in practice. To offset the financial asset and financial liability, the entity must also intend either to settle on a net
basis or to realise the asset and settle the liability simultaneously.
[IAS 32 para AG38E].
IND FAQ 4.1 – In what circumstances will the requirement in paragraph 42(b) of IAS 32 ‘to realise the asset and settle the
liability simultaneously’ be met?
IND FAQ 4.2 – What evidence is required to demonstrate an intention to settle a financial asset and a financial liability with
the same counterparty net or simultaneously?
5. Disclosure of offsetting financial assets and financial liabilities

The quantitative and qualitative disclosure requirements are set out in paragraphs 13A–13F of IFRS 7. As well as applying
to all recognised financial instruments that are offset in accordance with IAS 32, they apply to recognised financial
instruments that are subject to an enforceable master netting agreement or similar arrangements, even where they do not
meet the IAS 32 offsetting requirements.
Further guidance on offsetting disclosures is in paragraphs 47.56 to 47.63 of the Manual of accounting.
Appendix A – Bank acting as clearing member for derivative contracts

As a result of regulation in a number of territories, many derivative contracts are ‘centrally cleared’ with a central
counterparty (‘CCP’). For entities that themselves are not a clearing member of the relevant CCP, this requires the entity to
transact with a clearing member who will then interact with the CCP on the entity’s behalf. Clearing members are typically
major banks who are required to place ‘default fund’ deposits as well as collateral with the CCP, in order to mitigate the
credit risk of the CCP. In many cases, this can be represented as follows:
 View image
In this situation, the bank enters into derivative contracts, with related collateral, with its clients and back-to-back
derivative transactions, with related collateral, with the CCP. Typically there would be many derivative asset and liability
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positions with the CCP.
In determining what to present on its balance sheet, the bank should consider the following questions, typically in the
order set out below:
Consideration Relevant guidance

1 Should the bank recognise separate FAQ 42.5.2 How should a bank recognise
derivatives with both its clients and the centrally cleared derivative contracts where
CCP on its balance sheet? the bank acts solely as a clearing member?
Even though the bank is acting as a

‘broker’, where it is entering into separate
derivative transactions with its clients and
the CCP, the bank must recognise all of
the transactions on its balance sheet,
unless the transactions meet the
derecognition ‘pass-through’ requirements
in paragraph 3.2.5 of IFRS 9.
2 Does posting collateral result in IND FAQ 2.1 – Does daily posting of cash
derecognition of the related margin result in daily extinguishment through
derivative(s)? legal settlement of the contract, leaving no
recognised cash collateral balances to be
Daily posting of cash margin on offset?
derivatives can result in either partial
settlement of the outstanding contract
(‘Settled-to-Market’ transactions) or not
(‘Collateralised-to-Market’ transactions),
depending on facts and circumstances
driven by the terms and conditions of the
underlying contractual agreements.
For those circumstances where collateral

postings legally extinguish/settle some or
all of the related derivative, both the
collateral and related derivative are
derecognised to the extent of the
settlement, and no further consideration of
offsetting is typically needed.
3 Can the bank offset collateral and the IND FAQ 3.1 – Can cash collateral posted in
related derivative contracts on its respect of a portfolio of derivatives be offset
balance sheet? against the balance sheet derivative
positions?
For collateral that does not extinguish the
related derivative (see 2 above), the bank IND FAQ 3.2 – What impact does the ability
should offset collateral and related to post non-cash collateral (for example,
derivative contracts if the requirements in securities) have on offsetting a derivative
paragraph 42 of IAS 32 are met. against collateral?
IND FAQ 3.3 – What impact does the

existence of a physical settlement option
have on offsetting a derivative against cash
collateral?
IND FAQ 3.4 – What impact might a ‘one

way’ collateral posting arrangement have on
applying offsetting?
IND FAQ 3.8 – If a clearing house/exchange

has a right to change the rules applicable to
settlement processes, does this prevent
offsetting from being applied?
4 Can the bank offset derivative IND FAQ 3.5 – Where daily cash settlements
transactions against other derivatives contractually have to be made on a net basis
with the same counterparty? for all derivatives with a particular
counterparty, is it possible to offset
Derivative transactions with the same an uncollateralised derivative asset and
counterparty (either a client or the CCP) an uncollateralised derivative liability held
should be offset against other derivatives with that counterparty?
with that counterparty if the requirements
in paragraph 42 of IAS 32 are met. IND FAQ 3.8 – If a clearing house/exchange
has a right to change the rules applicable to
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Consideration Relevant guidance

However, this is only applicable if the settlement processes, does this prevent
derivative has not already been offset offsetting from being applied?
against cash collateral as per 3 above.
Appendix B – Industry FAQs
IND FAQ 2.1 – Does daily posting of cash margin result in daily extinguishment through legal settlement of the
contract, leaving no recognised cash collateral balances to be offset?
Reference to standard: IFRS 9 para 3.2.3(a) and IFRS 9 para 3.3.1

Reference to standing text: IND 2, Manual para 44.27 and para 44.100
Industry: Banking & Capital Markets, Insurance and Asset and Wealth Management
Question
Does daily posting of cash margin result in daily extinguishment through legal settlement of the contract, leaving no
recognised cash collateral balances to be offset?
Answer
Where cash margin is paid or received on a financial instrument contract, the accounting analysis is typically either:
the cash is partial settlement of the outstanding contract (Option A); or

the cash is payment of collateral, which might have to be repaid, depending on
future changes in the value of the trade being collateralised, and should be
separately recognised as a collateral asset/liability (Option B).
In order for Option A to apply and the cash payment to achieve partial derecognition of the original trade, the
derecognition requirements of IFRS 9 must be met. This will generally be because, under the terms of the relevant
contract(s), the cash payment causes:
for an asset, the contractual rights to cash flows of the original contract to expire
(since they are satisfied in full by the receipt of cash) in accordance with
paragraph 3.2.3(a) of IFRS 9; or
for a liability, the contractual obligations under the original contract to be
discharged in accordance with paragraph 3.3.1 of IFRS 9.
In order to conclude whether Option A or B is applicable, the specific contractual terms of the trade contract and any other
relevant terms (for example, where the contract is traded on an exchange, the exchange’s regulations or rules) will need to
be considered to determine whether, legally, the original contractual rights and obligations have been partially settled.
Where these contractual terms are not explicit, legal advice might be necessary in order to reach a conclusion. Factors
relevant to the legal analysis of whether cash margin does result in legal settlement of the original contract might include
whether the contract provides for:
payment of interest (sometimes referred to as ‘price alignment interest’)

calculated in respect of previous margin payments; this might indicate that,
economically, these previous margin payments are viewed as a loan or deposit
that accumulates interest and hence is collateral;
the amount of margin required to be subject to a valuation ‘haircut’; this might

indicate that the payment is collateral since, if there are no further changes in the
value of the trade contract, some of the margin (the ‘haircut’) will be returned; and
rights to substitute previous margin payments (that is, to repay cash margin and
post securities instead), which might indicate that the previous cash payments
were not utilised to discharge the original contract.
In practice, futures margin is often viewed as resulting in settlement (although there are exceptions), while margin on listed
and OTC derivatives is often not considered settlement. However, some CCPs, including LCH Swapclear and LME, have
amended their rules so that some or all payments of cash variation margin result in legal settlement of the previously
outstanding amount. Care should therefore be taken to ensure that the accounting reflects the most up-to-date terms and
conditions, including any recent changes.
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IND FAQ 3.1 – Can cash collateral posted in respect of a portfolio of derivatives be offset against the balance sheet
derivative positions?
Reference to standard: IAS 32 para 42

Reference to standing text: IND 3, Manual para 47.18 to 47.21
Question
Can cash collateral posted in respect of a portfolio of derivatives be offset against the balance sheet derivative positions?
Answer
As a simple example, an entity might have entered into a single derivative with a bank or clearing house. To reduce credit
risk, the two entities might have agreed to post cash collateral periodically with each other equal to the fair value of the
derivative. The posting of the collateral does not result in legal settlement of the outstanding balance. However, the terms
of the collateral agreement are that the collateral will be used to settle the derivative as and when payments are due (as
well as on a default or insolvency or bankruptcy of either party), and both entities intend to settle this way.
If this is the case, the entity will have a legally enforceable right to offset the derivative and the collateral, and will intend to
settle net. If market prices do not change, no further cash flows will arise. Any changes in the collateral balance after the
balance sheet date arise as a result of future events and are not relevant to the balance sheet date assessment. The
offsetting requirements in IAS 32 are therefore met, and the collateral should be offset against the balance sheet derivative
position. If, on the other hand, the cash collateral is not used to settle the derivative’s remaining cash flows, the offsetting
requirements in IAS 32 are not met.
More typically, an entity will have a portfolio of derivatives with a bank or clearing house, rather than just a single
derivative. If the net cash collateral required to be posted for the whole portfolio is the aggregate of the individual amounts
of cash collateral for each derivative in the portfolio (each individual amount being equal to the fair value of the derivative),
the above analysis for a single derivative should be applied. This is done by firstly dividing the net cash collateral payable
or receivable balance into the individual amounts relating to each derivative in the portfolio. For each individual derivative,
the derivative balance is then offset against the associated collateral balance in the same way as described in the simple
example above. In practice, in the absence of factors such as time delays between derivative fair value movements and
cash collateral movements, this should result in the entire derivative portfolio being offset against the cash collateral
balance.
In practice, bilateral OTC trades might not be subject to cash collateral netting in the ordinary course of business, with
collateral payments made separately from derivative payments. As a result, further cash flows will arise, even if market
prices do not move, and so offsetting is not permitted. Even where cash collateral netting is applied in the ordinary course
of business, if this is just a matter of practice but the contracts between the bank and the counterparty do not give them
the contractually enforceable right to do this, the parties are still not permitted to offset.
IND FAQ 3.2 – What impact does the ability to post non-cash collateral (for example, securities) have on offsetting
a derivative against collateral?

Reference to standing text: IND 3, Manual paras 47.18 to 47.21
Question
What impact does the ability to post non-cash collateral (for example, securities) have on offsetting a derivative against
collateral?
Answer
Non-cash collateral received (rather than posted) by an entity will not be recognised on the balance sheet, because it will
fail derecognition in the transferor and so provides the entity with no accounting entry against which to offset on-balance
sheet derivative positions. Therefore, consider a simple scenario where a firm has one trade that is an asset of 50 and
another trade that is a liability of 50; if the liability matures first, cash of 50 will be paid by the firm to settle the liability, and
securities of 50 will be received as collateral for the remaining asset trade of 50. As a result, the firm does not have the
legally enforceable right to offset the recognised amounts (that is, the asset trade of 50 and the liability trade of 50), and so
the requirements for offsetting are not met.
IND FAQ 3.3 – What impact does the existence of a physical settlement option have on offsetting a derivative
against cash collateral?
Reference to standard: IAS 32 para AG38B

Reference to standing text: IND 3, Manual para 47.20
Question
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What impact does the existence of a physical settlement option have on offsetting a derivative against cash collateral?
Answer
In some situations, it is possible that a contract will be settled not by cash being paid but by the delivery of a physical
asset. An example is an exchange-traded, cash-collateralised credit default swap (CDS). Ordinarily, the cash collateral
paid by an entity to the exchange is used to net settle the CDS liability when a credit event has occurred. However, on a
credit event the exchange could settle the contract by retaining the cash collateral already paid by the entity and physically
delivering to the entity the defaulted bond that is the reference asset underlying the CDS in return for the entity delivering
additional cash equal to the difference between the bond principal and the cash collateral already paid. Exchange-traded
commodity contracts are another example of contracts that can feature a physical settlement option.
By virtue of paragraph AG38B of IAS 32, the right of set-off must not be contingent on a future event and it must be
enforceable in the normal course of business in the event of default and in the event of insolvency or bankruptcy. If the
option to physically settle the contract can be imposed by the exchange and cannot be avoided by the entity, and the
bond and cash are not settled simultaneously in accordance with paragraph AG38F of IAS 32, the entity’s ability to offset
the cash collateral paid against the CDS liability is contingent on the decision of the exchange and is not legally
enforceable in all circumstances, and so fails the requirements of paragraph AG38B of IAS 32. If the physical settlement
option is solely at the discretion of the entity and not the exchange, this would not by itself prevent the entity from applying
offsetting.
In some cases, it might be possible to demonstrate that the return of cash collateral, the delivery of the physical asset and
the payment of any other monies required (for example, the exercise price) are settled simultaneously in accordance with
paragraph AG38F of IAS 32 and that offsetting should still be applied. However, this is likely to require very detailed
analysis of the different scenarios that could arise and the payment mechanisms that would be used for each.
IND FAQ 3.4 – What impact might a ‘one way’ collateral posting arrangement have on applying offsetting?

Question
What impact might a ‘one way’ collateral posting arrangement have on applying offsetting?
Answer
Under a so-called ‘one way’ collateral arrangement between a firm and an exchange, cash margin is typically only required
to be paid if a firm is in a net liability position. If the exchange is in a net liability position, it is not required to pay cash
margin to the firm. Consider a simple scenario where a firm has one trade that is an asset of 50, another trade that is a
liability of 30, and nil cash margin (because the exchange is in a net liability position); if the liability matures first, the firm
will be required to pay 30 to the exchange to settle it. Since the firm’s remaining position will be the asset of 50, under the
‘one way’ arrangement the exchange will remain in a net liability position, and so no margin payment will be made to the
firm. On this analysis, the liability would not have been offset against the asset – if this had been the case, only a net
payment of 20 would have been required. The requirement for an entity to have a legally enforceable right of set-off is not
therefore met, and so the positions should not be offset.
IND FAQ 3.5 – Where daily cash settlements contractually have to be made on a net basis for all derivatives with a
particular counterparty, is it possible to offset an uncollateralised derivative asset and an uncollateralised
derivative liability held with that counterparty?

Question
Where daily cash settlements contractually have to be made on a net basis for all derivatives with a particular
counterparty, is it possible to offset an uncollateralised derivative asset and an uncollateralised derivative liability held with
that counterparty?
Answer
Yes, but only if the two derivatives have matching terms so that all of their cash flows will occur on exactly the same dates
in all situations. If this is the case, under the daily net settlement process all future cash flows will be required to be settled
net, so that the entity has a legal right to offset the derivative asset (that is, all of the contracted cash flows) against the
liability.
However, in a typical situation the two derivatives are unlikely to have matching terms, and so their cash flows will not all
occur on exactly the same dates in all situations. In this case, the entity does not have a legally enforceable right to offset
the derivative asset (that is, all of the contracted cash flows) against the liability. This can be illustrated by a simple
example, where the derivative asset and liability both have one remaining cash flow, which occurs in one month’s time for
the asset and in two months’ time for the liability: the entity does not have the legally enforceable right to offset the
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recognised derivative asset against the liability, because the cash flows will occur on different dates and will not be net
settled under the net settlement process.
Similarly, where the derivative asset and liability are cash-settled American options (that is, where the option can be
exercised by the holder at any time before and including the expiration date) with matching terms, offsetting is not likely to
be achievable unless the entity will always be able to exercise its option in the derivative asset as soon as the counterparty
exercises their option in the derivative liability. That is because, without such a legally enforceable right, the entity will not
be able to ensure that both derivatives will always settle at the same time and so be net settled.
IND FAQ 3.6 – Do financial assets and liabilities that are subject to a legally enforceable arrangement for
simultaneous settlement qualify for offsetting?
Reference to standard: IAS 32 para 42(a)

Question
Do financial assets and liabilities that are subject to a legally enforceable arrangement for simultaneous settlement qualify
for offsetting?
Answer
Paragraph 42(a) of IAS 32 requires offsetting to be applied when, and only when, an entity currently has “a legally
enforceable right to set off the recognised amounts”, including in the normal course of business. However, the settlement
arrangements for a clearing house/exchange and its members might involve a member having:
both the right and the obligation to settle transactions in the normal course of
business through a gross settlement system that meets the characteristics set out
in paragraph AG38F of IAS 32 (that is, the outcome is in effect equivalent to net
settlement);
the right to actually offset and settle net in the event of the counterparty’s
default/insolvency/bankruptcy; and
an obligation to actually offset and settle net in the event of its own
default/insolvency/bankruptcy, if the counterparty so elects.
In such a case, the entity does not have a legal right to actual net settlement that is enforceable in the normal course of
business.
In our view, the requirement of paragraph 42(a) of IAS 32 to have a legally enforceable right of set-off is still met in this
scenario. This is supported by paragraph 45 of IAS 32 which explicitly states that: “A right of set-off is a debtor's legal
right, by contract or otherwise, to settle or otherwise eliminate all or a portion of an amount due to a creditor by applying
against that amount an amount due from the creditor”. In this scenario, the gross amounts are ‘eliminated’ during the
settlement process, and it is irrelevant that such elimination is carried out by exchanging the gross amounts using a
clearing system. In this situation, paragraph AG38F of IAS 32 indicates the types of gross settlement process that have an
outcome that is equivalent to net settlement in the normal course of business.
IND FAQ 3.7 – Can repos and reverse repos with different bond CUSIPs/ISINs be offset?

Question
Can repos and reverse repos with different bond CUSIPs/ISINs be offset?
Answer
When offsetting a sale and repurchase agreement (repo) and a reverse repo under IAS 32, the asset and liability being
offset are typically the cash payable on the repo and the cash receivable on the reverse repo, and not the bonds
themselves, given that they might not even be on the balance sheet (see IND FAQ 3.2). Therefore, offsetting can be
applied, provided that the terms of the cash payable and receivable meet the IAS 32 offsetting criteria, irrespective of
whether the bonds underlying the repo and reverse repo are identical and have the same security identification number
(that is, CUSIP/ISIN).
However, in practice the bonds and cash payments will typically all need to be settled through the same settlement
institution (for example, a central securities depository (CSD) such as EuroClear or ClearStream) in order to settle the cash
legs on a net basis or to realise them simultaneously in accordance with paragraph AG38F of IAS 32. This does therefore
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mean that the type of bond, and hence the CSD through which it settles, will restrict to some extent the repos and reverse
repos that qualify for offset.
IND FAQ 3.8 – If a clearing house/exchange has a right to change the rules applicable to settlement processes,
does this prevent offsetting from being applied?
Reference to standard: IAS 32 para AG38B

Question
If a clearing house/exchange has a right to change the rules applicable to settlement processes, does this prevent
offsetting from being applied?
Answer
IAS 32 states that the right of set-off “must not be contingent on a future event” (para AG38B) and explains in paragraph
BC84 that "a right of set-off that could disappear or that would no longer be enforceable after a future event that could
take place in the normal course of business or in the event of a default, or in the event of insolvency or bankruptcy, such
as a ratings downgrade, would not meet the currently legally enforceable criterion…".
Therefore, if a clearing house/exchange has a right that is judged to be substantive and which allows it to change the rules
in such a way that the right of set-off could disappear or no longer be enforceable, offsetting should not be applied.
This issue was raised historically in respect of a Regulation in the LCH.Clearnet Limited (‘LCH Limited’) rulebook, which
allows LCH Limited to unilaterally vary its rules, effective for existing open contracts, such that the legal right of set-off
could be withdrawn. For this specific situation, it was concluded that the Regulation was not a substantive right that could
be used to remove the right of set-off, due to factors including:
LCH Limited confirming that it did not currently envisage making any changes to
the rulebook with the intention of removing a member’s legally enforceable right
of set-off;
oversight by multiple global regulators and the likelihood of their intervention in
the event of any such change being proposed, given the impact on systemic
credit risk;
the adverse commercial consequences to LCH Limited of such a change, given
the importance of offsetting to its clients; and
the significant operational changes required by LCH Limited and all its members
to settlement processes in the event of any such change.
So, it was concluded that the Regulation did not prevent offsetting from being applied to contracts, such as those
transacted on the SwapClear or RepoClear platforms, with LCH Limited. For other clearing houses or exchanges with
similar powers, the individual facts and circumstances will need to be separately assessed. However, the factors set out
above are likely to be relevant in judging whether the powers are substantive and therefore prevent offsetting.
IND FAQ 4.1 – In what circumstances will the requirement in paragraph 42(b) of IAS 32 ‘to realise the asset and
settle the liability simultaneously’ be met?
Reference to standard: IAS 32 para 42(b)

Question
In what circumstances will the requirement in paragraph 42(b) of IAS 32 ‘to realise the asset and settle the liability
simultaneously’ be met?
Answer
In some situations, rather than being settled net, an asset might be realised and a liability settled simultaneously in a way
that still meets the requirement of paragraph 42(b) of IAS 32. This is often the case for repo and reverse repo transactions.
Further guidance is provided in paragraph AG38F of IAS 32, which states that “If an entity can settle amounts in a manner
such that the outcome is, in effect, equivalent to net settlement, the entity will meet the net settlement criterion in
paragraph 42(b). This will occur if, and only if, the gross settlement mechanism has features that eliminate or result in
insignificant credit and liquidity risk, and that will process receivables and payables in a single settlement process or
cycle”.
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In addition to this principle, paragraph AG38F of IAS 32 provides a set of characteristics based on LCH RepoClear as an
example of a gross settlement system that would meet this principle:
a. "financial assets and financial liabilities eligible for set-off are submitted at the same point in time for processing;
b. once the financial assets and financial liabilities are submitted for processing, the parties are committed to fulfil the settlement
obligation;
c. there is no potential for the cash flows arising from the assets and liabilities to change once they have been submitted for
processing (unless the processing fails – see (d) below);
d. assets and liabilities that are collateralised with securities will be settled on a securities transfer or similar system (for example,
delivery versus payment), so that if the transfer of securities fails, the processing of the related receivable or payable for which
the securities are collateral will also fail (and vice versa);
e. any transactions that fail, as outlined in (d), will be re-entered for processing until they are settled;
f. settlement is carried out through the same settlement institution (for example, a settlement bank, a central bank or a central
securities depository); and
g. an intraday credit facility is in place that will provide sufficient overdraft amounts to enable the processing of payments at the
settlement date for each of the parties, and it is virtually certain that the intraday credit facility will be honoured if called upon.”
Whilst these characteristics are not explicit requirements for offsetting under IAS 32, in practice they provide a helpful
basis for assessing whether the principle of paragraph AG38F of IAS 32 is met. Given the potential differences between
settlement processes made using different settlement institutions, a separate analysis might be required for each material
method of settlement. A detailed knowledge of all of the relevant payment processes is therefore typically needed in order
to perform this analysis.
IND FAQ 4.2 – What evidence is required to demonstrate an intention to settle a financial asset and a financial
liability with the same counterparty net or simultaneously?
Reference to standard: IAS 32 para AG38F

Question
What evidence is required to demonstrate an intention to settle a financial asset and a financial liability with the same
counterparty net or simultaneously?
Answer
The extent of evidence required will depend on the specific facts and circumstances, including the terms of the relevant
contracts. Where an entity is contractually required to settle on a net basis, or to realise the asset and settle the liability
simultaneously, and (where relevant) the settlement process meets the characteristics set out in paragraph AG38F of IAS
32, this alone will be sufficient.
In other situations where there is no such contractual requirement, factors such as broader market practice and the
entity’s own past practice for similar transactions should be considered, although this will not necessarily be conclusive by
itself. If there have been instances where settlement has not been on a net basis or simultaneous in accordance with the
criteria of paragraph AG38F of IAS 32, these should be assessed in detail.
For bespoke transactions, factors such as the commercial or operational implications of settling net versus gross – or
simultaneously versus at different times – should be considered in judging whether or not there is sufficient evidence to
demonstrate an intention to settle net or simultaneously.
Corporate treasury
In the Spotlight: A Corporate Treasury Focus

on Phase 2 Amendments for Interest Rate
Benchmark (IBOR) Reform
In the Spotlight: A Corporate Treasury Focus on Phase 2 Amendments for Interest Rate Benchmark (IBOR) Reform
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IBOR Phase 2: Top Accounting Issues for Corporate

Treasurers
Key points
The IASB has issued further amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16
that address issues arising during the reform of benchmark interest rates, including the
replacement of one benchmark rate with an alternative one. The amendments are effective
from 1 January 2021. In this Spotlight we focus on the implications for corporate entities
(that is, non-financial institutions) and, in particular, their treasury function. This Spotlight will
focus on:
changes in the basis for determining contractual cash flows of financial

assets and financial liabilities measured at amortised cost;
hedge accounting; and

IFRS 16, ‘Leases’.
While this Spotlight focuses on the areas listed above, there might be other related
accounting issues. Entities are reminded to consider all potential accounting issues and to
refer to In depth: Practical guide to Phase 2 amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4
and IFRS 16 for interest rate benchmark (IBOR) reform.
1. Introduction
This publication focuses on the impact on corporate entities’ accounting when applying the IASB’s Phase 2 amendments on
benchmark reform. For a more in-depth look at the Phase 1 reliefs and the linkage between the Phase 1 and Phase 2
implications, please refer to the following publications:
In depth 2019-04: Practical guide to Phase 1 amendments IFRS 9, IAS 39 and IFRS 7 for IBOR reform
In depth 2020-06: Practical guide to Phase 2 amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16 for interest rate
benchmark (IBOR) reform
2. Changes in the basis for determining contractual cash flows of

financial assets and financial liabilities measured at amortised cost or
FVOCI
Benchmark rate reform means that many contracts that currently have cash flows based on an IBOR benchmark rate will
need to be amended and, in the future, the financial instruments (including lease contracts for a lessee) will be measured
based on the new benchmark rate. Without the exemptions in IFRS 9 and IFRS 16, this change in measurement basis might
have resulted in a gain/loss, because it would have led to either a modification or derecognition of the instruments. With the
practical expedient, the carrying amount remains unchanged, as discussed in more detail below.
Examples of affected instruments that should be considered in a corporate treasury environment include:
cash equivalents;
loans and other receivables (including long-term trade receivables);

borrowings, lease liabilities (for lessees – see Section 4 below) and certain other
payables; and
inter-company loan arrangements (receivables and payables).
The reliefs from considering changes in the basis for determining contractual cash flows are not relevant to the measurement
of derivative instruments, since they are already carried at fair value through profit or loss. However, the manner in which
those instruments are amended for IBOR reform could affect the ability to use the hedge accounting reliefs (see Section 3
below).
PwC observation
Long-term payables and receivables will, by their nature, be more affected by IBOR reform and, although the interest
rate receivable or payable on cash equivalents such as deposits or money market funds will change, this is unlikely to
have a material accounting impact due to their short-term nature.
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PwC observation
Inter-company arrangements are also unlikely to be the focus of attention for some groups. However, where external
variable-rate debt has been passed to another group company on a back-to-back basis, both companies will need to
ensure that the intra-group loan is also updated and/or that the external finance costs are still covered.
Many groups have complex debt arrangements. This publication is not focused on the tax implications but, for example,
entities might need to meet certain tax transfer pricing or corporate interest restriction rules. Any changes made for
IBOR reform need to consider whether the new rate will still be seen as arm’s length (especially if any amendments are
not solely required as a direct consequence of the reforms but made for other commercial reasons). If not, there could
be implications for current or deferred tax balances.
The changes above all need to be factored into the overall strategy and project management process. Corporate
treasurers should liaise with their tax specialists and other relevant counterparties.
2.1 Current accounting treatment
A change in the market rate of a floating-rate instrument is treated in line with IFRS 9 para B5.4.5 for which the cash flows
are periodically updated, together with the effective interest rate curve used for discounting, which normally has no
significant effect on the carrying amount of the asset or the liability.
However, for changes not arising under the original contractual terms, management needs to assess whether this leads to a
modification gain or loss (IFRS 9 para 5.4.3 for financial assets and B5.4.6 for financial liabilities) or derecognition, where the
change is substantial in line with IFRS 9 paragraph 3.2.3a for financial assets and IFRS 9 para 3.3.2 for financial liabilities.
This assessment and calculation of relevant gain or loss can be complex, and it might not be intuitive to the readers of the
accounts, and so the practical expedient (explained in 2.2 below) is very welcome.
2.2 IASB Phase 2 practical expedient
Following IBOR reform, contracts that have a rate based on an IBOR (for example, GBP LIBOR) will be directly impacted
when the rate changes to the alternative reference rate (for example, SONIA). Such changes can be due to:
an amendment to the contractual terms specified at initial recognition (for example,

if the contract is amended to replace the benchmark rate with an alternative one);
a change that was not considered or contemplated in the contractual terms at
initial recognition (for example, if the method of calculating the benchmark rate is
changed, even though the contractual terms are not); or
as a result of the activation of an existing contractual term (for example, triggering

of an existing fallback clause in a contract).
[IFRS 9 paras 5.4.5, 5.4.6]
The practical expedient applies to qualifying changes to the basis for determining contractual cash flows for financial assets
and liabilities (including lease liabilities) that are required by interest rate benchmark reform – that is, they are necessary as a
direct consequence of IBOR reform and are economically equivalent.
Changes that will qualify for the practical expedient will be treated in line with IFRS 9 para B5.4.5. The effect is that the
carrying amount remains unchanged by the process of re-estimating future cash flows and updating the effective interest
rate. Any other changes to the terms that do not qualify for the expedient above will need to be assessed separately, and
they could result in modification or derecognition of the original asset or liability. Under modification accounting, a gain or
loss is recognised under IFRS 9 para 5.4.3 or IFRS 9 para B5.4.6. Similarly, if derecognition applies, the original asset and
liability will be removed from the balance sheet and replaced with a new asset or liability measured at fair value. This is
known as the two-step approach, and it is explained in more detail in the In depth on Phase 2 referred to in Section 1 above.
The two-step approach is not applicable to lessees (see Section 4 below).
Example 1 – Benchmark interest rate change

Entity A funded itself by entering into a 20-year IBOR borrowing of GBP 10 million in 2015. Every month, it pays interest
based on the 1-month IBOR rate with a fixed spread of 10bps. As a consequence of IBOR reform, the bank has
amended the contract, with the change commencing on 1 August 2021, whereby the 1-month IBOR rate will be
replaced by an alternative risk-free rate (RFR) with a fixed spread of 100bps.
Management evaluated the changes and concluded that both the change in the reference rate and the change in the
fixed spread are a direct consequence of the IBOR reform.
Furthermore, management concluded that the change in the fixed spread (from 10bps to 100bps) is equal to the market-
observed forward spread between the IBOR and the RFR at 1 August 2021, over the expected remaining life of the
instrument, and so the new basis for determining cash flows is economically equivalent to the previous basis. The
approach being applied here is the forward spread approach1.
At the date of the change, the practical expedient is applied and the effective interest rate is updated based on the new
RFR, by applying IFRS para B5.4.5. Therefore, the changes will not result in an immediate gain or loss in the income
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Example 1 – Benchmark interest rate change

statement.
1
There are various accepted methods for assessing the economically equivalent criterion. For further detail, see FAQ
2.2 – What does ‘economically equivalent’ mean?.
Further guidance is given in:
FAQ 2.1 – What does ‘required as a direct consequence of interest rate benchmark
reform’ mean?
PwC observation
Corporate treasurers are likely to be responsible for agreeing the changes to the relevant financial instruments. To
simplify an entity’s or group’s banking arrangements, the corporate entity or bank might suggest aligning the terms of
loan arrangements as part of the IBOR reform process.
Treasurers should be aware of the accounting implications of agreeing other commercially appropriate changes to the
rate or to the instrument’s terms, such as a term extension or inclusion of a floor. These are unlikely to be ‘required as a
direct consequence’, and so they could restrict the benefit obtained from the practical relief. Any other changes would
still need to be assessed under IFRS 9 for derecognition or modification, and they could result in recognition of a gain or
loss.
PwC observation
As noted above, there are various accepted methods for assessing the economically equivalent criterion. The markets
will continue to develop for the new rates, and views of what is appropriate and what is a direct consequence might also
evolve. We therefore recommend continuing to consult with advisers, especially on more complex arrangements.
For example, the replacement benchmark rate could be any reasonable alternative to the original IBOR rate for that
change to be considered a ‘direct consequence’ of IBOR reform (for example, a move from GBP LIBOR to the Bank of
England base rate would be considered a ‘direct consequence’ of IBOR reform, as would a move from GBP LIBOR to
SONIA). Furthermore, the replacement benchmark rate does not need to have the same term as the original IBOR rate if
there is insufficient liquidity in that term in the replacement benchmark rate. For example, for a 3-month IBOR contract,
the replacement would not need to be a 3-month alternative benchmark rate to be a ‘direct consequence’ if that term is
not available or not sufficiently liquid at the point of changing the contract. Conversely, moving to a 5-year alternative
benchmark rate from a 3-month IBOR rate would not be expected to be a reasonable alternative if a liquid overnight
alternative benchmark rate were also available (that is, it would not be viewed as a direct consequence of benchmark
reform).
3. Hedge accounting
The change in benchmark interest rate will mean that hedge accounting relationships are affected where the hedged item,
hedging instrument or designated hedged risk has a reference to an affected benchmark rate. When such changes take
place, the Phase 2 amendments require entities to update their hedge designation, the implications of which are discussed in
more detail below.
3.1 Temporary exception for changes made to the hedge designation and hedge documentation
When an entity ceases to apply the Phase 1 reliefs explained in In depth 2019-04, the Phase 2 amendments require an entity
to make changes to the formal designation and documentation of the hedge relationship, to reflect the changes that are
required by IBOR reform. Similar to the practical expedient for changes in the basis of contractual cash flows of financial
assets and financial liabilities, the change must be necessary as a direct consequence of interest rate benchmark reform,
and the new basis should be economically equivalent to the previous basis.
The hedge designation and documentation will, in this context, be amended only to make one or more of the following
changes:
designating an alternative benchmark rate as a hedged risk;

amending the description of the hedged item (including the description of the
designated portion of the cash flows or fair value being hedged); or
amending the description of the hedging instrument.

[IFRS 9 para 6.9.1]. [IAS 39 para 102P].
The amendments state that the hedge designation relating to the hedging instrument (see third bullet above) must also be
updated if the following three conditions are met:
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the entity makes a change required by IBOR reform using an approach other than
changing the basis for determining the contractual cash flows of the hedging
instrument;
the original hedging instrument (for example, the derivative) is not derecognised;
and
the approach is economically equivalent to changing the basis for determining the
contractual cash flows of the original hedging instrument.
[IFRS 9 para 6.9.2]. [IAS 39 para 102Q].
An example amendment would be to change the designated hedged risk from GBP LIBOR to SONIA. Previously, the entity
could have used the Phase 1 ‘highly probable’ relief to assume that the interest rate on which the hedged risk was based did
not change as a result of the reform. [IFRS 9 para 6.8.4]. [IAS 39 para 102D]. That relief ends once the uncertainty arising
from IBOR reform is no longer present, with respect to the timing or amount of benchmark-based interest cash flows, and
therefore the hedge designation and documentation will need to be updated.
The formal hedge documentation must be amended by the end of the reporting period during which a change required by
IBOR reform is made to the hedged risk, hedged item or hedging instrument. Amending the formal designation and
documentation of a hedging relationship, as required by this temporary exception, is not the discontinuation of the hedge
relationship nor the designation of a new hedging relationship. [IFRS 9 para 6.9.4]. [IAS 39 para 102S].
PwC observation
Treasurers should welcome the practical relief from updating the formal hedge designation as soon as the Phase 1
reliefs cease to apply.
However, the Phase 2 reliefs are only available once a change has been made to the hedge designation. Although
entities have relief from updating their hedge documentation until the end of a reporting period, there is nothing to
preclude earlier re-documentation and, in fact, this would help to evidence the changes that are made to hedge
accounting for the relationship.
3.2 Temporary exception for amounts accumulated in the cash flow hedge reserve
The Phase 1 relief from reclassifying the amount in the cash flow hedge reserve will cease when there is no longer
uncertainty arising from IBOR reform in respect of the timing or amount of interest-based cash flows of the hedged item.
When the entity amends the description of a hedged item under the temporary exception to amend the hedge designation
and documentation (see ‘Section 5.3 Amendments to the formal designation of hedge relationships’ of In depth 2020-06), the
amounts accumulated in the cash flow hedge reserve are deemed to be based on the alternative benchmark rate on which
the hedged future cash flows are determined. [IFRS 9 para 6.9.7]. [IAS 39 para 102W]. It follows that the original hedge
relationship is not treated as discontinued, and IBOR-related fair value movements held in the cash flow hedge reserve do
not need to be recycled immediately.
The Phase 2 amendments also provide for a similar temporary exception for previously discontinued cash flow hedges,
where the benchmark interest rate on which the hedged future cash flows were based has changed as required by IBOR
reform. [IFRS 9 para 6.9.8]. [IAS 39 para 102X]. An example of such a discontinued hedge might be where the hedge
objective had changed (the entity no longer wanted to fix the interest rate on a particular debt instrument). The interest cash
flows were still expected to occur, and so the accumulated cash flow hedge reserve was being released to profit or loss over
the remaining period of the original hedge relationship, and will continue to be, as permitted by the IBOR reform relief.
3.3 Temporary exception for the retrospective effectiveness test (IAS 39 only)
For the purpose of assessing retrospective effectiveness of a hedge relationship on a cumulative basis, an entity could elect,
on an individual hedging relationship basis, to reset to zero the cumulative fair value changes of the hedged item and
hedging instrument when ceasing to apply the retrospective effectiveness assessment relief provided by the Phase 1
amendments. [IAS 39 para 102V].
For a more detailed discussion on the choice to reset the retrospective effectiveness test on a cumulative basis to zero, see
In depth: Practical guide to Phase 2 amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16 for interest rate benchmark
(IBOR) reform.
PwC observation
The decision whether or not to reset to zero might be driven by how an entity’s effectiveness testing is currently set up.
However, we recommend that this relief is considered for all material hedge relationships.
If the cumulative testing result is close to the effectiveness threshold of 80–125% due to basis or timing differences, an
entity might prefer to reset the relationship. However, if there is likely to be significant market volatility in the first period
after transition to the new benchmark rate, the impact might be mitigated by a cumulative effectiveness calculation.
Treasurers should note that there is no exception from the recognition and measurement of hedge ineffectiveness, or the
measurement of hedged items and hedging instruments. Therefore, previous sources of ineffectiveness could still create
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PwC observation
profit or loss volatility.
3.4 Designation of risk components and portions
IFRS 9 paragraph 6.3.7 describes that an entity can designate a component of an item, provided that the risk component is
separately identifiable and reliably measurable.
IBOR Phase 2 allows for an alternative benchmark rate designated as a non-contractually specified risk component that is
not separately identifiable, at the date when it is designated, to be deemed to have met the requirements at that date if the
entity reasonably expects that it will meet the requirements within a period of 24 months.
The 24-month period will:
apply to each alternative benchmark rate separately (on a rate-by-rate basis); and
begin from the date when the entity designates the alternative benchmark rate as a
non-contractually specified risk component for the first time.
[IFRS 9 para 6.9.11]. [IAS 39 para 102Z1].
The non-contractually specified risk component will, however, be required to be reliably measurable at all times.
If, at a later date, the entity reasonably expects that the alternative benchmark rate will not be separately identifiable within
the 24-month period, it will cease to apply the temporary exception and prospectively discontinue hedge accounting from
the date of that reassessment. [IFRS 9 para 6.9.12]. [IAS 39 para 102Z2].
This relief will similarly apply to new hedging relationships where the alternative benchmark rate is not separately identifiable
at the date when the non-contractually specified risk component is designated. [IFRS 9 para 6.9.13]. [IAS 39 para 102Z3].
For entities reporting under IFRS 9 applying the Phase 2 amendments, further guidance is given in:
FAQ 46.67.3 – When can a new benchmark rate (such as SONIA) be designated as a non-contractually specified risk
component of a debt instrument?
PwC observation
This exemption is helpful because corporate treasurers might want to hedge the benchmark rate component of existing
and new debt instruments, but the new rates might not yet be separately identifiable.
However, many of the benchmark rates are expected to be separately identifiable in the next 24 months, and so fair
value hedges of the benchmark component of fixed-rate debt, for example, should be possible if the entity adopts the
Phase 2 IFRS 9 or IAS 39 amendments.
The amendments are applicable for periods beginning after 1 January 2021. Therefore, if an entity wants to designate a
new benchmark rate as the hedged risk component in an earlier period, it will need to early adopt the Phase 2
amendments and disclose that fact in the financial statements.
3.5 When might the hedge accounting reliefs not apply?
If additional changes other than those required by IBOR reform are made, an entity will first apply the applicable IAS 39 or
IFRS 9 hedge accounting requirements to determine if the changes result in the derecognition of the derivative and/or
discontinuance of hedge accounting. If the changes do not result in the derecognition of the derivative and/or
discontinuance of hedge accounting, the reliefs will be available, but the designation of the hedge relationship will need to be
updated as explained above.
PwC observation
The Basis of Conclusions on both IFRS 9 and IAS 39 describe various methods of ‘transitioning’ derivatives that fall into
the reliefs, all of which retain the original hedging instrument in some form or other.
Many corporate entities might just use the ISDA fallback protocols, but others might plan to replace the original hedging
instrument with a new instrument. This can be quicker and easier than negotiating changes to old terms, particularly if
other changes to notional or terms are needed. However, even if no other changes are made, treasurers should be
aware that, in some cases, this might mean that the original hedging arrangement is derecognised and the Phase 2
reliefs are not available.
4. IFRS 16, ‘Leases’

The change in rates will mean that many lease contracts with variable lease payments will need to be amended, affecting
both lessees and lessors. Without the exemption added to IFRS 16, lessees would need to remeasure the lease liability, with
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a corresponding adjustment to the right-of-use asset. With the practical expedient, the carrying amount of the lease liability
remains unchanged, as discussed in more detail below.
PwC observation
The decision to enter into leases, and accounting for such leases, was not historically a key feature of a corporate
treasurer’s role, but the decision to lease or borrow and buy has received more focus since the implementation of IFRS
16 led to many more on-balance sheet lease liabilities. Therefore, treasury departments are often part of the decision-
making process, and they also help to compute the incremental borrowing rate using their understanding of the
appropriate credit spread for secured and unsecured borrowings.
As noted above, many leases will need to be amended, and treasurers might be asked to support the negotiations to
ensure that any rate change made by lessors or lessees is a direct consequence of the reform and that the revised
payment is economically equivalent.
4.1 Accounting by lessees
IFRS 16 has been amended to include a practical expedient for all leases that are modified to change the basis for
determining future lease payments as a result of IBOR reform. As a practical expedient, a lessee will remeasure the lease
liability by discounting the revised lease payments using a discount rate that reflects the change in the interest rate. This
practical expedient applies only if the lease modification is necessary as a direct consequence of IBOR reform, and the new
basis for determining the lease payments is economically equivalent to the previous basis. [IFRS 16 para 105].
If lease modifications are made in addition to those required by IBOR reform, an entity will be required to apply IFRS 16
requirements to account for all lease modifications made at the same time, including those required by IBOR reform. [IFRS
16 para 106].
4.2 Accounting by lessors
The IASB decided not to amend requirements for lease modifications from a lessor's perspective. For finance lease
modifications, the Board noted that a lessor would be required to apply IFRS 9 to those modifications. As a result, a finance
lessor would be required to apply the practical expedient relief for modifications required by the reform. This follows the
same treatment as for affected financial assets described above, which means that a variable-rate lease asset recognised by
the lessor for which there is a qualifying change will be treated in line with IFRS 9 para B5.4.5. The effect is that the carrying
amount remains unchanged by the process of re-estimating future cash flows and the effective interest rate.
In addition, the Board noted that, for operating leases, lessors should follow the modification guidance in IFRS 16. [IFRS 16
para BC 267J].
Example 2 – Rate change

On 1 January 2018, entity B entered into a 10-year lease contract for a building with quarterly variable lease payments
(entity B is the lessee). The quarterly variable lease payments are based on the 3-month IBOR plus a spread of 50bps.
At the point of initial measurement, the lease liability is measured by assuming unadjusted lease payments over the life
of the lease. At the beginning of the next quarter when the rate changes, management remeasures the lease liability to
the present value of the revised payments based on 3-month IBOR at the date when the cash flows change for the
remainder of the lease term. Because the change in cash flows is caused by a change in floating interest rates, the lease
liability is calculated using a revised discount rate. [IFRS 16 para 43].
On 1 January 2022, the lessor and lessee agreed to change the rate from 3-month IBOR plus a spread of 50bps to an
alternative risk-free rate (RFR) plus a spread of 150bps. No other changes are made to the contract. Management of
entity B assessed (based on the criteria as set out in Example 1) whether this change is a direct consequence of the
IBOR reform and economically equivalent to the previous basis.
Since the change is a direct consequence of the interest rate benchmark reform and economically equivalent, entity B
applies the practical expedient to the revised discount rate, meaning that the carrying amount would not typically be
adjusted.
5. Disclosures and illustrative examples

We note that the Phase 2 amendments introduce new disclosure requirements, including information about how an entity is
managing its benchmark rate transition and financial instruments which have not yet transitioned to the replacement
benchmark rate. Illustrative disclosures will be available shortly after the publication of this Spotlight and can be accessed on
Viewpoint. A link will be added as soon as it is available.
In addition, for hedge accounting, the interaction between the Phase 1 and Phase 2 reliefs can be complex.
Illustrative examples will be published that should help treasurers and financial reporting teams to understand the timelines
and the accounting and reporting implications of changes made to the hedged item and hedging instruments. These will be
available shortly after the publication of this Spotlight and can be accessed on Viewpoint. A link will be added as soon as it is
available.
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6. Further information
For further information, contact Jessica Taurae (jessica.taurae@pwc.com), Claire Howells (claire.l.howells@pwc.com) or Jacov Rashty (jacov.x.rashty@pwc.com).
Achieving hedge accounting in practice under

IFRS 9
This publication answers the questions we are asked most often by corporates applying IFRS 9's hedge accounting rules for
a range of hedging strategies commonly used in practice.
As entities work through the detail of the standard, they have found it more challenging and complex than they initially
expected. We have therefore developed this guide to help navigate the complexity and show entities how to achieve hedge
accounting in a wide range of situations, with worked examples and helpful tips too.
For further guidance on IFRS 9, see our publication IFRS 9 - Understanding the basics.
Achieving hedge accounting in practice under

IFRS 9
1. Introduction
1.1. Background
In this first section we give an overview of the requirements of hedge accounting in IFRS 9 Financial Instruments. In
section 2 we answer some of the most commonly asked questions that have arisen in practice, and in the section 3 we
illustrate in detail how to apply the standard to some common hedge relationships.
1.1.1.Scope and interaction with macro hedging

IFRS 9 hedge accounting applies to all hedge relationships, with the exception of fair value hedges of the interest rate
exposure of a portfolio of financial assets or financial liabilities (commonly referred as ‘fair value macro hedges’). This
exception arises because the Board has a separate project to address the accounting for macro hedges. In the
meantime, until this project is completed, companies using IFRS 9 for hedge accounting can continue to apply IAS 39
requirements for fair value macro hedges.
The reason for addressing such hedges separately is that hedges of open portfolios introduce additional complexity.
Risk management strategies tend to have a time horizon over which an exposure is hedged; so, as time passes, new
exposures are continuously added to such hedged portfolios, and other exposures are removed from them.
PwC insight:
This scope exception is not applicable when hedging closed portfolios. IFRS 9 addresses the accounting for
hedges of closed portfolios or groups of items that constitute a gross or net position (refer to section 5 below for
further details).
1.1.2. Accounting policy choice

IFRS 9 provides an accounting policy choice: entities can either continue to apply the hedge accounting requirements
of IAS 39 until the macro hedging project is finalised (see above), or they can apply IFRS 9 (with the scope exception
only for fair value macro hedges of interest rate risk). This accounting policy choice will apply to all hedge accounting
and cannot be made on a hedge-by-hedge basis.
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PwC insight:
This accounting policy choice refers to the application of the hedge accounting only, and has no impact on the
implementation of the other sections of IFRS 9 (that are, ‘classification and measurement and ‘impairment’).
If an entity initially decides to continue applying IAS 39 hedge accounting, it can subsequently decide to change
its accounting policy and commence applying the hedge accounting requirements of IFRS 9 at the beginning of
any reporting period (subject to the other transition requirements of IFRS 9).
Whichever accounting requirements are applied (that is, IAS 39 or IFRS 9), there are specific hedge accounting
disclosure requirements in IFRS 7 that are applicable.
2. Hedge Accounting
2.1. What is hedge accounting?

Entities are exposed to financial risks arising from many aspects of their business. Different companies are concerned
about different risks (for example, some entities might be concerned about exchange rates or interest rates, while others
might be concerned about commodity prices). Entities implement different risk management strategies to eliminate or
reduce their risk exposures.
The objective of hedge accounting is to represent, in the financial statements, the effect of risk management activities
that use financial instruments to manage exposures arising from particular risks that could affect profit or loss (P&L) or
other comprehensive income (OCI).
In simple terms, hedge accounting is a technique that modifies the normal basis for recognising gains and losses (or
income and expenses) on associated hedging instruments and hedged items, so that both are recognised in P&L (or
OCI) in the same accounting period. This is a matching concept that eliminates or reduces the volatility in the statement
of comprehensive income that otherwise would arise if the hedged item and the hedging instrument were accounted for
separately under IFRS. Under IFRS 9, hedge accounting is optional, and management should consider the costs and
benefits when deciding whether to use it
2.2. Accounting for hedges

IFRS 9 has three hedge accounting model, as summarised below:
2.2.1. Fair value hedge

The risk being hedged in a fair value hedge is a change in the fair value of an asset or liability or an unrecognised firm
commitment that is attributable to a particular risk and could affect P&L. Changes in fair value might arise through
changes in interest rates (for fixed-rate loans), foreign exchange rates, equity prices or commodity prices.
The carrying value of the hedged item is adjusted for fair value changes attributable to the risk being hedged, and
those fair value changes are recognised in P&L. The hedging instrument is measured at fair value, with changes in fair
value also recognised in P&L.
2.2.2. Cash flow hedge

The risk being hedged in a cash flow hedge is the exposure to variability in cash flows that is attributable to a
particular risk associated with a recognised asset or liability, an unrecognised firm commitment (currency risk only) or
a highly probable forecast transaction, and could affect P&L.
Future cash flows might relate to existing assets and liabilities, such as future interest payments or receipts on floating
rate debt. Future cash flows can also relate to forecast sales or purchases in a foreign currency. Volatility in future
cash flows might result from changes in interest rates, exchange rates, equity prices or commodity prices.
Provided the hedge is effective, changes in the fair value of the hedging instrument are initially recognised in OCI. The
ineffective portion of the change in the fair value of the hedging instrument (if any) is recognised directly in P&L. The
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amount recognised in OCI should be the lower of:
The cumulative gain or loss on the hedging instrument from the inception of
the hedge, and
The cumulative change in the fair value (present value) of the expected cash
flows on the hedged item from the inception of the hedge.
If the cumulative change in the hedging instrument exceeds the change in the hedged item (sometimes referred to as
an ‘over-hedge’), ineffectiveness will be recognised. If the cumulative change in the hedging instrument is less than
the change in the hedged item (sometimes referred to as an ‘under-hedge’), no ineffectiveness will be recognised.
This is different from a fair value hedge, in which ineffectiveness is recognised on both over – and under-hedges.
For cash flow hedges of a forecast transaction which result in the recognition of a financial asset or liability, the
accumulated gains and losses recorded in equity should be reclassified to P&L in the same period or periods during
which the hedged expected future cash flows affect P&L. Where there is a cumulative loss on the hedging instrument
and it is no longer expected that the loss will be recovered, it must be immediately recognised in P&L.
For cash flow hedges of a forecast transaction which results in the recognition
of a non-financial item (such as a fixed asset or inventory), or where a hedged
forecast transaction for a non-financial asset or a non- financial liability
becomes a firm commitment for which fair value hedge accounting is applied,
the carrying value of that item must be adjusted for the accumulated gains or
losses recognised directly in equity (often referred to as ‘basis adjustment’).
"This is not a reclassification adjustment, as defined in IAS 1, and hence it
does not affect other comprehensive income."
Where the net position of a group of items containing offsetting risk positions
is designated as the hedged item, the cash flow hedge model can only be
applied to the hedge of foreign currency risk. The designation of that net
position must specify both the reporting period in which the forecast
transactions are expected to affect P&L and also the nature and volume that
are expected to affect P&L in each period. Hedging gains or losses must be
presented in a separate line item in the income statement.
For cash flow hedges of a group of items with no offsetting risk position, the
presentation of hedging gains or losses are apportioned to the line items
affected by the hedged items.
2.2.3. Net investment hedge

An entity might have overseas subsidiaries, associates, joint ventures or branches (‘foreign operations’). It might
hedge the currency risk associated with the translation of the net assets of these foreign operations into the parent
entity’s functional currency.
The amount of a net investment in a foreign operation under IAS 21 is the reporting entity’s interest in the net assets of
that operation, including any recognised goodwill. Exchange differences arising on the consolidation of these net
assets are deferred in equity until the foreign operation is disposed of or liquidated. They are recognised in P&L, on
disposal or liquidation, as part of the gain or loss on disposal.
The foreign currency gains or losses on the hedging instrument are deferred in OCI, to the extent that the hedge is
effective, until the subsidiary is disposed of or liquidated, when they become part of the gain or loss on disposal.
3. Qualifying criteria for hedge accounting

An entity’s risk management strategy is central to the objective of hedge accounting under IFRS 9. However, hedge
accounting is still seen as an exception to the normal accounting rules, and therefore, some restrictions are still necessary
to determine whether or not a proposed hedging relationship qualifies for hedge accounting. As a result, an entity is only
allowed to apply hedge accounting if it meets the specified qualifying criteria.
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The qualifying criteria in IFRS 9 is summarised in the following table, and detailed further below:
IFRS 9
3.1 Formal designation and documentation of:
Risk management objective and strategy

Hedging instrument
Hedged item
Nature of risk being hedged
Hedge effectiveness (including sources of ineffectiveness and how the
hedge ratio is determined)
3.2 Hedging relationship consists only of eligible hedging instruments and eligible
hedged items.
3.3 Hedge effectiveness requirements (prospective):
Economic relationship exists

Credit risk does not dominate value changes
Designated hedge ratio is consistent with risk management strategy.
3.4 Discontinuation of hedge accounting only under specified circumstances.
3.1. Formal designation and documentation

Formal designation and documentation must be in place at the inception of the hedge relationship.
Entities should also take into consideration that, under IFRS 9, documentation is not static but should be updated from
time to time. Examples of situations where modification of the hedge documentation would be required are where the
hedge ratio is rebalanced (see below) or where the analysis of sources of hedge ineffectiveness is updated.
3.2. Eligible items

The hedging relationship should consist only of eligible hedging instruments and hedged items. What is eligible for both
hedged items and hedging instruments is discussed in detail in sections 4 and 5 below.
3.3. Hedge effectiveness

Hedge effectiveness is defined as the extent to which changes in the fair value or cash flows of the hedging instrument
offset changes in the fair value or cash flows of the hedged item.
IFRS 9 has three hedge effectiveness requirements:
3.3.1 Economic relationship

IFRS 9 requires the existence of an economic relationship between the hedged item and the hedging instrument. So
there must be an expectation that the value of the hedging instrument and the value of the hedged item would move
in the opposite direction as a result of the common underlying or hedged risk. For example, this is the case for
forecast fixed interest payments and an interest rate swap that receives fixed interest payments and pays variable
interest.
An on-going analysis of the possible behaviour of the hedging relationship during its term is required in order to
ascertain whether it can be expected to meet the risk management objective.
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PwC insight:
The Board has regarded ‘proxy hedging’ (which is a designation that does not exactly represent an entity’s actual
risk management) as an eligible way of designating the hedged item under IFRS 9, as long as designation reflects
the risk management in that it relates to the same type of risk that is managed and the instruments used for that
purpose.
As part of the basis for conclusions in IFRS 9, the Board included as an example the fact that because IFRS 9
does not allow cash flow hedges of interest rate risk to be designated on a net position basis, entities must
instead designate part of the gross positions. This requires the use of proxy hedging, because the designation for
hedge accounting purposes is on a gross position basis, even though risk management typically uses a net
position basis.
Corporates refer to proxy hedging where for example they hedge commodity price risk but as a result of the
availability of commodity derivatives, entities use a hedging instrument referenced to a commodity different to the
actual commodity they are economically hedging, but the price of the two commodities are correlated enough to
make the hedge relationship work.
In addition, some financial institutions use intragroup derivatives for risk management purposes. However, as
intragroup derivatives do not qualify for hedge accounting at the group level, they are required to define external
derivatives as proxy hedges.
3.3.2 Credit risk

Even if there is an economic relationship, a change in the credit risk of the hedging instrument or the hedged item
must not be of such magnitude that it dominates the value changes that result from that economic relationship.
Because the hedge accounting model is based on a general notion of there being an offset between the changes of
the hedging instrument and those of the hedged item, the effect of credit risk must not dominate the value changes
associated with the hedged risk; otherwise, the level of offset might become erratic.
For example, where an entity wants to hedge its forecast inventory purchases for commodity price risk, it enters into a
derivative contract with Bank X to purchase a commodity at a fixed price and at a future date. If the derivative contract
is uncollateralised and Bank X experiences a severe deterioration in its credit standing, the effect arising from changes
in credit risk might have a disproportionate effect on the change in the fair value of the derivative contract arising from
changes in commodity prices; whereas the changes in the value of the hedged item (forecast inventory purchases)
would depend largely on the commodity price changes and would not be affected by the changes in the credit risk of
Bank X.
PwC insight:
IFRS 9 does not provide a definition of ‘dominate’. However, it is clear that the effect of credit risk should be
considered on both the hedging instrument and the hedged item. For example, an entity hedging the interest rate
or foreign currency risk of a financial asset (such as a bond) will need to look at the credit risk of the bond. If the
bond has high credit risk, the bond might not qualify for hedge accounting. During the financial crisis, there were
many situations where entities purchased loans to troubled financial institutions, and the amount that would
ultimately be realised was very uncertain. These might not have qualified for hedge accounting.
Following the financial crisis, many countries changed the regulations for derivatives. One of the main objectives
of these changes was to mitigate credit risk for example by requiring more derivatives to be collateralised. As a
result of these changes, this hedge effectiveness requirement is less likely to be a problem.
3.3.3. Hedge ratio

The hedge ratio is defined as the relationship between the quantity of the hedging instrument and the quantity of the
hedged item in terms of their relative weighting. IFRS 9 requires that the hedge ratio used for hedge accounting
purposes should be the same as that used for risk management purposes.
One of the key objectives in IFRS 9 is to align hedge accounting with risk management objectives. There is no
retrospective effectiveness testing required under IFRS 9, but there is a requirement to make an on-going assessment
of whether the hedge continues to meet the hedge effectiveness criteria, including that the hedge ratio remains
appropriate.
This means that entities will have to ensure that the hedge ratio is aligned with that required by their economic
hedging strategy (or risk management strategy). A deliberate imbalance is not permitted. This requirement is to ensure
that entities do not introduce a mismatch of weightings between the hedged item and the hedging instrument to
achieve an accounting outcome that is inconsistent with the purpose of hedge accounting. This does not imply that
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the hedge relationship must be perfect, but only that the weightings of the hedging instruments and hedged item
actually used are not selected to introduce or to avoid accounting ineffectiveness.
In some cases, there are commercial reasons for particular weightings of the hedged item and the hedging instrument
even though they create hedge ineffectiveness. This is the case, for example when using standardised contracts that
have a defined contract size (for instance, 1 standard aluminium future contract in the LME has a contract size of 25
tonnes). When an entity wants to hedge 90 tonnes of aluminium purchases with standard aluminium future contracts,
due to the standard contract size, the entity could use either 3 or 4 future contracts (equivalent to a total of 75 or 100
tonnes respectively). Such designation would result in a hedge ratio of either 0.83:1 or 1.11:1. In that situation the
entity designates the hedge ratio that it actually uses, because the hedge ineffectiveness resulting from the mismatch
would not result in an accounting outcome that is inconsistent with the purpose of hedge accounting. Hedge
ineffectiveness is still required to be measured and accounted for in P&L.
PwC insight:
In situations such as the above, where due to the standard size of contracts the hedge relationship may result in
an under-hedge, an alternative that entities might want to consider is the possibility of designating as the hedged
item a layer component as described in section 5.4 below.
3.3.4. Rebalancing
IFRS 9 introduces the concept of ‘rebalancing’. Rebalancing refers to adjustments to the designated quantities of
either the hedged item or the hedging instrument of an existing hedging relationship for the purpose of maintaining a
hedge ratio that complies with the hedge effectiveness requirements. This allows entities to respond to changes that
arise from the underlying or risk variables. This is good news, as rebalancing does not result in de-designation and re-
designation of a hedge, but it is accounted for as a continuation of the hedging relationship. However, on rebalancing,
hedge ineffectiveness is determined and recognised immediately before adjusting the hedge relationship.
Rebalancing is consistent with the requirement of avoiding an imbalance in weightings at inception of the hedge, but
also at each reporting date and on a significant change in circumstances, whichever comes first.
When rebalancing a hedging relationship, an entity must update its documentation of the analysis of the sources of
hedge ineffectiveness that are expected to affect the hedging relationship during its remaining term.
In some circumstances, rebalancing is not applicable (for example, where the changes in the hedge relationship –
which might arise from changes in the derivative counterparty credit risk or from a risk that was always present but
not captured by the hedging instrument – cannot be compensated by adjusting the hedge ratio). In addition, if the risk
management objective has changed, rebalancing is not allowed, and hedge accounting should be discontinued.
PwC insight:
In practice, entities will not need to rebalance very often if they have a good risk management strategy in place
and the economic relationship is stable. There is always some volatility in any hedging relationship but, if the initial
hedge ratio is appropriate and in line with the risk management strategy, rebalancing should only be necessary if
the ‘ideal’ hedge ratio changes significantly. Entities should document their tolerance to such variations.
3.3.5. Hedge effectiveness assessment

IFRS 9 does not prescribe a specific method for assessing whether a hedging relationship meets the hedge
effectiveness requirements. An entity must use a method that captures the relevant characteristics of the hedging
relationship, including the sources of hedge ineffectiveness that are expected to affect the hedging relationship during
its term. A qualitative assessment is always necessary and, depending on the characteristics of the hedge
relationship, entities might also need to perform a quantitative assessment. For example, in a simple hedge where all
the critical terms match (or are only slightly different), a qualitative test might be sufficient. On the other hand, in highly
complex hedging strategies, some type of quantitative analysis would likely need to be performed.
The assessment relates to expectations about hedge effectiveness, and so is only forward looking. Such an
assessment should be performed at inception and on an on-going basis at each reporting date or on a significant
change in circumstances, whichever comes first. The intention behind these requirements is to ensure that only
economically viable hedging strategies (that is, those reflecting the underlying economic relationship and aligned to
the risk management strategy) qualify for hedge accounting purposes.
3.3.6. Discounted cash flows for measuring hedge ineffectiveness
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Hedge accounting does not change the measurement of the hedging instrument, but only the location of where the
change in its carrying amount is presented for cash flow and net investment hedges. Hedging instruments are subject
to measurement at either fair value or amortised cost, both of which take into consideration the time value of money.
In order to be consistent, IFRS 9 has a requirement to measure the hedged item also on a present value basis;
therefore, subsequent changes would include the effect of the time value of money (for example, an undiscounted
spot approach cannot be used in a hedge of the foreign currency risk of a forecast transaction). The objective of this
requirement is to ensure the measurement of the effectiveness of the hedge relationship reflects the time value of
money and any mismatches in timing between the hedged item and the hedging instrument are recognised as
ineffectiveness.
PwC insight:
It is a common hedging strategy in some countries to hedge the foreign currency risk of foreign currency sales or
purchases and to assess effectiveness on an undiscounted spot basis. The IFRS 9 requirement to consider the
time value of money could have a significant impact where the risk management strategy is to hedge the spot risk
(that is, pure foreign currency risk without considering the forward points). This is because entities need to keep
track of the timing of the hedged transaction and measure ineffectiveness on a discounted basis, thus capturing
the ineffectiveness that arises from a difference in expected timing between the hedged transaction and the
derivative.
3.4. Discontinuation of hedge accounting

Voluntary de-designation is prohibited under IFRS 9.
Under IFRS 9, an entity cannot de-designate and thereby discontinue a hedging relationship that:
Still meets the risk management objective; and

Continues to meet all other qualifying criteria (after taking into account any
rebalancing, if applicable). For this purpose, it is necessary to understand the
distinction between the notions of ‘risk management strategy’ and ‘risk
management objective’.
A risk management strategy is the highest level at which an entity determines how it manages risk; typically, it identifies
the risks to which the entity is exposed and sets out how the entity responds to them. It is usually in place for a longer
period and might include some flexibility to react to changes in circumstances. It is normally a general document that
would be cascaded down through policies containing more specific guidelines. On the other hand, a risk management
objective is applied at the level of a particular hedging relationship.
A risk management strategy can (and often will) involve many different hedging relationships, each with a risk
management objective. Hence, the risk management objective for a particular hedging relationship can change, even
though an entity’s risk management strategy remains unchanged.
If the risk management objective for a hedge relationship has changed, hedge accounting must be discontinued.
Discontinuation of hedge accounting can affect a hedging relationship in its entirety or only part of it, depending on the
facts and circumstances.
Examples of discontinuation of a hedge in its entirety are:
Where the hedging relationship no longer meets the risk management objective.
Where the hedging relationship no longer complies with the qualifying criteria.
Where the hedging instrument has been sold or terminated.
Examples of discontinuation for only a part of the hedging relationship are:
For the volume of hedged item, where it is no longer part of the hedging
relationship due to an adjustment to the hedge ratio.
PwC insight:
IFRS 9 prohibits voluntary de-designation however, this is not expected to be a significant issue in practice, both
because in many cases an entity will want to de-designate because of a change to its risk management objective,
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PwC insight:
and because an entity always has the ability to terminate its hedging instruments.
4. What can be designated as hedging instruments

Most derivative financial instruments can be designated as hedging instruments, provided they are entered into with an
external party. Intra-group derivatives or other balances do not qualify as hedging instruments in consolidated financial
statements irrespective of whether a proposed hedging instrument, such as an intercompany borrowing, will affect
consolidated profit or loss. But they might qualify in the separate financial statements of individual entities in the group.
4.1. Derivative financial instruments

IFRS 9 generally does not restrict the circumstances in which a derivative can be designated as a hedging instrument
(provided the hedge accounting criteria are met), except for some written options.
4.2. Non-derivative financial instruments measured at fair value

through P&L
Under IAS 39, non-derivative financial instruments are only allowed as hedging instruments for hedges of foreign
currency risk. Under IFRS 9, non-derivative financial instruments continue to be allowedare allowed as hedging
instruments of foreign currency risk provided that such non-derivative financial instruments are not investments in equity
instruments for which the entity has elected to present the changes in fair value in OCI.
In addition, IFRS 9 also allows non-derivative financial instruments as hedging instruments to hedge other risks if
measured at fair value through P&L. However, financial liabilities designated at fair value through profit and loss for
which the changes in the liability’s own credit risk are presented in OCI are not eligible for designation as hedging
instruments.
For financial instruments that an entity has originally elected to designate at inception at fair value through P&L to
mitigate an accounting mismatch (commonly referred as the ‘fair value option’), a designation as hedging instruments is
allowed only if such designation mitigates an accounting mismatch, without creating another one (that is, no conflict
should exist between the purpose of the fair value option and the purpose of hedge accounting).
4.3. Embedded derivatives

Under IFRS 9’s requirements for the classification and measurement of financial instruments, embedded derivatives in
financial assets are not accounted for separately. In most cases, features that would not be not closely related to
payments of principal and interest in a financial asset would cause the instrument to fail to qualify as solely payments of
principal and interest and for the instrument to be carried at fair value through P&L. As a result, embedded features in
financial assets are not eligible as hedging instruments on their own. However, to the extent that the relationship would
be effective, entities could designate the instrument in its entirety (or a proportion of it) as a hedging instrument.
For financial liabilities, on the other hand, embedded derivatives that are not closely related to the host instrument are
separated (unless they meet a scope exception or the instrument is designated at fair value through profit and loss). If an
embedded derivative is separated from the host instrument and accounted for separately, it continues to be eligible as a
hedging instrument assuming that a freestanding derivative with the same terms would be eligible.
Embedded derivatives that are accounted for seprately from non-financial contracts (e.g. executory contracts) are also
eligible hedging instruments.
4.4. Purchased options

The fair value of an option can be divided into two portions: the intrinsic value (which is determined in terms of the
difference between the strike price and the current market price of the underlying) and the time value (that is, the
remaining value of the option which reflects the volatility of the price of the underlying, interest rates and the time
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remaining to maturity). Designating only the intrinsic value usually increases the volatility in P&L, due to the fact that
changes in the time value of the option are recognised in P&L.
IFRS 9 has specific accounting requirements on using purchased options as hedging instruments. It views a purchased
option as similar to purchasing insurance cover with the time value being the associated cost. If an entity elects to
designate only the intrinsic value of the option as the hedging instrument, it must account for the changes in the time
value in OCI. This amount will be removed from OCI and recognised in P&L, either over the period of the hedge if the
hedge is time related (for example, six-month fair value hedge of inventory), or when the hedged transaction affects P&L
if the hedge is transaction related (for example, a forecast sale). This is known as the ‘cost of hedging’ approach.
An entity needs to take into consideration that, once it designates the intrinsic value of the option, the accounting in
IFRS 9 is not optional, but mandatory. In addition, the aforementioned accounting for the initial time value of purchased
options applies only to the extent that the time value relates to the hedged item. This is called the ‘aligned time value’.
Where the hedging instrument and hedged item are not fully aligned, entities need to determine the aligned time value –
that is, how much of the time value included in the premium paid (actual time value) relates to the hedged item – and
apply this accounting treatment to that portion. This can be determined using the valuation of the option that would have
critical terms that perfectly match the hedged item. The residual amount is recognised in P&L.
4.5. Forward contracts

A forward is a contract to exchange a fixed amount of a financial or non-financial asset on a fixed future date at a fixed
price. The fair value of a forward contract is affected by changes in the spot rate and changes in the forward points (in
the case of an FX forward contract, the forward points arise from the interest rate differential between currencies
specified in a forward contract).
Under IFRS 9, an entity has a choice of whether to hedge using either the forward rate or the spot rate:
If the forward rate is used, the entity is hedging with the full fair value of the
forward contract. Changes in the fair value of the forward are accounted for in
accordance with the type of hedge (such as fair value hedge or cash flow
hedge). In this type of designation, some ineffectiveness would generally arise if
the hedged item is not similarly affected by interest rate differentials for example
if the timing of the hedged item differs from the maturity of the forward contract
designated as the hedging instrument.
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).
Changes in the spot rate are part of the hedge relationship, and so they are
accounted for in accordance with the type of hedge, whereas the changes in fair
value due to the forward points are immediately recognised in P&L.
In addition, where an entity designates only the change in the spot element as the hedging instrument an alternative
approach exists for the forward element of the forward contracts. Even though a forward contract can be considered to
be related to a time period, IFRS 9 states that the relevant aspect for its accounting is the characteristic of the hedged
item and how it affects profit or loss. An entity must assess the type of hedge on the basis of the nature of the hedged
item, regardless of whether the hedging relationship is a cash flow hedge or a fair value hedge. An entity assesses
whether the hedge is transaction related (for example, the hedge of a forecast purchase of inventory in foreign currency)
or whether it is time- period related (for example, a hedge of the fair value of commodity inventory for the next six
months using a commodity forward contract). The accounting treatment to be applied to the forward element of a
forward contract is the same as for the time value of hedging with options (described in 4.4 above). However, unlike
accounting for options, this ‘cost of hedging’ accounting treatment is optional rather than mandatory.
4.6. Accounting for currency basis spreads

IFRS 9 states that a hypothetical derivative cannot include features that do not exist in the hedged item. It clarifies that a
hypothetical derivative cannot simply impute a charge for exchanging different currencies (that is, the currency basis
spread), even though actual derivatives under which different currencies are exchanged might include such a charge (for
example, cross-currency interest rate swaps).
Under IFRS 9, where an entity separates the foreign currency basis spread from a financial instrument and excludes it
from the designation of that financial instrument as the hedging instrument, the entity can account for the changes in the
currency basis spread in the same manner (that is, transaction related or time-period related) as applied to the forward
element of a forward contract, as noted in 4.5 above.
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PwC insight:
Entities might want to use the cost of hedging approach for the currency basis spread to avoid ineffectiveness that
would otherwise arise, particularly for longer dated swaps or forwards or where hedging less common or more
volatile currencies, where the spread is likely to be larger.
5. What can be designated as hedged items?
5.1. Definition of hedged item

Under IFRS 9, a hedged item can be a recognised asset or liability, an unrecognised firm commitment, a forecast
transaction or a net investment in a foreign operation. The hedged item can be:
A single item, or
A group of items.
If the hedged item is a forecast transaction, it must be highly probable.
5.2. Risk components of non-financial items

Under IFRS 9, risk components can be designated for non-financial hedged items, provided the component is
separately identifiable and the changes in fair value or cash flows of the item attributable to the risk component are
reliably measurable. This requirement could be met where the risk component is either explicitly stated in a contract
(contractually specified) or implicit in the fair value or cash flows (non-contractually specified).
PwC insight:
An example of a contractually specified risk component that we have come across in practice is a contract to
purchase a product (such as aluminium cans), in which a metal (such as aluminium) is used in the production
process. Contracts to purchase aluminium cans are commonly priced by market participants based on a building
block approach, as follows:
The first building block is the London Metal Exchange (LME) price for a
standard grade of aluminium ingot.
The next building block is the grade premium or discount to reflect the
quality of aluminium used, as compared to the standard LME grade.
Additional costs will be paid for conversion from ingot into cans and delivery
costs.
The final building block is a profit margin for the seller.
Many entities may want to use aluminium LME futures or forwards to hedge their price exposure to aluminium. IFRS
9 allows entities to designate the LME price as the hedged risk, provided it is separately identifiable and reliably
measurable.
When identifying the non-contractually specified risk components that are eligible for designation as a hedged item,
entities need to assess such risk components within the context of the particular market structure to which the risks
relate and in which the hedging activity takes place. Such a determination requires an evaluation of the relevant facts
and circumstances, which differ by risk and market.
The Board believes that there is a rebuttable presumption that, unless inflation risk is contractually specified, it is not
separately identifiable and reliably measurable, and so it cannot be designated as a risk component of a financial
instrument. However, the Board considers that, in limited cases, it might be possible to identify a risk component for
inflation risk, and provides the example of environments in which inflation-linked bonds have a volume and term
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structure that result in a sufficiently liquid market that allows a term structure of zero-coupon real interest rates to be
constructed.
PwC insight:
Although the ability to hedge risk components of non-financial items is very beneficial for entities, the wording in
IFRS 9 is unclear. IFRS 9 requires an entity to assess risk components (that are separately identifiable and reliably
measurable) within the context of the particular market structure to which the risk or risks relate and in which the
hedging activity takes place. However, there are no criteria specified to be used in the analysis of the market
structure, nor are there any definitions of the market to be analysed.
5.3. Hedging groups of net positions

Treasurers commonly group similar risk exposures and hedge only the net position and so IFRS 9 provides the potential
to align the accounting approach with the risk management strategy.
For cash flow hedges of a group of items that are expected to affect P&L in different reporting periods, the qualifying
criteria are:
Only hedges of foreign currency risk are allowed.

The items within the net position must be specified in such a way that the
pattern of how they will affect P&L is set out as part of the initial hedge
designation and documentation (this should include at least the reporting
period, nature and volume).
PwC insight:
IFRS 9 requires the presentation of the gains and losses on recycling as a separate line item in P&L (separate from
the hedged items), and so it does not allow an entity to present net the post-hedging results of its commercial
activities for those line items. This may mean that hedginge net positions is not as widely used as it might
otherwise be.
In addition, net nil positions (that is, where hedged items among themselves fully offset the risk that is managed on a
group basis) are now allowed to be designated in a hedging relationship that does not include a hedging instrument,
provided that all the following criteria are met:
The hedge is part of a rolling net risk hedging strategy (that is, the entity
routinely hedges new positions of the same type);
The hedged net position changes in size over the life, and the entity uses eligible
hedging instruments to hedge the net risk;
Hedge accounting is normally applied to such net positions; and
Not applying hedge accounting to the net nil position would give rise to
inconsistent accounting outcomes. The Board expects that hedges of net nil
positions would be coincidental and therefore rare in practice.
5.4. Hedging layers of a group

Under IFRS 9, a layer of a group can be designated as the hedged item. A layer component can be specified from a
defined, but open, population or from a defined nominal amount. Examples include:
A part of a monetary transaction volume (such as the next CU10 cash flows
from sales denominated in a foreign currency after the first CU20 in March
201X);
A part of a physical or other transaction volume (such as the first 100 barrels of
the oil purchases in June 201X, or the first 100 MWh of electricity sales in June
201X); or
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A layer of the nominal amount of the hedged item (such as the last CU80 million
of a CU100 million firm commitment, or the bottom layer of CU20 million of a
CU100 million fixed rate bond, where the defined nominal amount is CU100
million).
If a layer component is designated in a fair value hedge, an entity must specify it from a defined nominal amount. To
comply with the requirements for qualifying fair value hedges, an entity must re-measure the hedged item for fair value
changes attributable to the hedged risk. The fair value adjustment must be recognised in P&L no later than when the
item is derecognised. Therefore, it is necessary to track the item to which the fair value hedge adjustment relates.
Entities are required to track the nominal amount from which the layer is defined in order to track the designated layer
(for example, the total defined amount of CU100 million sales must be tracked in order to track the bottom layer of CU20
million sales or the top layer of CU30 million sales).
A layer of a contract that includes a prepayment option (if the fair value of the prepayment option is affected by changes
in the hedged risk) is only eligible as a hedged item in a fair value hedge if the layer includes the effect of the prepayment
option when determining the change in fair value of the hedged item. In this situation, if an entity hedges with a hedging
instrument that does not have option features that mirror the layer’s prepayment option, hedge ineffectiveness would
arise.
5.5. Aggregated exposures

Under IFRS 9, a derivative can be a hedged item, and derivatives can be combined with another exposure (i.e. an
aggregated exposure) to be designated as a hedged item.
6. Alternatives to hedge accounting
6.1. Extended use of fair value option for 'own use' contracts
Under IFRS 9 entities can apply the fair value option to contracts to buy or sell non-financial items which qualify for the
‘own use’ exception at initial recognition. These are contracts that can be net settled but that were entered into for the
purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or
usage requirements.
6.2. Option to designate a credit exposure at fair value through P&L

IFRS 9 states that the credit risk of a debt instrument is a risk component that does not meet the eligibility criteria to be
designated as a hedged item. The spread between the risk free rate and the market interest rate incorporates credit risk,
liquidity risk, funding risk and any other unidentified risk components and margin elements. Therefore, the Board
believes that credit risk cannot be isolated, and so does not meet the separately identifiable criteria in IFRS 9.
Credit derivatives (such as credit default swaps) that are used to hedge credit risk are accounted for at fair value through
P&L, while credit exposures are usually measured at amortised cost or are unrecognised (for example, loan
commitments). Where there is credit deterioration, this results in recognising gains on the credit derivative while the
impairment on the hedged item is measured on a different basis, which results in P&L volatility that does not reflect the
credit protection obtained.
IFRS 9 provides the option to designate the financial instrument (all or a proportion of it) at fair value through P&L. This
option is available only where:
The name of the credit exposure (for example, the borrower or the holder of a
loan commitment) matches the reference entity of the credit derivative (‘name
matching’); and
The seniority of the financial instrument matches that of the instruments that can
be delivered in accordance with the credit derivative.
This fair value option is different from the one described for ‘own use’ contracts, since this can be elected at initial
recognition, subsequently or even while the hedged credit exposure is unrecognised (for example, in the case of a loan
commitment). In addition, it is not irrevocable but, once this option is elected, specified criteria must be met to
discontinue its use.
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PwC insight:
Banks often use credit default swaps linked to an index to hedge the credit risk for a portfolio of instruments. Due to
the IFRS 9 requirement of a link between the financial instrument through the matching of the name of the borrower
or seniority, such index-based credit default swaps would not be eligible hedging instruments.
Another aspect to consider is that the fair value of a financial instrument is comprised not only of credit risk but it
considers additional effects (for instance, interest rate risk). When designating a financial instrument at fair value
through P&L those additional effects would not be offset by the changes in the value of the credit derivative.
Corporates refer to proxy hedging where for example they hedge commodity price risk but as a result of the
availability of commodity derivatives, entities use a hedging instrument referenced to a commodity different to the
actual commodity they are economically hedging, but the price of the two commodities are correlated enough to
make the hedge relationship work.
In addition, some financial institutions use intragroup derivatives for risk management purposes. However, as
intragroup derivatives do not qualify for hedge accounting at the group level, they are required to define external
derivatives as proxy hedges.
7. Disclosures
The disclosures are required for each ‘category of risk’ that an entity decides to hedge (for example, interest rate risk,
foreign currency risk or commodity price risk). IFRS 9 does not prescribe the risk categories to be used. An entity should
apply judgement and categorise risks on the basis of how it manages its risks through hedging.
However, an entity should apply its risk categories consistently throughout the entire hedge accounting disclosures.
The required hedge accounting disclosures provide information about:
An entity’s risk management strategy and how it is applied to manage risk;

How the entity’s hedging activities might affect the amount, timing and
uncertainty of its future cash flows;
The effect that hedge accounting has had on the entity’s financial statements;
and
Whether the entity is applying the option to designate a credit exposure as

measured at fair value through P&L.
The disclosure requirements for each of these four areas are very detailed and are not covered in detail in this publication.
Frequently asked questions
Introduction
This section covers, in question and answer form, the issues that we are most frequently asked.
This section is designed as a quick reference guide for those seeking a short answer on a particular point. Most of the
questions and answers in this section are relatively brief; with many of the issues covered in further detail in the illustrations
in Section 3.
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We have organised the questions and answers under individual topics. Where questions cover more than one point they
have been classified under the main topic covered. An index of all the questions and answers is provided on the following
pages.
Some FAQs include a reference to IAS 39 Implementation Guidance. Although IFRS 9 did not carry forward the IAS 39
Implementation Guidance, in its Basis for Conclusions, the IASB emphasised that not carrying forward the Implementation
Guidance did not mean that it had rejected that guidance. [IFRS 9 para BC6.95].
Warning: hedge accounting can be obtained only if all of the relevant conditions in IFRS 9 are met. While individual questions
and answers may focus on only one aspect of a hedge relationship, this does not imply that the other requirements are
unimportant.
1. Hedged item
1.1. Risk components of non-financial items –

meaning of market structure
Reference to standard: IFRS 9 paras B6.3.8, B6.3.9, B6.3.10

Reference to standing text: 46.73
Industry: Corporate Treasury
Question
In determining whether a risk component is an eligible hedged component of a non-financial item, what is meant by
the market structure in which the hedging activity takes place?
Illustration
To be eligible for designation as a hedged item, a risk component must be a separately identifiable component, and the
changes in cash flows or fair value of the item attributable to a change in that component must be reliably measurable. (IFRS
9 paragraph B6.3.8)
IFRS 9 requires the qualifying criteria for an eligible risk component to be assessed in the context of the particular market
structure to which the risks relate and in which the hedging activity takes place (IFRS 9 paragraph B6.3.9).
Solution
In the case of a non-financial item, for there to be a hedgeable risk component it would generally be necessary for the price
of the entire item to be built up from various components using a ‘building block’ approach to demonstrate an appropriate
market structure. For example, it should be clear that informed buyers and sellers of this non-financial item would consider
the price of the component proposed to be hedged (such as raw materials) in establishing the price of the overall non-
financial item. Consideration of the approach of other market participants is necessary to demonstrate that the market
structure supports the designation as a risk component.
The evidence required to support the market structure is a matter of judgement based on facts and circumstances, but
should not rely solely on the entity’s own negotiating position or standard costing systems.

meaning of separately identifiable

Question
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How should an entity determine whether changes in cash flows or fair value attributable to changes in a hedged
component are separately identifiable? Is it sufficient for a risk component to be an input in the manufacturing
process of a non-financial item?
Illustration
changes in cash flows or fair value of the item attributable to change in that component must be reliably measurable (IFRS 9
paragraph B6.3.8).
An entity wishes to hedge a non-contractually specified risk component of a non-financial item. If the risk component is an
input in the manufacturing process of the non-financial item, is this sufficient for the risk component to be a separately
identifiable hedged item?
Solution
No. In general, it will be necessary for the risk component to be an input in the manufacturing process in order to be
considered as ‘separately identifiable’, and so meet the criteria in IFRS 9. However, merely being an input in the
manufacturing process is not, in itself, sufficient. Paragraph B6.3.9 of IFRS 9 requires that the qualifying criteria for an eligible
risk component should be assessed in the context of the particular market structure to which the risks relate and in which
the hedging activity takes place.
For example, wool is an input in the manufacturing process for woollen sweaters. Whether the wool price is a hedgeable risk
component of the total price of the sweater depends on the market structure for the particular sweater. In the luxury apparel
market, the price of the raw material (wool) will often have a low impact on the price of a woollen sweater that will instead
mainly reflect the perceived value of the brand. In such a market, the wool price is unlikely to be an eligible risk component
for a retailer. On the other hand, the price of a ‘no frills’ sweater of a generic design might be driven by the cost of the inputs
into the manufacturing process (such as raw materials, labour and overheads) and a production margin. This is likely to give
rise to a hedgeable risk component for the wool price component.
While it will, in general, be necessary for the risk component to be an input into the manufacturing process, there might be
rare cases where the market structure is clear that a non-financial risk component is a separately identifiable component,
even in the absence of a physical presence. For example, in some markets a long-term supply contract for natural gas may
be based on a contractually specified formula that refers to indices including, inter alia, the price of crude oil. If a supply
contract is in place, the crude oil price component would be considered to be an eligible risk component, because it is
‘explicitly specified’ in the contract. Equally, if a supply contract is not yet in place but the market commonly prices
purchases of natural gas under long-term contracts in this manner, the crude oil price component would still be a hedgeable
non-contractually specified risk component. This would be true for a highly probable forecast purchase of natural gas
beyond the period for which liquid derivatives are available, despite crude oil not being an input in the manufacturing process
for natural gas, when such pricing mechanism for natural gas (that is, the linkage to the crude oil prices) is the ‘industry
norm’. A different conclusion may be reached in a jurisdiction where pricing for natural gas is not based on crude oil, for
example, where there is a liquid spot and forward market for natural gas for the period being hedged.

meaning of reliably measurable

Reference to standing text:46.73
Question
How should an entity determine whether changes in cash flows or fair value attributable to changes in a hedged
component are reliably measurable?
Illustration
changes in cash flows or fair value of the item attributable to change in that component must be reliably measurable (IFRS 9
paragraph B6.3.8).
Company A wishes to designate a risk component as a hedged item. How should company A assess if the ‘reliably
measureable’ criterion is met?
Solution
Changes in cash flows or fair value attributable to changes in the hedged component would be considered reliably
measurable where the price of a non-contractually specified risk component has a predictable and direct impact on the price
of the entire item. A linear relationship, where changes in the price of the risk component have an equivalent (though not
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necessarily one-to-one) impact on the price of the entire item, in the absence of changes in other inputs, would generally
create such a predictable and direct impact.
Nevertheless, a non-linear relationship might also be sufficient for a risk component to be considered an eligible hedged
component. For example, the prices of many items are only updated periodically, or where input prices increase or decrease
beyond a reasonable threshold, creating ‘stepped’ changes in the link between the price of the risk component and the price
of the entire item. Accordingly, an entity will need to analyse the nature of the non-linear relationship, and the reasons for that
relationship, to establish whether the risk component is implicit in the fair value or cash flows of the entire item and hence is
an eligible hedged component.
Factors to be considered in making this assessment should include:
Absolute magnitude of the ‘steps’, before a change in the price of the risk
component influences the change in price of the entire item. For example, the price
of a luxury wool sweater will have limited correlation with the price of the raw
material (wool).
Frequency of updates to the price of the entire item in response to changes in the
price of the risk component.
Sensitivity of changes in the price of the entire item to its supply and demand (and
the supply and demand of substitutes), compared with changes in the price of the
risk component.
Whether changes to the price of the entire item are one-sided (such as increases
only) or prices are ‘stickier’ in one direction (for example, price increases occur
more frequently or in greater magnitude than decreases).
The reason that changes in the price of the component are not passed on
immediately. For example, where increases in the price of the component are not
passed on because the market cannot fully absorb such changes, this might
indicate that the market structure is not consistent with a ‘building block’ approach.
Whether or not the impact of a risk component on the price of the entire item is non-linear is factored into the assessment of
whether it qualifies as an eligible hedged component of the non-financial item; if an eligible risk component exists, it does not
impact hedge effectiveness. Accordingly, once an eligible risk component has been identified, it is assumed to have a linear
impact on the hedged item. This is because the non-linear element in the overall pricing reflects the willingness of an entity to
absorb certain input price movements within its profit margin rather than pass the increase on to customers. In such
circumstances the underlying relationship is linear, but the entity is willing to temporarily reduce or increase its margin.
Accordingly, part of the profit margin is inversely correlated with the risk component for short periods and/or small price
changes, which does not preclude the use of a linear relationship for assessing hedge effectiveness. If this inverse
correlation exists for longer periods or larger price changes, however, it would call into question the original assessment that
there is an eligible risk component and the validity of the hedge as a risk management strategy.
Assessing whether a risk component is implicit in the fair value or the cash flows of the entire item, and whether the changes
in fair value or cash flows that are attributable to the risk component are reliably measurable is highly judgemental. Practice
is likely to develop based on risk management strategies undertaken by entities. Management will need robust evidence,
demonstrating the particular market structure, to support its assertion that the risk component qualifies as a hedged item.
Given the judgement involved this could be a significant accounting judgement under IAS 1 that would require disclosure in
the financial statements.
1.4. Cash flow hedges of future interest flows
Reference to standard: IFRS 9 paras 6.4.1, 6.6.3

Question
Are the following cash flow hedge designations of future interest flows permitted under IFRS 9?
Illustration
Consider the following scenarios. NB: In all scenarios both the swap and the hedged debt are denominated in Company A’s
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functional currency.
Scenario 1
Company A enters into a forward starting swap in which it pays a fixed rate and receives a floating interest rate to hedge a
highly probable forecast debt issuance. The date of issuance is known, but it is not known whether the debt will be at fixed–
or floating– rates. Company A designates the swap as a cash flow hedge of the variability in cash flows of the debt to be
issued, due to changes in interest rates. As a result, the company considers the following:
If the forecast issuance is at fixed rate, the swap will be terminated (or an opposing swap with the same residual maturity will
be taken out to close the swap position) and hedge accounting will be discontinued.
If the forecast issuance is at floating–rate, then the hedge relationship is maintained with the existing swap and therefore
hedge accounting will continue to be applied.
Scenario 2
Company B enters into an interest rate swap in which it pays a fixed rate and receives a floating interest rate. Company B
designates the swap as a cash flow hedge of the variability, due to changes in interest rates, of the cash flows resulting from
a combination of current floating rate debt (with a maturity shorter than that of the swap), followed by a highly probable
forecast issuance of either fixed or floating rate debt for the remaining term of the swap (the latter is similar to scenario 1).
Scenario 3
Company C enters into a similar structure as in scenario 2 above. However, in this case the precise date when the existing
floating debt will be rolled over into either floating– or fixed–rate debt is not known. The company can demonstrate that it has
a highly probable funding requirement of at least CU1 million throughout the life of the swap, which will be satisfied by
issuing either fixed– or variable–rate debt. The swap is designated as a cash flow hedge of the variability of future interest
cash flows on the first CU1 million of debt in issue over the life of the swap.
Solution
Yes, all of the above designations are allowed under IFRS 9 provided all the qualifying criteria in IFRS 9 6.4.1 are met,
including for example that the intention to hedge changes in interest rates is in line with the entity’s risk management
strategy. Entities may designate their hedge relationships in alternative ways depending on their facts and circumstances.
Designation of the risks associated with forecast transactions is permitted as long as they are highly probable.
In the case of scenario 3, in which a layer is designated as the hedged item, IFRS 9 6.6.3 requires among other aspects that
the layer must be separately identifiable and reliably measurable. The forecast transaction must be identified and
documented with sufficient specificity so that when the transaction occurs it is clear whether the transaction is or is not the
hedged item. A drawback of designation of a layer is the complexity in proving that the designated level of funding is highly
probable. For example, when entities specify the interest payment for a particular loan, then there is no need to prove that
the cash flows are highly probable since those are contractually specified. When entities do not designate a specific contract
then it is necessary to demonstrate that it is highly probable that there will be a need for a certain level of financing of a kind
that meets the designated hedged item.
In all of the above scenarios, where the hedged item is issued floating–rate debt, ineffectiveness may arise, for example if the
reset dates or interest basis of the swap differ from those of the issued debt.
1.5. Forecast foreign currency debt issuance
Reference to standard: IFRS 9 para 6.5.2

Question
Is a highly probable forecast foreign currency debt issuance eligible as a hedged item in a cash flow hedge of foreign
currency risk?
Illustration
On 1 January 20X1, it is highly probable that company X (with EUR functional currency) will issue, on 1 July 20X1, USD 100
million of five–year, fixed–rate debt, with quarterly coupons. On 1 January 20X1, the EUR: USD spot and six–month forward
exchange rates are 1:1. The proceeds from the issuance of the debt are needed to finance the expansion of the company’s
production facilities in Europe. The company is concerned that the EUR:USD exchange rate will fluctuate, such that
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additional USD debt will need to be issued in order to lock in the desired EUR 100 million in proceeds, which in turn will
affect the interest incurred on the foreign currency debt to be issued.
Therefore, on 1 January 20X1, company X enters into a six–month forward to buy EUR and sell USD at 1:1. This transaction
is on market at zero cost, because the six–month forward rate is 1:1.
Is the variability in functional currency equivalent proceeds, expected to be received from the forecast issuance of debt
denominated in a currency other than the reporting entity’s functional currency, eligible for designation as the hedged
transaction in a cash flow hedge of foreign currency risk?
Solution
No. The hedged item (risk of changes in foreign exchange rates before the forecast issuance of foreign currency debt) does
not affect profit or loss when the transaction is settled or in subsequent periods. In this situation, company X is concerned
about foreign exchange spot movements between the hedge inception date and the debt issuance date, specifically the risk
associated with converting the foreign currency denominated debt proceeds into its functional currency. While this
represents a risk from an economic and cash flow perspective and will impact interest expense in future periods, the impact
on future interest expense is not the risk being hedged.
1.6. Aggregated hedge – forecast debt issuance

where the currency of issuance is not certain

Question
Is a highly probable forecast foreign currency debt issuance eligible as a hedged item in a cash flow hedge of
interest rate risk if the currency of issuance is not yet known?
Illustration
At 1 January 200X, entity A, whose functional currency is the Euro, intends to issue a variable interest rate debt in six
months’ time in order to finance future activities. Depending on the market conditions existing at 1 July 200X, entity A will
decide whether the debt is issued in Euros or in US dollars. If the debt is issued in US dollars, then at the debt issuance date
(1 July 200X) entity A will enter into a cross-currency swap in order to convert the US dollar exposure on the debt to a Euro
exposure.
Management wants to hedge its exposure to variable interest rates. On 1 January 200X, it contracts a forward-starting
interest rate swap (that is, an interest rate swap that will start on 1 July 200X) which is denominated in Euros.
Solution
Yes. Under IFRS 9, an aggregated exposure that is a combination of a forecast transaction that could qualify as a hedged
item and a derivative can be designated as a hedged item, provided that the aggregated exposure is highly probable and,
once it has occurred and is therefore no longer forecast, it is eligible as a hedged item.
As a result, the proposed designation is acceptable, provided that it is in line with entity A’s risk management strategy and
objectives. In the illustration, the designated hedged item would be the highly probable variable interest payments in Euros
(entity A’s functional currency), arising either from the Euro debt or the aggregated exposure (US dollar debt swapped into
Euros by using the cross-currency swap
1.7. Hedge of a net position

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Question
In what situations can an entity hedge a net position?
Illustration
A EUR-functional currency entity has a sales department that sells certain items in USD. At the same time, the purchasing
department buys certain products in USD. Each department is unaware of the other’s activities, but both want to hedge their
forecast USD sales and purchases respectively. Assume that the sales department has USD100,000 of sales in six months’
time, so it enters into a forward contract with the entity’s central treasury department (that is a separate entity within the
same group). The purchasing department has highly probable forecast purchases of USD90,000, also in six months’ time,
and it also enters into an internal derivative with the central treasury department. Both the sales and purchasing departments
view their derivative as a hedging instrument, but the group cannot apply hedge accounting, because the derivative is
internal to the group and so it is eliminated on consolidation.
However, in order to hedge the group’s exposure, the treasury department enters into a forward with a bank for USD10,000.
By doing this, the group is economically hedged. However, under IAS 39, it was not possible to designate the net position of
USD10,000 (comprised of USD100,000 sales and USD90,000 purchases) as a hedged item. Instead, the group had to
designate USD10,000 out of the USD100,000 of future sales as the hedged item. This did not reflect the entity’s risk
management strategy and is not how the entity tracked the appropriateness of the economic hedge relationship.
Under IFRS 9 can the group designate the net position of USD10,000 as the hedged item?
Solution
Yes. Under IFRS 9, a net position that incorporates offsetting positions can be designated as a hedged item, provided all
items included in the group are individually eligible as hedged items and the items in the group are managed together on a
group basis for risk management purposes. This means that the group can now apply hedge accounting to a net position
comprised of sales of USD100,000 and purchases of USD90,000 with a USD10,000 derivative, which mirrors the entity’s risk
management.
However, the hedging gains and losses on recycling must be presented as a separate line item in P&L (separate from the
hedged items). An entity cannot present the post–hedging results of its commercial activities for the individual line items
affected. [IFRS 9 para B6.6.15-16].
1.8. Hedging interest and foreign currency risk

by designating an aggregated exposure

Question
Can an entity achieve hedge accounting if it adds an additional derivative to a pre-existing hedge relationship?
Illustration
Entity A, which has USD as its functional currency, takes out a 10-year floating rate loan in EUR (a foreign currency). It wants
to eliminate its exposure to variability in cash flows from changes in interest rates, so it enters into a floating-to-fixed interest
rate swap in EUR. To reduce volatility in P&L, it designates the swap in a cash flow hedge. In a later period, it also wants to
eliminate the foreign currency exposure, so it takes out a USD:EUR fixed- fixed cross-currency interest rate swap to
eliminate its exposure.
Under IFRS 9 can entity A achieve hedge accounting by designating the cross-currency interest rate swap as hedge of the
combination of the debt and the existing interest rate swap?
Solution
Yes. Under IFRS 9 the aggregated exposure (that is, a combination of the debt instrument plus the interest rate swap) is
eligible to be designated as the hedged item, without needing to de–designate the original interest rate hedge. This is
consistent with the entity’s strategy of simply overlaying the second derivative to eliminate the net foreign currency risk.
This is different from IAS 39. IAS 39 would not allow the issuer to designate the combined loan and EUR interest rate swap
as the hedged item, as a derivative generally cannot be a hedged item. Under IAS 39, the entity would instead have needed
to combine the original swap and the new cross-currency interest rate swap as the hedging instrument, which would require
the de-designation of the original interest rate hedge.
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1.9. Hedging cash flows in specific time

buckets
Reference to standard: IFRS 9 para B6.3.18

Reference to standing text: 46.77, 46.35
Question
Can management designate forecast sales as the hedged item if it is unable to link the forecast future cash flows to
specific individual sales transactions?
Illustration
Company T manufactures and sells ice cream. Its functional currency is the Euro, and 30% of its sales are made in the UK
and denominated in GBP. Management forecasts highly probable sales in the UK for the next summer season on a monthly
basis. Using these forecasts, the entity enters into forward contracts to sell GBP in exchange for Euros. Due to the nature of
its business, company T is not able to forecast or track individual sales transactions.
Solution
Yes. Management can designate the forecast sales as the hedged item by using the layer approach. The layer approach is
specifically permitted by IFRS 9. It would designate the hedged item as the first GBP X million of highly probable cash flows
from sales in specific time buckets (for example, GBP sales in each month). To qualify for hedge accounting, the designation
must be sufficiently specific to ensure that, when a forecast transaction occurs, it is possible to determine objectively
whether that transaction is or is not one that is hedged. In addition, IFRS 9 requires that such forecast sales be discounted
from the date they are expected to occur. In the event the date of the forecast sale is not aligned to that of the hedging
instrument, some ineffectiveness will arise.
If the hedged cash flows do not occur in the designated time bucket, management cannot continue to defer the related
hedging gains/losses in equity and must transfer them to the income statement. Under IFRS 7, an entity will need to disclose
the amounts reclassified from the cash flow hedge reserve into profit or loss because the hedged item has affected profit or
loss separately from the amounts that have been transferred because the hedged future cash flows are no longer expected
to occur.
1.10. Forecast inter-company dividends
Reference to standard:IFRS 9 para 6.3.6

Question
Are forecast inter-company dividends which are undeclared but expected to be paid and received in a foreign
currency an eligible hedged item in consolidated financial statements?
Illustration
Company Q, whose functional currency is the GBP, has a subsidiary in the US, whose functional currency is the US dollar.
On 1 January 200X, company Q’s management forecasts that it will receive an USD100m dividend from its US subsidiary in
six months. The inter-company dividend was declared and approved on 30 April 200X, at which time both company Q and
its subsidiary recognised the dividend as a receivable and payable respectively.
The foreign currency dividend receivable in company Q’s balance sheet was retranslated at the reporting period end, 31 May
200X, resulting in a foreign currency loss. The subsidiary paid the dividend on 30 June 200X, resulting in a further foreign
currency loss.
Company Q’s management designated the highly probable inter-company dividend as the hedged item in a cash flow hedge
from 1 January 200X to 30 June 200X, in order to hedge the exposure to changes in the GBP/USD exchange rate.
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Solution
No. IFRS 9 does not permit hedge accounting to be applied to hedges of inter-company transactions in consolidated
accounts except in certain specified circumstances, such as where the foreign currency risk on intra-group monetary items is
not eliminated on consolidation.
Undeclared inter-company dividends are not foreign currency transactions that are eligible hedged items under IFRS 9,
because they do not affect the consolidated income statement; they are distributions of earnings.
On the other hand, the foreign currency exposure arising from the dividend receivable in US dollars recognised on 30 April
200X could be designated as a hedged item, because it gives rise to foreign currency gains and losses that do not fully
eliminate on consolidation and therefore affect the consolidated income statement. Company Q’s management can therefore
only apply hedge accounting from 30 April 200X, when the dividend is declared, until 30 June 200X when the cash is
received.
1.11. Hedging intra-group monetary items

Question
How can a parent, in its consolidated financial statements, hedge the foreign currency exposure of an intra-group
receivable?
Illustration
Group X comprises a parent and two subsidiaries, Subsidiary A and Subsidiary B. Subsidiary A, whose functional currency is
the euro, has an intra–group receivable from subsidiary B, whose functional currency is the Swiss franc (CHF). The receivable
is denominated in Swiss francs, and subsidiary A enters into a EUR/CHF forward contract with an external party to hedge the
resulting foreign currency risk.
In its separate financial statements, subsidiary A translates the receivable into euros, using the spot rate at the balance sheet
date, and recognises a foreign currency gain or loss in accordance with IAS 21. Subsidiary B, in its separate financial
statements, records the payable to subsidiary A in its own functional currency and does not recognise any gain or loss. On
consolidation, the gain or loss recognised by subsidiary A is translated into the group’s presentation currency and is
recognised in the group’s income statement. There is no offsetting loss or gain arising from subsidiary B.
Subsidiary A uses a EUR/CHF forward contract to hedge the foreign currency exchange risk on the receivable from
subsidiary B in its separate financial statements. As the receivable gives rise to an exposure to foreign currency gains or
losses that is not fully eliminated on consolidation, the foreign currency exposure on the intra–group receivable can be
designated as the hedged item in the consolidated financial statements.
Solution
The group can designate the EUR/CHF forward contract in subsidiary A as the hedging instrument. The hedge accounting
achieved by subsidiary A is reversed on consolidation and replaced with hedge accounting achieved by the group.
For group purposes, it is not necessary for the subsidiary to take out the forward contract for the foreign exchange exposure
on the intra–group receivable to qualify as a hedged item on consolidation. The parent entity could have taken out the same
forward contract hedging the EUR/CHF exchange risk instead.
1.12. Hedging intra-group forecast

transactions

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Question
In what situations will an entity be able to demonstrate linkage to an external transaction and hedge the foreign
currency risk of an intra-group forecast transaction?
Illustration
One of the conditions for the foreign currency risk of a highly probable forecast intra-group transaction to be designated as a
hedged item in the consolidated financial statements is that the foreign currency risk will affect the group’s consolidated
P&L. This condition is met where the forecast intra-group transaction is related to an external transaction. In which kinds of
scenarios will an entity be able to demonstrate the necessary linkage to an external transaction in order to meet this
condition?
Scenario 1 – Linkage to an external sale of the same item
Group A (which uses pound sterling as its presentation currency) includes entity B, with euro functional currency, and entity
C, with US dollar functional currency, in the consolidation. Entity B manufactures tyres and incurs production costs in euros.
It sells most of the tyres to entity C, and those transactions are denominated in US dollars. Entity C markets and sells those
tyres to external customers in the US, also in US dollars.
In June 20X6, entity B forecasts that it will sell tyres to entity C in October 20X6 amounting to US$10m. These sales are
highly probable, and all the other conditions in IFRS 9 for hedge accounting are met. Entity C expects to sell this inventory to
external customers in early 20X7. At the same time in June 20X6, entity B enters into a euro/US$ derivative (buy EUR/sell
US$) to hedge the foreign currency risk of the forecast sale of US$10m to entity C in October 20X6.
Group A intends to designate the forward contract as hedging the foreign currency risk of the forecast intra–group sales of
US$10m by entity B in a cash flow hedging relationship in the consolidated financial statements.
Solution
In this situation, the group can achieve hedge accounting because all of the following conditions are met:
The intra–group sales are highly probable, and all of the other conditions for using
hedge accounting are met.
The intra–group sales are denominated in a currency (US$) other than entity B's
functional currency (euro).
The existence of the expected onwards sale of the inventory in US dollars to third
parties outside the group results in the hedged exposure affecting the pound
sterling consolidated P&L. This is because the intra–group profit on sale recognised
in entity B is denominated in euros that is fixed according to the EUR/US$ rate
when the sale takes place in October 20X6. This profit is eliminated on
consolidation against the carrying value of tyre inventory in entity C and released to
consolidated P&L when the onward sale of inventory to third parties takes place in
20X7.
Gains/losses on the EUR/US$ derivative are recognised initially in other comprehensive income and consolidated equity to
the extent that the hedge is effective. These amounts are reclassified to consolidated profit or loss in 20X7 when the external
sales occur.
Scenario 2 – Linkage to an external sale of a different item
A parent company with a Swedish Krona (SEK) functional currency has incurred costs of SEK10m in developing the
manufacturing process necessary to make product A. The technical know–how is transferred to its US subsidiary.
Management estimates that 10,000 units of product A will be produced and sold at a market price of USD500 per unit over
the three–year period during which product A is marketed.
With the transfer of the manufacturing process, the US subsidiary agrees to pay the parent company a royalty of SEK 1,200
per unit sold of product A. According to the initial calculations, the cost of goods sold will be USD200 + USD150 for the
royalty payment to the parent company based on the exchange rate at the date of the agreement (SEK8 : USD1). The
agreement is for a period of three years and is capped at 10,000 units. At the end of three years or after 10,000 units have
been sold, the US subsidiary can use the technology without paying any further royalties.
At the date of the agreement, the US subsidiary enters into foreign currency forward contracts to hedge the foreign currency
risk of the forecast intra–group payments of royalties on the highly probable external sales transactions.
Solution
It is possible to designate the foreign currency risk in the intra–group royalty payment as the hedged item in a cash flow
hedge in the group accounts; this is because the royalty payments are a necessary cost of the goods being sold and are
therefore directly related to the external sale.
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The standard notes the difficulty in demonstrating that there is a related external transaction for intra–group royalty and
interest payments, but does not preclude the use of hedge accounting for such transactions where a clear link to an external
transaction can be demonstrated.
1.13. Hedging forecast foreign currency

revenue of a subsidiary

Question
Can a parent hedge forecast future revenues denominated in the functional currency of a subsidiary which is
different from the functional currency of the parent?
Illustration
Entity A, based in Germany, whose functional currency is the euro, has a subsidiary in the UK, whose functional currency is
GBP. The group's presentation currency is also the euro. The UK subsidiary sells gas within the UK for GBP to British
customers.
At the group level, the group’s treasury department enters into an external GBP/euro forward contract to hedge against
movements in GBP versus euro on behalf of the group.
Can the group apply cash flow hedge accounting?
Solution
No. The group cannot obtain cash flow hedge accounting for the UK subsidiary sales. The sales of the UK subsidiary are
made in its functional currency, so it has no foreign currency exposure. The consolidated group has a foreign currency
exposure, but it will not affect the group's reported net P&L. At the consolidated level, the foreign currency exposure will be
deferred as part of cumulative translation adjustment in equity when the UK subsidiary's financial statements are translated
into the group's presentation currency for consolidation. [IAS 21 para 39(c)]. Group management might, therefore, consider
the possibility of net investment hedge accounting under paragraph 6.5.2 of IFRS 9. However, the group will not be able to
obtain hedge accounting for hedges of the subsidiary’s forecast sales.
1.14. Cash flow hedge of the foreign currency

risk of a forecast business combination
Reference to standard: IFRS 9 paras 6.3.1, 6.3.3, 6.2.4(b)

Question
Can a hedge of the foreign currency risk on a forecast business combination be accounted for as a cash flow hedge?
Illustration
Entity A, whose functional currency is the Euro, on 1 March 20X1 started negotiations with entity B (an overseas entity) in
order to take control of entity B and gain access to the overseas market. On 1 August 20X1, entity A and entity B agree the
key terms of the transaction, including the purchase price which will be denominated in a fixed amount of the overseas
currency. However, entity A has not yet received a required approval from the overseas authorities. On 29 March 20X2, entity
A and entity B agree the full terms of the transaction and the overseas authorities have granted their approval. At this point,
there are no significant uncertainties that could affect the completion of the business combination. Entity A’s risk
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management strategy is to hedge forecast transactions in a foreign currency as soon as they are highly probable. The entity
intends to use a forward contract to hedge the payment in the overseas currency.
Can hedge accounting be achieved in this scenario?
Solution
Yes. However, the forecast business combination must be highly probable in order to be an eligible hedged item.
Could entity A apply hedge accounting to the forecast transaction at 1 August

20X1?
It depends. In order to apply hedge accounting to a forecast transaction, this transaction must be highly probable. Whether
this is the case will depend on the specific facts and circumstances and the significance of the outstanding contingencies
affecting the completion of the transaction. In some territories, a regulatory process could be considered perfunctory or a
‘rubber stamping’ of the agreement and so the transaction can be considered highly probable before receiving the formal
approval. However, in other cases the regulatory approval process will be more substantive and there will be significant
uncertainty over whether it will be received, such that the transaction can be considered highly probable only once the formal
approval is received.
Can entity A designate only the spot component of the forward contract as the
hedging instrument?
Yes. Once the hedge accounting criteria are met, the entity can choose either to designate the full fair value of the forward
contract as a hedging instrument or to separate the forward element and to designate only the spot component of the
hedging instrument (on a discounted basis). ). Similarly, the entity may choose to separate the foreign currency basis spread
and exclude it from the designated hedge. Changes in the value of the forward element/foreign currency basis spread are
either taken to P&L or to OCI if the cost of hedging approach is applied as explained further in FAQ 3.7 and section 4.5-6 of
Section 1.
2. Hedging instrument
2.1. Purchased option as a hedging instrument
Reference to standard: IFRS 9 paras 6.2.1, 6.3.7, B6.3.12

Question
Can an entity use a purchased option as a hedging instrument in a cash flow hedge?
Illustration
Entity A operates a mail–order business. Its functional currency is the euro, but it purchases approximately 20% of its
merchandise from the USA.
Entity A issues the mail–order catalogue for the coming year, incorporating its price list, before entering into a firm purchase
commitment with US suppliers. Entity A, therefore, sets the prices in the catalogue based on expected exchange rates of
EUR1=USD1.25. It is highly probable that the entity will make purchases of at least EUR500,000 from the USA in the first six
months.
The entity's documented risk management policy requires it to hedge the risk that exchange rates will be higher than
expected by purchasing a call option to buy US dollars for euros, with a strike price equal to the expected exchange rate.
Entity A, therefore, purchased a call option at a rate of EUR1=USD1.25, for EUR500,000 in six months' time at a cost of
EUR60,000. The purchases will be settled in cash at the date of delivery.
The spot rate at the time of entering into the option contracts was EUR1=USD1.1.
Solution
Yes. Entity A can designate the intrinsic value of the purchased option as a hedge against movements in the exchange rate
on the forecast purchases. The exposure being hedged is the variability in cash flows that arises if the US dollar exchange
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rate exceeds the expected level of EUR1=USD1.25. To the extent the hedge is effective, fair value movements on the
intrinsic value of the option are recorded through other comprehensive income and deferred in equity until the hedged item
(the forecast purchases) occur.
The use of options as hedging instruments under IAS 39 was limited due to the need to record fair value movements in the
time value through profit or loss. IFRS 9 requires the costs of hedging model to be used when an entity designates as the
hedging instrument only the change in intrinsic value of an option. The benefit of the costs of hedging model is that the fair
value movements in time value are recorded through other comprehensive income and deferred in equity until the purchases
are made.
When the purchases are made and Entity A recognises inventory it transfers the balance in the hedging reserve to inventory
(known as a basis adjustment). The balance in the costs of hedging reserve is also transferred to inventory at the same time.
Note that these are not reclassification adjustments and the transfers do not go through other comprehensive income.
See FAQ 4.2 for further details on de-designation of hedges when hedged purchases result in accounts payable balances.
2.2. Calculation of intrinsic value
Reference to standard: IFRS 9 paras 6.2.4(a), ,

Question
How should an entity calculate the intrinsic value of an option?
Illustration
Entity A takes out an interest rate cap to hedge the exposure to interest rates on floating–rate debt of C1 million. The cap has
a strike rate of 3% and the designated hedged risk is changes in the interest cash flows of the debt above this strike rate.
Entity A designates only the intrinsic value of the option as the hedging instrument. How can entity A calculate the intrinsic
value of the option for this purpose?
Solution
IFRS 9 does not specify how the intrinsic value of an option should be determined. In practice it is calculated as either:
the difference between the strike price of the option and the spot price of the
underlying multiplied by the notional amount of the option (the 'spot intrinsic
value'). In the case of the interest rate cap described above, this would be
calculated by projecting all future cash flows on the cap at the current spot rate,
comparing them to the cap’s strike rate and discounting the result (if positive) using
the zero-coupon curve. If the current spot rate is below the strike rate, the cap is
'out of the money' in all periods ; or
the difference between the strike price of the option and the forward price of the
underlying multiplied by the notional amount of the option (the 'forward intrinsic
value'). In the case of the interest rate cap described above, this would be
calculated by projecting each cash flow using the relevant forward rate for the
relevant date. The result would be compared to the cap’s strike rate and the result
(if positive) would be discounted using the zero–coupon curve. Using this method,
the cap might be in the money in some periods, even when the current spot rate is
below the strike price.
IFRS 9 is silent on whether the calculation of intrinsic value should be on a discounted basis. However, if the calculation is
performed on an undiscounted basis, this will likely give rise to ineffectiveness when comparing the intrinsic value to the
discounted value of the hedged item. So for this reason a discounted calculation will generally be preferable.
However, the intrinsic value of an American–style option can be defined as the difference between the undiscounted spot
price on the day when the value is determined and the strike price specified in the option contract. This is because the
American–style option can be exercised at any time.
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2.3. Derivative with knock-in or knock-out

feature

Question
Can an option with knock-in or knock-out features qualify as a hedging instrument?
Illustration
Management of company U has invested into securities that bear a floating money market rate (that is, three–month SONIA
plus a spread). At inception, the current three–month SONIA interest rate is 3.5%. It wishes to enter into a floor option in
order to limit the downside in interest rates. But to reduce the cost of the hedging strategy, management is considering
purchasing a SONIA three–month interest rate floor with an out–of–the–money strike rate of 3% that is contingent on the
SONIA three–month rate not falling below 2% at some time during its life (such contingency is commonly known as a ‘knock–
out barrier’).
Can company U designate this instrument as a hedging instrument?
Solution
It depends. There is no specific prohibition on designating an option with a knock–in or a knock–out feature as a hedging
instrument, provided that the derivative is not a net written option. A combination of options is not a net written option when
the entity does not receive a net premium for it, the critical terms of the options (except for the strike prices) are the same
and the nominal amount of the written option is not greater than the notional amount of the purchased option. Furthermore,
even though IFRS 9 does not require a quantitative assessment of effectiveness, an entity would need to consider whether
this hedging transaction is in line with its risk management strategy and whether there is an economic relationship between
the hedged item and the hedging instrument.
Company U does not expect SONIA rates to fall below 2% and therefore does not expect the knock–out barrier to be
activated; so it considers that there is an economic relationship between the hedging instrument and the hedged item, and it
expects that the change in the present value of the hedged item’s interest rate flows will be partially offset by the change in
the fair value of the hedging instrument. This assumption should be reassessed prospectively at each reporting date in order
to determine whether hedge accounting can continue to be applied. Should company U expect the barrier to be activated,
then hedge accounting should be discontinued because there would no longer be an economic relationship between the
hedged item and the hedging instrument.
However, when calculating and posting fair value movements on the hedging instrument and hedged item, there will be
ineffectiveness to record, because the hedged item does not contain a matching knock–out feature.
If hedge effectiveness is calculated on the basis of intrinsic value, the provisions of aligned time value need to be taken into
account.
2.4. Use of cross currency interest swaps in net

investment hedges
Reference to standard: IFRIC 16 para 14

Question
How is a fixed–fixed cross–currency interest rate swap accounted for in a net investment hedge?
Illustration
Company A, with Pound sterling (GBP) as its functional currency, has a net investment in a foreign subsidiary of US$120m.
Company A wishes to eliminate foreign exchange risk associated with the retranslation of part of this net investment into its
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functional currency, and enters into a fixed–fixed cross currency interest rate swap (‘CCIRS’). The swap has a GBP100m
receive leg receiving interest at 3%, and a US$80m pay leg paying interest at 5% (assume that GBP100m and US$80m are
equivalent, based on the spot rate at inception). The swap has annual interest settlements, a five-year maturity and a zero fair
value at inception.
How should hedge accounting be applied?
Solution
Management should bear in mind that hedges of a net investment in a foreign operation are accounted for similarly to cash
flow hedges. [IFRS 9 para 6.5.13].
There is no other guidance, within IFRS 9, regarding the basis for this similarity and we believe that there are two different
acceptable accounting approaches.
Approach 1
One acceptable approach is to view a net investment hedge as analogous to a cash flow hedge of the foreign currency risk
on the cash flows that would arise from a sale of the net investment at a (or several) future date(s). This approach would give
a rationale for accounting for net investment hedges in a similar manner to cash flow hedges and requires de–constructing a
fixed:fixed CCIRS into a series of forward contracts.
The hedged US dollar net investment is viewed as a series of cash flows on various 'deemed disposal' dates in the future so
as to match the cash flows on the US$ leg of the CCIRS. In other words, the net investment hedge would be treated in a
manner similar to a cash flow hedge of cash flows arising on a deemed sale of US$4m (that is, US$80m × 5%) of the net
investment at the end of each of the next four years, and a deemed sale of US$84m at the end of year 5. The total net
investment of US$120m exceeds the aggregate of the deemed disposals (US$4m + US$4m + US$4m + US$4m + US$84m =
US$100m), and so this designation is acceptable.
This net investment (series of deemed cash flows that match each cash flow on the CCIRS) is identical to the profile of cash
flows of a US$80m foreign currency debt (which is an asset of company A) that pays interest annually at 5%. Hence the
effective portion of the gain or loss on the swap can be measured in a manner similar to that used for a cash flow hedge of a
fixed–rate foreign currency debt. If a hypothetical derivative method is used, the most appropriate hypothetical derivative is a
CCIRS that is equivalent (and opposite) to the actual hedging instrument. However, the hypothetical derivative should
exclude currency basis given there is no currency basis in the net investment, and this may give rise to volatility in profit or
loss – see FAQs 3.4 and 3.6 for further details.
Note that this designation requires the net investment to equal or exceed the aggregate of notional principal and interest
flows on the CCIRS (in this case, US$100m). This approach cannot be adopted where the notional principal in the CCIRS is
equal to the net investment balance
Approach 2:
An alternative acceptable view is that a CCIRS is similar in nature to a long dated forward. The key difference is that the
forward points due to the interest differential on the two currencies are paid off over the period (via the interest payments on
the swap) rather than at the end.
Under this view the fixed-fixed CCIRS is treated similarly to a forward contract for hedge accounting purposes. As such, the
exchange of principal of US$80m can be seen as the spot component and only this component designated as the hedging
instrument (with the interest cash flows being seen as forward points and excluded from the designated hedge under IFRS 9
6.2.4(b)). As with approach 1, if a hypothetical derivative method is used to measure the effective portion of the gain or loss
on the swap, the hypothetical derivative should exclude currency basis given there is no currency basis in the net
investment. Hence both fair value movements on the forward points and the impact of currency basis may give rise to
volatility in profit or loss – see FAQ 4.5 for further details.
This designation requires the net investment to equal or exceed only the aggregate of notional principal on the CCIRS (in this
case, US$80m) and so can be adopted where the notional principal in the CCIRS is equal to the net investment balance.
2.5. Using a single hedging instrument in a

hedge of multiple risks

Question
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Can a single hedging instrument be designated in a hedge of multiple risks?
Illustration
Entity A's functional currency is the Japanese yen (JPY). Entity A has a five–year floating–rate US dollar liability and a five–
year fixed–rate pound sterling–denominated bond (an asset). The principal amounts of the asset and liability, when converted
into Japanese yen, are the same. Entity A enters into a single foreign currency forward contract to hedge its foreign currency
exposure on both instruments, under which it receives US dollars and pays pounds sterling at the end of five years.
Entity A designates the forward exchange contract as a hedging instrument in a cash flow hedge against the foreign currency
exposure on the principal repayments of both instruments. Since entity A's functional currency is yen, it is exposed to
USD/JPY foreign currency risk on the floating–rate liability, and JPY/GBP foreign exchange risk on the fixed–rate asset.
Can the forward exchange contract be designated as a hedge of both of the risks described above?
Solution
Yes. IFRS 9 permits a single hedging instrument to be designated as a hedge of multiple types of risk, provided it is
documented and designated in accordance with paragraph B6.2.6 of IFRS 9, as follows:
The risks hedged can be identified clearly. The risks are the exposures to changes in the forward exchange rates between
US dollars and yen, and yen and pounds, respectively. The hedged items are the principal amounts of the liability and the
note receivable in their respective currency of denomination.
The economic relationship can be demonstrated. For the pound sterling bond, the effectiveness could be measured as the
degree of offset between the fair value of the principal repayment in pounds sterling and the fair value of the pound sterling
payment on the forward exchange contract. For the US dollar liability, the effectiveness could be measured as the degree of
offset between the fair value of the principal repayment in US dollars and the US dollar receipt on the forward exchange
contract.
It should be noted that, in respect of the second bullet point above, the USD/GBP forward is theoretically divided into two
different derivatives. The yen is imputed as the base currency for the two derivatives, creating a synthetic USD/JPY (receive
US dollar, pay yen) foreign currency forward, and a synthetic JPY/GBP (receive yen, pay sterling) foreign currency forward.
The synthetic yen leg is defined in such a manner that the fair value of each synthetic forward contract is nil at the hedge's
inception. This can be pictorially represented as follows:
 View image
Furthermore, it should be noted that the hedge accounting criteria must be satisfied for both of the designated hedged risks.
For instance, if one of the hedged risks no longer exists, both hedges must be discontinued. This is because a derivative
instrument must be fair valued and used as a hedging instrument in its entirety, apart from the specific exemptions set out in
IFRS 9 paragraph 6.2.4.
2.6. Designation of a combination of

derivatives and non-derivatives

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Question
Can a combination of derivatives and non-derivatives be designated as a hedging instrument?
Illustration
IFRS 9 permits joint designation of hedging instruments. Can this be applied to combinations of derivatives and non-
derivatives designated jointly as the hedging instrument in the same hedge relationship?
Solution
Yes. For example, an entity that has Swedish krona as its functional currency could hedge its net investment in a Korean
subsidiary with debt denominated in US dollars, combined with a pay Korean won, receive US dollar swap (excluding
forward points) in its consolidated financial statements.
Alternatively, if the entity wanted to minimise ineffectiveness, it could impute two identical (but offsetting) Swedish krona pay
and receive legs and then designate the resulting pay Swedish krona receive US dollar swap as a hedge of the US dollar
debt, and the receive Swedish krona pay Korean won swap as a hedge of its foreign net investment in Korea.
Similarly, an entity could use a combination of a foreign currency cash instrument and a derivative to hedge the foreign
currency risk of a firm commitment, provided all the hedge accounting conditions are met.
2.7. All-in-one hedges of failed own use

commodity contracts
Reference to standard: IFRS 9 para BC6.95

Reference to standing text: 46.133, Manual EX 46.133.1
Background
A ‘gross-settled derivative’ is an instrument settled by delivery of the underlying asset (that is, the underlying commodity) and
the payment of the price specified in the contract, rather than by net settlement of the difference between the two. An ‘all-in-
one’ hedge is the designation of a gross-settled derivative as the hedging instrument in a cash flow hedge of the variability of
the consideration to be paid or received in the future transaction that will occur on gross settlement of the derivative contract
itself, assuming that the other cash flow hedge accounting criteria are met.
The IAS 39 Implementation Guidance (at former para IG F.2.5 on an ‘all in one’ hedge) permitted that a gross-settled, fixed-
price derivative can be designated as a hedging instrument in a cash flow hedge of the variability of the consideration to be
paid or received in the future transaction that will occur on gross settlement of the derivative contract itself, assuming that
the other cash flow hedge accounting criteria are met. Without the derivative, there would be an exposure to variability in the
purchase or sale price of the underlying asset. Since the derivative eliminates the cash flow variability that would otherwise
arise, it qualifies as a hedging instrument. This guidance remains applicable to all gross-settled, fixed-price contracts that are
accounted for as derivatives under IFRS 9.
Such an ‘all-in-one’ hedge accounting strategy can be beneficial to entities. For instance, if an entity enters into a fixed-price
contract to buy a commodity that falls to be accounted for as a derivative under IFRS 9, the contract would be recognised at
fair value, with gains and losses recognised in the statement of profit or loss. By applying an all-in-one hedge accounting
strategy, the entity is able to defer gains and losses on the hedging instrument in other comprehensive income under cash
flow hedge accounting until the hedged transaction occurs. In other words, the entity is able to keep revaluation gains and
losses from being recognised in the statement of profit or loss on what is effectively a fixed-price purchase or sale
commitment. The hedge needs to meet all of the typical hedge accounting requirements, for example:
The hedged item cannot be a written option, unless it is designated as an offset to

a purchased option. [IFRS 9 App B para B6.2.4].
The hedged item must be highly probable. Therefore, even though the entity
applies an all-in-one hedge, it does not automatically mean that the hedge will be
100% effective. Refer to FAQ 46.83.9 – Is hedge accounting available where highly
probable forecast sales or purchases are hedged using a load following swap? and
EX 46.43.1 – Hedging considerations for virtual power purchase agreements.
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The list above is not exhaustive; for further guidance on hedge accounting requirements, refer to chapter 46.
(full Viewpoint subscription required to see chapter 46, FAQ 46.83.9 and EX 46.43.1, see here for details)
Example
An entity enters into a fixed-price contract, denominated in its functional currency, for the delivery of electricity that fails to
qualify as ‘own use’, because the contract is expected to be in excess of consumption needs and excess electricity will be
sold in the spot market. The contract is therefore accounted for as a derivative in accordance with IFRS 9.
In this case, the entity could designate the derivative contract as a hedging instrument in a cash flow hedging relationship of
the highly probable forecast deliveries under the contract.
The expected sales in the spot market do not prevent the designation in a cash flow hedge, because the entity is meeting its
hedging objective to fix the cash flows for the purchases of electricity. The actual sale or usage is not a consideration when
determining whether the forecast transaction can be designated in a cash flow hedging relationship.
Assuming that all of the other qualifying criteria for hedge accounting are met, this will usually result in the majority of fair
value gains and losses during the life of the contract being recorded in other comprehensive income, and the net fair value
gain/loss being recognised as an adjustment to the cost of the power purchased.
However, because only the highly probable purchases of power can be designated as part of the hedged item, some
ineffectiveness will arise.
Where the purchase of electricity is in a different currency from the entity’s functional currency, all-in-one hedging could
generally fix cash flows in that foreign currency, or the entity might layer on a foreign exchange derivative (as a combined
hedging instrument with the purchase contract or by using the aggregated exposure guidance in IFRS 9), to attempt to fix
the cash flows in the entity's functional currency. However, additional complications might arise in finding a foreign currency
derivative that matches the volumetric variability of the purchase contract.
2.8. Offsetting internal derivative contracts

used to manage interest rate risk

Question
In the consolidated financial statements of a group, can a single external derivative which offsets several internal derivatives
qualify as a hedging instrument?
Illustration
Entity A has a number of subsidiaries. All treasury activities of the group are undertaken by entity A. Individual subsidiaries
intending to hedge their exposure to interest rate risk are required to enter into separate derivative contracts with entity A.
Entity A aggregates the internal derivative contracts and enters into a single external derivative contract that offsets the
internal derivative contracts on a net basis. For instance, entity A might enter into three internal receive–fixed, pay–variable
interest rate swaps (total notional amount of C100m) that lay off the exposure to variable interest cash flows on variable–rate
liabilities in the three subsidiaries, and one internal receive–variable, pay–fixed interest rate swap (notional amount of C80m)
that lays off the exposure to variable interest cash flows on variable–rate assets in another subsidiary. It then enters into a
receive–variable, pay–fixed interest rate swap (notional amount of C20m) with an external counterparty that exactly offsets
the four internal swaps. It is assumed that the hedge accounting criteria are met.
Solution
In entity A’s consolidated financial statements, the single offsetting external derivative would not qualify as a hedging
instrument in a hedge of an overall net position – that is, it cannot be used to hedge all of the items that the four internal
derivatives are hedging, because paragraph 6.6.1 of IFRS 9 only allows a net position to be designated as the hedged item in
a cash flow hedge if the hedged risk is foreign currency risk.
However, designating a part of the underlying items as the hedged position on a gross basis is permitted (that is, the external
derivative can hedge C20m of variable–rate liabilities totalling C100m). Therefore, even though the purpose of entering into
the external derivative was to offset internal derivative contracts on a net basis, hedge accounting is permitted if the hedging
relationship is defined and documented as a hedge of a part of the underlying cash inflows or cash outflows on a gross basis
and this is consistent with the entity’s risk management strategy.
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2.9. External derivative contracts that are

settled net

Question
Can several external derivatives with the same counterparty, which are net settled, be designated in separate hedging
relationships?
Illustration
Entity A has a number of subsidiaries. All of the group's treasury activities are undertaken by entity A. Individual subsidiaries
intending to hedge their exposure to interest rate risk are required to enter into separate derivative contracts with entity A,
which in turn enters into a separate offsetting matching derivative contract with a single external counterparty B. For
instance, if entity A enters into an intra–group receive 5% fixed, pay SONIA interest rate swap, entity A would also enter into
a separate offsetting pay 5% fixed, receive SONIA interest rate swap with counterparty B.
Although each of the external derivative contracts is formally documented as a separate contract, only the net of the
payments on all of the external derivative contracts is settled by entity A, as there is a netting agreement with the external
counterparty B.
Can each of the external derivatives with the counterparty B, which are net settled, be designated in separate hedging
relationships?
Solution
Yes. The individual external derivative contracts, such as the pay 5% fixed, receive SONIA interest rate swap above, can be
designated as hedging instruments of underlying gross exposures (such as the exposure to changes in variable interest
payments on the pay SONIA borrowing above) in the group’s consolidated financial statements, even though the external
derivatives are settled on a net basis.
External derivative contracts that are legally separate contracts and serve a valid business purpose (such as laying off risk
exposures on a gross basis) qualify as hedging instruments, even if those external contracts are settled on a net basis with
the same external counterparty, provided that the hedge accounting criteria in IFRS 9 are met. Note that it would not be
considered a valid business purpose if the entity entered into the two transactions only to achieve hedge accounting for one
of them (that is, if accounting treatment for one of them was the only reason for entering into two transactions and not one).
It might well be that, by entering into the external offsetting contracts and including them in the centralised portfolio, entity A
is no longer able to evaluate the exposures on a net basis. As a result, it might decide to manage the portfolio of offsetting
external derivatives separately from the entity's other exposures. Thus, it enters into an additional, single derivative to offset
the portfolio's risk.
In this situation, the individual external derivative contracts in the portfolio can still be designated as hedging instruments of
underlying gross exposures. This is so, even if the final external derivative is effected with the same counterparty under the
same netting arrangement and, as a result, might net to zero.
The purpose of structuring the external derivative contracts in the above manner, which is consistent with the entity's risk
management objectives and strategies, constitutes a substantive business purpose. Therefore, external derivative contracts
that are legally separate contracts and serve a valid business purpose qualify as hedging instruments. In other words, hedge
accounting is not precluded simply because the entity has entered into a swap that mirrors exactly the terms of another
swap with the same counterparty, if there is a substantive business purpose for structuring the transactions separately.
3. Hedge effectiveness
3.1. Sources of ineffectiveness

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Reference to standard: IFRS 9 para 6.4.1(b)

Question
What are common examples of sources of ineffectiveness?
Illustration
IFRS 9 requires an analysis of the potential sources of hedge ineffectiveness. Ineffectiveness will almost always arise, with
the result that changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk and the
hedging instrument do not exactly offset within a period. Hedge accounting can continue, provided the hedging criteria are
still met, but the ineffectiveness will need to be booked through P&L.
What are common examples of sources of ineffectiveness?
Solution
Examples of differences that can produce ineffectiveness and might need to be documented at inception include:
Basis differences – the fair value or cash flows of the hedged item depend on a
variable that is different from the variable that causes the fair value or cash flows of
the hedging instrument to change. For example, an entity designates the
benchmark interest rate as the hedged risk when the hedged item uses a different
index, such as the prime base rate. The basis difference between those indices
would affect the assessment and measurement of hedge ineffectiveness.
Location differences – the fair value or cash flows of the hedged item and hedging
instrument both depend on the price of the same commodity, but are based on the
price at different locations. The price of a commodity will be different in different
locations, because of factors such as regional supply and demand and
transportation costs.
Timing differences – the hedged item and hedging instrument occur or are settled
at different dates. For example, an entity hedges the forecast purchase of a
commodity with a derivative that settles at an earlier or later date than the date of
the forecast purchase. Another example is a floating–rate debt whose variability is
hedged with an interest rate swap where the interest rate reset dates on the two
instruments are different.
Quantity or notional amount differences – the hedged item and hedging instrument
are based on different quantities or notional amounts.
Other risks – changes in the fair value or cash flows of a derivative hedging
instrument or hedged item relate to risks other than the specific risk being hedged.
For example, an entity hedges the variability in the price of a forecast purchase of a
commodity with a derivative whose cash flows are based on the price of a different
commodity (used as a proxy), or there is a change in estimated future cash flows
following impairment of the hedged item.
Use of off–market derivatives – an off–market derivative is an existing derivative
that has a non–zero fair value when hedge accounting is first applied. Hedge
ineffectiveness can arise when using an off–market derivative in a number of
commonplace scenarios, such as documentation of a hedge not completed at
inception, temporary interruption of a hedging strategy due to changes in the
hedge objective, hedges acquired in a business combination, and renegotiation of
terms of the derivative.
Currency basis and forward points – the different treatment of currency basis and
forward points in calculating changes in the fair value of a derivative hedging
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instrument and the hedged item might create ineffectiveness if not excluded from
the designation of the hedging instrument.
Credit risk – counterparty and own credit risk will be a source of ineffectiveness.
Discount rate used – the hedging instrument, and any hypothetical derivative used
to calculate the change in fair value of the hedged risk, might be fair valued using
different curves. For example, the overnight index swap (OIS) curve is commonly
used as the discount rate when valuing collateralised swaps, whereas the entity
might use a SONIA–based swap curve to measure the change in the hedged item.
3.2. Economic relationship

Question
Is a quantitative test sufficient to prove an economic relationship?
Illustration
One of the qualifying criteria for hedge accounting under IFRS 9 is that an economic relationship must exist between the
hedging instrument and the hedged item. This means that there must be an expectation that the value of the hedging
instrument and the value of the hedged item would generally move in the opposite direction as a result of having the same or
economically related underlyings or hedged risk.
Can a company assess the existence of an economic relationship by using only a quantitative test?
Solution
No. An economic relationship exists when the hedging instrument and the hedged item have values that generally move in
the opposite direction because of the same risk (that is, the hedged risk). IFRS 9 specifies that the mere existence of a
statistical correlation between two variables does not, by itself, support a valid conclusion that an economic relationship
exists. As a result, entities should always perform a qualitative analysis of the nature of the economic relationship between
the hedged item and the hedging instrument.
Certain situations might only require a qualitative assessment. For example, where the critical terms of the hedged item and
hedging instrument are closely aligned and the offsetting nature of the underlying economic relationship is readily apparent,
it might be possible for an entity to conclude on the appropriateness of applying hedge accounting based on a qualitative
assessment. This would be the case where a currency exposure associated with a forecast sale denominated in a foreign
currency is hedged with a forward contract for the same currency, with the same amount and maturing on approximately the
same date as the forecast foreign currency denominated sale.
Where the strength of the economic relationship is not obvious, entities may have to also include in their assessment a
quantitative analysis of the possible behaviour of the hedging instrument and the hedged item during their respective terms,
in order to demonstrate that there is an economic relationship. For example, if there is an exposure to risk of a foreign
currency that is pegged to another currency, a forward contract that is perfectly matched to the forecast foreign currency
transaction, other than it is denominated in the pegged currency, might be used because there is greater liquidity in that
currency. In this situation, the hedge documentation should include a qualitative assessment explaining the manner in which
the two currencies are pegged and the resulting economic relationship. Depending on the rigor of the currency controls used
to peg the two currencies, the hedge documentation may need to be supplemented with a quantitative analysis of the
historical exchange rates of the two currencies to further support the existence of the economic relationship.
Another instance would be where there is a common underlying between the hedged item and the hedging instrument, but
there is also a basis difference (that is, a location difference or a quality difference associated with the price of the
commodity). Because movements in the price of the common underlying may be offset by the movements in the basis
difference, a quantitative analysis of historical total price movements may be necessary to support the presence of an
economic relationship between the hedged item and the hedging instrument.
Different scenarios may need to be analysed in order to demonstrate that the behaviour of the hedging instrument is in line
with those of the hedged item.
In any case, the hedging documentation should identify and explain the economic relationship, especially in the case when
the underlying of the hedging instrument is not the same as the risk being hedged.
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3.3. Rebalancing
Reference to standard: IFRS 9 para B6.5.7–B6.5.21

Question
In what situations is rebalancing required?
Illustration
An entity with a EUR functional currency has a forecast purchase in HKD in six months’ time amounting to HKD7.8 million. In
order to hedge its foreign currency exposure, the entity wants to purchase foreign currency (that is, enter into foreign
currency forward contracts) to effectively fix the purchase price in EUR.
The HKD is pegged to the USD (which means that the exchange rate is maintained within a band or at an exchange rate set
by the Hong Kong Monetary Authority).
The entity could enter into a forward contract to buy HKD and pay EUR. However, entering into a forward contract to buy
HKD and pay EUR is more expensive than entering into an agreement to buy USD and pay EUR (as there is a smaller market
and less liquidity in HKD compared with USD). The entity decides instead to enter into a USD: EUR forward. As long as the
HKD remains pegged to the USD, using a USD derivative as a hedging instrument will provide an economic hedge of the
forecast HKD purchase.
In what situations is rebalancing required or not required?
Solution
Rebalancing not required
Assume the peg ratio is HKD7.8:USD1. However, even though it is pegged, it is not completely fixed (as the HKD is allowed
to trade within the narrow range of HKD7.75 to 7.85). Since the range is very small, the entity is willing to accept this risk, so
it enters into a forward contract for USD1 million (HKD7.8 million).
Rebalancing is not required where ineffectiveness arises merely because of fluctuations in exchange rates within the narrow
trading range around the hedge ratio.
Rebalancing required
Consider the facts of the previous example, but assume that the exchange rate HKD: USD is re-pegged to, say,
HKD7.2:USD1. If the derivative continues to be for USD1 million, the hedge ratio will no longer reflect the relationship
between the hedging instrument and hedged item, and so will result in mandatory rebalancing.
Rebalancing should reflect the entity’s risk management strategy, which could either be reducing the hedged item to HKD7.2
million of the forecast purchase of HKD7.8 million, or increasing its hedging instrument by buying another derivative to cover
the remaining HKD600,000 of the hedged item.
Rebalancing not applicable
Continuing the above example, assume that sometime after the inception of the hedge, the peg between HKD and USD is
removed, such that the currency exchange rate is floating (instead of pegged) within a very broad range such that now it is
not possible to demonstrate that an economic correlation exists between the two currencies. In this situation, a change in the
hedge ratio would not be applicable, since this may not ensure that the hedging relationship continues to meet that hedge
effectiveness requirement. Accordingly, the hedge cannot be rebalanced but may need to be discontinued.
3.4. The hypothetical derivative method
Reference to standard: IFRS 9 paras B6.4.1, B6.4.13–B6.4.19

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Question
What is the hypothetical derivative method?
Illustration
Although IFRS 9 has eliminated the 80-125% bright line effectiveness test, entities are still required to identify and measure
ineffectiveness, and record it through P&L. The hypothetical derivative method is commonly used to calculate the change in
fair values of the hedged item.
How can the hypothetical derivative method be applied in practice?
Solution
The hypothetical derivative method is a common approach used to measure hedge ineffectiveness. It compares the change
in the fair value or cash flows of the hedging instrument with the change in the fair value or cash flows of a hypothetical
derivative that models the hedged risk. The derivative is ‘hypothetical’ because it does not exist. Paragraph B6.5.5 of IFRS 9
notes that this is ‘not a method in its own right but a mathematical expedient that can only be used to calculate the value of
the hedged item’.
For example, a cash flow hedge of the interest rate risk on a variable–rate asset or liability, the hypothetical derivative would
be a swap with the same notional amount and the same re–pricing dates as the hedged item. Also, the index on which the
hypothetical swap's variable rate is based should match the index on which the asset or liability's variable rate is based (not
the one on which the hedging instrument’s rate is based), and should reflect any caps, floors or any other non–separated
embedded derivative features of the hedged item. Thus, the hypothetical swap would be expected to perfectly mirror the
hedged cash flows. The change in fair value of the 'perfect' hypothetical swap is regarded as a proxy for the present value of
the cumulative change in expected future cash flows on the hedged transaction. However, if hedge accounting starts part
way through the life of the hedge relationship, the hypothetical swap (or benchmark rate) will not identically match the critical
terms of the hedging instrument, as the relevant rate for the fixed leg of the hypothetical derivative or benchmark rate will be
the market rate at inception of the hedge, and not the rate at inception of the hedged item or hedging instrument. This will
give rise to ineffectiveness and might preclude the use of hedge accounting if rates have moved so significantly since the
hedging instrument was taken out that an economic relationship no longer exists.
Once an entity has determined the change in fair value of the hypothetical swap and the change in the fair value of the actual
swap for particular periods, it would use this data to measure the ineffectiveness in the hedging relationship. The actual
swap would be recorded at fair value on the balance sheet, and the amount reported in equity would be adjusted (via OCI) to
a balance that reflects the lesser of the cumulative change in the actual swap's fair value and the cumulative change in the
'perfect' hypothetical swap's fair value. Determining the fair value of both the 'perfect' hypothetical swap and the actual
swap should use discount rates based on a relevant swap curve. Thus, for the hypothetical swap the discount rates used
may be the spot rates implied by the current yield curve for hypothetical zero coupon bonds due on the date of each future
net settlement of the swap. The amount of ineffectiveness, if any, recorded in P&L would then be equal to the excess of the
cumulative change in the fair value of the actual swap over the cumulative change in the fair value of the 'perfect'
hypothetical swap.
The hypothetical derivative method could be used in measuring the ineffectiveness of cash flow hedging relationships
involving derivatives, such as cross–currency swaps, commodity swaps and forward exchange contracts. However,
paragraph B6.5.5 of IFRS 9 states that the hypothetical derivative cannot include items that exist in the hedging instrument
but not in the hedged item.
For example, in the valuation of cross–currency interest rate swaps and long–term currency forwards, spreads are applied to
cash flows in currencies with a perceived higher credit risk or lower liquidity. These spreads – commonly referred to as
‘currency basis spreads’ – are typically quoted in the market against a SOFR benchmark. These currency spreads could lead
to hedge ineffectiveness, as the hypothetical derivative cannot include currency basis because it only exists in the hedging
instrument. However, the IASB recognised the risk of ineffectiveness, and so it permits entities to separate the foreign
currency basis from the hedging instrument and account for the changes in spread in the same manner as forward points as
a cost of hedging as explained in Section 1, paras 4.4-5.
3.5. Impact on hypothetical derivative of

rebalancing
Reference to standard: IFRS 9 paras B6.5.7–B6.5.21

Question
Should the terms of a hypothetical derivative be reset to have a zero fair value after rebalancing?
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Illustration
Rebalancing refers to adjustments to the designated quantities of either the hedged item or the hedging instrument of an
existing hedge relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness
requirements (see IFRS 9 paragraph B6.5.7 and FAQ 3.3).
Does this mean that the terms of a hypothetical derivative used to measure ineffectiveness must also be reset to give a fair
value of zero after rebalancing?
Solution
No. Rebalancing differs from discontinuation and re-designation of a hedging relationship, because it is considered a
continuation of the hedging relationship. Rebalancing refers to the quantity of either the hedging instrument or the hedged
item and not to their characteristics. As such, any hypothetical derivatives that have been created in order to perform
effectiveness testing would not be reset to have a zero fair value. However, they would need to be adjusted for changes in
the hedged quantity (that is, due to changes in the revised hedge ratio).
In addition, IFRS 9 paragraph B6.5.21 requires that an entity update its documentation of the analysis of the sources of
hedge ineffectiveness that are expected to affect the hedge relationship during its remaining term when it rebalances a
hedge relationship.
3.6. Measuring ineffectiveness when hedging

changes in spot foreign currency rates

Question
When an entity hedges changes in a spot foreign currency rate, how is the time value of money included when
measuring ineffectiveness?
Illustration
Entity XYZ whose functional currency is the euro, decides to hedge the foreign currency risk of USD1m highly probable sales
in 9 months’ time. In accordance with its risk management policy it designates changes in the spot foreign currency rate as
the hedged risk. The designated hedging instrument is the spot component of a three month foreign exchange forward
contract, which will be rolled forward until the time the forecast sales occur.
Solution
IFRS 9 requires that entities consider the time value of money when measuring hedge effectiveness. Hence, for the purpose
of measuring ineffectiveness the hedged item should be measured on a present value basis (which means the spot foreign
currency rate will need to be discounted). This is a change from IAS 39 under which entities often do not discount when
hedging changes in the spot rate.
More specifically, when measuring ineffectiveness, the forecast sales are translated at the current spot rate at the date of the
effectiveness test and this amount should be discounted over nine months to reflect the present value of the hedged item.
This is compared to the spot component of the forward contract which should be discounted over its three month maturity.
This will create ineffectiveness, which must be recorded directly in profit or loss. Foreign currency basis spread could also be
a source of ineffectiveness unless excluded from the designated hedging instrument – see FAQ 3.7 for further details.
It should be noted that for a short term hedge between currencies with limited interest rate volatility the impact of this
discounting may not be significant. However it could be more significant for longer term hedges. Entities will therefore need
to consider the impact of the IFRS 9 requirements on their risk management strategy and whether to designate the forward
or spot rate.
3.7. Foreign currency basis spread
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Reference to standard: IFRS 9 paras 6.2.4(b), B6.5.34–B6.5.39

Question
Does foreign currency basis spread result in ineffectiveness in a hedge relationship?
Illustration
Company K, a Euro functional currency entity, issues a USD variable rate debt. Company K’s risk management strategy is to
hedge the variability in both interest rates and foreign exchange rates. To meet its risk management strategy, entity K enters
into a floating-to-fixed cross-currency interest rate swap with matching critical terms (that is, matching currencies, payment
dates, re-pricing dates, and interest basis on the variable leg).
Solution
Yes, foreign currency basis will result in ineffectiveness if not excluded from the designation of the hedging instrument.
A cross-currency interest rate swap or currency forward contract includes a pricing element (liquidity charge or credit) that
reflects the fact that the derivative instrument results in the exchange of two currencies in the future. This pricing element is
usually referred to as ‘foreign currency basis spread’. On the other hand, a hedged item (for example, a fixed or variable
interest rate debt denominated in foreign currency) is usually a single currency instrument that, unlike the cross-currency
interest rate swap, does not involve the exchange of two currencies. Hence its value does not include a foreign currency
basis spread.
As the foreign currency basis spread is a feature in the hedging instrument that is not included in the hedged item, it results
in ineffectiveness in the hedging relationship.
As an alternative to recognising this ineffectiveness, IFRS 9 allows separation of the initial foreign currency basis spread and
excluding it from the designated hedging instrument. If so separated, the foreign currency basis spread may be accounted
for as a cost of hedging in a way similar to the forward points in a forward contract.
Hence Company K can choose to:
include the currency basis spread in the hedge designation which would result in
some ineffectiveness because the currency basis spread does not exist in the
hedged item (the USD debt);
exclude the currency basis spread from the designated hedging instrument and
recognise all movements in currency basis in profit or loss; or
apply the cost of hedging model in IFRS 9 para 6.5.15-16. In this case changes in
the fair value of the forward contract attributable to currency basis are recognised
in other comprehensive income. Because the hedged item is time related (the
interest and foreign currency risks exist for the life of the debt), the initial currency
basis spread will be amortised to profit or loss over the period of the hedge.
3.8. Hedging with pre-existing derivatives?

Question
What is the effect of hedging with pre-existing derivatives?
Illustration
When a pre-existing derivative is designated as a hedging instrument, it will usually have a non–zero fair value because of its
‘off–market terms’. How does this affect hedge accounting?
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Solution
The 'off–market' nature of the derivative will be a source of ineffectiveness in the hedge relationship. In a cash flow hedge,
ineffectiveness is commonly measured using a hypothetical derivative method [see question 3.4]. At the inception of the
hedge relationship, the terms of the hypothetical derivative will be set to be ‘on–market’ and so will differ from those of the
actual derivative, with the difference giving rise to ineffectiveness.
The 'off–market' nature of the derivative can be described as an 'embedded financing' within the derivative. For example, a
derivative asset can be thought of as containing an 'embedded loan receivable', and a derivative liability as containing an
'embedded loan payable'. This 'embedded' financing is the source of the ineffectiveness due to fair value movements on the
opening balance and on the off–market element of the interest.
The actual settlement of the original carrying value is not itself a fair value change and can be excluded from the
measurement of ineffectiveness at each reporting date. However, it does not change the fact that the instrument is still a
derivative and must be carried in its entirety at fair value, with all fair value movements posted to P&L or OCI, as appropriate.
Although ineffectiveness will need to be calculated and accounted for in profit or loss, IFRS 9 does not require the 80-125%
‘highly effective’ bright-line for the application of hedge accounting. Therefore, if using a non-zero fair value swap complies
with the entity’s risk management strategy and the IFRS 9 criteria for using hedge accounting are met (including that there is
an economic relationship between the hedged item and the hedging instrument, and the proper determination of the hedge
ratio), hedge accounting can still be applied.
4. Accounting and risk management
4.1. Changes to risk management objectives
Reference to standard: IFRS 9 paras 6.5.6, B6.5.23

Question
Can the risk management objective for a hedge change even if the risk management strategy does not?
Illustration
Company X’s risk management strategy is to fix the interest rate of a proportion of its debt in a range between 60% and 90%.
The level of hedging will depend on market conditions, but the company’s currently documented risk management objective
is to have 80% of total debt bearing fixed interest.
Due to changes in market conditions, company X decides to modify its risk management objective to reduce the proportion
of fixed-rate debt from 80% to 70% of total debt.
Under IFRS 9, can the risk management objective change even though the risk management strategy remains unchanged,
and what are the consequences for hedge accounting?
Solution
Yes. In certain situations, risk management objectives can change while the risk management strategy does not. IFRS 9
requires discontinuation of hedge accounting if the hedge relationship no longer meets the risk management objective.
As a result of the change in risk management objective, company X is required to discontinue its hedge accounting. The
discontinuation of hedge accounting applies to the extent to which the risk management objective has changed (that is,
10%).
If the de-designated portion of the original hedging instruments is retained, it can be designated in another hedging
relationship or measured at fair value through profit or loss.
4.2. De-designation of hedge relationships

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Question
Is it possible to de-designate a hedge of foreign currency exposure on forecast purchases or sales under IFRS 9?
Illustration
Entity A has highly probable forecast purchases of EUR10 million on 31 May 20X7 with payment due on 31 July 20X7. The
entity’s risk management strategy is to hedge the foreign currency risk on foreign currency sales and purchases.
On 1 April 20X7, a EUR forward maturing on 31 July 20X7 is taken out and designated in a hedge relationship to offset EUR
cash outflows on 31 July 20X7. The EUR cash flow on the derivative matches the cash flow on the hedged item.
Hedge accounting is applied from inception of the hedge with the designated foreign currency risk being movements in the
forward foreign exchange rate.
How could hedge accounting be applied in the above scenario, in particular in the period after the inventory has been
recognised?
Solution
Entity A has a risk management strategy whereby it manages the foreign currency risk of forecast purchases and resulting
receivables. In this regard Entity A designates the hedging strategy as mitigating volatility in cash flows arising from foreign
currency risk on forecast purchases of EUR 10 million and the resulting accounts payable balances. However, Entity A has a
choice of how to implement that strategy via its documented risk management objective for the hedge, which, which will
determine the accounting required after recognition of the inventory purchased.
Risk management objective 1: The entity’s documented hedging objective is to mitigate volatility in cash flows arising from
foreign currency risk on forecast purchases of EUR 10 million and the resulting accounts payable balances using a EUR
forward.
In these circumstances:
For the period up to 31 May 20X7 the movement in the fair value of the derivative
(assuming the hedge is 100% effective) is taken to the cash flow hedge reserve.
On 31 May, when inventory is recognised, a basis adjustment is required. Therefore

the gain/loss in the cash flow hedge reserve relating to the period from 1 April 20X7
to 31 May 20X7 is transferred to inventory.
For the period from 31 May 20X7 to 31 July 20X7 the hedged item is foreign
currency movements on the accounts payable balance. Changes in the fair value of
the derivative (assuming the hedge is 100% effective) are taken to the cash flow
hedge reserve, however the movement in spot rate is recycled to profit or loss to
offset the IAS 21 translation of the accounts payable balance.
Risk management objective 2: The entity’s documented hedging objective is to manage foreign currency risk of forecast
purchases and resulting payables, the entity manages foreign currency risk as a particular relationship only up to the point of
recognition of the payable. After that date Entity A manages together the foreign currency risk from the EUR payables and
EUR forward.
In these circumstances:
For the period up to 31 May 20X7 the movement in the fair value of the derivative
(assuming the hedge is 100% effective) is taken to the cash flow hedge reserve.
On 31 May, when inventory is recognised, a basis adjustment is required. Therefore

the gain/loss in the cash flow hedge reserve is transferred to inventory.
Once inventory has been recognised, there is a ‘natural’ hedge because the gains
and losses from the foreign currency risk on the derivative and payables are
immediately recognised in profit or loss. Consequently, the hedging objective of the
original hedge relationship no longer applies and Entity A can no longer apply
hedge accounting (see IFRS 9 para B6.5.24).
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Hence fair value movements on the derivative for the period from 1 June 20X7 to
31 July 20X7 are recorded directly in profit or loss.
However, on 31 May an accounts payable balance is also recognised. Because this

balance will be retranslated under IAS 21 with the foreign currency impact recorded
in profit or loss this provides a natural offset to the gains and losses on the
derivative and there is no need for hedge accounting.
Note: The analysis would be similar for a forecast sale on credit which results in
recognition of an accounts receivable balance (except that no basis adjustment
would be required).
4.3. Replacing the underlying hedged item
Reference to standard: IFRS 9 paras 6.4.1(b), B3.3.6

Question
Does the replacement of a hedged item result in discontinuance of hedge accounting, if the terms of the new hedged
item are substantially different (under IFRS 9 B3.3.6) from the original instrument?
Illustration
Company A is exposed to interest rate risk on interest bearing debt. The company manages its exposure to interest rate risk
through the proportion of fixed and variable rate net debt in its total net debt portfolio.
For the current period, Company A’s approved strategy in accordance with its risk management policies is to maintain a
certain ratio of fixed: floating rate net debt. To meet this chosen ratio, management has decided to enter into interest rate
swaps to swap the floating rate of certain debt to fixed. As a result of this risk management strategy the company has
designated a cash flow hedge of variable rate debt. In order to manage liquidity risk, the company has a strategy of
exchanging existing variable rate debt instruments some time before their maturity with new variable rate instruments
(normally with a longer maturity). As the strategy is to replace existing variable rate debt with new variable rate debt the
underlying 'cash flow' risk is not changing.
For example: Company A entered into a 10 year debt instrument with the following terms:
Notional: £50 m
Interest rate: SONIA + 25bp
Start date: 30 June 2008
Maturity date: 30 June 2018

Interest settlement dates: Semi–annual – 1 January and 30 June.
The interest rate cash flow risk was initially hedged using the following interest rate swap:
Notional: £50 m
Receive leg: SONIA

Pay leg: GBP 5 %
Start date: 30 June 2008
Maturity date: 30 June 2018

Interest settlement dates: Semi–annual – 1 January and 30 June.
The terms of the interest rate swap match the terms of the hedged item.
At 30 June 2016 when the current debt only has 2 years remaining, management decides to extend the term of the funding
arrangements for liquidity purposes. Management decides to replace the current debt with debt of a longer maturity. In this
scenario, assume the new debt has a maturity of 8 years and has terms (that is, interest settlement dates, interest basis, and
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currency) similar to that of the current debt. The underlying 'cash flow risk' will still be SONIA related (consistent with the
cash flow risk of the 'old debt').
If the terms of the new hedged item are substantially different from the original instrument (that is, the present value of the
new debt is more than 10% different than the present value of the remaining cash flows of the old debt), IFRS 9 paragraph
B3.3.6 requires de–recognition of the old debt. Does this:
Require immediate discontinuation of the hedge relationship and release of the amount deferred in cash flow hedge reserve;
or
Can the amount in cash flow hedge reserve remain in equity if the new debt has similar cash flow risk characteristics than the
old debt (that is, also have cash flow risk associated with SONIA) and merely continues to be a hedge of the cash flow risk
associated with the first two years of the new 8 year variable rate debt?
Solution
It depends how the hedged risk has been identified in the original hedge documentation.
If the hedged risk has been defined as the cash flow variability from a 'specific identified debt instrument' then when the
original debt instrument is de-recognised, hedge accounting has to be discontinued and the associated cash flow hedge
reserve has to be reclassified to profit or loss.
If however the hedged risk has been defined as the ‘cash flow variability due to changes in SONIA’ and the hedged item as,
for example, ‘group of forecast interest rate cash flows that are expected to occur with a high degree of probability in
specific future periods either from the current debt instrument or any other debt instrument taken out to refinance or
otherwise replace the current debt instrument prior to its maturity and that has similar risk characteristics’ – then the new
debt instrument may still fall within the designated hedged item. In this case, replacement or restructuring of the current debt
instrument would not require discontinuance of hedge accounting (or the associated reclassification to profit or loss of the
cash flow hedge reserve), even when the original debt instrument is de-recognised. To ensure continuance of hedge
accounting the new underlying debt instrument should have similar cash flow variability risk as the previous debt instrument
and meet all of the hedge accounting requirements (including the appropriate hedge effectiveness requirements).
A number of further issues require consideration to determine whether continuation of the current hedge relationship is
appropriate:
If the original hedged cash flows extended beyond management’s planning horizon
for financing (for example, if management’s planning horizon for financing is 7
years, the variable rate debt was issued for a period of 10 years and management
does not plan to replace the debt during the 7 year planning horizon) then the
probability of the future cash flows being hedged is supported by the existence of
the current loan. As it may be difficult to support the 'highly probable' requirement,
the designation would have to be based on the specific loan. In this case it may be
difficult to define the hedged risk in a flexible manner that would not only include
the 'specific debt instrument'.
If, however, the hedged cash flows are within management’s planning horizon for financing (for example, if management’s
planning horizon for financing is 7 years, the original variable rate debt was issued for a period of 7 years or less and
management plans to replace the debt within the 7 year planning horizon for financing), it may be possible to designate the
'forecast highly probable variable interest rate payments' as the hedged item and not necessarily the cash flows from a
specific debt instrument. It is however important that the 'highly probable' requirement is sufficiently supported. The hedged
cash flows need to be sufficiently designated to ensure they are clearly identifiable when they occur and all the hedge
qualifying criteria are met.
4.4. Aligned time value of an option
Reference to standard: IFRS 9 paras 6.5.15, B6.5.29–B6.5.33

Question
When hedging with options, how should the ‘alignment’ principle be applied?
Illustration
An entity’s risk management objective is to hedge the forecast purchase of 100 tonnes of a commodity on April 15, 20X1
against an increase in price above a specified threshold (that is, a one-sided risk). To meet this objective, the entity
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purchases a commodity option. The underlying commodity is the same and the option’s strike price matches the specified
threshold. However, it matures on April 30, 20X1.
How should the aligned time value of the option be determined in this scenario?
Solution
The entire time value of the option relates to the hedged item if the critical terms (such as the notional amount, strike price,
term and underlying) of the option and the hedged item are aligned.
In the above illustration, the entity cannot consider that the time value of the option is aligned with the hedged item because
the dates do not match.
When the critical terms of the hedging option are not aligned with the critical terms of the hedged item, the entity determines
the aligned time value using the valuation of the option whose critical terms would exactly match the critical terms of the
hedged item (that is, in the above example an option that matures on 15 April 20X1).
If, at inception of the hedging relationship, the actual time value is higher than the aligned time value, the entity should:
determine the amount that is accumulated in a separate component of equity on

the basis of the aligned time value; and
account for the differences in the fair value changes between the actual and
aligned time values in profit or loss.
If, at inception of the hedging relationship, the actual time value is lower than the aligned time value, the entity should
determine the amount that is accumulated in a separate component of equity by reference to the lower of the cumulative
change in fair value of the actual and the aligned options. Any differences should be recognised in profit or loss.
The entity may need to use an option pricing model to measure the initial value of an option having characteristics that
exactly match the critical terms of the hedged item.
4.5. Net investment hedge (requirement to

consider time value of money
Reference to standard: IFRS 9 paras B6.5.4, BC6.124.

Question
How should a parent account for a net investment hedge in its consolidated accounts? In particular when does the
requirement in IFRS 9 to consider the time value of money result in ineffectiveness?
Illustration
Entity A, a GBP functional currency entity, has a net investment in a EUR foreign operation.
Scenario 1 – hedging instrument is a term loan
In its consolidated accounts, Entity A hedges the net investment with a 5 year EUR term loan and applies hedge accounting.
Solution 1
Accounting impact
All foreign currency gains and losses on retranslating the net assets of the foreign operation are recognised in other
comprehensive income in accordance with IAS 21. These are calculated by retranslating the net investment at the relevant
spot rate. The effective portion of the gains and losses on the hedging instrument (the loan) are also recognised in other
comprehensive income in accordance with IFRS 9 para 6.5.13. These gains and losses remain in the hedging reserve until
disposal or partial disposal of the foreign operation when they are reclassified to profit or loss.
Consideration of the time value of money and ineffectiveness
The hedging instrument (the loan) is measured at amortised cost which is itself a present value measurement that takes into
account the time value of money (IFRS 9 para BC 6.28). Furthermore IFRS 9 para BC 6.124states that the foreign currency
risk component of a non-derivative, such as a loan, that is used as a hedging instrument is the amount determined in
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accordance with IAS 21. IAS 21 also requires the net investment to be translated at the closing spot rate. This means that
there is no requirement to make a further separate adjustment for the time value of money on either the hedged item or the
hedging instrument. Accordingly, no ineffectiveness will arise from IFRS 9’s requirement to consider the time value of money.
Scenario 2 – hedging instrument is a currency forward contract
In its consolidated accounts, Entity A hedges the net investment with an 18 month foreign currency forward contract and
applies hedge accounting. It designates the hedged risk as changes in the forward exchange rate,
Solution 2
Accounting impact
By designating the hedged risk as changes in the 18 month forward exchange rate, Entity B is imputing a life of 18 months
into the hedge relationship.
All foreign currency gains and losses on retranslating the net assets of the foreign operation are recognised in other
comprehensive income in accordance with IAS 21. These are calculated by retranslating the net investment at the relevant
spot rate.
The effective portion of the gains and losses on the hedging instrument (the forward contract) are also recognised in other
comprehensive income in accordance with IFRS 9 para 6.5.13. The gains and losses on the hedging instrument are
calculated using the forward rate and the effective portion include movements in value of the forward points as the
designated hedged risk is changes in the forward exchange rate. Therefore, there will be a difference between the amount
recorded on the hedged net investment and the amount recorded on the hedging instrument (the forward contract).
These gains and losses remain in reserves until disposal or partial disposal of the net investment (when they are reclassified
to profit or loss) even though the life of the hedging instrument is only 18 months. This is because the hedged item (the net
investment) does not affect profit or loss until its disposal or partial disposal.
Since the term of the hedge relationship matches the maturity of the forward contract (18 months), no ineffectiveness will
arise from IFRS 9’s requirement to consider the time value of money.
However, not all of the fair value movements on the hedging instrument are recognised in other comprehensive income. This
is because the hedging instrument (the forward contract) will contain a foreign currency basis spread that is not present in
the hedged item (the net investment). Entity B can choose to:
recognise all movements in currency basis in profit or loss,
apply the cost of hedging model in IFRS 9 para 6.5.15-16. In this case changes in
the fair value of the forward contract attributable to currency basis are recognised
in other comprehensive income. Because the hedged item is time related, the initial
currency basis spread will be amortised to profit or loss over the life of the hedge,
here 18 months, or
include the currency basis spread in the hedge designation which would result in
some ineffectiveness because the currency basis spread does not exist in the
hedged item (the net investment).
4.6. Hedging revenue with a term loan or

issued bond
Reference to standard: IFRS 9 paras 6.2.2, B6.2.3

Question
How should an entity account for a cash flow hedge of a forecast sale where the hedging instrument is a term loan or
issued bond? In particular does the requirement in IFRS 9 to consider the time value of money result in
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ineffectiveness?
Scenario 1 – hedging instrument is a zero coupon foreign currency loan or bond
Entity A, a GBP functional currency entity, has a zero coupon USD $400k loan repayable in 1 years’ time. It designates the
loan as a hedge of the foreign currency risk on a highly probable USD $400k forecast sale in 1 year. The hedged risk is
designated as changes in the spot foreign exchange rate.
Solution
Note: When discussing ineffectiveness, the following solution does not consider the impact of credit risk.
Accounting impact
In accordance with IFRS 9 para 6.5.11, the lower of the cumulative gain or loss on the hedging instrument (the loan) and the
cumulative change in fair value of the hedged item (the sale) is recognised through other comprehensive income in a
separate component of equity. In the case of a loan (a non-derivative financial instrument) the relevant gain or loss on the
hedging instrument is the IAS 21 retranslation amount (IFRS 9 BC 6.281). If this exceeds the cumulative change in fair value
of the hedged item (the sale), the excess is recorded through profit or loss.
The amount in the hedging reserve is reclassified to profit or loss in the same period as the hedged cash flows (the forecast
sale) takes place.
The designated hedged item is a future cash flow in 1 years’ time. Accordingly the fair value change of the hedged item (the
forecast sale) is calculated by discounting changes in the spot exchange rate from the date of sale so as to take into account
the time value of money.
account the time value of money (IFRS 9 para BC 6.281). Furthermore IFRS 9 para BC 6.124 states that the foreign currency
accordance with IAS 21. This means that there is no requirement to make a further separate adjustment for the time value of
money on the hedging instrument.
The issue arises of what discount rate should be used when measuring the change in fair value of the hedged item (the
forecast sale) and measuring ineffectiveness. IFRS 9 has no explicit guidance on what rate should be used. An acceptable
approach would be to use a risk free interest rate to discount both the hedged item and hedging instrument for the purposes
of calculating ineffectiveness.
Accordingly, the spot movement in the cash flows associated with both the forecast sale and the USD loan could be
discounted at the risk free rate.
To the extent that the cumulative discounted spot movement on the hedged sale equals, or exceeds, that on the USD loan
then the entire IAS 21 retranslation gain/loss on the loan would be recognised in OCI though application of the 'lower of'
guidance in [IFRS 9 para 6.5.11.]. On the other hand, to the extent that the cumulative spot movement on the USD loan,
when discounted at the risk free rate, exceeds that on the hedged sale the amount deferred in OCI would be the discounted
spot movement on the forecast sale. However the amount deferred in OCI should be restricted, where necessary, to the IAS
21 retranslation of the debt (in recognition of the fact that the discounted loan balance might be lower than the amount
arising from discounting the loan cash flow at the risk free rate.
Scenario 2 – hedging instrument is a one year interest bearing loan
Entity A, a GBP functional currency entity, has an interest bearing USD $400k loan repayable in 1 years’ time. It designates
the loan as a hedge of the foreign currency risk on a highly probable USD $400k forecast sale in 1 year. The hedged risk is
designated as changes in the spot foreign exchange rate.
Solution
The following solution covers three alternative scenarios for the cash flows on the loan and their implication for hedge
accounting.
Scenario 2.1
There are monthly interest cash flows paid throughout the term of the loan and a principal repayment at maturity. The
designated hedged amount of sales is equal to the principal repayment at maturity of the loan.
Accounting impact
The principal cash flows on the forecast sale and loan match, but there are additional cash flows on the loan, the interest
payments, which are not matched against forecast sales. These interest cash flows will result in some ineffectiveness (this is
discussed further below).
cumulative change in fair value of the hedged item (the sale) is recognised through other comprehensive income in a
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of the hedged item (the sale), the excess is recorded through profit or loss.
sale) takes place.
The designated hedged item is a future cash flow in 1 year’s time. Accordingly the fair value change of the hedged item (the
forecast sale) is calculated by discounting changes in the spot exchange rate from the date of sale so as to take into account
the time value of money.
account the time value of money (IFRS 9 para BC 6.281). Furthermore IFRS 9 para BC 6.124states that the foreign currency
However there will be interest cash flows on the loan over the next year, that are reflected in its amortised cost carrying value
(that is the present value of both principal and interest cash flows discounted using the original effective interest rate), but
that are not matched by equivalent cash flows on the forecast sale. The carrying amount of the loan matches the forecast
sale only if compared on an undiscounted basis. IFRS 9 requires that an entity considers the time value of money (IFRS 9 BC
6.281) for calculating ineffectiveness, so the calculation of the fair value change attributable to foreign exchange risk of the
hedged item (a forecast sale in 1 year’s time) must be on a discounted basis.
For example, assume the amortised cost of the loan is $400k, but the present value of the future sale is $380k. This means
that there will be greater foreign currency gains or losses on the loan based on its retranslation under IAS 21, than on the
hedged item (the forecast sale). As only the lower amount is recognised through other comprehensive income in equity, the
difference will be recorded as ineffectiveness in profit or loss.
See Scenario 1 above for a discussion of the appropriate discount rate to use.
Scenario 2.2:
There are monthly interest cash flows paid throughout the term of the loan and a principal repayment at maturity. The
designated hedged amount of sales is equal to the principal repayment at the maturity of the loan but Entity A also
designates additional sales during the term of the loan to match the interest cash flows.
Accounting impact
The cash flows on the loan (both principal and interest) match those on the forecast sales so no ineffectiveness will arise (this
is discussed further below).
cumulative change in fair value of the hedged item (the sales) is recognised through other comprehensive income in a
of the hedged item (the sales), the excess is recorded through profit or loss.
sales) take place. Therefore an amount will be recycled each month as that month’s hedged sales occur.
The designated hedged item is a series of future cash flows arising on sales in each month for the next year. Accordingly the
fair value change of the hedged item (the forecast sales) is calculated by discounting changes in the spot exchange rate from
the date of each sale so as to take into account the time value of money.
account the time value of money (IFRS 9 para BC 6.281). Furthermore IFRS 9 para BC 6.124 states that the foreign currency
The cash flows on the hedging instrument, being interest payments made during the term of the loan and the principal
repayment match the forecast sales during the period including the forecast sale at maturity of the loan. If the discount rate
used for the calculation of ineffectiveness is the same for both the hedged item (the forecast sales) and the hedging
instrument (the loan) no ineffectiveness will arise (see the discussion on discount rates in Scenario 1 above).
Scenario 2.3
Interest accrues on the loan that is settled together with principal amount at maturity. The carrying value of the loan at the
date of designating the hedge matches the principal repayment due at maturity in 1 year’s time (i.e. there are no transaction
costs or premium/discounts on the loan) and also the (undiscounted) amount of the forecast future sale.
Accounting impact
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The principal cash flow on the loan matches the cash flow on the forecast sale. But there is an additional interest cash flow
on the loan, which is not matched against forecast sales. This interest cash flow will result in some ineffectiveness (this is
discussed further below).
cumulative change in fair value of the hedged item (the sales) is recognised through other comprehensive income in a
of the hedged item (the sales), the excess is recorded through profit or loss.
sales) take place.
As Entity A has only designated sales equal to the amount of the principal repayment on the loan, similar to Scenario 1
above, the cash flows on the loan at maturity are greater than the designated value of sales and as a result ineffectiveness
will arise.
Alternatively, similar to Scenario 2.2 above, Entity A could designate additional sales, to equal the value of the cash
repayment at maturity of the loan. In this case no ineffectiveness will arise from the time value of money (see also the
discussion on discount rates used under Scenario 1 above).
4.7. Partial term hedge of a financial asset or

financial liability
Reference to standard: IFRS 9 para BC6.95

Question
Can cash flows or fair value movements be hedged for only a portion of the time to maturity of the financial asset or financial
liability?
Illustration
Entity A acquires a 10% fixed–rate government bond with a remaining term to maturity of ten years. Entity A measures the
bond at amortised cost. On the same date, to hedge against fair value exposure on the bond associated with the first five
years’ of its life, the entity acquires a five–year pay-fixed, receive-floating swap. The swap has a fair value of zero at the
inception of the hedge relationship.
Solution
Yes.
The IAS 39 Implementation Guidance (at former para IG F.2.17 on partial term hedging) allowed hedging a financial
instrument (the hedged item) for only a portion of its cash flows or fair value, if effectiveness can be measured and the other
hedge accounting criteria are met.
The swap could be designated as hedging the fair value exposure of the interest rate payments on the government bond
until year 5, and the change in value of the principal payment due at maturity, to the extent affected by changes in the yield
curve relating to the five years of the swap.
The same principle applies if the hedged item had been a financial liability instead of a financial asset with the same terms. In
that situation, the entity could designate the fair value exposure of the first five years’ interest payments due to changes in
interest rate only, and hedge that exposure using a five–year receive–fixed, pay–floating interest rate swap.
The entity is also able to achieve hedge accounting for partial term cash flow hedges of financial items. For instance, assume
an entity issues a ten–year floating–rate debt and wishes to hedge the variability in the first three years of interest payments
using a three–year receive–floating, pay–fixed interest rate swap. The entity could designate the swap as hedging the
variability in cash flows arising from the first three years of interest payments.
Detailed illustrations
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Introduction
The following detailed examples illustrate how hedge accounting can be applied in practice. The objective is to present the
mechanics of applying IFRS 9 requirements, starting with the entity's risk management and effectiveness testing policies,
working through the necessary designation, assessment of economic relationships and culminating with the accounting
entries.
The examples illustrate some of the most common hedging strategies used in practice and those now possible under the
new hedge accounting criteria of IFRS 9. The issues addressed are summarised in the table below:
Illustration Type of hedge and Key points

hedged risk
1. Hedge of forecast Cash flow hedge
foreign currency Spot rate designated
purchases FX risk (spot component only).
Basis adjustment required
for inventory
Cost of hedging approach
elected – Forward points
taken to OCI
Inclusion of time value of
money in measuring hedge
ineffectiveness

foreign currency sales Intrinsic value designated
with a purchased FX risk (one-sided risk and
option intrinsic value designation) Reclassification of intrinsic
value and time value when
sales occur
required given intrinsic
value designation
3. Hedge of net Cash flow hedge

foreign currency Hedging of net position
position comprising FX net risk (forward risk).
offsetting risk Presentation of the effect of
positions hedging
4. Hedge of a floating Cash flow hedge

rate borrowing with a SONIA risk designated
floating to fixed swap Interest rate risk.

rate borrowing with a Amortisation of time value
purchased cap Interest rate risk (one-sided of option
risk and intrinsic value
designation).
Impact of cap being in or
out of the money
required given intrinsic
value designation
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6. Hedge of a fixed Fair value hedge and Cash

rate borrowing to flow hedge Ability to add a hedge on
floating with top of a previous hedged
subsequent hedge Interest rate risk
back to fixed position and designate the
hedged item as a
combination of a derivative
and a non-derivative
(aggregated hedge)
7. Jet fuel hedging Cash flow hedge

(designation of risk Ability to hedge
components being Commodity risk components components of non-
crude oil price risk
and refining margin or a. Crude oil (hedge financial items i.e. exclude
‘crack spread’ price 1) fixed margin, tax and other
risk) b. Refining
margin/crack costs
spread (hedge Basis adjustment required
2) at a later
date. for inventory
No need to reset
hypothetical derivative on
hedge 1 when hedge 2 is
entered into as hedge 2 is a
new hedge

aluminium purchases Ability to add a hedge on
denominated in a a. Commodity risk top of a previous hedged
foreign currency aluminium
forward price, position and designate the
and hedged item as a
b. FX risk at a later
date combination of a derivative
and a non-derivative
(aggregated hedge)
No need to reset
hypothetical derivative
when additional risk is
layered on (new hedge
relationship)
9. Hedge of a net Net investment hedge

investment in a Consideration of time value
foreign operation Foreign currency risk of money
10. Hedge of foreign Cash flow hedge

currency denominated A method of accounting for
borrowing with a Currency risk. currency basis spread
cross-currency
interest rate swap
(CCIRS)
rate debt with floating Implications of using a
to fixed swap that has Interest rate risk. hedging instrument with a
a starting value upon
designation starting value
These illustrations do not set out all of the ways of complying with IFRS 9’s hedge accounting requirements. Nor are they
exhaustive other approaches to hedge accounting may be equally acceptable. The illustrations include ‘helpful hint’ boxes
that highlight important issues, give additional guidance and contain tips relating to the illustrations.
In the illustrations both current and deferred tax effects have been excluded. The tax rules for derivatives vary between
jurisdictions and can be complex such that specialist assistance is recommended.
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The illustrations also exclude the disclosures required by IFRS 7.
UK Contacts
Yann Umbricht
E: yann.umbricht@pwc.com
Jessica Taurae
E: jessica.taurae@pwc.com
David Coulon
E: david.coulon@pwc.com
Chris Raftopoulos
E: christopher.raftopoulos@pwc.com
Claire Howells
E: claire.l.howells@pwc.com
Frances Coldham
E: frances.coldham@pwc.com
Robert Waddington
E: robert.waddington@pwc.com
Sally Nicholson
E: sally.nicholson@pwc.com
Energy, utilities and mining
Financial reporting in the oil and gas industry
This publication focuses on areas of financial reporting under IFRS that are of most interest to companies in the oil and gas
industry. The issues are addressed following the oil and gas value chain: exploration and development, production and sales
of product, together with issues that are pervasive to a typical oil and gas entity.
3. Midstream and downstream activities
3.1 Overview
Midstream and downstream activities in the oil and gas industry include the transportation of crude oil and gas, the refining
of crude oil and the sales of the refined products. This part of the value chain is also dependent on significant capital
investment. This includes refineries, liquefied natural gas (LNG) facilities, pipeline networks and retail stations. Integrated oil
and gas companies might also have divisions that perform speculative trading of oil and gas.
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3.2 Inventory valuation
Inventory is usually measured at cost as determined under IAS 2. Various methods are available; specific identification,
weighted average or first-in first-out (FIFO). Generally, most entities use cost. In some circumstances inventory of
commodities can be valued at net realisable value (NRV) or fair value less costs of disposal (FVLCOD). FVLCOD for
commodities is usually equivalent to their NRV. The circumstances in which FVLCOD/NRV can be used are described below.
3.2.1 Producers’ inventories
Inventory of minerals and mineral products should be measured at NRV when this is wellestablished industry practice. [IAS 2
para 3]. It is not usual industry practice for inventories of oil and gas to be measured on this basis, especially by downstream
producers. It might however be established practice in certain countries or for commodity trading businesses. Entities
operating in those territories might be able to adopt this policy.
Changes in the carrying amount of inventories that are carried at NRV are recognised in the income statement in each
period. Determination of NRV reflects the conditions and prices that exist at the balance sheet date. [IAS 2 para 30].
Adjustments are not made to valuations to reflect the time that it will take to dispose of the inventory or the effect that the
sale of a significant inventory quantity might have on the market price.
The prices of firm sales contracts are used to calculate NRV only to the extent of the contract quantities, but only if the
contracts are not themselves recognised on the balance sheet under another standard, such as IFRS 9.
3.2.2 Broker-dealer inventories
Inventories held by broker-dealers are measured at FVLCOD. [IAS 2 para 3]. The fair value used is the spot price at the
balance sheet date. It is not appropriate to modify the price to reflect a future expected sale by applying a future expected
price from a forward price curve.
The definition of broker-trader within IAS 2, and inventories which will fall into this category, is narrow. Items in this category
should be principally acquired for the purpose of resale. It is expected that there would be minimal repackaging of such
items, and nothing which would change its underlying nature. This requirement can prevent entities from qualifying for the
broker-trader exemption if they perform a blending activity, because this changes the chemical composition of the product
which is sold. A blending process, for example, might occur not only as part of an entity’s deliberate repackaging of a
product, but also as a by-product of its storage process. Where an entity wishes to treat its inventory as a broker-trader,
careful consideration must be given to whether any activities are performed which would change the nature of the product
and therefore prevent it from meeting the requirements of IAS 2.
The carrying amount of inventories that are valued at FVLCOD must be disclosed in the notes. [IAS 2 para 36].
3.2.3 Line fill and cushion gas
Some items of property, plant and equipment, such as pipelines, refineries and gas storage, require a certain minimum level
of product to be maintained in them in order for them to operate efficiently. This product is usually classified as part of the
PPE, because it is necessary to bring the PPE to its required operating condition. [IAS 16 para 16(b)]. The product will
therefore be recognised as a component of the PPE at cost, and it will be subject to depreciation to estimated residual value.
Product owned by an entity that is stored in PPE owned by a third party is usually classified as inventory. This would include,
for example, all gas in a rented storage facility. It does not represent a component of the third party’s PPE or a component of
PPE owned by the entity. Such product should therefore be measured at FIFO or weighted average cost.
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Cushion gas
Should cushion gas be accounted for as PPE or as inventory?
Background
Gaseous Giant SA (GG) is an entity involved in the production and trading of natural gas. GG has purchased salt caverns
to use as underground gas storage.
The salt cavern storage is reconditioned to prepare it for injection of gas. The natural gas is injected and as the volume of
gas injected increases, so does the pressure. The salt cavern therefore acts as a pressurised container.
The pressure established within the salt cavern is used to push out the gas when it needs to be extracted. When the
pressure drops below a certain threshold, there is no pressure differential to push out the remaining natural gas. This
remaining gas within the cavern is therefore physically unrecoverable until the storage facility is decommissioned. This
remaining gas is known as cushion gas.
Should GG’s management account for the cushion gas as PPE or as inventory?
Solution
GG’s management should classify and account for the cushion gas as PPE.
The cushion gas is necessary for the cavern to perform its function as a gas storage facility. It is therefore part of the
storage facility and should be capitalised as a component of the storage facility PPE asset.
The cushion gas should be depreciated to its residual value over the life of the storage facility in accordance with para 43
of IAS 16. However, if the cushion gas is recoverable in full when the storage facility is decommissioned, depreciation
will be recorded against the cushion gas component only if the estimated residual value of the gas decreases below cost
during the life of the facility.
When the storage facility is decommissioned and the cushion gas extracted and sold, the sale of the cushion gas is
accounted for as the disposal of an item of PPE in accordance with para 68 of IAS 16. Accordingly, the gain/loss on
disposal is recognised in profit or loss.
The natural gas in excess of the cushion gas that is injected into the cavern should be classified and accounted for as
inventory in accordance with IAS 2.
New leasing standard IFRS 16 is effective on 1 January 2019. Refer to section 7.3.6
for further guidance on lessee accounting.
3.2.4 Net realisable value of oil inventories
Oil produced or purchased for use by an entity is valued at the lower of cost and net realisable value (NRV) unless it is raw
product which the entity intends to process to create a new product e.g. refining of crude oil. Determining NRV requires
consideration of the estimated selling price in the ordinary course of business less the estimated costs to complete
processing and to sell the inventories. An entity determines the estimated selling price of the oil/oil product using the market
price for oil at the balance sheet date, or where appropriate, the forward price curve for oil at the balance sheet date. Use of
the forward price curve would be appropriate where the entity has an executory contract for the sale of the oil. Movements in
the oil price after the balance sheet date typically reflect changes in the market conditions after that date and so they should
not be reflected in the calculation of NRV.
NRV of oil inventories
Should NRV for oil inventories at the balance sheet date be calculated using the oil price at the balance sheet date, or
should changes in the market price after the balance sheet date be taken into account? In other words, is the decline in
the market price an adjusting event?
Background
Entity A is a retailer of oil. It has oil inventories at the balance sheet date. The cost of the oil was C800. Valuing the oil at
market price at the balance sheet date, the value is C750. The market price of oil has fallen further since the balance
sheet date, and the value of the inventory at the balance sheet date is now C720, based on current prices.
Should entity A calculate NRV for the oil at the balance sheet date using the market value at the balance sheet date, or
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using the subsequent, lower, price?
Solution
Entity A should calculate the NRV of the oil inventory using the market price at the balance sheet date. The market price
of oil changes daily in response to world events. So the changes in the oil price since the balance sheet date reflect
events occurring since the balance sheet date. These represent non-adjusting events as defined by IAS 10.
Disclosure of the fall in the price of oil since the balance sheet date, and its potential impact on inventory values, should
be made in the financial statements if this is relevant to an understanding of the entity’s financial position. [IAS 10 para
2].
If further processing of the inventory is required in order to convert it into a state suitable for sale, the NRV should be
adjusted for the associated processing costs.
3.2.5 Spare parts
The plant and machinery used in the refining process can be complex pieces of equipment, and entities usually maintain a
store of spare parts and servicing equipment for critical components. These are often carried as inventory and recognised in
profit or loss as consumed. Major spare parts, stand-by equipment and servicing equipment can also qualify as property,
plant and equipment when they meet the definition of PP&E. Spare parts in inventory or PP&E should be carried at cost,
unless there is evidence of damage or obsolescence.
3.4 Emissions trading schemes
Carbon credits can be used by companies to meet:
compliance requirements, such as a net emission cap or the cap under an

Emission Trading Scheme or ETS (also referred to as ‘cap and trade’) where
companies are typically allocated emission allowances based on their targeted
levels of emissions; or
voluntary emission targets. This is called the voluntary carbon market or VCM.
For additional discussion of voluntary and compliance schemes refer to the following PwC publications:
In depth - Impact of ESG matters on IFRS financial statements (Section 5 -

Emissions Trading Schemes)
In depth - IFRS Financial reporting considerations for entities participating in the
voluntary carbon market
In depth - Accounting for Green/Renewable Power Purchase Agreements from the
Buyer’s Perspective
EX 16.85.9 – Detailed discussion of applying the recognition criteria to emissions
obligations
FAQ 33.21.3 – How does the ability to generate carbon credits affect a forest's fair
value?
Emissions Trading Systems: The Opportunities Ahead
3.5 Depreciation of downstream assets

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This section focuses on the depreciation of downstream assets such as refineries, gas treatment installations, chemical
plants, distribution networks and other infrastructure.
Downstream phase assets are depreciated using a method that reflects the pattern in which the asset’s future economic
benefits are expected to be consumed. The depreciation is allocated on a systematic basis over an asset’s useful life. The
residual value and the useful lives of the assets are reviewed at least at each financial year-end and, if expectations differ
from previous estimates, the changes are accounted for as a change in an accounting estimate in accordance with IAS 8
Accounting policies, changes in accounting estimates and errors.
Downstream assets such as refineries are often depreciated on a straight line basis over the expected useful lives of the
assets. An alternative approach is using a throughput basis. For example, for pipelines used for transportation, depreciation
can be calculated based on units transported during the period as a proportion of expected throughput over the life of the
pipeline.
IFRS has a specific requirement for ‘component’ depreciation, as described in IAS 16. Each significant part of an item of
property, plant and equipment is depreciated separately. [IAS 16 paras 43–44]. The requirements of IFRS in respect of
components are considered in section 2.8.3.
The significant components of these types of assets must be separately identified. This can be a complex process,
particularly on transition to IFRS, because the detailed recordkeeping might not have been required to comply with national
GAAP. Some components can be identified by considering the routine shutdown/ turnaround schedules and the replacement
and maintenance routines associated with these.
3.5.1 Cost of turnaround/overhaul
The costs of performing a major turnaround/overhaul are capitalised if the turnaround gives access to future economic
benefits. Such costs will include the labour and materials costs of performing the turnaround. However, turnaround/overhaul
costs that do not relate to the replacement of components or the installation of new assets should be expensed as incurred.
[IAS 16 para 12]. Turnaround/overhaul costs should not be accrued over the period between the turnarounds/overhauls,
because there is no legal or constructive obligation to perform the turnaround/overhaul.
Refinery turnarounds
How should refinery turnarounds be accounted for?
Background
Entity Y operates a major refinery. Management estimates that a turnaround is required every 30 months. The costs of a
turnaround are approximately $500,000: $300,000 for parts and equipment, and $200,000 for labour to be supplied by
employees of entity Y.
Management proposed to accrue the cost of the turnaround over the 30 months of operations between turnarounds and
to create a provision for the expenditure.
Is management’s proposal acceptable?
Solution
No. It is not acceptable to accrue the costs of a refinery turnaround. Management has no constructive obligation to
undertake the turnaround. The cost of the turnaround should be identified as a separate component of the refinery at
initial recognition and depreciated over a period of 30 months. This will result in the same amount of expense being
recognised in the income statement over the same period as the proposal to create a provision.
4. Sector-wide accounting issues
4.2 Joint arrangements
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4.2.1 Overview
Joint ventures and other similar arrangements (joint arrangements) are frequently used by oil and gas companies as a way to
share the higher risks and costs associated with the industry or as a way of bringing in specialist skills to a particular project.
The legal basis for a joint arrangement may take various forms; establishing a joint venture might be achieved through a
formal joint venture contract, or the governance arrangements set out in a company’s formation documents might provide
the framework for a joint arrangement. The feature that distinguishes a joint arrangement from other forms of cooperation
between parties is the presence of joint control. An arrangement without joint control is not a joint arrangement.
4.2.2 Joint control
Joint control is the contractually agreed sharing of control of an arrangement, which exists only when the decisions about the
relevant activities require the unanimous consent of the parties sharing control. Joint operators and joint ventures need not
hold equal shareholdings in an entity for joint control to exist. Further guidance can be found in the PwC Manual of
Accounting Chapter 32 paragraphs 5 to 21.
PwC Observation
Not all parties to the joint venture need to share joint control. Some participants may share joint control and other
investors may participate in the activity but not in the joint control. Section 4.2.7 discusses the accounting for these
participants. Similarly, joint control may not be present even if an arrangement is described as a ‘joint venture’.
Decisions over financial and operating decisions that are made by ‘simple majority’ rather than by unanimous consent
could mean that joint control is not present.
In the upstream oil and gas industry one of the parties to a joint arrangement, usually referred to as the operator, carries
out the day-to-day management of the production activities. This does not mean that this party would control the
arrangement. As long as these decisions represent less important issues that arise in the day-to-day management of the
business, and that are made within the parameters set out by the parties exercising joint control, this should not impact
the existence of joint control.
This is a complex area which will require careful analysis of the facts and circumstances. If joint control does not exist,
the arrangement would not be a joint venture. A key test when identifying if joint control exists is to identify how disputes
between ventures are resolved. If joint control exists, resolution of disputes will usually require eventual agreement
between the venturers, independent arbitration, or dissolution of the joint venture.
General FAQs and EXs of Particular Relevance to the Industry
FAQ 32.6.2 – How should a joint arrangement account for businesses contributed to it by its investors, on formation or
otherwise?
EX 32.9.1 – Unequal interests
EX 32.11.1 – Presence of contractual arrangement through articles of association
FAQ 32.11.2 – Presence of contractual arrangement through informal agreements
EX 32.14.1 – Impact of designating one of the joint partners to carry out the day-to-day activities in determining joint control
4.2.3 Classification of joint ventures
There are two types of joint arrangements for accounting purposes:
Term IFRS 11 definition

Joint operation The arrangement is a joint operation where the contractual agreement provides rights to assets
and obligations for liabilities for those parties sharing joint control.
Parties who share joint control over a joint operation are called joint operators.
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Joint venture The arrangement is a joint venture where the agreement grants rights to the arrangement’s net
assets.
Parties who share the joint control over a joint venture are called joint venturers. Reference to
net assets indicates that the joint venturer has an investment in the arrangement. Venturers
could also have a net liability involvement in the joint venture.
Classification depends on the rights and obligations that arise from the contractual arrangement. An entity that shares joint
control needs to look at the contractual arrangement’s substance and apply judgement, to determine whether it is party to a
joint operation or a joint venture. Further guidance can be found in the PwC Manual of Accounting Chapter 32 paragraphs 23
to 26.
Determining the classification of joint arrangements is a four-step process. Further guidance can be found in the PwC
Manual of Accounting Chapter 32 paragraph 29.
Step 1: Is the arrangement structured through a separate vehicle?
A separate vehicle is a separately identifiable financial structure including separate legal entities or entities recognized by
statute, regardless of whether those entities have a legal personality. Further guidance can be found in the PwC Manual of
Accounting Chapter 32 paragraph 30.
PwC Observation
The definition of a ‘separate vehicle’ is quite broad. It does not necessarily need to have a legal personality. Separate
vehicles are generally separately identifiable financial structures having separately identifiable assets, liabilities,
revenues, expenses, financial arrangements, financial records etc.
Local laws and regulations also need consideration before determining whether a particular structure meets the
definition of a ‘separate vehicle’.
Joint arrangement not in a separate vehicle
An arrangement that is not structured through a separate vehicle is a joint operation. The parties determine in such
contractual arrangements their rights to the assets, and their obligations for the liabilities, relating to the arrangement. These
are classified as joint operations. Further guidance can be found in the PwC Manual of Accounting Chapter 32 paragraphs
31 to 33.
PwC Observation
Oil and gas joint working arrangements such as “working interests” often do not operate through separate vehicles and
so are classified as joint operations.
General EXs of Particular Relevance to the Industry
EX 32.32.1 – Joint operation not in a separate vehicle

EX 32.33.1 – Examples of joint operations in the oil and gas industry
Joint arrangement in a separate vehicle
A joint arrangement that is structured through a separate vehicle can be either a joint operation or a joint venture, depending
on the parties’ rights and obligations relating to the arrangement.
The parties need to assess whether the legal form of the separate vehicle, the terms of the contractual arrangement and,
when relevant, any other facts and circumstances give them:
a. rights to the assets and obligations for the liabilities relating to the arrangement (i.e. joint operation); or
b. rights to net assets of the arrangement (i.e. joint venture).
Further guidance can be found in the PwC Manual of Accounting Chapter 32 paragraphs 34 to 36.
Management assesses the parties’ rights and obligations arising from the arrangement as they exist in the ‘normal course of
business’. Legal rights and obligations arising in circumstances other than in the ‘normal course of business’, such as
liquidation and bankruptcy, are less relevant. Further guidance can be found in the PwC Manual of Accounting Chapter 32
paragraph 26.
Step 2: Does the legal form confer direct rights to assets and obligations for liabilities to the parties of the
arrangement?
If the legal structure of the arrangement is such that the parties have rights to assets and are obligated for the liabilities of the
arrangement, then it is a joint operation. The local laws and regulations need to be carefully assessed in order to ascertain
this.
The key question is whether the separate vehicle can be considered in its own right i.e. are the assets and liabilities held in
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the separate vehicle those of the separate vehicle or are they the assets and liabilities of the parties?
PwC Observation
Type of separate vehicle:
Partnerships - In some jurisdictions general partnerships cannot be considered

in their own right i.e. the partners have obligations for the liabilities and the
partnership does not have beneficial title to assets. In other jurisdictions general
partnerships may be able to hold beneficial titles to certain assets, so a clear
understanding of the relevant legal and contractual terms is required. A limited
liability partnership (LLP) would typically be considered in its own right since the
partners are not obligated for the liabilities of the LLP and the assets of the LLP
are its own assets.
Limited liability companies - In most jurisdictions these can be considered in
their own right i.e. the assets and liabilities of the company are its own assets
and liabilities. The creditors and lenders of the company do not have a right to
claim payments from the shareholders. However, unlimited liability companies
may sometimes provide direct rights to assets and obligations for liabilities to
the parties depending on the relevant facts and circumstances.
Unincorporated entities - when an arrangement is operated through this type
of vehicle, in most cases, the parties will have the right to assets and have
obligations for liabilities of the arrangement.
Local laws and regulations play a key role in the assessment of the rights and obligations conferred by the separate
vehicle. The same legal form (such as a partnership) in different territories could give different rights and obligations
depending on the local laws and regulations. The contractual terms between the parties and, when relevant, other facts
and circumstances can override the assessment of the rights and obligations conferred by the legal form.
General FAQ and EX of Particular Relevance to the Industry
EX 32.39.1 – Legal form provides separation

FAQ 32.39.2 – Can two arrangements be classified differently, if one is structured as a separate vehicle and the other is not?
Step 3: Does the contractual arrangement between parties confer direct rights to assets and obligations for liabilities
to the parties of the arrangement?
The joint arrangement’s legal form is an important factor, but it might not provide sufficient evidence to classify a joint
arrangement as a joint venture. The terms agreed by the venturers and other facts might reverse the separation granted by
the legal form. The parties may enter into contractual terms which modify or reverse the rights and obligations conferred by
the legal form of the arrangement. The contractual terms have to be carefully assessed to ensure the appropriate
classification of a joint arrangement. Further guidance can be found in the PwC Manual of Accounting Chapter 32
paragraphs 40 to 45.
Impact of guarantees on classification of a joint arrangement
Parties to joint arrangements often provide guarantees to third parties on behalf of the arrangement when the arrangement is
purchasing goods, receiving services or obtaining financing. Issuing a guarantee does not on its own mean that the
arrangement is a joint operation. Further guidance can be found in the PwC Manual of Accounting Chapter 32 paragraph 44.
PwC Observation
All relevant facts and circumstances should be considered in determining the classification. Rights and obligations of the
parties to a joint arrangement are assessed as they exist in the normal course of business. It is not appropriate to make
a presumption that the arrangement will not settle its obligations and that the parties will be obligated to settle those
liabilities because of the guarantee issued. This would not be seen as a normal course of business.
General EXs of Particular Relevance to the Industry
EX 32.42.1 – Contractual agreement reversing the impact of legal form

EX 32.45.1 – Determining joint arrangement classification
Step 4: Do other facts and circumstances lead to direct rights to assets and obligations for liabilities being conferred
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to the parties of the arrangement?
The terms and conditions in the contractual agreement do not always provide sufficient evidence to determine what type of
joint arrangement the parties are entering into. Parties should look at the other facts surrounding the joint arrangement’s
existence. The design and purpose of the investee can provide further evidence of the nature of the arrangement. Further
guidance can be found in the PwC Manual of Accounting Chapter 32 paragraphs 46 to 49.
PwC Observation
Assessment of ‘other facts and circumstances’ grows more challenging as the arrangements between parties become
increasingly complex. When arrangements are incorporated in limited liability companies, classifying them as joint
operations on the basis of ‘other facts and circumstances’ is not easy and is a high hurdle to overcome. This is because
classifying them as joint operations means that the corporate veil has to be pierced. The parties’ will then record assets
and liabilities relating to the arrangement, although legally they neither have rights to the assets nor the obligation for the
liabilities. Consideration should be given to all facts and circumstances before reaching a conclusion.
The IFRS Interpretations Committee has determined that the assessment of other facts and circumstances should be
undertaken with a view towards whether those facts and circumstances can create enforceable rights to assets and
obligations for liabilities.
Some of the general characteristics of an arrangement with the purpose and design of a joint operation:
Parties generally restrict the arrangement from selling the output to third parties
to ensure that they have uninterrupted access to the output.
There is a binding obligation on the parties to purchase substantially all of the
output – if the parties did not have an obligation to take the output, the
arrangement may sell the output to third parties, indicating that the purpose and
design of the arrangement was not to provide all of its output to the parties.
Monetary value of the output is more relevant than physical quantities. Nature of
the output does not impact the assessment.
The demand, inventory and credit risks relating to the activities of the
arrangement are passed on to the parties and do not rest with the arrangement.
The parties ensure that the output is purchased from the arrangement at a price
that covers all the costs of the arrangement and it operates at a break-even
level. Market price might not provide cash flows at sufficient level. Selling output
at a market price does not prevent classifying the arrangement as a joint
operation. The key is to assess the purpose and design of the arrangement. It
may not be necessary for the arrangement to operate at a break-even level. If
the arrangement is designed to provide all the output to the parties, the price at
which the output is purchased by the parties may become a less relevant factor
in determining the classification.
The arrangement does not generally have any borrowings and the parties are
substantially the only source of cash flows. Arrangements may have borrowings
for financing their working capital requirements or for capital expansion. As long
as the arrangement is designed to provide all the output to the parties, it means
that the arrangement will not be able to make the interest payments and the
principal repayments without receiving funds from the parties. This may indicate
that the arrangement continues to be a joint operation.
EX 32.49.1 – Joint construction and use of a pipeline

FAQ 32.49.2 – Other facts and circumstances
FAQ 32.49.3 – Should the assessment of ‘other facts and circumstances’ be based only on contractual and legally
enforceable terms?
FAQ 32.49.4 – Does the sale of the output from the joint arrangement to the parties at a market price prevent classification
as a joint operation?
FAQ 32.49.5 – What factors might be less relevant when assessing other facts and circumstances?
FAQ 32.49.6 – Should volumes or monetary values of output be the basis when determining ‘substantially all of the output’?
Industry Specific EX
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IND EX 4.2.3.1 - Other facts and circumstances
Reassessment of classification
An entity should re-assess whether the type of joint arrangement has changed if facts and circumstances change. Further
guidance can be found in the PwC Manual of Accounting Chapter 32 paragraph 27.
4.2.4 Accounting for joint operations
Investors in a joint operation are required to recognise the following:
its assets, including its share of any assets held jointly;

its liabilities, including its share of liabilities incurred jointly;
its revenue from the sale of its share of the output arising from the joint operation;
its share of the revenue from the sale of the output by the joint operation; and
its expenses, including its share of any expenses incurred jointly.
The operator treats the operations as if it conducted them directly. The accounting entries are booked in the joint operator’s
own financial statements.
PwC Observation
The share of assets and liabilities is not the same as proportionate consolidation. ‘Share of assets and liabilities’ means
that the investor should consider their interest or obligation in each underlying asset and liability under the terms of the
arrangement – it will not necessarily be the case that they have a single, standard percentage interest in all assets and
liabilities.
FAQ 32.6.1 – Does IFRS 11 apply to the accounting by the joint arrangement itself: joint operations?
FAQ 32.51.1 – What are the accounting treatments of the investor in different types of joint arrangements in the consolidated
and separate financial statements?
FAQ 32.54.1 – Obtaining an interest in a joint operation: what are the main differences between a business combination and
an asset acquisition?
FAQ 32.60.1 – What are the accounting implications in the separate financial statements of the joint operator?
FAQ 32.62.3 – How should an investor account for a joint arrangement with legal separation that is a joint operation?
FAQ 32.62.5 – What is the accounting treatment where all of the output is taken by joint operators?
FAQ 32.62.6 – What is the accounting treatment where the share of output purchased differs from ownership interest?
EX 32.62.7 – Accounting by the operator in a joint operation
EX 32.62.8 – Output received differs from entitled output ('overlift and underlift')
4.2.5 Accounting for joint ventures (JVs)
A joint venturer uses the equity method to account for its investment in a joint venture. Equity accounting is covered in IAS
28 Investments in associates and joint ventures.
The key principles of the equity method of accounting are described in IAS 28 Investments in associates and joint ventures:
investment in the JV is initially recognised at cost;

changes in the carrying amount of investment are recognised based on the
venturer’s share of the profit or loss of the JV after the date of acquisition;
the venturer only reflects their share of the profit or loss of the JV; and
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distributions received from a JV reduce the carrying amount of the investment.

PwC Observation
The results of the joint venture are incorporated by the venturer on the same basis as the venturer’s own results – i.e.
using the same GAAP (IFRS) and the same accounting policy choices. The growing use of IFRS and convergence with
US GAAP has helped in this regard but the basis of accounting should be set out in the formation documents of the joint
venture.
FAQ 32.73.1 – Formation of a joint venture: What is the accounting by the joint venturer on formation of a joint venture from
previous investment?
FAQ 32.73.2 – Formation of a joint venture: How should an entity account for any difference between the fair value of a
business contributed and the fair value of the assets contributed by the other venturers?
FAQ 31.49.1 – Practical situation requiring adjustment for different accounting policies
4.2.6 Contributions to joint arrangements
Participants frequently contribute assets such as cash, non-monetary assets or a business to a joint arrangement on
formation.
Contributions of assets are a partial disposal by the contributing party. The party to the arrangement receives in return a
share of the assets contributed by the other participants. Accordingly, the contributor should recognise a gain or loss on the
partial disposal. The gain is measured as the proportionate share of the fair value of the assets contributed by the other
participants less the portion of the book value of the contributor’s disposed asset now attributed to the other participants.
The participant recognises its share of an asset contributed by other participants at its share of the fair value of the asset
contributed. For a joint operation this is classified in the balance sheet according to the nature of the asset. For a joint
venture, the equivalent measurement basis is achieved when equity accounting is applied; however, the interest in the asset
forms part of the equity accounted investment balance.
The same principles apply when one of the other participants contributes a business to a joint arrangement; however, one of
the resulting assets will normally be goodwill, calculated in the same way as in a business combination. It will be recognised
as a goodwill for an interest in a joint operation or included as part of the investment cost (notional goodwill) for an equity-
accounted joint venture.
Further guidance can be found in the PwC Manual of Accounting Chapter 32 paragraph 56 and PwC Manual of Accounting
Chapter 32 paragraph 73.
An entity might contribute a controlled business to a joint venture or associate, or it might decrease its stake in a controlled
business to that of an investment in an associate or joint venture. There is a conflict between the requirements of IFRS 10
and IAS 28 on accounting for such a transaction. This acknowledged conflict gives rise to an accounting policy choice.
The IASB has published amendments to IFRS 10 and IAS 28, to resolve the conflict and to clarify that full gain or loss is
recognised by the investor on contribution of a business, and partial gain or loss on the contribution of assets that do not
meet the definition of a business. The amendments are available to be adopted, but the IASB has deferred the mandatory
effective date of the amendment indefinitely, pending finalisation of its research project on the equity method.
EX 32.56.1 – Contribution of asset on formation of a joint operation

EX 32.56.2 – Obtaining joint control of a joint operation: contribution of assets
EX 32.73.3 – Venturer transfers a business to a joint venture in exchange for equity interest: accounting policy under IAS 28
EX 32.73.4 – Venturer transfers a business to a joint venture in exchange for equity interest: accounting policy under IFRS 10
4.2.7 Investments with less than joint control
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The parties that do not share joint control should evaluate whether they have rights to individual assets and obligations for
liabilities, because they would need to account for these in their financial statements. If they have such rights and
obligations, their accounting would be similar to joint operators. Parties that do not share joint control might not have direct
rights to assets and obligations for liabilities. For example, this might be the case where a party that does not have joint
control has contributed funding to an operation in return for a right to a share of the output from the operation, as opposed
to direct rights to assets or obligations for liabilities. Parties that do not have rights to individual assets should account for
their investment in accordance with the relevant IFRSs. Further guidance can be found in the PwC Manual of Accounting
Chapter 32 paragraph 91.
The investors in a joint operation, including those who do not share joint control but have rights to the assets and obligations
for the liabilities, account for their rights and obligations. They recognise, in both their consolidated and separate financial
statements, the assets and obligations that arise from the joint arrangement. Further guidance can be found in the PwC
Manual of Accounting Chapter 32 paragraph 92.
PwC Observation
Some co-operative arrangements may appear to be joint arrangements but fail on the basis that unanimous agreement
between venturers is not required for key strategic decisions. This may arise when a super majority, for example an 80%
majority, is required but where the threshold can be achieved with a variety of combinations of shareholders and no
venturers are able to individually veto the decisions of others. Accounting for these arrangements will depend on the
way they are structured and the rights of each venturer.
A party to a joint venture that does not share joint control should account for its investment in the consolidated financial
statements in accordance with IFRS 9, or in accordance with IAS 28 if the party has significant influence. Further guidance
can be found in the PwC Manual of Accounting Chapter 32 paragraph 93.
PwC Observation
Investors may have an undivided interest in a tangible or intangible asset where there is no joint control and the
investors have a right to use a share of the operative capacity of that asset. An example is when a number of investors
have invested in a shared pipeline network and an investor with a 20% interest has the right to use the network. Industry
practice is for an investor to recognise its undivided interest at cost less accumulated depreciation and any impairment
charges.
An undivided interest in an asset is normally accompanied by a requirement to incur a proportionate share of the asset’s
operating and maintenance costs. These costs should be recognised as expenses in the income statement when
incurred and classified in the same way as equivalent costs for wholly-owned assets.
This accounting would not be appropriate where the investment was made through a legal entity as opposed to a direct
ownership interest in the assets.
General EX of Particular Relevance to the Industry
EX 32.50.1 – Party to a joint arrangement
Industry Specific FAQ
IND FAQ 4.2.7.1 Can a venturer account for its share of revenue and assets?
4.2.8 Changes in ownership in a joint

arrangement
A participant in a joint arrangement may increase or decrease its interest in the arrangement. The appropriate accounting for
an increase or decrease in the level of interest in the joint arrangement will depend on the type of joint arrangement and on
the nature of the new interest following the change in ownership.
Change in ownership - Joint operations
The accounting for a change in the ownership will depend on whether the assets under the arrangement represent a
business and the level of control which exists after the change in ownership. If the operation meets the definition of a
business and control is obtained, this represents a business combination and the pre-existing interest held will be
considered disposed of and revalued to its fair value. The accounting for business combinations is discussed in section 4.1.
Where a joint operator acquires an additional interest the joint operator should apply business combination accounting to the
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extent of its share, where the activity of the joint operation constitutes a business. However, the pre-existing interest will not
be re-measured if the joint operator obtains joint control or retains joint control.
Reductions in the interest in joint operations will result in derecognising an amount of carrying value equivalent to the
proportionate share disposed, if joint control remains. Further guidance can be found in the PwC Manual of Accounting
Chapter 32 paragraphs 57 to 58 and PwC Manual of Accounting Chapter 31 paragraph 34. If joint control does not remain,
the operators have to re-evaluate whether they still have rights to individual assets and obligations for liabilities and account
for the remaining interest accordingly. See section 4.2.7 for detail.
General FAQs of Particular Relevance to the Industry
FAQ 31.34.1 – Partial disposal of an associate retaining significant influence

FAQ 31.71.1 – Practical considerations regarding loss of significant influence
FAQ 32.57.1 – What are the accounting implications of obtaining control over a joint operation that meets the definition of a
business?
FAQ 32.57.2 – Changes in levels of ownership whilst retaining joint control: new joint operator in the contractual arrangement
FAQ 32.57.3 – What are the accounting implications of obtaining control over a joint operation that does not meet the
definition of a business?
Change in ownership - Joint ventures
Accounting for increases in interest in a joint venture will depend on the level of control post acquisition. If control is
obtained, a business combination has taken place. The carrying amount previously recognised under equity accounting
would be derecognised, acquisition accounting would be applied and the entity would be fully consolidated. This would
require a fair value exercise, remeasurement of the previously held interest and measurement of non-controlling interest and
goodwill. There may also be a gain or loss to recognise in the income statement.
A partial disposal of an equity accounted interest that results in no change in joint control or a change to significant influence
results in the entity derecognising a proportion of the carrying amount of the investment. It will recognise any gain or loss
arising on the disposal in the income statement. The entity does not remeasure the retained interest.
Further guidance can be found in the PwC Manual of Accounting Chapter 32 paragraphs 83 to 85 and PwC Manual of
Accounting Chapter 31 paragraph 31 .
General FAQ of Particular Relevance to the Industry
FAQ 32.85.1 – What are the implications of changes in levels of ownership whilst retaining joint control?
4.2.9 Accounting by the joint arrangement
Accounting by the joint venture
The joint venture itself will normally prepare its own financial statements for reporting to the joint venture partners and for
statutory and regulatory purposes. Joint ventures are typically created by the venturers contributing assets or businesses to
the joint venture in exchange for their equity interest in the JV. An asset contributed to a joint venture in exchange for issuing
shares to a venturer is a transaction within the scope of IFRS 2 Share-based payments. These assets are recognised at fair
value in the financial statements of the joint arrangement. However, the accounting for the receipt of a business contributed
by a venturer is not specifically addressed in IFRS as it is outside the scope of IFRS 2 and IFRS 3.
Two approaches have developed in practice. One is to recognise the assets and liabilities of the business, including
goodwill, at fair value, similar to the accounting for an asset contribution and the accounting for a business combination. The
second is to recognize the assets and liabilities of the business at the same book values as used in the contributing party’s
IFRS financial statements.
General FAQ of particular relevance to the industry
FAQ 13.4.6 – Are shares issued on formation of a joint venture in the scope of IFRS 2?
FAQ 32.6.2 – How should a joint arrangement account for businesses contributed to it by its investors, on formation or
otherwise?
FAQ 32.6.3 – Accounting for the contribution of a business by a new joint venturer
Accounting by the joint operation
The joint operation needs to reflect rights and obligations of operators in JO’s reported assets and liabilities.
General FAQ of particular relevance to the industry
FAQ 32.6.1 – Does IFRS 11 apply to the accounting by the joint arrangement itself: joint operations?
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4.2.10 Farm outs
A ‘farm out’ occurs when a venturer (the ‘farmor’) assigns an interest in the reserves and future production of a field to
another party (the ‘farmee’). This is often in exchange for an agreement by the farmee to pay for both its own share of the
future development costs and those of the farmor. There may also be a cash payment made by the farmee to the farmor.
This is a “farm in'' when considered from the farmee’s perspective. This typically occurs during the exploration or
development stage and is a common method entities use to share the cost and risk of developing properties. The farmee
hopes that their share of future production will generate sufficient revenue to compensate them for performing the
exploration or development activity.
Accounting by the farmor
Farm out agreements are largely non-monetary transactions at the point of signature for which there is no specific guidance
in IFRS. Different accounting treatments have evolved as a response. The accounting depends on the specific facts and
circumstances of the arrangement, particularly the stage of development of the underlying asset.
Assets with proven reserves
If there are proven reserves associated with the property, the farm-in should be accounted for in accordance with the
principles of IAS 16. If there is a commitment given by the farmee to pay cash in the future, the farm out will be viewed as an
economic event, as the farmor has relinquished its interest in part of the asset on the disposal date in return for the farmee
delivering a developed asset in the future. There is sufficient information for there to be a reliable estimate of fair value of
both the asset surrendered and the asset received in return (farmee’s commitment given).
Assets with no proven reserves
The accounting is not as clear where the mineral asset is still in the exploration or evaluation stage. The asset would still be
subject to IFRS 6 Exploration for and evaluation of mineral resources rather than IAS 16. The reliable measurement test in
IAS 16 for non-cash exchanges may not be met. Neither IFRS 6 nor IFRS 11 gives specific guidance on the appropriate
accounting for farm outs.
Several approaches have developed in practice by farmors:
recognise only any cash payments received and do not recognise any
consideration in respect of the value of the work to be performed by the farmee
and instead carry the remaining interest at the previous cost of the full interest
reduced by the amount of any cash consideration received for entering the
agreement. The effect will be that there is no gain recognised on the disposal date
unless the cash consideration received exceeds the carrying value of the entire
asset held;or
follow an approach similar to that for assets with proven resources, recognising
both cash payments received and the value of future assets to be developed (if the
definition of an asset is met) with a gain recognised on the disposal date.
PwC Observation
These approaches are used today under current IFRS for assets without proven reserves. However, in our experience,
the first approach is more widely used in the exploration phase.
There can be significant estimation uncertainty associated with determining the value of the asset to be received as
consideration for a disposal in a farm out of assets even with proven resources and this uncertainty becomes even more
significant for those assets in the exploration phase.
IND FAQ 4.2.10.1 - How should the farmor account for assets with proven reserves in a farm out?
IND EX 4.2.10.2 - Accounting for farm outs on exploration properties
Accounting by the farmee
The farmee will generally only recognise costs as incurred, regardless of the stage of development of the asset, if they can
walk away without penalties (other than forfeiture of their interest). Sometimes for the farmee, the arrangement is similar to
an option to acquire an interest (that is, they are not obligated to incur the costs and the costs they do incur may be equated
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to the payment of the strike on an option). In such a case the farmee earns its interest in the assets by actually incurring all
the promised costs, the farmee may account for its interest as a deposit rather than as a fully entitled interest.
The farmee is required to disclose its contractual obligations to construct the asset and meet the farmor’s share of costs.
The farmee should follow its normal accounting policies for capitalisation, and also apply them to those costs incurred to
build the farmor’s share.
4.2.11 Unitisation agreements
Unitisation usually occurs in the exploration or development stage of O&G assets. Entities may own assets or exploration
rights in adjacent areas, and enter into a contract to combine these into a larger area and share the costs of exploration,
development and extraction. The entity will receive in exchange a share of the expected future output of the larger area. The
unitised field is usually a joint operation. Unitisations are often required by governments to reduce the overall cost of
extraction through a more efficient deployment of infrastructure.
The share of output allocated to each participant will depend on the contribution their existing asset made to the total
production of this area. This is known as a ‘unitisation’. A preliminary assessment of the allocated interest is made on the
initial unitisation and the entity will be responsible for future expenditure for the area in accordance with its allocated interest.
The interest will be subsequently amended as more certainty is obtained over the final output of each component and
redeterminations are made. Adjustments to future production entitlement or cost contributions may be made accordingly.
Cash payments may be made between the participants where there is insufficient production or development remaining to
true up contributions to date.
The initial unitisation is accounted for as a contribution of assets. No change is recorded in the carrying amount of existing
interests unless cash payments have been made on unitisation. The value of the asset being received is equivalent to the
value of the asset being given up. If a cash payment has been paid or received, it is adjusted against the carrying value of the
oil and gas asset. This will also be the case when a redetermination of the unitisation is performed.
The unitisations and redeterminations will also affect the relevant reserves base to be used for the purposes of the Depletion,
Depreciation and Amortization (DD&A) calculation. The carrying value of the oil and gas asset is depreciated over any revised
share of reserves on a prospective basis. The entity will also be required to reassess the decommissioning obligation
associated with the asset.
IND EX 4.2.11.1 - How should an entity account for a redetermination of a unitisation?
4.3 Production sharing agreements (PSAs)
4.3.1 Overview
The effect of new revenue standard IFRS 15 on the accounting for PSAs is discussed
in section 7.2.2. IFRS 15 is effective on 1 January 2018.
A PSA is the method whereby governments facilitate the exploitation of their country’s hydrocarbon resources by taking
advantage of the expertise of a commercial oil and gas entity. Governments try to provide a stable regulatory and tax regime
to create sufficient certainty for commercial entities to invest in an expensive and long-lived development process. There are
as many forms of PSA and royalty agreements as there are combinations of national, regional and municipal governments in
oil producing areas.
An oil and gas entity in a typical PSA will undertake exploration, supply the capital, develop the resources found, build the
infrastructure and lift the natural resources. The oil and gas entity (usually referred to as the operator) will have the right to
extract resources over a specified period of time; this is typically the full production life of the field such that there would be
minimal residual value of the asset at the end of the PSA. The terms of the PSA are likely to include asset decommissioning
requirements. The oil and gas entity will be entitled to a share of the oil produced which will allow the recovery of specified
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costs (‘Cost oil’) plus an agreed profit margin (‘Profit oil’). The government will retain title to all of the hydrocarbon resources
and often the legal title to all fixed assets constructed to exploit the resources.
The residual value of the fixed assets in most cases would be minimal and the operator would decommission them under the
terms of the PSA. The company is viewed as having acquired the right to extract the oil in the future when it performs the
development work under the PSA. The development expenditure is capitalised according to the requirements of IFRS 6 and
IAS 16.
The government will take a substantial proportion of the output in PSAs. The oil may be delivered in product or paid in cash
under an agreed pricing formula.
An entity should consider its overall risk profile in determining whether it has a service agreement or a working interest.
Certain PSAs may be more like service arrangements whereby the government compensates the entity for exploration,
development and construction activities. These are arrangements where the PSA is substantially shorter than the expected
useful life of the production asset or are explicit cost plus arrangements. The entity thus bears the risks of performing this
contract rather than traditional exploration and development risks. Expenditure incurred on the exploration and development
plus a profit margin is usually capitalised as a receivable from the government rather than an interest in the future production
of the field.
A concession or royalty agreement is much the same as a PSA arrangement where the entity bears the exploration risk. The
entity will usually retain legal title to its assets and does not directly share production with the government. The government
will still be compensated based on production quantities and prices – this is often described as a concession rent, royalty or
a tax. PSAs and concession agreements are not standard even within the same legal jurisdiction. The more significant a new
field is expected to be, the more likely that the relevant government will write specific legislation or regulations for it. Each
PSA must be evaluated and accounted for in accordance with the substance of the arrangement. The entity’s previous
experience of dealing with the relevant government will also be important, as it is not uncommon for governments to force
changes in PSAs or royalty agreements based on changes in market conditions or environmental factors.
The PSA may contain a right of renewal with no significant incremental cost. The government may have a policy or practice
with regard to renewal. These should be considered when estimating the life of the agreement.
The legal form of the PSA or concession should not impact the principles underpinning the recognition of exploration and
evaluation (E&E) assets or production assets. Costs that meet the criteria of IFRS 6, IAS 38 or IAS 16 should be recognised in
accordance with the usual accounting policies where the entity is exposed to the majority of the economic risks and has
access to the probable future economic benefits of the assets.
4.3.4 Decommissioning in PSAs
Decommissioning of oil and gas production assets may be required by law, the terms of operating licences or an entity’s
stated policy and past practice. All of these create an obligation and thus a liability under IFRS.
PSAs sometimes require that a decommissioning fund be created with the objective of settling decommissioning costs to be
incurred in the future. The PSA may require that contributions to these funds be made by participating entities on an annual
basis until the date of decommissioning or allow them to be made on a voluntary basis prior to the decommissioning date.
The decommissioning arrangements can have a number of structures:
the operating entity is expected to perform the decommissioning activity using the
established fund;
the participating entities are required to pay for the decommissioning activity and
claim for reimbursement from the fund; and
the government has the right to take control of the asset at the end of the PSA term
(there may still be reserves to produce), take over the decommissioning obligation
and be entitled to the decommissioning fund established.
IFRIC 5 is applicable to funds which are both administered separately and where the contributor’s right to access the assets
is restricted.
The participants should recognise their obligation to pay the decommissioning costs as a liability and recognise their interest
in the decommissioning fund separately. They should determine the extent of their control over the fund (full, joint or
significant influence) and account for their interest in the fund in accordance with the relevant accounting standard.
Note that the IFRIC has released an agenda decision indicating that where restrictions on demand deposits are merely
contractual vs. changing the nature of the deposit to be other than demand, the entity may be required to account for the
deposit as cash versus separating it as restricted cash. Refer to FAQ 7.46.7 for further guidance on how an entity should
classify, in the statement of cash flows and in the statement of financial position, demand deposits that are subject to
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contractual restrictions on use agreed with a third party and FAQ 7.46.1 for guidance on whether restricted funds be
classified in the cash flow statement as part of ‘cash and cash equivalents’.
4.3.5 Taxes on PSAs
A crucial question arises about the taxation of PSAs – when are amounts paid to the government as an income tax (part of
revenue), when are amounts a royalty (excluded from revenue) and when are amounts to be treated as a production cost.
Some PSAs include a requirement for the national oil company or another government body to pay income tax on behalf of
the operator of the PSA. When does tax paid on behalf of an operator form part of revenue and income tax expense?
Classification as income tax or royalty
The revenue arrangements and tax arrangements are unique in each country and can vary within a country, such that each
major PSA is usually unique. However, there are common features that will drive the assessment as income tax, royalty or
government share of production. Among the common features that should be considered in making this determination are:
whether a well-established income tax regime exists;

whether the tax is computed on a measure of net profits; and
whether the PSA requires the payment of income taxes, the filing of a tax return
and establishes a legal liability for income taxes until such liability is discharged by
payment from the entity or a third party.
Classification of profit oil as income tax or royalty (1)
The upstream company or operator generally receives two components of revenue, most often described as cost oil and
profit oil. Cost oil is calculated as a ‘reimbursement’ for the costs incurred in the exploration phase and some (or all) of
the costs incurred during the development and production phase. Profit oil is the company’s share of oil after cost
recovery or as a result of applying a profit factor. The PSC typically specifies, among other items, which costs are
recoverable, the order of recoverability, any limits on recoverability, and whether costs not recovered in one period can
be carried forward into a future period (see section 4.3.2 for a worked example).
Is a share of profit oil an income tax or royalty?
Background
Mammoth Oil has a PSC in Small Republic in Africa. The PSC agreement calls for a 10% royalty of gross proceeds of all
revenue to be paid to the Ministry of Taxation. The cost oil is calculated as 10% of exploration costs, plus 10% of costs
of production assets plus all current operating costs subject to a ceiling. The profit oil is then split 50% to Mammoth and
50% to the National Oil Company. The PSC calls for a further payment to the National Oil Company if Mammoth’s share
of profit oil exceeds its cost oil and is calculated at 10% of the excess in these circumstances.
Management has deemed the further payments as an income tax because it is calculated on a formula that includes
items described as profit and costs. The amounts are included in revenue and income tax expense. Is this treatment
appropriate?
Solution
No. The further payment by the National Oil Company is simply a further apportionment of the profit oil and thus is
excluded from revenues. It may be described as an ‘income tax’ in the PSC but it is not an income tax as described in
IAS 12.
Classification of profit oil as income tax or royalty (2)
The upstream company or operator generally receives two components of revenue, most often described as cost oil and
profit oil. Cost oil is calculated as a ‘reimbursement’ for the costs incurred in the exploration phase and some (or all) of
the costs incurred during the development and production phase. Profit oil is the company’s share of oil after cost
recovery or as a result of applying a profit factor. The PSC typically specifies, among other items, which costs are
recoverable, the order of recoverability, any limits on recoverability, and whether costs not recovered in one period can
be carried forward into a future period (see section 4.3.2 for a worked example). Is a share of profit oil an income tax or
royalty?
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Background
Mammoth Oil has a PSC in Utopia. The PSC agreement calls for a 10% royalty of gross proceeds of all revenue to be
paid to the Ministry of Taxation. The cost oil is calculated as 10% of exploration costs, plus 10% of costs of production
assets plus all current operating costs subject to a ceiling. The profit oil is then split 50% to Mammoth and 50% to the
National Oil Company.
The PSC is explicit that the operations of Mammoth Oil in Utopia are subject to the tax rules and regulation of Utopia.
The company files a tax return and pays income tax under the normal tax rules. The tax regulations include a 10%
surcharge on any income tax that is due under the ordinary tax rules. The PSC requires the National Oil Company to pay
this surcharge on behalf of Mammoth and notify Mammoth that it has been paid. The tax counsel of Mammoth has legal
advice that Mammoth is liable for the tax until it is paid; if the National Oil Company does not pay, Mammoth must pay
the tax and then attempt to recover it from National Oil Company.
Management has deemed this an income tax and is including it in revenue and income tax expense. Is this treatment
appropriate?
Solution
Yes. The payment by the National Oil Company qualifies as an income tax. It is based on taxable profits as defined in the
tax code. Mammoth Oil is liable for the tax until it is paid by National Oil Company. It is appropriately included as
revenues and income tax expense. The tax rate used to calculate deferred tax assets and liabilities should include the
amount of the tax surcharge. The fact that the government calls the payment ‘a royalty’ does not determine the
accounting; it is the nature of the payment that is relevant to its classification.
Tax paid in kind
Many PSAs specify that income taxes owed by the entity are to be paid in delivered oil rather than cash. ‘Tax oil’ is recorded
as revenue and as a reduction of the current tax liability to reflect the substance of the arrangement where the entity delivers
oil to the value of its current tax liability. Volume-based levies are usually accounted for as royalty or excise tax within
operating results. See section 4.6 for further details.
‘Tax paid on behalf’ (POB)
POBs can arise under a PSA where the upstream entity is the operator of fields and the government entity is the national oil
company that holds the government’s interest in the PSA. POB arrangements are varied, but generally arise when the
government entity will pay the income tax due by the foreign upstream entity to the government on behalf of the foreign
upstream entity. The crucial issue in accounting for tax POB arrangements is to determine if they are akin to a tax holiday or
if the upstream entity retains an obligation for the income tax. POB arrangements that represent a tax holiday such that the
upstream company has no legal tax obligation are accounted for as a tax holiday. The upstream company, under a tax
holiday scenario, presents no tax expense and does not gross up revenue for the tax paid on its behalf by the government
entity. If the upstream company retains an obligation for the income tax, it would follow the accounting described in section
4.6.3 Taxes paid in cash or in kind.
4.4 Decommissioning
The oil and gas industry can have a significant impact on the environment. Decommissioning or environmental restoration
work at the end of the useful life of a plant or other installation may be required by law, the terms of operating licences or an
entity’s stated policy and past practice.
An entity that promises to remediate damage or has done so in the past, even when there is no legal requirement, may have
created a constructive obligation and thus a liability under IFRS. There may also be environmental clean-up obligations for
contamination of land that arise during the operating life of an installation. The associated costs of remediation/restoration
can be significant. The accounting treatment for decommissioning costs is therefore critical.
4.4.1 Decommissioning provisions
A provision is recognised when an obligation exists to perform the clean-up [IAS 37 para 14]. The local legal regulations
should be taken into account when determining the existence and extent of the obligation. Obligations to decommission or
remove an asset are created at the time the asset is put in place. An offshore drilling platform, for example, must be removed
at the end of its useful life. The obligation to remove it arises from its placement. However, there is some diversity in practice
as to whether the entire expected liability is recognised when activity begins, or whether it is recognised in increments as the
development activity progresses. There is also diversity in whether decommissioning liabilities are recognised during the
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exploration phase of a project. The asset and liability recognised at any particular point in time needs to reflect the specific
facts and circumstances of the project and the entity’s obligations.
Decommissioning provisions are measured at the present value of the expected future cash flows that will be required to
perform the decommissioning [IAS 37 para 45]. The obligation does not change in substance if the platform produces 10,000
barrels or 1,000,000.
The cost of the provision is recognised as part of the cost of the asset when it is put in place and depreciated over the
asset’s useful life [IAS 16 para 16(c)]. The total cost of the fixed asset, including the cost of decommissioning, is depreciated
on the basis that best reflects the consumption of the economic benefits of the asset (typically UOP). Provisions for
decommissioning and restoration are recognised even if the decommissioning is not expected to be performed for a long
time, for example 80 to 100 years.
The effect of the time to expected decommissioning will be reflected in the discounting of the provision. The discount rate
used is the pre-tax rate that reflects current market assessments of the time value of money. Entities also need to reflect the
specific risks associated with the decommissioning liability. Different decommissioning obligations will, naturally, have
different inherent risks, for example different uncertainties associated with the methods, the costs and the timing of
decommissioning. The risks specific to the liability can be reflected either in the pre-tax cash flow forecasts prepared or in
the discount rate used. The future cash flows expected to be incurred in performing the decommissioning may be
denominated in a foreign currency. When this is relevant the foreign currency future cash flows should be discounted at a
rate relevant for that currency. The present value is translated into the entity’s functional currency using the exchange rate at
the balance sheet date.
4.4.2 Revisions to decommissioning provisions
Decommissioning provisions are updated at each balance sheet date for changes in the estimates of the amount or timing of
future cash flows and changes in the discount rate [IAS 37 para 59]. This includes changes in the exchange rate when some
or all of the expected future cash flows are denominated in a foreign currency. Changes to provisions that relate to the
removal of an asset are added to or deducted from the carrying amount of the related asset in the current period [IFRIC 1
para 5] However, the adjustments to the asset are restricted. The asset cannot decrease below zero and cannot increase
above its recoverable amount [IFRIC 1 para 5]:
if the decrease in provision exceeds the carrying amount of the asset, the excess is
recognised immediately in profit or loss;
adjustments that result in an addition to the cost of the asset are assessed to
determine if the new carrying amount is fully recoverable or not. An impairment test
is required if there is an indication that the asset may not be fully recoverable.
The accretion of the discount on a decommissioning liability is recognised as part of finance expense in the income
statement.
4.4.3 Deferred tax on decommissioning

provisions
The amount of the asset and liability recognised at initial recognition of decommissioning are generally viewed as being
outside of scope of the current ‘initial recognition exemption (IRE)’ in IAS 12 [paras 15 and 24]. The amount of accretion in
the provision from unwinding of the discount gives rise to a book/tax difference and will result in a further deferred tax asset,
subject to an assessment of recoverability. The IFRS IC considered a similar question at its April and June 2005 meetings of
whether the IAS 12 IRE applied to the recognition of finance leases. IFRS IC acknowledged that there was diversity in
practice in the application of the IRE for finance leases but decided not to issue an interpretation because of the IASB’s
short-term convergence project with the FASB. Accordingly, some entities might take an alternative view that the IAS 12 IRE
should be applied for finance leases and decommissioning liabilities. However, a consistent policy should be adopted for
deferred tax accounting for decommissioning liabilities and finance leases [IAS 8 para 13].
4.4.4 Decommissioning funds

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Many oil and gas entities contribute to a separate fund established to help fund decommissioning and environmental
obligations. These funds may be required by regulation or law or may be voluntary.
Typically, a fund is separately administered by independent trustees who invest the contributions received by the fund in a
range of assets, usually debt and equity securities. The trustees determine how contributions are invested, within the
constraints set by the fund’s governing documents, and any applicable legislation or other regulations. The oil and gas entity
then obtains reimbursement of actual decommissioning costs from the fund as they are incurred. However, the oil and gas
entity may only have restricted access or no access to any surplus of assets of the fund over those used to meet eligible
decommissioning costs.
IFRIC 5 Rights to interests arising from decommissioning, restoration and environmental rehabilitation funds provides
guidance on the accounting treatment for these funds in the financial statements of the oil and gas entity. Management must
recognise its interest in the fund separately from the liability to pay closure and environmental costs. Offsetting is not
appropriate unless the contributor is not liable to pay decommissioning costs even if the fund fails to pay.
Management must determine whether it has control, joint control or significant influence over the fund and account for the
fund accordingly. In the absence of these, rights to receive assets of the fund are accounted for as a reimbursement of the
entity’s closure and environmental obligation, at the lower of the amount of the decommissioning obligation recognised and
the entity’s share of the fair value of the net assets of the fund.
Any movements in a fund accounted for as a reimbursement are recognised in the income statement. The movements in the
fund (based on the IFRIC 5 measurement) are assessed separately from the measurement of the provision (under IAS 37).
Accounting for performance guarantees
Background
In Ukraine, upstream gas entity A’s subsidiary has recognised a closure and rehabilitation provision in respect of an
abandonment liability for a field.
Entity A has also been required by law to place a parental performance guarantee equivalent to the estimated total
amount required to fulfil the abandonment liabilities at the end of the life of the field it operates.
How should entity A account for this performance guarantee?
Solution
The performance guarantee should be disclosed in the consolidated financial statements as security for the obligation.
The related decommissioning liability has already been accounted for under IAS 37.
4.4.5 Termination benefits
Payments made to employees in connection with the closure of a field must be accounted for under IAS 19 Employee
benefits.
If it is certain that a field’s hydrocarbon reserves will be exhausted at the end of the life of the field, it often follows from this
that redundancy costs will arise unless employees can be relocated to other projects.
IAS 19 restricts when termination benefits can be recognised, with a liability only recognised when the entity is demonstrably
committed to the redundancies by having:
a detailed formal plan for the terminations; and

no realistic possibility of withdrawal.
IAS 37 also sets out criteria for when a ‘restructuring provision’ can be accrued which requires a constructive obligation to
arise.
Termination benefits can generally only be recognised when the closure date has been announced, specific plans are
established, and other recognition criteria are met.
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4.5 Impairment of development, production

and downstream assets
4.5.1 Overview
The oil and gas industry is distinguished by the significant capital investment required and volatile commodity prices. The
heavy investment in fixed assets leaves the industry exposed to adverse economic conditions and therefore impairment
charges.
Oil and gas assets should be tested for impairment whenever indicators of impairment exist [IAS 36 para 9]. The normal
measurement rules for impairment apply to assets with the exception of the grouping of E&E assets with existing producing
cash generating units (CGUs) as described in section 2.3.7.
Impairments are recognised if a CGU’s carrying amount exceeds its recoverable amount [IAS 36 para 6]. Recoverable
amount is the higher of fair value less costs to sell (FVLCOD) and value in use (VIU).
4.5.2 Impairment indicators
Entities must use judgement in order to assess whether an impairment indicator has occurred. If an impairment indicator is
concluded to exist, IAS 36 requires that the entity perform an impairment test.
Impairment triggers relevant for the petroleum sector include declining long-term market prices for oil and gas, significant
downward reserve revisions, increased regulation or tax changes, and deteriorating local conditions such that it may become
unsafe to continue operations and expropriation of assets.
Impairment indicators (1)
Is a decline in market prices of oil and gas always an indicator of impairment?
Background
An entity has producing oil and gas fields. There has been a significant decline in the prices of oil and gas during the last
six months.
Is such a decline in the prices of oil and gas an indicator of impairment of the field?
Solution
Price decreases are not automatically impairment indicators. The nature of oil and gas assets is that they often have a
long useful life and the price point at which producing fields become uneconomic varies widely. Commodity price
movements can be volatile and move between troughs and spikes.
Price reductions can assume more significance over time. If a decline in prices is expected to be prolonged and for a
significant proportion of the remaining expected life of the field, an impairment indicator will likely have occurred.
Short-term market fluctuations may not be impairment indicators if prices are expected to return to higher levels within
the near future. Such assessments can be difficult to make, with price forecasts becoming difficult where a longer view is
taken. Entities should approach this area with care. In particular, entities should consider any downward movements
carefully for fields which are high cost producers.
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Might a change in government be an indicator of impairment?
Background
An upstream company has a production sharing contract (PSC) in a small country in equatorial Africa. The company’s
investment in the PSC assets is substantial. There is a coup in the country and the democratically elected government is
replaced by a military regime. Management of the national oil company (NOC), partner in the PSC, is replaced. The NOC
has been paying income tax on behalf of the operator of the PSC.
New management of the NOC announces that it will no longer pay the income taxes on behalf of the operator. The
operator will be required to pay income taxes and the petroleum excess profits tax from its share of the PSC profit oil.
The combined effective tax rate is 88%.
The operator of the PSC expects that operating costs will increase principally due to increased wages and bonuses for
expatriate employees and will not be recovered under the terms of the PSC.
Does the change in government constitute an indicator of impairment?
Solution
Yes. The change in government is a change in the legal and economic environment that will have a substantial negative
impact on expected cash flows. The PSC assets should be tested for impairment.
What are some common potential indicators of impairment in the oil and gas industry?
Solution
significant reductions in estimates of reserves;

a significant decline in the market capitalisation of the entity or other entities
producing the same commodity;
a decline in long-term market prices for oil and gas;
a significant adverse movement in foreign exchange rates;
a significant increase in production costs;

a large cost overrun on a capital project such as an overrun during the
development and construction of new wells;
operation issues which may require significant capital expenditure to remediate;

a significant increase in the expected cost of dismantling assets and restoring
the site, particularly towards the end of a field’s life;
a significant revision of the plan for the development of the field;
significant reductions in estimates of probable reserves;

production difficulties;
problems with securing infrastructure necessary to transport product to market;
adverse changes in government regulations and environmental law, including a
significant increase in the tax or royalty burden payable;
increased security or political risk for the relevant area.
Impairment indicators can also be internal in nature. Evidence that an asset or CGU has been damaged or become obsolete
is likely to be an impairment indicator; for example a refinery destroyed by fire is, in accounting terms, an impaired asset.
Changes in development costs, such as a well requiring significant rework, or significantly increased decommissioning costs,
may also be impairment indicators. Other common indicators are a decision to sell or restructure a CGU or evidence that
business performance is less than expected.
Management should be alert to indicators on a CGU basis; for example learning of a fire at an individual petrol station would
be an indicator of impairment for that station as a separate CGU. However, generally, management is likely to identify
impairment indicators on a regional or area basis, reflective of how they manage their business. Once an impairment
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indicator has been identified, the impairment test must be performed at the individual CGU level, even if the indicator was
identified at a higher level.
4.5.3 Cash generating units
A CGU is the smallest group of assets that generates cash inflows largely independent of other assets or groups of assets
[IAS 36 para 6]. A field and its supporting infrastructure assets in an upstream entity will often be identified as a CGU.
Production, and therefore cash flows, can be associated with individual wells. However, the field investment decision is
made based on expected field production, not a single well, and all wells are typically dependent on the field infrastructure.
An entity operating in the downstream business may own petrol stations, clustered in geographic areas to benefit from
management oversight, supply and logistics. The petrol stations, by contrast, are not dependent on fixed infrastructure and
generate largely independent cash inflows.
Identifying the CGU (1)
What is the CGU in upstream oil and gas operations?
Background
Entity GBO has upstream operations in a number of locations around the world. The majority of operations are in
production-sharing contracts for single fields or major projects. However it owns a number of properties in the Gulf of
Mexico. The fields are supported by a shared loading platform and connected to a pipeline to the loading platform.
Management considers that the CGU for impairment testing purposes is a region or country. Is management’s proposal
appropriate?
Solution
No. Each field is generally capable of generating cash inflows largely independently from the other fields. It is unlikely
that an outage on one field would require the shut-down of another field. However, where this would be the case then it
would be appropriate to group such fields together.
The Gulf of Mexico fields might meet this criterion if all depend on the shared loading platform to generate future cash
flows. Thus if all these fields would have to be shut-down if the shared loading platform was out of operation, then it
could be argued that the fields it serves do not generate cash flows independently from each other. However, if
alternative loading facilities are readily available, then each field should be treated as a separate cash generating unit and
the shared loading platform should be treated as a common asset and allocated to each CGU.
Identifying the CGU (2)
What is the CGU in retail petroleum operations?
Background
The company owns retail petrol stations across Europe. It monitors profitability on a regional basis for larger countries
such as Spain, Italy, France, Germany and the UK. Geographically smaller countries such as Greece, Austria,
Switzerland and Portugal are monitored on a country basis. The costs of shared infrastructure for supply, logistics and
regional management are grouped with the regions or countries that they support.
Station and regional managers are compensated based on performance of their station or stations, cash flow and
profitability information is available at the level of the individual stations.
Management considers that the CGU for impairment testing purposes is a region or country. Is management’s proposal
appropriate?
Solution
No. The regions and countries are not CGUs. The lowest level at which largely separate cash flows are generated is at
the level of an individual petrol station. Management assesses business performance on a station-specific basis to
compensate station managers and on a regional basis to assess return on investment incorporating shared infrastructure
assets.
When impairment testing is required because of the presence of impairment indicators, petrol stations should be
individually tested for impairment. The cash flows of the stations are then grouped for the purposes of assessing
impairment of shared infrastructure assets.
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4.5.4 Shared assets
Several fields located in the same region may share assets (for example, pipelines to transport gas or oil onshore, port
facilities or processing plants). Judgement is involved in determining how such shared assets should be treated for
impairment purposes. Factors to consider include:
whether the shared assets generate substantial cash flows from third parties as
well as the entity’s own fields – if so, they may represent a separate CGU;
how the operations are managed.

Any shared assets that do not belong to a single CGU but relate to more than one CGU still need to be considered for
impairment purposes. There are two ways to do this and management should use the method most appropriate for the
entity. Shared assets can be allocated to individual CGUs or the CGUs can be grouped together to test the shared assets.
Under the first approach, the assets should be allocated to each individual CGU or group of CGUs on a reasonable and
consistent basis. The cash flows associated with the shared assets, such as fees from other users and expenditure, form
part of the cash flows of the individual CGU.
The second approach has the group of CGUs that benefit from the shared assets grouped together to test the shared assets.
The allocation of any impairment identified to individual CGUs should be possible for shared assets used in the processing or
transportation of the output from several fields and, for example, could be allocated between the fields according to their
respective reserves/resources.
4.5.5 Fair value less cost of disposal (FVLCOD)
Fair value less cost of disposal is the amount that a market participant would pay for the asset or CGU, less the costs of
sale. The use of discounted cash flows for FVLCOD is permitted where there is no readily available market price for the asset
or where there are no recent market transactions for the fair value to be determined through a comparison between the asset
being tested for impairment and a recent market transaction.
FVLCOD is less restrictive in its application than VIU and can be easier to work with. It is more commonly used in practice,
particularly for recently acquired assets. The underlying assumptions in a FVLCOD model are usually, but not always, closer
to those that management have employed in their own forecasting process. The output of a FVLCOD calculation may feel
intuitively more correct to management.
The assumptions and other inputs used in a DCF model for FVLCOD should incorporate observable market inputs as much
as possible. The assumptions should be both realistic and consistent with what a typical market participant would assume.
Assumptions relating to forecast capital expenditures that enhance the productive capacity of a CGU can therefore be
included in the DCF model, but only to the extent that a typical market participant would take a consistent view. The amount
calculated for FVLCOD is a post-tax recoverable amount. It is therefore compared against the carrying amount of the CGU
on an after-tax basis; that is, after deducting deferred tax liabilities relating to the CGU/group of CGUs. This is particularly
relevant in upstream businesses when testing goodwill for impairment. A major driver of goodwill in upstream acquisitions is
the calculation of deferred tax on the reserves and resources acquired. Marginal tax rates in the 80% to 90% region are not
unheard of, thus the amount of goodwill can be substantial. The use of FVLCOD can alleviate the tension of substantial
goodwill associated with depleting assets.
Post-tax cash flows are used when calculating FVLCOD using a discounted cash flow model. The discount rate applied in
FVLCOD should be a post-tax market rate based on a market participant’s weighted average cost of capital.
4.5.6 Value in use (VIU)
VIU is the present value of the future cash flows expected to be derived from an asset or CGU in its current condition [IAS 36
para 6]. Determination of VIU is subject to the explicit requirements of IAS 36.The cash flows are based on the asset that the
entity has now and must exclude any plans to enhance the asset or its output in the future but include expenditure necessary
to maintain the current performance of the asset [IAS 36 para 44]. The cash flows used in the VIU calculation are based on
management’s most recent approved financial budgets/ forecasts. The assumptions used to prepare the cash flows should
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be based on reasonable and supportable assumptions. Assessing whether the assumptions are reasonable and supportable
is best achieved by benchmarking against market data or performance against previous budgets.
The discount rate used for VIU is pre-tax and applied to pre-tax cash flows [IAS 36 para 55]. This is often the most difficult
element of the impairment test, as pre-tax rates are not available in the market place. Arriving at the correct pre-tax rate is a
complex mathematical exercise. Computational short cuts are available if there is a significant amount of headroom in the
VIU calculation. However, grossing up the post-tax rate seldom gives an accurate estimate of the pre-tax rate.
Period of projections
The cash flow projections used to determine VIU can include specific projections for a maximum period of five years, unless
a longer period can be justified. A longer period will often be appropriate for oil and gas assets based on the proven and
probable reserves and expected annual production levels. After the five-year period a VIU calculation should use
assumptions consistent with those used in the final period of specific assumptions to arrive at a terminal value. Assumptions
on the level of reserves expected to be produced should be consistent with the latest estimates by reserve engineers, annual
production rates should be consistent with those for the preceding five years, and price and cost assumptions should be
consistent with the final period of specific assumptions.
Commodity prices in VIU
Estimates of future commodity prices will need to be included in the cash flows prepared for the VIU calculation.
Management usually take a longer-term approach to the commodity price; this is not always consistent with the VIU rules.
Spot prices are used unless there is a forecast price available as at the impairment test date. In the oil and gas industry there
are typically forward price curves available and in such circumstances these provide a reference point for forecast price
assumptions. Those forecast prices should be used for the future periods covered by the VIU calculation. Where the forward
price curve does not extend far enough into the future, the price at the end of the forward curve is generally held steady,
unless there is a compelling reason to adjust it.
The future cash flows relating to the purchase or sale of commodities might be known from forward purchase or sales
contracts. Use of these contracted prices in place of the spot price or forward curve price for the contracted quantities will
generally be appropriate.
However, some forward purchase and sales contracts will be accounted for as derivative contracts at fair value in
accordance with IFRS 9 and are recognised as current assets or liabilities. They are therefore excluded from the IAS 36
impairment test. The cash flow projections used for the VIU calculation should exclude the pricing terms of the sales and
purchase contracts accounted for in accordance with IFRS 9.
Foreign currencies in VIU
Foreign currencies may be relevant to impairment testing for two reasons:
a. when all the cash flows of a CGU are denominated in a single currency that is not the reporting entity’s functional currency; and
b. when the cash flows of the CGU are denominated in more than one currency.
a) CGU cash flows differ from entity’s functional currency
All future cash flows of a CGU may be denominated in a single currency, but one that is different from the reporting entity’s
functional currency. The cash flows used to determine the recoverable amount are forecast in the foreign currency and
discounted using a discount rate appropriate for that currency. The resulting recoverable amount is translated into the
entity’s functional currency at the spot exchange rate at the date of the impairment test [IAS 36.54].
b) CGU cash flows are denominated in more than one currency
Some of the forecast cash flows may arise in different currencies. For example, cash inflows may be denominated in a
different currency from cash outflows. Impairment testing involving multiple- currency cash flows can be complex and may
require consultation with specialists.
The currency cash flows for each year for which the forecasts are prepared should be translated into a single currency using
an appropriate exchange rate for the time period. The spot rate may not be appropriate when there is a significant expected
inflation differential between the currencies. The forecast net cash flows for each year are discounted using an appropriate
discount rate for the currency to determine the net present value. If the net present value has been calculated in a currency
different from the reporting entity’s functional currency, it is translated into the entity’s functional currency at the spot rate at
the date of the impairment test [IAS 36.54].
The use of the spot rate, however, can generate an inconsistency, to the extent that future commodity prices denominated in
a foreign currency reflect long-term price assumptions but these are translated into the functional currency using a spot rate.
This is likely to have the greatest impact for operations in countries for which the strength of the local currency is significantly
affected by commodity prices. Where this inconsistency has a pronounced effect, the use of FVLCOD may be necessary.
Assets under construction in VIU
The VIU cash flows for assets that are under construction and not yet complete should include the cash flows necessary for
their completion and the associated additional cash inflows or reduced cash outflows. An oil or gas field that is part-
developed is an example of a part-constructed asset. The VIU cash flows should therefore include the cash flows to
complete the development to the extent that they are included in the original development plan and the associated cash
inflows from the expected sale of the oil and gas.
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4.5.7 Interaction of decommissioning

provisions and impairment testing
Decommissioning provisions and the associated cash flows can be either included or excluded from the impairment test,
provided the carrying amount of the asset and the cash flows are treated consistently. IAS 36 requires the carrying amount of
a liability to be excluded from the carrying amount of a CGU unless the recoverable amount of the CGU cannot be
determined without consideration of that liability [IAS 36 paras 76, 78]. This typically applies when the asset/CGU cannot be
separated from the associated liability.
Decommissioning obligations are closely linked to the asset that needs to be decommissioned, although the cash flows
associated with the asset may be independent of the cash flows of the decommissioning liability.
The VIU cash flow model uses a discount rate that is specific to the assets being tested, reflects time value of money and the
return investors would require to invest in the asset. The performance of the asset will have a number of uncertainties
associated with it; demand, price and operational risk among others. The cash outflows associated with a decommissioning
obligation have different uncertainties associated with them, but these are more around amount and timing rather than
occurrence or performance risk. Future sales might be uncertain but the need to restore at the end of the asset’s life is not.
These cash outflows should be discounted using the risk free rate required by IAS 37.
There is no guidance in the impairment standard on using FVLCOD as the recoverable amount for a CGU with a non-
separable liability.
One approach could be to produce a single cash flow model that provides a fair
value of a CGU that includes the cash outflows for the decommissioning obligation.
This approach is consistent with how a market participant would think about
determining the fair value of the business. Timing of the decommissioning should
be considered. Cash outflows for the decommissioning that will commence many
years in the future would be incorporated in the later period in the cash flow model
and have less impact on the recoverable amount determined. As a field
approaches the end of its life and cash outflows are expected to begin within the
next few years, these cash outflows would have more impact on the recoverable
amount.
An alternative approach would be to calculate the fair value of the asset excluding
the cash outflows to satisfy the decommissioning obligation. The liability would be
calculated separately using market participant assumptions rather than the IAS 37
approach. The liability measurement should reflect the amount the entity would
need to pay to a third party to assume the obligation. This is likely to produce a
higher value for the liability than under IAS 37. The amount determined for the
liability would then be deducted from the amount determined for the asset to
produce a ‘net’ fair value. This second approach is likely to be appropriate when
the end of the life of the field is within the foreseeable future, less than five years or
so.
The recoverable amount under FVLCOD is then compared to the carrying amount of the CGU including the decommissioning
obligation measured under IAS 37.
Interaction of decommissioning provision and impairment testing
How is a decommissioning provision included in an impairment test?
Background
Entity A incurs expenditure of C100 constructing an oil production platform. The present value of the decommissioning
obligation at the date on which the platform is put into service is C25. The present value of the future cash inflows from
expected production is C180. The present value of the future cash outflows from operating the platform is C50, and the
present value of the future cash outflows from performing the decommissioning of the platform is C25.
Solution
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The following example illustrates the results of both the inclusion and exclusion of the decommissioning liability in the
carrying amount of the CGU and the cash flow projections.
The net present value of future cash flows associated with operating the field is as follows:
VIU calculation Including Excluding

Cash inflows from sale of oil produced 180 180
Operating cash outflows (50) (50)
Cash outflows from decommissioning at end of (25) -
field life
Net present value of cash flows (recoverable 105 130
amount)
Carrying amount of PPE (including cost of future 125 125
decommissioning)
Carrying amount of decommissioning provision (25) -
Net carrying amount of CGU 100 125
Determination of carrying amount
The recoverable amount in both cases exceeds the carrying amount of the assets and hence, no impairment charge is
required. However, if the discount rate used for arriving at the cash outflows from decommissioning is different from that
used for the carrying amount of decommissioning provision, a difference in their values could arise.
4.5.8 Goodwill impairment testing
IAS 36 requires goodwill to be tested for impairment at least annually and tested at the lowest level at which management
monitors it. The lowest level cannot be higher than the operating segment to which goodwill belongs under IFRS 8 Operating
segments.
The grouping of CGUs for impairment testing should reflect the lowest level at which management monitors the goodwill. If
that is on an individual CGU basis, testing goodwill for impairment should be performed on that individual basis. However,
when management monitors goodwill based on a group of CGUs, the impairment testing of the goodwill should reflect this.
Goodwill is tested for impairment annually and when there are impairment indicators. Those indicators might be specific to
an individual CGU or group of CGUs.
IAS 36 requires a bottom up then top down approach for impairment testing, and the order in which the testing is performed
is crucial. The correct approach is particularly important if there is goodwill, indefinite lived assets, shared assets or
corporate assets. First, any individual CGUs with indicators of impairment must be tested and the impairment loss recorded
in the individual CGU. Then CGUs can be grouped for the purposes of testing shared assets, indefinite lived intangibles,
goodwill and corporate assets. The amended carrying values of any individual CGUs that have been adjusted for an
impairment charge are used as part of the second stage of the impairment test.
If the impairment test shows that the recoverable amount of the group of CGUs exceeds the carrying amount of that group of
CGUs (including goodwill), there is no impairment to recognise. However, if the recoverable amount is less than the
combined carrying value, the group of CGUs and the goodwill allocated to it is impaired. The impairment charge is allocated
first to the goodwill balance to reduce it to zero, and then pro rata to the carrying amount of the other assets within the group
of CGUs.
Goodwill is also tested for impairment when there is an indicator that it is impaired, or when there is an indicator that the
CGU(s) to which it is allocated is impaired. When the impairment indicator relates to specific CGUs, those CGUs are tested
for impairment separately before testing the group of CGUs and the goodwill together.
Impairment testing of goodwill
At what level is goodwill tested for impairment?
The diagram below illustrates the levels at which impairment testing may be required. The entity has two operating
segments, Upstream Production and Refining. The Upstream Production segment comprises four producing fields which
each represent CGUs; the Refining segment comprises two refineries which represent separate CGUs. There is goodwill
allocated to each CGU. The goodwill within the Upstream Production segment is monitored in two parts. The goodwill
allocated to CGUs 1, 2 and 3 is monitored on a collective basis; the goodwill allocated to CGU 4 is monitored separately.
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The goodwill within the Refining segment is monitored at the Refining level – that is, goodwill allocated to CGUs 5 and 6
is monitored on a combined basis.
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If there is an impairment indicator for CGU 2, the CGU is tested for impairment separately, excluding the goodwill
allocated to it. Any impairment loss calculated in this impairment test is allocated against the assets within the CGU. This
allocation of the impairment charge is made on a pro rata basis to the carrying value of the assets within the CGU. The
testing of CGU 2 at this level excludes goodwill, so no impairment is allocated against goodwill in this part of the
impairment test.
After recording any impairment arising from testing CGU 2 for impairment, CGUs 1, 2 and 3 and the goodwill allocated to
them is then tested for impairment on a combined basis. Any impairment loss calculated in this impairment test is
allocated first to the goodwill. If the impairment charge in this test exceeds the value of goodwill allocated to CGUs 1, 2
and 3, the remaining impairment charge is allocated against the fixed and intangible assets of CGUs 1, 2 and 3 pro rata
to the carrying value of the assets within those CGUs.
A similar approach is taken for CGU 4. However, because no other CGU is combined with CGU 4 for goodwill
impairment testing, there is no need to test CGU 4 for impairment separately from the goodwill allocated to it.
4.5.9 Impairment reversals
The actual results in subsequent periods should be compared with the cash flow projections (used in impairment testing)
made in the previous year. Where performance has been significantly better than previously estimated, this is an indicator of
potential impairment reversal. Impairment charges are reversed (other than against goodwill) where the increase in the
recoverable amount arises from a change in the estimates used to measure the impairment. Estimates of variables, such as
commodity prices, reflect the expectations of those variables over the period of the forecast cash flows, rather than changes
in current spot prices. The use of medium to long-term prices for commodities means that impairment charges and reversals
tend not to reflect the same volatility as current spot prices. Impairment reversals should only be recognised where there has
been a clear increase in the service potential of a CGU and not simply due to headroom created by the passage of time; for
instance, the unwind in discount rates, further DD&A charges or other similar items.
4.6 Royalties and income taxes
Petroleum taxes generally fall into two main categories – those that are calculated on profits earned (income taxes) and those
calculated on sales (royalty or excise taxes). The categorisation is crucial: royalty and excise taxes do not form part of
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revenue, while income taxes usually require deferred tax accounting but form part of revenue. In some countries the
authorities may also charge ‘production taxes’: charges which are based on a specified tax rate per quantity of oil or gas
extracted regardless of whether that oil or gas is subsequently sold. Such taxes may be recognised as operating expenses.
4.6.1 Petroleum taxes – royalty and excise
Petroleum taxes that are calculated by applying a tax rate to volume or a measure of revenue which has not been adjusted
for expenditure do not fall within the scope of IAS 12 Income taxes and are not income taxes. Determining whether a
petroleum tax represents an income tax can require judgement.
Petroleum taxes outside the scope of IAS 12 do not form part of revenue or give rise to deferred tax liabilities. These taxes
are most often described as royalty or excise taxes. They are measured in accordance with the relevant tax legislation and a
liability is recorded for amounts due that have not yet been paid to the government. No deferred tax is calculated. The
smoothing of the estimated total tax charge over the life of a field is not appropriate [IAS 37 paras 15, 36].
Royalty and excise taxes are in effect the government’s share of the natural resources exploited and are a share of
production free of cost. They may be paid in cash or in kind. If in cash, the entity sells the oil or gas and remits to the
government its share of the proceeds. Royalty payments in cash or in kind are excluded from gross revenues and costs.
4.6.2 Petroleum taxes based on profits
Petroleum taxes that are calculated by applying a tax rate to a measure of profit fall within the scope of IAS 12 [IAS 12 para
5]. The profit measure used to calculate the tax is that required by the tax legislation and will, accordingly, differ from the
IFRS profit measure. Profit in this context is revenue less costs as defined by the relevant tax legislation, and thus might
include costs that are capitalised for financial reporting purposes. However it is not, for example, an allocation of profit oil in
a PSA. Examples of taxes based on profits include Petroleum Revenue Tax in the UK, Norwegian Petroleum Tax and
Australian Petroleum Resource Rent Tax.
Does Petroleum Revenue Tax (PRT) in Utopia fall within the scope of IAS 12?
Background
Entity A has an interest in an oil field in Utopia. The field is subject to PRT levied by the government of Utopia.
The determination of the amount of PRT payable by an entity is set out in the tax legislation created by the Utopian
government. The PRT payable by an entity is calculated based on the profits earned from the production of oil.
The profits against which PRT is calculated are determined by legislation. The PRT taxable profit is calculated as the
revenue earned from the sale of oil, on an accruals basis, less the costs incurred to produce and deliver the oil to its
point of sale.
The deductible costs permitted by the legislation include all direct costs of production and delivery. Capital-type costs
are allowable as incurred – there is no spreading/amortisation of capital costs as occurs in financial reporting or
corporation tax calculations.
The non-deductible costs are financing costs, freehold property costs and certain other types of costs. However, an
additional allowance (‘uplift’) against income is permitted in place of interest costs. The uplift deduction is calculated as
35% of qualifying capital expenditure.
Solution
PRT falls within the scope of IAS 12. PRT is calculated by applying the PRT tax rate to a measure of profit that is
calculated in accordance with the PRT tax legislation.
Petroleum taxes on income are often ‘super’ taxes applied in addition to ordinary corporate income taxes. The tax may apply
only to profits arising from specific geological areas or sometimes on a fieldby-field basis within larger areas. The petroleum
tax may or may not be deductible when determining corporate income tax; this does not change its character as a tax on
income. The computation of the tax is often complicated. There may be a certain number of barrels or bcm that are free of
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tax, accelerated depreciation and additional tax credits for investment. Often there is a minimum tax computation as well.
Each complicating factor in the computation must be separately evaluated and accounted for in accordance with IAS 12.
Deferred tax must be calculated in respect of all taxes that fall within the scope of IAS 12 [IAS 12 paras 15, 24]. The deferred
tax is calculated separately for each tax by identifying the temporary differences between the IFRS carrying amount and the
corresponding tax base for each tax. Petroleum income taxes may be assessed on a field-specific basis or a regional basis.
An IFRS balance sheet and a tax balance sheet will be required for each area or field subject to separate taxation for the
calculation of deferred tax.
The tax rate applied to the temporary differences will be the statutory rate for the relevant tax. The statutory rate may be
adjusted for certain allowances and reliefs (e.g. tax-free barrels) in certain limited circumstances where the tax is calculated
on a field-specific basis without the opportunity to transfer profits or losses between fields [IAS 12 paras 47, 51].
Should deferred tax be recognised on super deductions receivable on income tax?
Background
Entity A has an interest in an oil field and the field is subject to Petroleum Revenue Tax (PRT) levied by the government of
Utopia. Entity A receives ‘uplift’ in respect of the cost of the qualifying capital expenditures for PRT purposes. Uplift
provides entity A with an additional deduction against profits chargeable to PRT of 35% of qualifying capital
expenditures. Entity A is able to recognise a deduction of 100% of the costs of qualifying capital expenditure in
calculating profits subject to PRT when the tax authorities agree the deductibility.
A further 35% deduction is allowed when the tax authorities agree that the specific expenditure qualifies for uplift. The
test for deductibility for the 35% uplift is more restrictive than the test for the base 100% deduction. The deductions are
made in full against the calculation of profits subject to PRT in the period in which the respective agreements are
received from the tax authorities. The cumulative amount of depreciation charged for financial reporting purposes under
IFRS remains at 100% over the life of the asset, i.e. the regulations allow for a higher deduction to be charged than the
depreciation charge over the life of the asset.
The following is an illustration of how super deduction works.
Say the company has developed four assets A, B, C and D having a capital cost of 1000, 1500, 2000 and 2500 GBP
respectively. All these assets are qualifying capital expenditures and assets A and C qualify for an additional deduction
(uplift) of 35%. In such case the following will be the amounts deductible:
Asset allowed Capital cost Amount of Uplift

(GBP) deduction
A 1,000 1,350 = 1,000 + 35% of 1,000
350
B 1,500 1,500 Not eligible
C 2,000 2,700 = 2,000 + 35% of 2,000
700
D 2,500 2,500 Not eligible
Deduction for uplift is allowed in the year in which the tax authorities agree that the specific expenditure qualifies for
uplift, which may be different from the year in which the capital expenditure is incurred or the year in which the 100%
deduction is claimed.
At what value should A’s management recognise deferred PRT in respect of the capital assets?
Solution
The portion of the PRT tax base relating to the uplift arises on initial recognition of the asset. As per paragraph 24 of IAS
12, 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, unless the deferred tax
asset arises from the initial recognition of an asset or liability in a transaction that:
a. is not a business combination; and

b. at the time of the transaction, affects neither accounting profit nor taxable profit
(tax loss).
From the above, it can be seen that the deferred PRT would be covered under the IRE, and deferred taxes on the same
would not be recognised. The availability of the super deduction would have been factored into any final price agreed
between the seller and buyer for the transaction. Accordingly, the cost of the acquisition to the purchaser would
represent its full value and no additional uplift should be made to this in respect of the super deduction. US GAAP allows
a gross up of the asset and a related deferred tax liability in respect of such a super deduction; however, this is not
permitted under IAS 12.
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4.6.3 Taxes paid in cash or in kind
Tax is usually paid in cash to the relevant tax authorities. However, some governments allow payment of tax through the
delivery of oil instead of cash for income taxes, royalty and excise taxes and amounts due under licences, production sharing
contracts and the like.
The accounting for the tax charge and the settlement through oil should reflect the substance of the arrangement.
Determining the accounting is straightforward if it is an income tax (see definition above) and is calculated in monetary terms.
The volume of oil used to settle the liability is then determined by reference to the market price of oil. The entity has in effect
‘sold’ the oil and used the proceeds to settle its tax liability. These amounts are appropriately included in gross revenue and
tax expense.
Arrangements where the liability is calculated by reference to the volume of oil produced without reference to market prices
can make it more difficult to identify the appropriate accounting. These are most often a royalty or volume-based tax. The
accounting should reflect the substance of the agreement with the government. Some arrangements will be a royalty fee,
some will be a traditional profit tax, some will be an appropriation of profits and some will be a combination of these and
more. The agreement or legislation under which oil is delivered to a government must be reviewed to determine the
substance and hence the appropriate accounting. Different agreements with the same government must each be reviewed
as the substance of the arrangement, and hence the accounting may differ from one to another.
4.6.4 Deferred tax and acquisitions of

participating interests in jointly controlled
assets
The deferred tax consequences of the acquisition of a participating interest in a jointly controlled asset are discussed in
section 4.1.9.
4.6.5 Discounting of petroleum taxes
Tax liabilities are measured at the amount expected to be paid to the taxation authorities and accordingly would not be
discounted. Accordingly, petroleum taxes which fall within the scope of IAS 12 would not be discounted. Petroleum taxes
outside the scope of IAS 12 can be measured after considering the effects of discounting.
4.6.6 Royalties to non-governmental bodies

and retained interests
Petroleum ‘taxes’ do not always relate to dealings with government authorities. Sometimes arrangements with third parties
are such that they result in the payment of a royalty. For example, one party may own the licence to a field which is used by
an operating party on the terms that, once the operator starts producing, it must pay the license holder a percentage of its
profits or a percentage of production.
In cases where the license holder receives a fixed payment per unit extracted or sold, it would generally be in the nature of
royalty. However, if the licence holder is entitled to a portion of the oil or gas extracted, it could potentially mean that the
licence holder retains an interest in the field.
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It would be important to consider whether the license holder has a claim on the profits of the entity or on its net assets. If the
license holder retains an interest in the net assets of the entity, it would have to be accounted for under the relevant IFRS.
4.7 Functional currency
4.7.1 Overview
Oil and gas entities commonly undertake transactions in more than one currency, as commodity prices are often
denominated in US dollars and costs are typically denominated in the local currency. Determination of the functional
currency can require significant analysis and judgement.
4.7.2 Determining the functional currency
Identifying the functional currency for an oil and gas entity can be complex because there are often significant cash flows in
both the US dollar and local currency. Management should focus on the primary economic environment in which the entity
operates when determining the functional currency. The denomination of selling prices is important but not determinative.
Many sales within the oil and gas industry are conducted either in, or with reference to, the US dollar. However, the US dollar
may not always be the main influence on these transactions. Although entities may buy and sell in dollar denomination, they
are not exposed to the US economy unless they are exporting to the US or another economy closely tied to the US.
Dollar denomination is a pricing convention rather than an economic driver. Instead, the main influence on the entity is
demand for the products and ability to produce the products at a competitive margin, which will be dependent on the local
economic and regulatory environment. Accordingly, it is relatively common for oil and gas entities to have a functional
currency which is their local currency rather than the US dollar, even where their sales prices are in dollars.
Functional currency is determined on an entity-by-entity basis for a multi-national group. It is not unusual for a multi-national
oil and gas company to have many different functional currencies within the group.
There are primary indicators of functional currency: the currency of sales prices, the currency of the country that will
consume and regulate the products, and the currency of the cost of labour.
It is difficult to identify a single country whose competitive forces and regulations mainly determine selling prices in oil and
gas. If the primary indicators do not provide an obvious answer to the functional currency question, the currency in which an
entity’s finances are denominated should be considered, i.e. the currency in which funds from financing activities are
generated and the currency in which receipts from operating activities are retained.
How to determine the functional currency of an entity with products normally traded in a non-local currency (1)
What is the functional currency of an entity which is based in Saudi Arabia but prices all products sold in US dollars?
Background
Entity A operates an oil refinery in Saudi Arabia. All of the entity’s income is denominated and settled in US dollars.
Refined product is primarily exported by tanker to the US. The oil price is subject to worldwide supply and demand, and
crude oil is routinely traded in US dollars around the world. Around 55% of entity A’s cash costs are imports or expatriate
salaries denominated in US dollars. The remaining 45% of cash expenses are incurred in Saudi Arabia and denominated
and settled in riyal. The non-cash costs (depreciation) are US dollar denominated, as the initial investment was in US
dollars.
Solution
The factors point toward the functional currency of entity A being the US dollar. The product is primarily exported to the
US. The revenue analysis points to the US dollar. The cost analysis is mixed. Depreciation (or any other non-cash
expenses) is not considered, as the primary economic environment is where the entity generates and expends cash.
Operating cash expenses are influenced by the riyal (45%) and the US dollar (55%). Management is able to determine the
functional currency as the US dollar, as the revenue is clearly influenced by the US dollar and expenses are mixed.
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What is the functional currency of an entity which is based in Russia but prices all products sold in US dollars?
Background
Entity A operates a producing field and an oil refinery in Russia and uses its product to supply independent petrol
stations in Moscow. All of the entity’s income is denominated in US dollars but is settled in a mixture of dollars and local
currency. Around 45% of entity A’s cash costs are expatriate salaries denominated in US dollars. The remaining 55% of
cash expenses are incurred and settled in roubles.
Solution
The factors point toward the functional currency of entity A being the Russian Rouble. Although selling prices are
determined in dollars, the demand for the product is clearly dependent on the local economic environment in Russia.
Although the cost analysis is mixed based on the level of reliance on the Moscow marketplace for revenue and margin
management is able to determine the functional currency as the Russian rouble.
Determining the functional currency of holding companies and treasury companies may present some unique challenges;
these have largely internal sources of cash although they may pay dividends, make investments, raise debt and provide risk
management services. The underlying source of the cash flows to such companies is often used as the basis for determining
the functional currency.
4.7.3 Change in functional currency
Once the functional currency of an entity is determined, it should be used consistently, unless significant changes in
economic facts, events and conditions indicate that the functional currency has changed.
Oil and gas entities at different stages of operation may reach a different view about their functional currency. A company
which is in the exploration phase may have all of its funding in US dollars and be reliant on its parent company. It may also
incur the majority of its exploration costs in US dollars (the availability of drilling rigs may require these to be sourced from
the US). At this stage it may conclude US dollars as being the functional currency.
However, when it reaches the development phase, its transactions may be predominantly denominated in local currency as it
is more reliant on the local workforce and suppliers to perform the development activity. The functional currency may then
change to being the local currency.
The functional currency may then change again when the project reaches the production phase and revenue is generated in
US dollars. As explained above, a selling price in dollars would not automatically mean that the functional currency is US
dollars and factors such as the territory the company sells to and marketplace in which it operates would have to be
considered. This does, however, illustrate that determination of the functional currency can be an ongoing process and
conclusions may change depending on the current facts and circumstances.
4.9 Operating segments
4.9.1 Overview
Oil and gas companies often operate in a range of geographic locations and, in many cases, produce a diverse range of
commodities from numerous fields. The core principle of segment reporting is to provide information to the users of financial
statements to enable them to evaluate the nature, economic environments and financial effects of the business activities in
which a company operates. Entities are often managed on a geographic or even product group basis. Financial reporting
requirements for segment reporting are covered in IFRS 8.
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Certain entities that do not have public debt or equity and are not in the process of registering any public securities may
choose not to present segmented information.
4.9.2 Operating and reportable segments
IFRS 8 requires an entity to first identify its ‘operating segments’. Once an entity has done that, it is required to determine its
‘reportable segments’. Reportable segments might comprise single operating segments, or an aggregation of operating
segments. Reportable segments are the basis for disclosure of segment information in the financial statements. Further
guidance can be found in the PwC Manual of Accounting Chapter 8 paragraphs 7 to 8.
PwC Observation
A development project or exploration project will not necessarily earn revenues but it might still constitute an operating
segment.
FAQ 8.7.1 – Is an entity that has yet to earn revenue an operating segment?
EX 8.7.3 – CODM reviews revenue information only
FAQ 8.7.4 – Is a segment balance sheet required for discrete financial information to exist?
EX 8.7.5 – Vertically integrated operations
FAQ 8.7.6 – Are discontinued operations and operations being wound down operating segments?
FAQ 8.7.7 – Is a joint venture an operating segment?
FAQ 8.8.1 – Is a corporate headquarters support function an operating segment?
4.9.3 Identifying operating segments: ‘The

management approach’
The concept of defining segments at the level of review of the CODM is commonly referred to as the ‘management
approach’. The key benefits of this approach are that detailed segment information can be reported more frequently at a low
incremental cost to prepare that allows a user to better understand an entity as they are able to see an entity through the
eyes of management. Further guidance can be found in the PwC Manual of Accounting Chapter 8 paragraphs 10 to 11.
Identification of operating segments typically involves a four-step process:
1. Identify the CODM

2. Identify the business activities (these could be different fields or wider geographic regions as well as development/exploration or
Corporate head office)
3. Determine whether discrete information is available for the business activities
4. Determine whether that information is reviewed by the CODM
The CODM defines a function and not necessarily a position or title – examples of the CODM include the Chief Executive
Officer, the Chief Operating Officer and a group of executives or directors functioning in the CODM capacity. Further
guidance can be found in the PwC Manual of Accounting Chapter 8 paragraph 9.
FAQ 8.9.1 – Can a supervisory board or committee of non-executive directors be CODM?

EX 8.9.3 – Impact of reorganisation on CODM
FAQ 8.12.1 – What are the operating segments where CODM receives reports by product and by geographical region?
FAQ 8.12.2 – What are the operating segments where CODM reviews multiple levels of reports?
EX 8.13.1 – Role of segment manager as an indicator of operating segments
4.9.4 Aggregation of operating segments
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Two or more operating segments may be aggregated into a single operating segment for reporting purposes if the segments
have similar economic characteristics and the segments are similar in each of the following respects:
a. the nature of the products and services;

b. the nature of the production processes;
c. the type or class of customer for their products and services;
d. the methods used to distribute their products or provide their services; and
e. if applicable, the nature of the regulatory environment.
The ability of an entity to aggregate its segments based on the ‘similar economic characteristics’ criteria requires judgement
to be applied to each set of facts and circumstances.
The aggregation of such segments is for presentation purposes only, it does not affect the level at which goodwill is tested
for impairment (i.e. the maximum level that goodwill can ever be tested at is the level of an operating segment prior to
aggregation). Further guidance can be found in the PwC Manual of Accounting Chapter 8 paragraph 55.
General EX of Particular Relevance to the Industry
EX 8.17.2 – Aggregating an entity’s segments where the management reporting is prepared on a geographical basis
IND EX 4.9.4.1 - Aggregation of operating segments
4.9.5 Minimum reportable segments
After identifying operating segments and aggregating those that meet the aggregation criteria, an entity should determine
which operating segments or aggregations of operating segments meet the quantitative thresholds for separate disclosure
as reportable segments. An entity must report information separately if any of the following quantitative thresholds is met:
a. Reported revenues, including sales to external customers and intersegment sales/transfers are 10% or more of the combined
internal and external revenue of all operating segments.
b. The absolute amount of the reported profit or loss is 10% or more of the greater, in absolute amounts, of:
the combined reported profit of all operating segments that did not report a loss; and
the combined reported loss of all reporting segments that reported a loss.
c. Its assets are 10% or more of the combined assets of all operating segments.
If the total external revenue reported by reportable segments is less than 75% of the entity’s revenue, additional operating
segments will need to be identified as reportable segments until at least 75% of the entity’s revenue is included in reportable
segments.
EX 8.18.1 – Reportable segments: revenue threshold

EX 8.18.2 – Reportable segments: revenue and results thresholds
EX 8.18.3 – Reportable segments: all quantitative thresholds
EX 8.18.4 – Reportable segments: quantitative thresholds for a number of segments
FAQ 8.18.5 – What level of profit or loss should be used in determining whether the quantitative thresholds for reportable
segments have been met?
4.9.6 Disclosure
Entities are required to disclose information consistent with the core principles of segment reporting. Further guidance can
be found in the PwC Manual of Accounting Chapter 8 paragraphs 27 to 56.
EX 8.30.1 – Management commentary and composition of segments

EX 8.31.1 – Disclosure of assets
EX 8.31.2 – Voluntary disclosure of aggregated revenue streams
EX 8.37.1 – Determining how each segment item should be calculated and use of non-GAAP measures in segmental
disclosure
EX 8.37.2 – Measures of profit for segmental reporting
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EX 8.37.3 – Currency and segmental reporting
EX 8.37.8 – Issues with allocating costs, expenses and assets to segments
EX 8.39.1 – Two measures of profit used for each operating segment
EX 8.46.1 – Allocating revenue to geographical areas
4.10 Consolidation
This section focuses on the requirements of IFRS 10 and the definition and guidance with regard to ‘control’.
4.10.1 Control
IFRS 10 confirms consolidation is required where control exists. The standard defines control: where an investor has the
power and exposure to variable returns and the ability to use that power it controls the investee. Factors to be assessed by
oil and gas entities to determine control include:
the purpose and design of an investee;

whether rights are substantive or protective in nature;
existing and potential voting rights;
whether the investor is a principal or agent; and
relationships between investors and how they affect control.
Only substantive rights are considered in the assessment of power – protective rights, designed only to protect an investor’s
interest without giving power over the entity and which may only be exercised under certain conditions, are not relevant in
the determination of control.
Potential voting rights are ”rights to obtain voting rights of an investee, such as those within an option or convertible
instrument.” Potential voting rights with substance should be considered when determining control. This is a change from
the previous standard where all and only presently exercisable rights were considered in the determination of control.
The ‘principal versus agent’ determination is also important. Parties in oil and gas arrangements will often be appointed to
operate the project on behalf of the investors. A principal may delegate some of its decision authority to the agent, but the
agent would not be viewed as having control when it exercises such powers on behalf of the principal.
Economic dependence in an arrangement, such as a refinery which relies on crude oil to be provided by a specific supplier,
is not uncommon, but is not a priority indicator. If the supplier has no influence over management or decision-making
processes, dependence would be insufficient to constitute power.
4.1 Business Combinations
4.1.1 Overview
Acquisitions of assets and businesses are common in the oil and gas (O&G) industry. Acquisitive entities that seek to secure
access to reserves or replace depleting reserves face a variety of accounting issues. The broad requirements of IFRS 3,
‘Business combinations’, include:
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recognition at fair value of all forms of consideration at the date of the business
combination;
remeasurement to fair value of previously held interests in the acquiree, with
resulting gains through the income statement as part of the accounting for the
business combination;
providing more guidance on separation of other transactions from the business
combination, including share-based payments and settlement of pre-existing
relationship;
expensing transaction costs;

accounting for deferred taxes; and
two options for the measurement of any non-controlling interest (NCI) on a
combination-by-combination basis: fair value, or proportion of net asset value.
4.1.2 Definition of a business
Under IFRS 3, a business is defined as an integrated set of activities and assets that is capable of being conducted and
managed for the purpose of providing goods or services to customers, generating investment income (such as dividends or
interest) or generating other income from ordinary activities. The three components of a business are: inputs; processes; and
outputs. To be considered a business, an acquisition would have to include an input and a substantive process that together
significantly contribute to the ability to create outputs. Further guidance can be found in the PwC Manual of Accounting
chapter 29 paragraphs 6 to 19.
The concentration test
There is an optional concentration test that, if met, allows an entity to account for the acquisition as an asset acquisition
rather than as a business combination. Under the concentration test, companies consider whether substantially all of the fair
value of the gross assets acquired is concentrated in a single asset (or a group of similar assets). If so, the assets acquired
would not represent a business and no further analysis is required. Although ‘substantially all’ is not defined under IFRS, in
practice we observe the use of approximately a 90% threshold in defining what constitutes ‘substantially all’.
PwC Observation
The optional concentration test includes the concept of aggregating ‘similar’ assets. In the energy industry, it is common
for acquisitions to include various classes of asset in various stages of the production cycle. Companies should carefully
consider the specific facts and circumstances, including product (for example, oil or gas), development stage (for
example, exploration and evaluation (E&E), proved undeveloped, developed) and geographical location (for example,
onshore or offshore) and other relevant factors when concluding whether the assets purchased in a transaction are
similar. A group of assets are not similar if they have significantly different risk characteristics. [IFRS 3 App B para B7B(f)
(vi)].
IFRS 3 further stipulates that tangible and intangible assets cannot be considered similar assets for the purpose of
applying the concentration test. Similarly, tangible assets in different asset classes cannot be combined for this purpose.
This restriction on combining assets is significant to the energy industry: E&E assets cannot be combined with property,
plant and equipment (PP&E), because they are different classes of asset and have significantly different risk
characteristics. That is, E&E assets are reclassified to tangible or intangible assets within the scope of IAS 16 or IAS 38
once they qualify for recognition under those standards (for example, when the commercial viability of reserves is
established).
IFRS 6 also requires E&E assets to be classified as tangible or intangible according to the nature of the assets acquired.
Therefore, a preparer of financial statements would need to look beyond just the distinction between PP&E and E&E
assets. The classification of E&E assets between tangible and intangible sometimes requires significant judgement. For
example, exploration licences might be intangible, and wells drilled and related equipment will be considered tangible.
The concentration test prohibits the combination of tangible and intangible assets. As such, the distinction has become
more important.
Industry-specific EXs
IND EX 4.1.2.1 – Acquisition of E&E assets and producing properties
IND EX 4.1.2.2 – Acquisition of producing properties
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IND EX 4.1.2.3 – Acquisition of an exploration entity
FAQ 29.6.1 – What is the definition of a business ‘framework’ for evaluating whether a set of assets should be accounted for
as an acquisition of a business or a group of assets?
FAQ 29.19.1 – How should an entity evaluate whether an acquired integrated set of activities and assets is a business or a
group of assets?
4.1.3 Identifying a business combination
Transactions can be structured in a variety of ways, including purchase of shares, purchase of net assets, and establishment
of a new company that takes over existing businesses and restructures existing entities. If there are a number of transactions
linked together, or transactions that are contingent on completion of each other, the overall result is considered as a whole.
IFRS focuses on the substance of transactions and not the legal form to determine if a business combination has taken
place.
The only exemptions to applying business combination accounting under IFRS are:
where the assets acquired do not constitute a business;

the formation of a joint arrangement in the financial statements of the joint
arrangement itself (see section 4.2); and
businesses that are under common control (where no change in ownership takes
place).
A business combination occurs when control over a business is obtained. Both existing voting rights and capacity to control
the business in the form of currently exercisable options and rights are considered in determining when control or capacity to
control exists. Further guidance can be found in the PwC Manual of Accounting chapter 29 paragraphs 20 to 25.
General FAQs and EXs of particular relevance to the industry
EX 29.21.1 – Share repurchase by investee
EX 29.21.2 – Change in the rights of other shareholders
EX 29.21.3 – Contracts or other arrangements
EX 29.21.4 – Exchange of assets resulting in acquisition of a business
FAQ 29.23.1 – Are stapling transactions and the formation of dual-listed entities considered business combinations?
FAQ 29.24.1 – Are the merger of equals, mutual enterprises, and ‘roll-up’ or ‘put-together’ transactions considered business
combinations?
EX 29.25.1 – Effecting a business combination through a series of linked transactions
4.1.4 Acquisition method
The acquisition method of accounting is applied to all business combinations. The acquisition method comprises the
following steps:
identifying the acquirer (see PwC Manual of Accounting chapter 29 paragraphs 27

to 41);
determining the acquisition date (see PwC Manual of Accounting chapter 29
paragraphs 42 to 44);
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recognising and measuring the consideration transferred, including any previously

held interest and non-controlling interest on acquisition (see PwC Manual of
Accounting chapter 29 paragraphs 45 to 87);
recognising and measuring the identifiable assets acquired and liabilities assumed
and non-controlling interests (see PwC Manual of Accounting chapter 29
paragraphs 88 to 167); and
recognising and measuring goodwill or a gain from a bargain purchase (see PwC
Manual of Accounting chapter 29 paragraphs 168 to 182).
Identifying the acquirer:
EX 29.39.1 – New entity formed to effect a business combination
EX 29.39.2 – Identifying the acquirer through domination of key management
EX 29.40.1 – New company set up by venture capital entity to acquire business
EX 29.40.2 – New company is not the acquirer
Determining the acquisition date:
EX 29.43.1 – Determining the date when control passes: not the date of agreement
FAQ 29.43.2 – How should a company determine the acquisition date where no consideration is transferred?
Recognising and measuring the consideration transferred, including any previously held interest and non-controlling interest
on acquisition:
FAQ 29.48.1 – How should a company assess employee compensation arrangements in a business combination?
FAQ 29.63.1 – What challenges might a company face when accounting for contingent consideration?
EX 29.67.1 – Interest-free loan treated as deferred consideration
FAQ 29.68.1 – What should a company consider when measuring contingent consideration?
FAQ 29.73.2 – How should a company account for an acquisition of a controlling interest for shares in another entity?
FAQ 29.86.1 – What is the framework used to determine the classification of contingent consideration arrangements?
FAQ 7.37.7 – How should payments to settle contingent consideration for a business combination be classified?
PwC Observation
Contingent consideration in the O&G industry often takes the form of:
royalties payable to the vendor as a percentage of future oil revenue;

payments based on the achievement of specific levels of production or specific
prices of oil; and
payments on achievement of milestones in the different phases (that is,
exploration, development and production).
An arrangement containing a royalty payable to the vendor is different from a royalty payable to a country’s tax
authorities. A royalty payable to the vendor in a business combination is often contingent consideration; essentially a
type of earn-out. However, amounts described as royalties might often instead be the retention of a working interest. If
so, different accounting will be applied. Judgement is required as to whether the royalty or a retained working interest
exists.
Where the acquirer has taken control of the entire property or business and cannot avoid making future payments to the
seller, it is more likely to be contingent consideration. However, where some or all of the risks (for example, reserve risk,
extraction risk or price risk) are shared with the previous owners, it becomes less clear. Retained interests with capped
volume, fixed prices or a limited duration are usually contingent consideration.
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PwC Observation
The acquirer should fair value all of the consideration at the date of acquisition, including any contingent consideration
(earn-out). Since fair value takes account of the probabilities of different outcomes, there is no requirement for payments
to be probable. Therefore, contingent consideration is recognised whether it is probable that a payment will be made or
not.
Any subsequent payment or transfer of shares to the vendor should be scrutinised to determine if it is a contingent
consideration.
Contingent consideration can take the form of a liability or equity. If an earn-out is a liability (cash or shares to the value
of a specific amount), any subsequent remeasurement of the liability is recognised in profit or loss. If the earn-out is
classified as equity, it is not remeasured and any subsequent settlement is accounted for within equity.
Recognising and measuring the identifiable assets acquired and liabilities assumed and non-controlling interests:
FAQ 29.96.1 – What are examples of assets and liabilities identified in an acquisition that were not identified before the
acquisition?
FAQ 29.98.1 – What are examples of where a classification, designation or assessment decision is required?
EX 29.105.1 – Favourable and unfavourable purchase contracts
FAQ 29.118.1 – How should an acquirer determine the useful life of a re-acquired right?
EX 29.119.3 – Decommissioning and site restoration costs
FAQ 29.159.1 – How should an acquirer measure non-controlling interest
EX 29.159.2 – Measurement of non-controlling interest in a business combination including preference shares
PwC Observation
Some of the common identifiable assets and liabilities specific to the O&G industry that might be recognised in a
business combination, in addition to inventory or property, plant and equipment, include the following:
exploration, development and production licences;

O&G properties;
purchase and sale contracts; and
environmental/closure provisions.
Key questions for management to consider in this aspect:
Have all intangible assets, such as geological and geophysical information, O&G
property, and exploration potential, been separately identified? There could be
tax advantages in allocating value to certain assets, and each will need to be
assessed in terms of their useful lives and impact on post-acquisition earnings.
Have environmental and rehabilitation liabilities been fully captured? The value
that the acquirer would need to pay to a third party to assume the obligation
could be significantly different from the value calculated by the target.
Does the acquiree have purchase or sale contracts at a price that is favourable
or unfavourable when compared to the market? Such contracts would have to
be fair valued as at the date of acquisition.
Do the terms of purchase provide for an ongoing royalty, other payments or
transfer of equity instruments? These arrangements could be contingent
consideration that need to be fair valued as at the date of acquisition
Does the acquiree use derivative instruments to hedge exposures? Post-
combination hedge accounting for pre-combination hedging instruments can be
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PwC Observation
complex. The acquirer will need to designate these and prepare new
contemporaneous documentation for each hedging relationship.
Have all embedded derivatives been identified? New ownership of the acquired
entity might mean that there are changes in the original conclusions reached
when contracts were first entered into
Industry-specific FAQ
IND FAQ 4.1.4.1 – How should an acquirer measure the fair value of undeveloped properties/resources?
4.1.5 Goodwill in O&G acquisitions
Goodwill remains a residual in business combination accounting – that is, the difference between consideration transferred
and the fair value of identifiable assets acquired and liabilities assumed. Further guidance can be found in the PwC Manual
of Accounting chapter 29 paragraphs 168 to 169.
PwC Observation
Management of the acquirer should carry out a thorough analysis and fair value exercise for all of the identifiable
tangible and intangible assets of the acquired business. Once this has been completed, any residual forms goodwill.
Goodwill might also arise mechanically from the requirement to record deferred tax in a business combination, and this
is further discussed below.Goodwill can arise from several different sources. For example, goodwill might arise if a
specific buyer can realise synergies from shared infrastructure assets (for example, oil pipelines) or oil extraction
techniques that are not available to other entities. Goodwill might also represent access to new markets, community/
government relationships, portfolio management, expertise, the existence of an assembled workforce, and deferred tax
liabilities. An O&G entity might be willing to pay a premium to protect the value of other O&G operations that it already
owns, and this would also represent goodwill.
Goodwill could also arise from the requirements to recognise deferred tax on the difference between the fair value and
the tax value of the assets acquired in a business combination. The fair value uplift to O&G properties and exploration
assets is often not tax deductible and therefore results in a deferred tax liability.
The fair value attributed to some intangible assets could increase if their associated amortisation is deemed to be
deductible for tax purposes. This gives rise to a tax amortisation benefit which results in an increase in the value of the
asset and no related deferred tax liabilities, and a decrease in the value of goodwill.
Goodwill and non-controlling interest
IFRS 3 gives entities a choice on the measurement of NCI that arises in a less than 100% business combination. The choice
is available on a transaction-by-transaction basis. An acquirer can recognise the NCI either at fair value, which leads to 100%
of goodwill being recognised (full goodwill), or at the NCI’s proportionate share of the acquiree’s identifiable net assets
(partial goodwill) – this leads to goodwill being recognised only for the parent’s interest in the entity acquired. Further
guidance can be found in the PwC Manual of Accounting chapter 29 paragraphs 159 to 160.
Bargain purchase
A gain on a bargain purchase occurs where the consideration, non-controlling interest and the previously held interest are
less than the value of the identifiable net assets. A gain on a bargain purchase is immediately recognised by the acquirer in
profit or loss. A bargain purchase might occur where there is a forced sale or because some items in a business combination
are not measured at fair value (for example, deferred tax assets). The acquirer should ensure that it does have a gain on a
bargain purchase, and that it has used all of the available evidence at the date of acquisition and re-assessed the business
combination accounting. Further guidance can be found in the PwC Manual of Accounting chapter 29 paragraphs 174 to
176.
EX 29.171.1 – Components making up goodwill
EX 29.173.1 – Goodwill recognised depends on how non-controlling interest is measured
EX 29.173.2 – Gain on a bargain purchase depends on how non-controlling interest is measured
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FAQ 29.176.1 – What should an acquirer do prior to recognising a gain on a bargain purchase?
4.1.6 Deferred tax
Deferred income taxes are recognised and measured in accordance with IAS 12. Deferred taxes are provided on all of the
temporary differences arising between the values assigned to identifiable assets and their tax bases. Fair value adjustments
made to the acquired entity’s identifiable assets and liabilities and contingent liabilities might give rise to temporary
differences, and these are tax-effected and recognised as deferred taxes. Further guidance can be found in the PwC Manual
of Accounting chapter 29 paragraphs 121 to 123.
PwC Observation
An entity recognises deferred tax on the fair value adjustments to the assets and liabilities of an acquired O&G company,
including any increase in the value of O&G properties and/or exploration assets. No deferred tax liability is recognised on
goodwill itself, unless it arises subsequent to acquisition where the goodwill is tax deductible. Tax-deductible goodwill is
rare and presents specific accounting issues. The tax base should reflect the manner in which the value of the asset will
be realised. Some tax jurisdictions do not allow companies to claim tax deductions on acquired O&G properties based
on the purchase price, if the asset will be realised through production of oil and gas. In such cases, it is likely that a large
deferred tax liability will need to be recognised, because the carrying amount might be significantly higher than the tax
base.
This deferred tax liability can result in the recognition of goodwill, because it reduces the net assets of the acquired
entity. The extent of such goodwill will depend on the fair value of the O&G properties and the exploration assets, and it
could be significant.
Tax losses
The acquired entity might not have recognised a deferred tax asset in respect of its past tax losses or deductible temporary
differences because it was unable to satisfy the deferred tax asset recognition criteria. The acquirer might determine that
other entities within the group will have sufficient future taxable profits to realise the tax benefits through transfer of those
losses, as permitted by the tax laws. Alternatively, the expected future taxable profits of the acquiree might increase as a
result of cost savings or other synergies after acquisition. The tax benefits satisfy the criteria in paragraph 24 of IAS 12 for
separate recognition of an identifiable asset of the acquiree at the acquisition date. A deferred tax asset attributable to the
unused tax losses is recognised as an acquired asset in the business combination accounting. Further guidance can be
found in the PwC Manual of Accounting chapter 29 paragraphs 124 to 125.
4.1.7 Provisional assessments of fair values
Acquirers have a reasonable time (not exceeding 12 months) from the date of an acquisition to finalise the purchase price
allocation. This is known as the ‘measurement period’. The measurement period ends on the earlier of the date when the
acquirer receives the information that it needs (or determines that it cannot obtain the information) and one year after the
acquisition date. Where the accounting for a business combination is not complete by the end of the reporting period in
which the business combination occurred, provisional amounts should be reported and disclosure given. The comparative
information for prior periods presented in the current financial statements should be revised as needed, including recognising
any change in depreciation, amortisation or other income effects recognised based on the original accounting. Information
pertaining to events that occur after the acquisition date (such as exploration activities undertaken after the acquisition date)
does not give rise to measurement period adjustments. All changes that do not qualify as measurement period adjustments
are included in current period profit or loss. Further guidance can be found in the PwC Manual of Accounting chapter 29
paragraphs 177 to 182.
Adjustments to deferred taxes will only affect goodwill if they are made within the 12-month period for finalising the business
combination accounting, and if they result from new information about facts and circumstances that existed at the
acquisition date. After the 12-month period, adjustments are recorded as normal under IAS 12, through the statement of
comprehensive income.
PwC Observation
Acquirers will frequently use the measurement period to finalise the evaluation of the acquired O&G properties and
exploration assets, provided that the result is not impacted by events that occur after the acquisition date. The process
of determining a reliable value for assets that are still in the early phase of exploration can be challenging. The level of
uncertainty in ascribing a value to such assets increases the likelihood of subsequent changes having an effect on
reported profit.
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PwC Observation
General EX of particular relevance to the industry
EX 29.182.1 – Measurement period adjustment
4.1.8 Business combinations achieved in stages
A business combination achieved in stages is accounted for using the acquisition method at the acquisition date. Previously
held interests are remeasured to fair value at the acquisition date, and a gain or loss is recognised in the income statement.
The gain or loss would require disclosure in the financial statements. The fair value of the previously held interest then forms
one of the components that are used to calculate goodwill, along with the consideration and non-controlling interest less the
fair value of identifiable net assets. Further guidance can be found in the PwC Manual of Accounting chapter 29 paragraphs
166 to 167.
FAQ 29.167.1 – How should an acquirer account for step acquisitions?
EX 29.167.2 – Control obtained in step acquisition
4.1.9 Acquisitions of participating interests in

joint operations
Joint operations that are not incorporated entities are a common method of undertaking development and production within
the industry. Acquisition of interests in these assets, where there are proven resources (and therefore in the development or
production phase), is common. The acquirer needs to assess whether the activity of the joint operation constitutes a
business using the framework discussed in section 4.1.2 above. All principles of business combination accounting should be
applied to the acquisition of an interest in the joint operation that constitutes a business.
The acquisition of an interest in joint operations that do not meet the definition of a business would not result in a business
combination. As explained in section 4.1.2, an important consequence is that the acquisition would be treated as the
purchase of an asset, with no goodwill or deferred tax arising. Further guidance can be found in the PwC Manual of
Accounting chapter 32 paragraph 54.
General EX of particular relevance to the industry
FAQ 32.54.1 – Obtaining an interest in a joint operation: what are the main differences between a business combination and
an asset acquisition?
IND EX 4.1.9.1 – Accounting for purchase of an interest in a non-producing field
IND EX 4.1.9.2 – Accounting for purchase of an interest in a producing field
4.1.10 Restructuring costs
Major restructuring programmes often follow business combinations. These costs can only be recognised as part of the
business combination if they were previously recognised by the acquiree. Any other costs (such as terminations subsequent
to the business combination) must be recorded as an expense in the post-combination income statement of the acquired
business. Similarly, any restructuring or other costs incurred by the acquirer itself cannot be included in the business
combination. Further guidance can be found in the PwC Manual of Accounting chapter 29 paragraphs 149.
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EX 29.149.1 – Recognition of restructurings or exit activities
EX 29.149.2 – Redundancy costs
FAQ 29.149.3 – How should a company account for contractual payments that the acquiree is required to make on a
business combination?
EX 29.149.4 – Restructuring costs incurred after acquisition
IND EX 4.2.3.1 - Other facts and circumstances
Each example below has the following facts and assumptions:
joint control exists; and

the legal structure of the separate vehicle and the contractual terms do not give the
parties rights to assets and obligations for liabilities.
The initial indicators may suggest a joint venture, however other facts and circumstances are analysed to see how they may
affect the classification of the arrangement.
Example 1
Reference to standard: IFRS 11 App B para B31

Reference to standing text: IND 4.2.3, Manual para 32.47
Industry: Oil and gas industry
The arrangement produces oil and the parties are obligated to take all of the output in the ratio of their shareholding. The
price of output is set by the parties at a level such that the arrangement operates at break-even level. The oil is a commodity
which is readily saleable in the market i.e. if the parties do not buy, it can be easily sold to a third party. The arrangement is
prohibited from selling the output to third parties.
Question
What is the classification of the joint arrangement?
Answer
The joint arrangement is a joint operation. The fact that the product is readily saleable becomes less relevant because there
is an obligation on the arrangement to sell all of its output to the parties.
Example 2
Reference to standard: IFRS 11 App B para B31, B14, B32

Reference to standing text: IND 4.2.3, Manual para 32.47 and 32.49
The arrangement produces two products: oil and gas. 100% of oil is taken by one party and 100% of gas is taken by the
other party at market value. Since these are purchased by the parties at market value, there is a residual profit or loss left in
the arrangement which is distributed by way of dividends to the parties or shared by the parties if there are accumulated
losses in the proportion of their shareholding.
Question
Answer
The joint arrangement is likely to be a joint operation. The parties do not have to set up a joint arrangement for an interest in
the same product. They may have interest in different products but may set up a joint arrangement for reasons such as cost
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saving or similar manufacturing processes. It appears that this arrangement is dependent on the parties for cash flows and
the parties take all output. This is a strong indicator that the arrangement may be a joint operation.
Before determining the classification, consideration should be given to all facts and circumstances. Certain other factors may
impact classification including:
whether the parties have a contractual obligation to take all of the output; and
the relative values of the products purchased compared to the proportion of
investments made by the parties.
Example 3
Reference to standard: IFRS 11 App B para B31, B14, B32

Reference to standing text: IND 4.2.3, Manual para 32.47 and 32.49
Two parties set up a joint arrangement. One of the parties is obligated to take 100% of the gas produced at market prices
and the other party only takes its share of the profit/loss made by the entity.
Question
Answer
Judgement is required. All facts and circumstances have to be considered before determining the classification. Assessment
of the economic rationale behind such an arrangement might give an indication of the purpose and design of the
arrangement. An assessment should be made as to whether one of the parties actually controls the arrangement or if there is
a lease arrangement. If it is concluded that there is joint control, it seems that the arrangement has some indicators of a joint
operation. This is because the arrangement does not sell to third parties and is dependent on one of the parties for its
continuous cash flows. On the other hand, one of the parties does not consume any output and this is less typical of a joint
operation.
IND FAQ 4.2.7.1 Can a venturer account for its

share of revenue and assets?

Entity A, B, C and D (venturers) each hold 25% in Entity J, which owns a refinery. Decisions in Entity J need to be approved
by a 75% vote of the venturers. Entity J is not a joint arrangement because the proportion required for approval of decisions
can be achieved by more than one combination of investors.
Entity A’s management wants to account for its interest in Entity J for its share of revenue and assets in its IFRS
consolidated financial statements.
Question
Can Entity A’s management apply their proposed accounting treatment? ?
Answer
No. Entity A cannot account for Entity J using its share of revenue and assets because Entity J is not a joint arrangement
under IFRS 11. The voting arrangements would require unanimous agreement between those sharing the joint control of
Entity J to qualify as a joint arrangement. The voting arrangements of Entity J allow agreement of any combination of three of
the four partners to make decisions.
Each venturer must therefore account for its interest in Entity J as an associate since they each have significant influence but
they do not have joint control. Equity accounting must be applied. If the venturers had joint control under IFRS 11, they
would assess whether the arrangement is a joint operation or a joint venture.
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IND FAQ 4.2.10.1 - How should the farmor

account for assets with proven reserves in a
farm out?

Reference to standing text: IND 4.2.10, Manual para 22.106 to 108
Question
How should the farmor account for assets with proven reserves in a farm out?
Answer
The rights and obligations of the parties need to be understood while determining the accounting treatment.
The consideration received by the farmor in exchange for the disposal of their interest is the value of the work performed by
the farmee plus any cash received. This is presumed to represent the fair value of the interest disposed of in an arm’s length
transaction.
The farmor should de-recognise the carrying value of the asset attributable to the proportion given up on the disposal date,
and then recognise the ‘new’ asset to be received at the expected value of the work to be performed by the farmee. After
also recording any cash received as part of the transaction, a gain or loss is recognised in the income statement. The asset
to be received is normally recognised as an ‘other receivable’ or intangible asset. When the expenditure is incurred, it is
transferred to property, plant and equipment.
Assessing the value of the asset to be received may be difficult, given the unique nature of each development. Most farm out
agreements will specify the expected level of expenditure to be incurred on the project (based on the overall budget
approved by all participants in the field development). The agreement may contain a cap on the level of expenditure the
farmee will actually incur. The value recognised for the asset will often be based on this budget. A consequence is that the
value of the asset will be subject to change as the actual expenditure is incurred, with the resulting adjustments affecting the
gain or loss previously recognised. The stage of development of the asset and the reliability of budgeting will impact the
volatility of subsequent accounting.
IND EX 4.2.10.2 - Accounting for farm outs on

exploration properties
Reference to standard: IFRS 6

Reference to standing text: IND 4.2.10
Company N and Company P participate jointly in the exploration and development of an oil and gas deposit located in
Venezuela. Company N has an 18% share in the arrangement, and Company P has an 82% share. Companies N and P have
signed a joint arrangement agreement that establishes the manner in which the area should operate. Companies N and P
have a joint operation under IFRS 11. The assets of the joint operation comprise the oil and gas field, machinery and
equipment. There are no proven reserves.
The companies have entered into purchase and sale agreements to each sell 45% of their participation to a new investor –
company R. Company N receives cash of C4 million and company P receives cash of C18 million. The three companies
entered into a revised ‘joint operating agreement’ to establish the rights and obligations of all three parties in connection with
the exploration, development and operations of the asset.
The composition of the interests of the three companies is presented in the table below:
Company N Company P Company R Total
Before transaction 18% 82% - 100%
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After transaction 10% 45% 45% 100%
Cash received C4 million C18 million - C22 million
Each party to the joint operating agreement is liable in proportion to their interest for costs subsequent to the date of the
agreement. However, 75% of the exploration and development costs attributable to companies N and P must be paid by
company R on their behalf. The total capital budget for the exploration and development of the asset is C200 million.
Company N’s share of this based on its participant interest would be C20 million; however, company R will be required to
pay C15 million of this on behalf of company N.
The carrying value of the asset in Company N’s financial statements prior to the transaction was C3 million as an exploration
and evaluation (E&E) asset.
Question
How should Company N (the farmor) account for such transaction?
Answer
This transaction has all the characteristics of a farm out agreement. The cash payments and the subsequent obligation of
company R to pay for development costs on behalf of companies N and P appear to be part of the same transaction.
Companies N and P act as farmors and company R acts as the farmee. The structure described is a joint operation.
Company N should account for its share of the assets and liabilities and share of the revenue and expenses.
The gain on disposal could be accounted for by company N using one of two approaches, as follows:
1. Recognise the reduction of assets and a gain based on the cash payment on the disposal date.
Company N will reduce the carrying value of O&G assets by the C4 million cash received on the disposal date. The C1
million excess over the carrying amount is credited to the income statement as a gain. The C15 million of future expenditure
to be incurred by company R on behalf of company N is not recognised as an asset at any point in time.
2. Recognise the reduction of assets and a gain based on the cash payment plus the value of the future assets to be received on the
disposal date.
Company N will recognise the C4 million as above. In addition, it will recognise an ‘other receivable’ or intangible asset for
the future expenditure to be incurred by company R on company N’s behalf to the extent that Company R cannot walk away
without penalty, with a further gain of this amount recognised in the income statement. Company N would have to assess
the expected value of the future expenditure. Although one method to estimate this would be the budgeted expenditure of
C15 million, company N would need to assess whether this would be the actual expenditure incurred. Any difference in the
final amount would require revision to the asset recognised and also the gain, creating volatility in the income statement.
Often in a farm-out the other party may walk away without incurring a penalty other than the forfeiture of their ownership and
therefore this approach may lead to a higher impairment should the exploration be unsuccessful.
IND EX 4.2.11.1 - How should an entity

account for a redetermination of a unitisation?

Reference to standing text: IND 4.2.11
Company A and B owned the adjoining oil prospects Alpha and Delta respectively. Both prospects were in the exploration
phase with no proven reserves. The companies entered into an agreement to develop the prospects jointly and the
combined area, Omega, which is considered to be a joint operation. The initial unitisation agreement stated that each was
entitled to 50% of the output of the combined area. This allocation was subject to future redetermination when the
exploration of Alpha and Delta was complete and proven reserves were determined. Additional redetermination would take
place on an ongoing basis after that as production commenced and reserve estimates were updated.
The exploration of the two prospects was completed. Both were found to have proven reserves and based on these results
the following redetermination was performed:
Company A Company B Total
Initial unitization 50% 50% 100%
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Redetermination 40% 60% 100%
Exploration cost to date C5 million C5 million C10 million
Future development expenditure C40 million
The companies have agreed that they will take a share of future production in line with the new determination of interests.
Additionally, the true-up of costs incurred to date will be made via adjustments to future expenditure rather than an
immediate cash payment.
Prior to redetermination company A had capitalised the C5 million cost incurred as an exploration asset, and transferred this
to tangible assets when proven reserves were discovered.
Question
How should Company A account for this redetermination?
Answer
Company A has incurred expenditure of C1 million greater than the share required by the revised allocation of interest. In
theory, it has a C1 million receivable from company B. The agreement between the companies indicates that this will be
trued-up via adjustment to future development expenditure i.e. company A will only be responsible for C15 million of future
spend rather than C16 million (C40 million*40%). It would be appropriate for company A to retain this C5 million asset as a
development asset with no adjustment for the C1 million. It should consider whether the change in the reserve estimates
indicates any impairment has occurred in the carrying value of the asset. Based on the revised share of future production
and the development costs still to come, impairment would be unlikely.
IND EX 4.9.4.1 - Aggregation of operating

segments
Reference to standard: IFRS 8 para 12

Example 1
An entity has three conventional gas fields in one region using the same pipeline. Production processes and cash costs are
similar and marketing of the product is performed centrally and sold based on the same benchmark price. The CODM
reviews information for the individual fields. Each of the three fields is an operating segment.
Question
Can they be aggregated into a single reportable segment?
Answer
Yes, the aggregation criteria are met due to the similarity of economic characteristics (products, processes and financial and
operating risks).
Example 2
An entity has two fields in the same region. One is a conventional field and the other is a field requiring hydraulic fracturing.
The operating costs per barrel of oil equivalent (BoE) are quite different for each field. One field produces oil and the other
produces a combination of oil and gas. The CODM reviews information for each of the fields and investors are provided with
reserves and operational information for each field. Each of the fields is an operating segment.
Question
Can they be aggregated into a single reportable segment?
Answer
It is unlikely that the fields would be aggregated due to the differences in products and processes. They do not have similar
economic characteristics and would be two reportable segments.
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6. First time adoption
IFRS 1 First time adoption of IFRSs provides transition relief and guidance for entities adopting IFRS and it is regularly
updated and amended by the IASB. The amendments either update IFRS 1 for new standards and interpretations or address
newly identified issues. However, keeping abreast of these changes can be challenging.
Entities in the oil and gas industry face many of the same transition issues as entities in other industries. This section focuses
on the specific transition issues and reliefs provided by IFRS 1 that are of particular importance in the industry.
6.1 Deemed cost
Many upstream oil and gas companies used a variant of full cost under local GAAP and will need to make some changes on
to IFRS. Successful efforts or a field-by-field based approach needs more detailed information; entities using full cost may
not have maintained the detailed records to allow reconstruction of historical cost carrying amounts.
IFRS 1 contains specific relief for entities that have previously used full cost accounting. The relief enables a first-time
adopter to measure oil and gas assets at the date of transition to IFRS at a ‘deemed cost’ basis. Exploration and evaluation
assets are measured at the carrying value determined under the entity’s previous GAAP, this becomes deemed cost for IFRS
purposes. The full cost pools are adjusted for the specific allocation of exploration and evaluation. The adjusted cost is then
allocated across producing assets and assets under development based on a reasonable method. The assets are then
tested for impairment at the date of transition.
This relief applies only to assets used in the exploration, evaluation, development or production of oil and gas. There is a
broader ‘deemed cost’ exemption which can be applied on an asset-by-asset basis to all tangible assets. The broader
exemption allows an entity to assess the deemed cost as being:
the fair value of the asset; or

a previous GAAP revaluation as deemed cost if the revaluation was broadly
comparable to fair value, or to the IFRS cost or depreciated cost adjusted to reflect
changes in a price index.
Few first-time adopters have chosen to use the fair value approach. Those that have used it have done so selectively as
permitted under the standard. Fair value as deemed cost often results in a significant increase in carrying value with the
corresponding credit adjusting retained earnings. There is also a higher depreciation charge in subsequent years.
There is also an exemption that allows the use of fair value for intangible assets at transition to IFRS. However, it requires
there to be an active market in the intangible assets as defined in IAS 38; this criterion is not met for common intangibles in
the oil and gas industry such as licenses and patents.
6.2 Componentisation
IFRS requires that major assets are depreciated using a componentisation approach. The requirement for component
depreciation is the major reason that full cost pools must be allocated to field-size groups of assets. Component deprecation
may represent a significant change from practice under national GAAP for oil and gas companies for both upstream and
downstream assets.
Refineries are a particular downstream asset where implementing the component approach creates challenges. These are
large, complex assets and if detailed asset records have not previously been maintained it can be a major exercise to try to
recreate this information. Entities can use the deemed cost exemption previously described if a fair value for the refinery can
be determined. It may also be possible to identify the significant components that will require replacement or renewal
through looking at capital budgets and planned replacements. The depreciated carrying amount at transition to IFRS could
be estimated through considering replacement cost and timing and making appropriate adjustments.
The deemed cost exemption is only available on initial transition. Subsequent acquisitions will need to follow the
componentisation rules prospectively. These are discussed in more detail in sections 2.8.3 and 3.5.
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6.3 Decommissioning provisions
Decommissioning provisions are recognised at the present value of expected future cash flows, discounted using a pre-tax
discount rate. The discount rate should be updated at each balance sheet date if necessary and should reflect the risks
inherent in the asset.
The requirements for a pre-tax rate and periodic updating can also result in differences on adoption of IFRS. An entity’s
previous GAAP may not have required an obligation to be recognised, allowed a choice of rate or not required the rate to be
updated.
Changes in a decommissioning liability are added to or deducted from the cost of the related asset under IFRIC 1. There is
an optional short cut method for recognition of decommissioning obligations and the related asset at the date of first time
adoption. The entity calculates the liability in accordance with IAS 37 as of the date of transition (the opening balance sheet
date). The related asset is derived by discounting the liability back to the date of installation of the asset from the opening
balance sheet date. This estimated asset amount at initial recognition is then depreciated to the date of transition using the
appropriate method.
Use of the full cost exemption described in section 6.1 means that the IFRIC 1 exemption cannot be used. The entity must
measure the decommissioning liability at the date of transition to IFRS and recognise any difference from the carrying
amount under previous GAAP as an adjustment to retained earnings.
IFRS distinguishes between the functional currency and the presentation currency. An entity can choose to present its
financial statements in any currency; the functional currency is that of the primary economic environment in which an entity
operates. Functional currency must be determined for each entity in the group and is the currency of the primary economic
environment in which the specific entity operates. Functional currency is determined by the denomination of revenue and
costs and the regulatory and economic environment that has the most significant impact on the entity.
A first-time adopter must determine the functional currency for each entity in the group. Changes of functional currency on
adoption of IFRS are not unusual as previous GAAP may have required the use of the domestic currency or allowed a free
choice of functional currency. This can result in a significant amount of work to determine the opening balance sheet
amounts for all non-monetary assets. An entity needs to determine the historical purchase price in functional currency for all
non- monetary assets. These amounts may have been recorded in US dollars, for example. There is no exemption in IFRS 1
for this situation, although use of the fair value as deemed cost exemption may prove less complex and time consuming than
reconstruction of historical cost.
Other common foreign currency challenges for oil and gas entities on adoption of IFRS include the impact of hyper-inflation,
revaluations of fixed assets in a currency other than the functional currency and the impact on hedging strategies. These can
involve significant time and effort to address and need to be considered early during the planning process for transition to
IFRS.
IFRS 1 does provide an exemption that allows all cumulative translation differences in equity for all foreign operations to be
reset to nil at the date of transition. This exemption is used by virtually all entities on transition to IFRS as the alternative is to
recast the results for all foreign operations under IFRS for the history of the entity.
6.5 Assets and liabilities of subsidiaries,

associates and joint ventures
A parent or group may well adopt IFRS at a different date from its subsidiaries, associates and joint ventures (‘subsidiaries’).
Adopting IFRS for the group consolidated financial statements means that the results of the group are presented under IFRS
even if the underlying accounting records are maintained under national GAAP, perhaps for statutory or tax reporting
purposes.
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IFRS 1 provides guidance on a parent adopting IFRS after one or more of its subsidiaries and for subsidiaries adopting after
the group. When a parent adopts after one or more subsidiaries, the assets and liabilities of the subsidiary are measured at
the same carrying value as in the IFRS financial statements of the subsidiaries after appropriate consolidation and equity
accounting adjustments.
A subsidiary that adopts after the group can choose to measure its assets and liabilities at the carrying amounts in the group
consolidated financial statements as if no consolidation adjustments (excluding purchase accounting adjustments) were
made, or as if the subsidiary were adopting IFRS independently.
6.6 Financial instruments
Embedded derivatives are discussed in section 5.4. Upon adoption of IFRS, an entity must assess whether an embedded
derivative is required to be separated from a host contract and accounted for as a derivative on the basis of the conditions
that existed at the later of the date it first became a party to the contract and the date any reassessment is required.
Therefore, if an entity became a party to a contract containing an embedded derivative prior to the transition date, and the
entity is still a party to the contract, the embedded derivative must be recognised as of the IFRS transition date. This would
include contracts where the definition of a derivative was not met under previous GAAP.
The embedded derivative would then be measured at fair value using facts and circumstances in existence as of the
transition date.
6.7 Impairment
A first time adopter should apply IAS 36 regardless of whether there are any indicators of impairment, to test goodwill for
impairment at the date of transition to IFRS, based on conditions at the transition date. Any impairment loss at that date
should be recorded in retained earnings.
In addition, IFRS requires that impairment losses be reversed if the circumstances leading to the impairment charge have
changed and cause the impairment to be reduced. Some local GAAPs would not have allowed this approach.
6.8 Borrowing costs
The cost of borrowing should be capitalised for qualifying assets. Previous GAAP may also have allowed an entity to
expense borrowing costs. IAS 23 Borrowing costs is mandatory from the date of transition; however, an entity can choose to
adopt it with effect from an earlier date.
Transitioning entities must determine the date from which they will apply the standard, identify all qualifying projects
commencing after that date and capitalise costs accordingly. The deemed cost exemption described in section 6.1 above
may provide some relief where an entity does not have the detailed records to perform this for all qualifying assets. IFRS 1
also provides a separate exemption from restating any borrowing cost component capitalised under a previous GAAP –
instead, for qualifying assets under construction at the date of transition, IAS 23 requirements are only applied to borrowing
costs incurred after that date.
An entity’s previous GAAP may also have allowed the capitalisation of borrowing costs for investments accounted for using
the equity method of accounting. An investment in an associate or joint venture would not meet the IAS 23 definition of a
qualifying asset. The associate or joint venture may only capitalise borrowing costs if they have their own borrowings and a
qualifying asset.
Therefore, an entity should consider whether it needs to make any adjustments to reverse previously capitalised interest on
transition.
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6.9 Disclosure requirements
A first-time adopter is required to present disclosures that explain how the entity’s financial statements were affected by the
transition from previous GAAP to IFRS. These include:
an opening balance sheet, prepared as at the transition date, with related footnote
disclosure;
reconciliation of equity reported in accordance with previous GAAP to equity in

accordance with IFRS;
reconciliation of total comprehensive income in accordance with IFRSs to the latest
period in the entity’s most recent annual financial statements;
sufficient disclosure to explain the nature of the main adjustments that would make
it comply with IFRS.
If the entity used the deemed cost exemption, the aggregate of the fair values used and aggregate adjustment to the carrying
amounts reported under previous GAAP.
IAS 36 disclosures if impairment losses are recognised in the opening balance sheet.
Some common adjustments applicable to first-time adopters of the oil and gas industry are:
use of deemed cost as fair value for assets;

depletion for oil and gas properties on the UOP method under IFRS;
reversal of impairment losses recognised under previous GAAP;
componentisation approach for major refineries based on the capitalisation criteria
of major turnarounds under IFRS;
derivative contracts that do not qualify for hedging under IFRS;
downstream petroleum product inventory valued using FIFO or weighted average
method as opposed to LIFO;
consequential adjustments to deferred tax under IFRS produced by some of the
previous adjustments.
7. IFRS 15 and 16
This section focuses on standards which have been issued on or after 1 January 2014 (IFRS 15 in May 2014 and IFRS 16 in
January 2016), for IFRS 9 refer to chapter 5. Ongoing projects which have not been finalised will be examined in separate
publications as the development of those standards progresses.
No decision has been taken on next steps for the Extractive Activities project. It will be considered as part of the wider
agenda consultation.
7.1 Revenue recognition – IFRS 15
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7.1.1 How does it impact the oil and gas sector?
Entities in the oil and gas industry can enter into complex contractual arrangements relating to the sale of products or
services. These transactions include partnerships with other entities and arrangements for which the consideration is based
on future production, agency arrangements, transportation services, provisionally-priced commodity sales contracts and
long-term take-or-pay arrangements. The complexities around pricing and delivery are likely to be affected by the new
standard, including requirements to identify separate performance obligations and determine the extent to which transaction
prices are subject to the risk of significant reversal. The decision of when to recognise revenue and how to measure it under
the new standard could become more challenging.
There is also a significant increase in the disclosure required.
7.1.2 Scope
IFRS 15 applies to contracts with customers and does not exclude extractive activities from its scope. Oil and gas entities
will need to use judgement as they evaluate whether or not the parties in the transaction have a vendor-customer
relationship, and therefore fall within the scope of IFRS 15.
Definition of a customer
A customer is a party that contracts with an entity to obtain goods or services that are the output of that entity’s ordinary
activities. The scope includes transactions with collaborators or partners if the collaborator or partner obtains goods or
services that are the output of the entity’s ordinary activities. It excludes transactions where the parties are participating in an
activity together and share the risks and benefits of that activity.
Production sharing arrangements
Governments are increasingly using production sharing arrangements (PSAs) to facilitate the exploration and production of
their country’s hydrocarbon resources by using the expertise of a commercial oil and gas entity. It can be challenging to
determine whether the government is a customer, and therefore whether the arrangement is within the scope of IFRS 15.
Under a typical PSA, an oil and gas entity will be responsible for all of the exploration costs, as well as some or all of the
development and production costs associated with the hydrocarbon interest. In return, the oil and gas entity is usually
entitled to a share of the production, which will allow the recovery of specified costs plus an agreed profit margin.
PSAs, including royalty agreements, are becoming more complex and the terms might vary even within the same jurisdiction.
Governments often write specific legislation or regulations for each significant new field. Each PSA should be evaluated and
accounted for in accordance with the substance of the arrangement to determine whether the government meets the
definition of a customer and is within the scope of the standard:
A PSA in which the government is not a customer is outside the scope of the new
standard. The oil and gas entity would recognise the construction of its own
tangible assets and would apply other relevant guidance including guidance on
property, plant and equipment, intangible assets and exploration. Revenue would
be recognised when the oil and gas entity delivers its share of production to its
customers. The cost of the share of production delivered to the government would
be an operating cost.
A PSA in which the government is a customer is in the scope of the new standard.
The proposed guidance requires the operator to recognise revenue for the delivery
of services, which might include exploration or construction services, in exchange
for future production. The future production would be variable non-cash
consideration and would affect the measurement of revenue.
Product exchanges
IFRS 15 scopes out non-monetary exchanges, specifically “non-monetary exchanges between entities in the same line of
business to facilitate sales to customers other than the parties to the exchange (for example an exchange of oil to fulfil
demand on a timely basis in a specified location).” Non-monetary exchanges should be accounted for based on other
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guidance (paragraph 24 of IAS 16 Property, plant and equipment is relevant for non-monetary exchanges of property, plant
or equipment).
Non-monetary exchanges between entities in the same line of business to facilitate sales to the end customer are outside the
scope of IFRS 15, even if the products are not the same. This might increase the number of transactions outside the scope
of the standard.
IFRS 15 also requires that there be a contract with a customer before revenue is recognised. A contract must be approved
by a customer and fulfil other conditions such as enforceability at law and collectability. Furthermore, a contract with a
customer only exists if it has commercial substance (that is, the entity’s future cash flows are expected to change as a result
of the contract). Arrangements not meeting the conditions of a ‘contract with a customer’ would be outside the scope of the
standard and revenue should likely not be recorded.
Interaction with other standards
Contracts that are within the scope of other guidance under IFRS, such as financial instruments, are outside the scope of the
new standard.
Elements of contracts within the scope of IFRS 16 Leases are also outside the scope of the revenue standard. However, a
contract may contain a lease and other non-lease elements that are within the scope of IFRS 15.
The standard provides application guidance for evaluating contracts with repurchase arrangements that will assist oil and
gas entities in determining whether the arrangement is a sale to a customer, a financing arrangement or a lease. This may
impact some tolling agreements with refineries.
7.1.3 Oil and gas balances – overlift and

underlift
It is not clear if other parties in a collaborative arrangement will meet the definition of a customer in the standard. Underlift
and over-lift transactions might therefore be outside the scope of the standard. Entities will need to make an assessment as
to whether an overlifter is a customer, and this judgement should consider all facts and circumstances including the purpose
of the arrangement and transactions.
Even if an overlifter meets the definition of a customer, transactions might still be outside the scope of the standard because
the transaction is a non-monetary exchange between entities in the same line of business. The accounting might therefore
differ from the model applied under current guidance if there is no net cash settlement alternative.
Scope
Contractual arrangements that bind the participating parties and specify their entitlement to the output (usually in proportion
to each party’s equity interest) are common in the oil and gas industry. These arrangements allow parties to take shares of
output in a given period which are different from their entitlement. The contractual arrangement creates an ‘obligation’ for the
underlifter to deliver output to the overlifter.
The obligation would be satisfied and revenue recognised by the underlifter when the output is lifted by the overlifter only if
the transaction is in the scope of IFRS 15 because:
the overlifter meets the definition of a customer in the standard; and

the transaction is not a non-monetary exchange between entities in the same line
of business.
If the overlifter does not meet the definition of a customer or the transaction is a non-monetary exchange, the transaction
would be outside the scope of the standard; the underlifter would not recognise revenue from a contract with a customer
(that is, arising for the application of IFRS 15) until it took its share of the output and sold it to a third party in a subsequent
period.
The underlifter might still recognise a receivable in the scope of IFRS 9 at the time of lifting even when the transaction is
outside the scope of the new standard.
Management would need to determine where in the income statement to recognise the credit. The credit would not be
recorded within revenue from contracts with customers, as it is outside the scope of the standard. However, it might be
recognised as other revenue or other income.
Settlement of the IFRS 9 receivable would occur when the underlifter takes its entitlement in the next period. The receivable
is derecognised, and the debit recognised as inventory if the output is retained or as cost of sales if sold to customers.
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The overlifter would recognise revenue when it delivered the output it actually lifted to its customers.
Determining the transaction price
Settlement by the overlifter to the under-lifter is usually made via a change in the lifting schedule, which allows the underlifter
to take additional liftings in the future.
The additional liftings will be ‘non-cash consideration’, which will be measured at fair value where the overlifter meets the
definition of a customer, and the transaction is not a non-monetary exchange between entities in the same line of business.
The accounting and presentation for the transaction will be similar to current IFRS if an overlifter does meet the definition of a
customer, unless the transaction is a non-monetary exchange. When determining the transaction price, the standard requires
that non-cash consideration is measured at fair value.
The accounting and presentation for an under-lift might be different from current practice if an overlifter does not meet the
definition of a customer. The entity should use judgement in selecting an accounting policy that is relevant and reliable. If the
transaction is not a non-monetary exchange, this accounting policy might reflect the principles of the new revenue standard.
However, an entity should ensure that any income classified as revenue is consistent with the definition of revenue in the
Framework.
The accounting should be based on other guidance, such as IAS 16 Property, plant and equipment if the transaction is a
non-monetary exchange.
The underlifter will need to recognise the receivable at fair value where the overlifter does not meet the definition of a
customer or the transaction is a non-monetary exchange, but the underlifter recognises a receivable in the scope of IFRS 9.
The entity is likely to use an alternative approach and not deplete its PP&E for the volume relating to the underlift if there is
no receivable in the scope of IFRS 9.
7.1.4 Agency relationships
The indicators under the new standard are similar to the existing guidance but are provided in a new context. The indicators
are designed to help entities determine if they obtain control of the goods or services before transferring control of those
goods or services to the customer. The complexity of determining whether the entity is acting as principal or agent appears
to be increasing within the industry, particularly in relation to entities that provide value-added services to entities that extract
oil and gas such as transportation and distribution.
Principal versus agent considerations
To determine whether an entity is acting as principal or agent the following should be considered:
an entity must first identify the specified good or service being provided to the
customer;
the unit of account for the principal versus agent assessment is each performance
obligation in a contract;
the indicators in the standard help an entity evaluate whether it is the principal (that
is, whether it controls a good or service before it is transferred to a customer); and
an entity should assess whether it controls services performed by another party
(e.g. a subcontractor).
An entity is the principal in an arrangement if it obtains control of the goods or services of another party in advance of
transferring control of those goods or services to the customer.
Obtaining title momentarily before transferring a good or service to a customer does not necessarily constitute control.
An entity is an agent if its performance obligation is to arrange for another party to provide the goods or services.
Indicators that the entity is an agent include:
the other party is primarily responsible for delivering goods or services;

the entity does not have inventory risk;
the entity does not have latitude in establishing prices.
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An agent recognises revenue for the fee earned for facilitating the transfer of goods or services. Its consideration is the ‘net’
amount retained after paying the principal for the goods or services that were provided to the customer.
7.1.5 Delivery – cost, insurance and freight

versus free on board
An entity will recognise revenue when (or as) a good or service is transferred to the customer and the customer obtains
control of that good or service. Control of an asset refers to an entity’s ability to direct the use of and obtain substantially all
of the remaining benefits (that is, the potential cash inflows or savings in outflows) from the asset.
In both CIF and FOB approaches, contractual terms mean that risk and title and therefore control of the commodity normally
pass at the ship’s rail. However, the timing of revenue recognition could change under the new standard, depending on the
terms of trade. The difference between the shipping terms only affects which party is responsible for freight costs.
Cost, insurance and freight (CIF)
Identifying separate performance obligations
The new standard will require an entity to account for each distinct good or service as a separate performance obligation.
Freight services may meet the definition of a distinct service.
Satisfaction of performance obligations
An entity recognises revenue when it satisfies a performance obligation by transferring a promised good or service to a
customer. A good or service is transferred when the customer obtains control of that good or service. The new standard lists
indicators of control transferring, including an unconditional obligation to pay, legal title, physical possession, transfer of risk
and rewards and customer acceptance.
Sales of goods: Revenue is recognised at the point when control transfers to the customer. This will generally follow the
terms of the contract and is usually when the goods pass the rail on a vessel selected by the buyer, at which point the buyer
will control the goods.
Transportation: A performance obligation for transportation generally meets the criteria for a performance obligation that is
settled over a period of time, and revenue will be recognised over the period of transfer to the customer. If it does not meet
the criteria, the performance obligation would be settled at a point in time, and revenue would likely be recognised when the
customer receives the goods.
The new standard is generally not expected to change the point at which revenue is recognised for the performance
obligation to provide goods. However, when an entity is responsible for organising or executing the shipping, it should
evaluate whether it has separate performance obligations for the goods and the freight services. This could mean recognition
of a portion of the revenue when control of the goods passes and recognition over time for the portion of revenue relating to
the freight services. Where freight services are considered to be a separate performance obligation, the entity should also
assess whether it is acting as agent or principal, as this might also affect the timing and amount of revenue recognition.
Factors which might indicate that there is a separate performance obligation for transportation include:
specialisation of any vehicles or technology involved with providing the

transportation;
level of cost, distance or time associated with providing the transportation; and
whether the terms of the contract allow the customer to opt out of the
transportation element and collect the commodity themselves.
There cannot be a separate performance obligation for an entity to transport its own goods (that is, prior to transfer of control
of the goods to the customer).
Free on board (FOB)
Identifying separate performance obligations
An entity recognises revenue when it satisfies a performance obligation by transferring a promised good or service to a
customer. A good or service is transferred when the customer obtains control of that good or service.
The new standard lists indicators of control transferring, including an unconditional obligation to pay, legal title, physical
possession, transfer of risk and rewards and customer acceptance.
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The new standard is generally not expected to change the point at which revenue is recognised for the performance
obligation to provide goods. However, an entity should evaluate whether it has a separate performance obligation for the
freight services. This could mean recognition of a portion of the revenue when control of the goods passes and recognition
over time for the portion of revenue relating to freight services.
7.1.6 Provisional pricing arrangements
Satisfaction of performance obligations
The sales contract would be in the scope of the new standard. There will be a single performance obligation, being the
delivery of the promised product. Revenue will be recognised when the performance obligation is satisfied, which is when
the customer obtains control of the product.
Determining the transaction price
The entity will need to determine the transaction price, which is the amount of consideration it expects to be entitled to in the
transaction.
Management should first consider whether provisionally priced contracts include embedded derivatives that are in the scope
of financial instrument guidance. An oil and gas entity will apply the separation and/or measurement guidance in other
standards first, and then apply the guidance in the revenue standard to the remaining portion of the contract.
The transaction price might be variable or contingent on the outcome of future events, which could include provisional
pricing arrangements.
Variable consideration is subject to a constraint. The objective of the constraint is that an entity should recognise revenue as
performance obligations are satisfied to the extent that it is ‘highly probable’ that a significant revenue reversal will not occur
in future periods. Such a reversal would occur if there is a significant downward adjustment of the cumulative amount of
revenue recognised for that performance obligation.
Judgement will be required to determine if there is an amount that is variable consideration and, if so, whether it is subject to
a significant reversal. The new standard has a list of factors that could increase the likelihood or magnitude of a revenue
reversal.
Management’s estimate of the transaction price will be reassessed each reporting period.
Judgement will be required to determine if the provisional pricing results in the identification of an embedded derivative or
variable consideration. If the entity determines that the provisional pricing results in variable consideration, further judgement
will be required to determine whether the estimated transaction price is subject to significant reversal. This might be
particularly relevant where the final quality of product being delivered will not be known until assessment at its destination.
Where price is conditional upon the quality of the product, this is more likely to be variable consideration.
Judgement will also be required to identify the point at which the variable consideration becomes unconditional, and is then
considered a financial asset within the scope of IFRS 9/IAS 39.
Where provisional pricing features represent embedded derivatives, oil and gas entities would be required to continue to
separate them and recognise and measure them in accordance with financial instrument guidance. However, given the
revised presentation requirements in the new standard, it may no longer be appropriate to present movements in the
embedded derivative in revenue from contracts with customers.
7.1.7 Take-or-pay and similar long-term supply

agreements
Long-term sales contracts are common in the oil and gas industry. Producers and buyers may enter into sales contracts that
are often a year or longer in duration to secure supply and reasonable pricing arrangements. Such contracts are often
fundamental to supporting the business case or to finance, develop or continue activity at a particular field.
Contracts will typically stipulate the sale of a set volume of product over the period at an agreed price. There are often
clauses within the contract relating to price adjustment or escalation over the course of the contract to protect the producer
and/or the seller from significant changes to the underlying assumptions in place at the time the contract was signed. Long-
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term commodity contracts frequently offer the counterparty flexibility and options in relation to the quantity of the commodity
to be delivered under the contract.
Oil and gas entities should continue to first assess whether these arrangements represent financial instruments or contain
embedded derivatives that should be accounted for under the financial instruments standards (e.g. whether a contract with
volume flexibility contains a written option that can be settled net in cash or another financial instrument). In addition, oil and
gas entities should continue to evaluate whether such arrangements convey the right to use a specific asset, and therefore
constitute a lease under the leasing standards.
Identifying the contract
In relation to take-or-pay contracts, only the minimum amount specified would generally be considered a contract, as this is
the only enforceable part of the agreement. Options in the contract to acquire additional volumes will likely be considered a
separate contract at the time the customer exercises the option, unless such options provide the customer with a material
right. Where there is a material right, the option should be accounted for as a separate performance obligation in the original
contract.
A contract may also contain renewal or extension options. These options also need to be considered in the context of
whether they provide a material right to the customer. Where such a material right exists it is accounted for as a separate
performance obligation or an entity may elect a practical expedient to assume the renewal term in the period over which
revenue is recognised [IFRS 15.B43].
Breakage
Customers may not exercise all of their contractual rights to receive a good or service in the future. Unexercised rights are
often referred to as breakage.
An entity should recognise estimated breakage as revenue in proportion to the pattern of exercised rights. Management
might not be able to conclude whether there will be any breakage, or the extent of such breakage. In this case, they should
consider the constraint on variable consideration, including the need to record any minimum amounts of breakage. Breakage
that is not expected to occur should be recognised as revenue when the likelihood of the customer exercising its remaining
rights becomes remote. The assessment should be updated at each reporting period.
In take-or-pay arrangements, this may mean that an entity may be able to recognise revenue in relation to breakage amounts
in a period earlier than when the breakage occurs, provided that it can demonstrate it expects that the customer will not
exercise these rights. Given the nature of these arrangements and the inherent uncertainty in being able to predict a
customer’s behaviour, it may be difficult to obtain sufficient evidence to meet this requirement.
The new standard will require oil and gas entities to apply judgement in identifying the performance obligations, as well as
the reasons for any price changes over the term of the arrangement. These judgements will determine whether the total
transaction price is allocated and recognised based on stand-alone selling prices (e.g., using forward curves), contractual
pricing, straight line or another basis. Oil and gas entities will also have to consider whether such arrangements include a
significant financing component that will have to be accounted for separately.
7.1.8 Significant financing elements
Some contracts contain a financing component (either explicitly or implicitly) because payment by a customer occurs either
significantly before or significantly after performance. This timing difference can benefit either the customer, if the entity is
financing the customer’s purchase, or the entity, if the customer finances the entity’s activities by making payments in
advance of performance. An entity should reflect the effects of any significant financing benefit on the transaction price.
The amount of revenue recognised differs from the amount of cash received from the customer when an entity determines
that a significant financing component exists. Revenue recognised will be less than cash received for payments that are
received in arrears of performance, as a portion of the consideration received will be recorded as interest income. Revenue
recognised will exceed the cash received for payments that are received in advance of performance, as interest expense will
be recorded and increase the amount of revenue recognised.
The longer the period between when a performance obligation is satisfied and when cash is paid for that performance
obligation, the more likely it is that a significant financing component exists.
This is particularly relevant for oil and gas entities that have received significant prepayments from a customer for the
purchase of a commodity. These arrangements may be obtained in lieu of financing and may contain a significant financing
component. Where a significant financing element exists within a contract, the deferred revenue recognised would effectively
be accreted through financing costs using a rate at which the vendor would receive financing in a separate transaction with
the customer at inception.
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7.1.9 Disclosures
IFRS 15 includes a number of extensive disclosure requirements intended to enable users of financial statements to
understand the amount, timing, and judgements related to revenue recognition and corresponding cash flows arising from
contracts with customers. We highlight below some of the more significant disclosure requirements, but the list is not all-
inclusive.
The disclosures include qualitative and quantitative information about:
contracts with customers;

the significant judgements, and changes in judgements, made in applying the
guidance to those contracts; and
assets recognised from the costs to obtain or fulfil contracts with customers.
The standard requires disclosures that disaggregate revenue into categories that depict how the nature, amount, timing and
uncertainty of revenue and cash flows are affected by economic factors. The standard contains guidance on how to select
categories.
The disclosure requirements are more detailed than currently required under IFRS and focus significantly on the judgements
made by management. For example, they include specific disclosures of the estimates used and judgements made in
determining the amount and timing of revenue recognition.
IFRS 15 also requires an entity to disclose the amount of its remaining performance obligations and the expected timing of
the satisfaction of those performance obligations for contracts with durations of greater than one year, and both quantitative
and qualitative explanations of when amounts will be recognised as revenue. This requirement could have a significant
impact on the oil and gas industry, where long-term contracts are a significant portion of an entity’s business.
7.2 Leases – IFRS 16
7.2.1 Scope
IFRS 16 applies to all lease contracts except for:
leases to explore for or use minerals, oil, natural gas and similar non-regenerative
resources;
leases of biological assets within the scope of IAS 41 Agriculture held by lessees;
service concession arrangements within the scope of IFRIC 12 Service concession
arrangements;
licences of intellectual property granted by a lessor within the scope of IFRS 15
Revenue from contracts with customers; and
rights held by a lessee under licensing agreements within the scope of IAS 38
Intangible assets for items such as motion picture films, video recordings, plays,
manuscripts, patents and copyrights.
A lessee may choose to apply IFRS 16 to leases of intangible assets other than those mentioned above to software).
Mineral lease
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Background
Company C has rights to extract minerals from property. The rights include rights of surface access only for purposes of
extraction (freehold land).
Lease term is one year with perpetual renewal.
Analysis
Mineral leases are specifically outside of the scope of IFRS 16. Surface rights may be out of scope where exclusively
used for extractive activities.
Conclusion
This contract is not a lease.
Leases are different from service contracts: a lease provides a customer with the right to control the use of an asset;
whereas, in a service contract, the supplier retains control.
IFRS 16 states that a contract contains a lease if:
there is an identified asset; and

the contract conveys the right to control the use of the identified asset for a
period of time in exchange for consideration.
7.2.2 Identifiable asset
An asset can be identified either explicitly or implicitly. If explicit, the asset is specified in the contract (for example, by a
serial number or a similar identification marking); if implicit, the asset is not mentioned in the contract (so the entity cannot
identify the particular asset) but the supplier can fulfil the contract only by the use of a particular asset. In both cases there
may be an identified asset.
In any case, there is no identified asset if the supplier has a substantive right to substitute the asset. Substitution rights are
substantive where the supplier has the practical ability to substitute an alternative asset and would benefit economically from
substituting the asset.
The term ‘benefit’ is interpreted broadly. For example, the fact that the supplier could deploy a pool of assets more
efficiently, by substituting the leased asset from time to time, might create a sufficient benefit as long as there are no
significant costs. It is important to note that ‘significant’ is assessed with reference to the related benefits (that is, costs must
be lower than benefits; it is not sufficient if the costs are low or not material to the entity as a whole). Significant costs could
occur, in particular, if the underlying asset is tailored for use by the customer. For example, a leased aircraft might have
specific interior and exterior specifications defined by the customer. In such a scenario, substituting the aircraft throughout
the lease term could create significant costs that would discourage the supplier from doing so.
The assessment whether a substitution right is substantive depends on the facts and circumstances at inception of the
contract and does not take into account circumstances that are not considered likely to occur.
A right to substitute an asset if it is not operating properly, or if there is a technical update required, does not prevent the
contract from being dependent on an identified asset. The same is true for a supplier’s right or obligation to substitute an
underlying asset for any reason on or after a particular date or on the occurrence of a specified event because the supplier
does not have the practical ability to substitute alternative assets throughout the period of use.
If the customer cannot readily determine whether the supplier has a substantive substitution right, it is presumed that the
right is not substantive (that is, that the contract depends on an identified asset).
7.2.3 Determining whether a contract contains

a lease
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Contracts often combine different kinds of obligations of the supplier, which might be a combination of lease components or
a combination of lease and non-lease components. For example, the lease of an industrial area might contain the lease of
land, buildings and equipment, or a contract for a car lease might be combined with maintenance.
Where such a multi-element arrangement exists, IFRS 16 requires each separate lease component to be identified (based on
the guidance on the definition of a lease) and accounted for separately.
The right to use an asset is a separate lease component if both of the following criteria are met:
the lessee can benefit from use of the asset either on its own or together with
other resources that are readily available to the lessee; and
the underlying asset is neither highly dependent on, nor highly interrelated with,
the other underlying assets in the contract.
If the analysis concludes that there are separate lease and non-lease components, the consideration must be allocated
between the components as follows:
Lessee: The lessee allocates the consideration on the basis of relative stand-alone
prices. If observable stand-alone prices are not readily available, the lessee shall
estimate the prices, and should maximise the use of observable information.
Lessor: The lessor allocates the consideration in accordance with IFRS 15 (that is,
on the basis of relative stand-alone selling prices).
As a practical expedient, lessees are allowed not to separate lease and non-lease components and, instead, account for
each lease component and any associated non-lease components as a single lease component. This accounting policy
choice has to be made by class of underlying asset. Because not separating a non-lease component would increase the
lessee’s lease liability, the Board expects that a lessee will use this exemption only if the service component is not
significant.
Multi-shipper pipeline
Background
Company P operates and maintains the natural gas pipeline. Several companies enter into agreements with P for various
volumes of the pipeline capacity: two or more companies are substantive firm service customers and there are several
other interruptible customers.
Analysis
Step 1: Is there an identified asset?

No. The leased asset is the capacity portion of the pipeline. None of the customers uses substantially all of the pipeline
capacity.
Step 2: Does the customer have a right to obtain substantially all of the economic benefits from the use of the asset
throughout the period of use?
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A single purchaser will not obtain substantially all the economic benefits from the use of the pipeline capacity during the
terms of the arrangement.
Conclusion
This contract does not contain a lease. None of the customers use substantially all of the pipeline’s capacity.
Single user pipeline
Background
Company P operates and maintains the natural gas pipeline. Company E enters into an agreement with P for all capacity
of this specified pipeline. Company E has uninterruptible service and dispatch rights.
Company E makes the relevant decisions about how and for what purpose the pipeline will be used by determining when
and how much natural gas will be transported through the pipeline during the period of use.
Analysis

Yes. The leased asset is the capacity potion of the pipeline. Company E uses all of the pipeline capacity.
Company E will obtain substantially all the economic benefits from the use of the pipeline capacity during the terms of
the arrangement.
Step 3: The rights to direct the use of the asset

The rights to direct the use of the asset is controlled by company E.
Conclusion
This contract is a lease of the pipeline.
Company E uses 100% of the pipeline’s capacity. The fulfilment of the contract is dependent upon an identified pipeline.
Drilling contract (1)
Background
Company A owns drilling rigs and leases them to E&P companies. Company A operates based on locations directed by
E&P companies. Company Q (purchaser) contracts for exclusive use of a drilling rig for a two year period in a remote
location. The drilling rig is not of a specialised nature and the contract allows for substitution, but company A would be
responsible for significant mobilisation costs if the assets are substituted. Useful life of drilling rig is 15 years.
Analysis

There is an identified asset. Substitution right is possible per the terms of the contract but is not substantive as company
A would not benefit economically from substitution. Company A would have to bear the significant mobilisation costs if
assets are substituted.
As it is exclusive use, substantially all the benefits accrue to company Q (the E&P company) during the contract term.

The most important decisions about rights to direct the use of the asset (drilling locations) appear to be controlled by
company Q (the purchaser).
Conclusion
This contract is a lease of the drilling rig.
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Background
Company A owns 50 drilling rigs and leases them to E&P companies. Company A operates based on locations directed
by E&P companies.
Company Q (purchaser) contracts for exclusive use of a drilling rig for a two year period in a location where there is an
active drilling market. The drilling rig is not of a specialised nature and contract allows for substitution. Company A often
substitutes rigs to reduce transportation costs. This is evident based on past history.
Useful life of drilling rig is 15 years.
Analysis

Substitution is possible. It appears to be economic rationale for company A to substitute other assets. The drilling rig is
not specialised and 50 others are available. Past history supports that substitution happens.
Conclusion
This contract is likely not to be a lease. The final conclusion depends on whether or not the substitution right is
considered substantive.
Background
Company A owns drilling rigs and leases them to E&P companies. Company A operates based on locations directed by
E&P companies.
Company Q (purchaser) contracts for exclusive use of a drilling rig for a six month period in a remote location. The
contract does not contain a renewal option. The drilling rig is not of a specialised nature and the contract allows for
substitution, but company A would be responsible for significant mobilisation costs if assets are substituted.
Useful life of drilling rig is 15 years.
Analysis

There is an identified asset. Substitution is possible per the terms of the contract but is not substantive as company A
would not benefit economically from substitution. Company A would have to bear the significant mobilisation costs if
assets are substituted.
As it is exclusive use, substantially all the benefits accrue to company Q (the E&P company) during the contract term.

The most important decisions about rights to direct the use of the asset (drilling locations) appear to be controlled by
company Q (the purchaser).
Conclusion
This contract is likely to be a lease, except for the short-term nature of the contract. Company A should account for this
contract as a lease. Company Q (purchaser) may choose to exempt the contract from lease accounting. Lease payments
could be recorded as operating expenses or capitalised in the cost of PPE.
Interaction between IFRS 15 and IFRS 16
IFRS 15 contains guidance on how to evaluate whether a good or service promised to a customer is distinct for lessors. The
question arises of how IFRS 16 interacts with IFRS 15.
For a multi-element arrangement that contains (or might contain) a lease, the lessor has to perform the assessment as
follows:
1. Apply the guidance in IFRS 16 to assess whether the contract contains one or more lease components.
2. Apply the guidance in IFRS 16 to assess whether different lease components have to be accounted for separately.
3. After identifying the lease components under IFRS 16, the non-lease components should be assessed under IFRS 15 for separate
performance obligations.
The criteria in IFRS 16 for the separation of lease components are similar to the criteria in IFRS 15 for analysing whether a
good or service promised to a customer is distinct.
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7.2.4 Lease term
The lease term is defined as the non-cancellable period of the lease plus periods covered by an option to extend or an
option to terminate if the lessee is reasonably certain to exercise the extension option or not exercise the termination
option.
The interpretation of the term ‘reasonably certain’ has been a source of controversial discussions, under IAS 17, that led to
diversity in practice. To address this, the standard states the principle that all facts and circumstances creating an economic
incentive for the lessee to exercise the option must be considered, and provides some examples of such factors:
Contractual terms and conditions for optional periods compared with market rates.
It is more likely that a lessee will not exercise an extension option if lease payments
exceed market rates. Other examples of terms that should be taken into account
are termination penalties or residual value guarantees.
Significant leasehold improvements undertaken (or expected to be undertaken). It
is more likely that a lessee will exercise an extension option if a lessee has made
significant investments to improve the leased asset or to tailor it for its special
needs.
Costs relating to the termination of the lease/signing of a replacement lease. It is

more likely that a lessee will exercise an extension option if doing so avoids costs
such as negotiation costs, relocation costs, costs of identifying another suitable
asset, costs of integrating a new asset and costs of returning the original asset in a
contractually specified condition or to a contractually specified location.
The importance of the underlying asset to the lessee’s operations. It is more likely
that a lessee will exercise an extension option if the underlying asset is specialised
or if suitable alternatives are not available.
If an option is combined with one or more other features such as for example a
residual value guarantee with the effect that the cash return for the lessor is the
same regardless of whether the option is exercised, an entity shall assume that the
lessee is reasonably certain to exercise the option to extend the lease, or not to
exercise the option to terminate the lease.
When the option can only be exercised if one or more conditions are met, the likelihood that those conditions will exist
should also be taken into account.
The lessee’s past practice regarding the period over which it has typically used particular types of assets, and its economic
reasons for doing so, may also provide helpful information.
The assessment of whether the exercise of an option is reasonably certain is made at the commencement date (that is, the
date on which the lessor makes the underlying asset available for use).
The lease term is reassessed in only limited circumstances:
where the lessee exercises or does not exercise an option in a different way than
the entity had previously determined was reasonably certain;
where an event occurs that contractually obliges the lessee to exercise an option
(prohibits the lessee from exercising an option) not previously included in the
determination of the lease term (previously included in the determination of the
lease term); or
where a significant event or change in circumstances occurs that is within the
control of the lessee and affects whether it is reasonably certain to exercise an
option. This trigger is only relevant for the lessee (and not the lessor).
This approach is similar to the one for impairment testing – a reassessment is only made if there are indicators that it would
result in a different outcome.
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7.2.5 Recognition and measurement

exemptions
The standard contains two recognition and measurement exemptions. Both exemptions are optional and they only apply to
lessees. If one of these exemptions is applied, the leases are accounted for in a way that is similar to current operating
lease accounting (that is, payments are recognised on a straight line basis or another systematic basis that is more
representative of the pattern of the lessee’s benefit):
Short-term leases: Short-term leases are defined as leases with a lease term of 12
months or less. The lease term also includes periods covered by an option to
extend or an option to terminate if the lessee is reasonably certain to exercise the
extension option or not exercise the termination option. A lease that contains a
purchase option is not a short-term lease. If a lessee elects this exemption, it has
to be made by class of underlying asset.
If an entity applies the short-term lease exemption it shall treat any subsequent
modification or change in lease term as resulting in a new lease.
Leases for which the underlying asset is of low value: The standard does not
define the term ‘low value’, but the Basis for Conclusions explains that the Board
had in mind assets of a value of USD5,000 or less when new. Examples of assets
of low value are IT equipment or office furniture. For certain assets (such as assets
that are dependent on, or highly interrelated with, other underlying assets), the
exemption is not applicable.
The election can be made on a lease-by-lease basis. It is important to note that the analysis does not take into account
whether low-value assets in aggregate are material. Accordingly, although the aggregated value of the assets captured by
the exemption may be material, the exemption is still available.
IFRS 16 also clarifies that both a lessee and a lessor can apply the standard to a portfolio of leases with similar
characteristics if the entity reasonably expects that the resulting effect is not materially different from applying the standard
on a lease-by-lease basis.
7.2.6 Lessee accounting
Initial recognition and measurement
Under IFRS 16, lessees will no longer distinguish between finance lease contracts (on balance sheet) and operating lease
contracts (off balance sheet), but they are required to recognise a right-of-use asset and a corresponding lease liability for
almost all lease contracts. This is based on the principle that, in economic terms, a lease contract is the acquisition of a right
to use an underlying asset with the purchase price paid in instalments.
The effect of this approach is a substantial increase in the amount of recognised financial liabilities and assets for entities
that have entered into significant lease contracts that are currently classified as operating leases.
The lease liability is initially recognised at the commencement day and measured at an amount equal to the present value of
the lease payments during the lease term that are not yet paid; the right-of-use asset is initially recognised at the
commencement day and measured at cost, consisting of the amount of the initial measurement of the lease liability, plus any
lease payments made to the lessor at or before the commencement date less any lease incentives received, the initial
estimate of restoration costs and any initial direct costs incurred by the lessee. The provision for the restoration costs is
recognised as a separate liability.
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Lease payments
Lease payments consist of the following components:
fixed payments (including in-substance fixed payments), less any lease incentives
receivable;
variable lease payments that depend on an index or a rate;
amounts expected to be payable by the lessee under residual value guarantees;

the exercise price of a purchase option (if the lessee is reasonably certain to
exercise that option); and
payments of penalties for terminating the lease (if the lease term reflects the lessee
exercising the option to terminate the lease).
IFRS 16 distinguishes between three kinds of contingent payments, depending on the underlying variable and the
probability that they actually result in payments:
i. Variable lease payments based on an index or a rate. Variable lease payments based on an index or a rate (for example, linked to
a consumer price index, a benchmark interest rate or a market rental rate) are part of the lease liability. From the perspective of
the lessee, these payments are unavoidable, because any uncertainty relates only to the measurement of the liability but not to its
existence. Variable lease payments based on an index or a rate are initially measured using the index or the rate at the
commencement date (instead of forward rates/indices). This means that an entity does not forecast future changes of the
index/rate; these changes are taken into account at the point in time in which lease payments change. The accounting for variable
lease payments that depend on an index or a rate is illustrated in the example on page 18.
ii. Variable lease payments based on any other variable. Variable lease payments not based on an index or a rate are not part of
the lease liability. These include payments linked to a lessee’s performance derived from the underlying asset, such as payments
of a specified percentage of sales made from a retail store or based on the output of a solar or a wind farm. Similarly, payments
linked to the use of the underlying asset are excluded from the lease liability, such as payments if the lessee exceeds a specified
mileage. Such payments are recognised in profit or loss in the period in which the event or condition that triggers those payments
occurs.
iii. In-substance fixed payments.Lease payments that, in form, contain variability but, in substance, are fixed are included in the
lease liability. The standard states that a lease payment is in-substance fixed if there is no genuine variability (for example, where
payments must be made if the asset is proved to be capable of operating, or where payments must be made only if an event
occurs that has no genuine possibility of not occurring). Furthermore, the existence of a choice for the lessee within a lease
agreement can also result in an in-substance fixed payment. If, for example, the lessee has the choice either to extend the lease
term or to purchase the underlying asset, the lowest cash outflow (that is, either the discounted lease payments throughout the
extension period or the discounted purchase price) represents an in-substance fixed payment. In other words, the entity cannot
argue that neither the extension option nor the purchase option will be exercised.
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If payments are initially structured as variable lease payments linked to the use of the underlying asset but the variability will
be resolved at a later point in time, those payments become in-substance fixed payments when the variability is resolved.
A residual value guarantee captures any kind of guarantee made to the lessor that the underlying asset will have a
minimum value at the end of the lease term. The Board indicated it believed that a residual value guarantee could be
interpreted as an obligation to make payments based on variability in the market price for the underlying asset and is similar
to variable lease payments based on an index or a rate.
Discount rate
The lessee uses as the discount rate the interest rate implicit in the lease – this is the rate of interest that causes the
present value of (a) lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the
underlying asset and (ii) any initial direct costs of the lessor. Determining the interest rate implicit in the lease is a key
judgement that can have a significant impact on an entity’s financial statements.
If this rate cannot be readily determined, the lessee should instead use its incremental borrowing rate.
The incremental borrowing rate is defined as the rate of interest that a lessee would have to pay to borrow, over a similar
term and with a similar security, the funds necessary to obtain an asset of a similar value to the cost of the right-of-use asset
in a similar economic environment.
Restoration costs
The lessee is often obliged to return the underlying asset to the lessor in a specific condition or to restore the site on which
the underlying asset has been located. To reflect this obligation, the lessee recognises a provision in accordance with IAS 37
Provisions, contingent liabilities and contingent assets. The initial carrying amount of the provision, if any (that is, the initial
estimate of costs to be incurred), should be included in the initial measurement of the right-of-use asset. This corresponds to
the accounting for restoration costs in IAS 16 Property, plant and equipment.
Any subsequent change in the measurement of the provision, due to a revised estimation of expected restoration costs, is
accounted for as an adjustment of the right-of-use asset as required by IFRIC 1 Changes in existing decommissioning,
restoration and similar liabilities.
Initial direct costs
The standard defines initial direct costs as incremental costs that would not have been incurred if a lease had not been
obtained. Such costs include commissions or some payments made to existing tenants to obtain the lease. All initial direct
costs are included in the initial measurement of the right- of-use asset.
Subsequent measurement
The lease liability is measured in subsequent periods using the effective interest rate method. The right-of-use asset is
depreciated in accordance with the requirements in IAS 16 Property, plant and equipment which will result in a depreciation
on a straight line basis or another systematic basis that is more representative of the pattern in which the entity expects to
consume the right-of-use asset. The lessee must also apply the impairment requirements in IAS 36 Impairment of assets to
the right- of-use asset.
The carrying amount of the right-of-use asset and the lease liability will no longer be equal in subsequent periods. The
carrying amount of the right-of-use asset will, in general, be below the carrying amount of the lease liability.
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Reassessment
As actual lease payments can differ significantly from lease payments incorporated in the lease liability on initial recognition,
the standard specifies when the lease liability is to be reassessed. It is important to note that a reassessment only takes
place if the change in cash flows is based on contractual clauses that have been part of the contract since inception. Any
changes that result from renegotiations are discussed under ‘Modification of a lease’ below.
The requirements for reassessment are summarised below:
Component of the lease liability Reassessment

Lease term and associated extension and When? – If there is a change in the lease term.
termination payments
How? – Reflect the revised payments using a revised
discount rate (the interest rate implicit in the lease for the
remainder of lease term (if that rate can be readily
determined); otherwise: incremental borrowing rate at the
date of reassessment).
Exercise price of a purchase option When? – If a significant event or change in circumstances

occurs that is within the control of the lessee and affects
whether the lessee is reasonably certain to exercise an
option.
How? – Reflect the revised payments using a revised

discount rate (the interest rate implicit in the lease for the
remainder of the lease term (if that rate can be readily
determined); otherwise: incremental borrowing rate at the
date of reassessment).
Amounts expected to be payable under a When? – If there is a change in the amount expected to be
residual value guarantee paid.
How? – Include the revised residual payment using the

unchanged discount rate.
Variable lease payment dependent on an When? – If a change in the index/rate results in a change
index or a rate in cash flows.
How? – Reflect the revised payments based on the

index/rate at the date when the new cash flows take effect
for the remainder of the term using the unchanged
discount rate. (Exception: the discount rate has to be
updated if the change results from a change in floating
interest rates.)
Aside from this, the lease liability shall be remeasured if payments initially structured as variable payments become in-
substance fixed lease payments because the variability is resolved at some point after the commencement date.
Any remeasurement of the lease liability results in a corresponding adjustment of the right-of-use asset. If the carrying
amount of the right-of-use asset has already been reduced to zero, the remaining remeasurement is recognised in profit or
loss.
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The right-of-use asset is also remeasured if the carrying amount of the provision for restoration costs has changed due to a
revised estimate of expected costs. In that instance, the change in the carrying amount of the right-of-use asset is equal to
the change in the carrying amount of the provision. If adjustments result in an addition, the entity shall consider whether this
is an indication that the new carrying amount of the right-of-use asset may not be fully recoverable.
Modification of a lease
There are many different reasons why the parties to a contract might decide to renegotiate and modify an existing lease
contract during the lease term. One objective might be to extend or shorten the term of an existing contract (with or without
changing the other contractual terms); another reason might be to change the underlying asset (for example, a lessee already
leases two floors of a building and the parties agree to add a third one). If the lessee is in financial difficulties, the lessor
might agree to reduce lease payments as a concession to support a restructuring.
IFRS 16 defines a modification as a change in the scope of a lease, or the consideration for a lease, that was not part of
the original terms and conditions of the lease. Any change that is triggered by a clause that is already part of the original
lease contract (including changes due to a market rent review clause or the exercise of an extension option) is not regarded
as a modification.
The accounting for the modification of a lease depends on how the contract is modified. The standard distinguishes between
three different scenarios:
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An example for a renegotiation that would result in a change of the scope of the lease would be adding an additional floor to
the existing lease of a building for the remaining lease term. The effective date of the modification is the date on which the
parties agree to the modification of the lease.
In cases where the modification is not accounted for as a separate lease, the lessee shall, in a first step, allocate the
consideration in the modified contract between separate lease and non-lease components and determine the lease term of
the modified lease (that is, reassess the previous estimation of the lease term).
Decrease in scope
If the lease is modified to terminate the right of use of one or more underlying assets (for example, a lessee already
leases three floors of a building and the parties agree to reduce the lease by one floor for the remaining contractual term) or
to shorten the contractual lease term, the lessee remeasures the lease liability at the effective date of the modification
using a revised discount rate. The revised discount rate is the interest rate implicit in the lease for the remainder of the
lease term (or, if not readily determinable, the lessee’s incremental borrowing rate at that time). Furthermore, it decreases the
carrying amount of the right-of-use asset to reflect the partial or full termination of the lease. Any gain or loss relating to the
partial or full termination is recognised in profit or loss.
Increase in scope
If there has been an increase in the scope of the lease and the consideration for the lease increase is commensurate
with the stand-alone price for the increase in scope, the modification is accounted for as a separate lease. To be
commensurate, the increase in the consideration does not need to be equal to the stand-alone price of the increase in
scope. The standard makes clear that any ‘appropriate adjustments’ to reflect the circumstances of the particular contract
are still in line with the assumption that a change in the consideration is commensurate. So for example a discount that
reflects the costs the lessor would have incurred when looking for a new lessee (such as marketing costs), may be an
appropriate adjustment.
It is important to note that an increase in the scope of the lease only arises if the parties add the right to use one or more
underlying assets. The extension of an existing right of use (for example, by a change in the lease term) is not an increase in
scope and, therefore, always results in the continuation of the existing lease. However, it is still accounted for as a
modification of a lease.
If the consideration paid for the increase in the scope of the lease does not increase by a commensurate amount (that is,
the stand-alone price for the increase in scope and any appropriate adjustments), the lessee remeasures the lease liability at
the effective date of the modification using a revised discount rate and makes a corresponding adjustment to the right-of-
use asset.
The revised discount rate is the interest rate implicit in the lease for the remainder of the lease term (or, if not readily
determinable, the lessee’s incremental borrowing rate at that time).
Change in the lease consideration
If the parties to the contract change the consideration of the lease without increasing or decreasing the scope of the lease,
the lessee remeasures the lease liability using the interest rate implicit in the lease for the remainder of the lease term (or, if
not readily determinable, the lessee’s incremental borrowing rate at the effective date of modification) and makes a
corresponding adjustment to the right-of-use asset.
Other measurement models
Aside from the cost model described above, IFRS 16 contains two alternative measurement models that can impact
measurement for certain right-of-use assets:
A right-of-use asset must be subsequently measured in accordance with the fair

value model in IAS 40 if the right-of-use asset meets the definition of investment
property and the lessee has elected the fair value model in IAS 40.
A right-of-use asset can be subsequently measured at the revalued amount in
accordance with IAS 16 if it relates to a class of property, plant and equipment and
the lessee applies the revaluation model to all assets in that class.
Presentation and disclosures
On the balance sheet, the right-of-use asset can be presented either separately or in the same line item in which the
underlying asset would be presented. The lease liability can be presented either as a separate line item or together with other
financial liabilities. If the right-of-use asset and the lease liability are not presented as separate line items, an entity discloses
in the notes the carrying amount of those items and the line item in which they are included.
In the statement of profit or loss and other comprehensive income, the depreciation charge of the right-of-use asset is
presented in the same line item/items in which similar expenses (such as depreciation of property, plant and equipment) are
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shown. The interest expense on the lease liability is presented as part of finance costs. However, the amount of interest
expense on lease liabilities has to be disclosed in the notes.
In the statement of cash flows, lease payments are classified consistently with payments on other financial liabilities:
The part of the lease payment that represents cash payments for the principal
portion of the lease liability is presented as a cash flow resulting from financing
activities.
The part of the lease payment that represents interest portion of the lease liability is
presented either as an operating cash flow or a cash flow resulting from financing
activities (in accordance with the entity’s accounting policy regarding the
presentation of interest payments).
Payments on short-term leases, for leases of low-value assets and variable lease
payments not included in the measurement of the lease liability, are presented as
an operating cash flow.
To provide users with information that allows them to assess the amount, timing and uncertainty of lease payments, IFRS 16
includes enhanced disclosure requirements.
7.2.7 Lessor accounting
IFRS 16 does not contain substantial changes to lessor accounting. The lessor still has to classify leases as either finance or
operating, depending on whether substantially all of the risk and rewards incidental to ownership of the underlying asset
have been transferred. For a finance lease, the lessor recognises a receivable at an amount equal to the net investment in the
lease which is the present value of the aggregate of lease payments receivable by the lessor and any unguaranteed residual
value. If the contract is classified as an operating lease, the lessor continues to present the underlying assets.
Modification of a lease
The modification of an operating lease should be accounted for as a new lease by the lessor. Any prepaid or accrued lease
payments are considered to be payments for the new lease (that is, they will be spread over the new term of the modified
lease). A lessor accounts for the modification of a finance lease as a separate lease if:
the modification increases the scope of the lease; and

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
price to reflect the circumstances of the particular contract.
This mirrors the guidance for lessees.
If one of the above criteria is not met, the lessor has to assess whether the modification would have resulted in either an
operating or a finance lease if it had been in effect at inception of the lease:
If the lease would have been classified as an operating lease, the lessor accounts
for the modification as a new lease (operating lease). The carrying amount of the
underlying asset that has to be recognised is measured as the net investment in the
original lease immediately before the lease modification.
If the lease would have been classified as a finance lease, the lessor accounts for
the lease modification in accordance with IFRS 9.
5. Financial instruments
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Key points
This publication examines the accounting issues that are most significant
for the oil and gas industry.
The issues cover the accounting implications for financial instruments

under IFRS 9 Financial instruments applicable to the oil and gas industry
including classification and measurement, determination and accounting
for own use contracts, embedded derivatives and hedging.
What's inside (Free registration required to view):
5.1 Overview
5.1.1 Scope of IFRS 9
5.1.2 Application of ‘own use’
5.1.3 The fair value option for own use contracts
5.1.4 Centralised trading units
5.1.5 Presentation of derivatives in the income statement
5.2 Measurement of long-term contracts that do not qualify for 'own use'
5.2.1 Day 1 gains or losses
5.3 Volume flexibility (optionality), including ‘take or pay’ arrangements
5.4 Embedded derivatives
5.4.1 Assessing whether embedded derivatives are closely related
5.4.2 Timing of assessment of embedded derivatives
5.5 Overview of hedge accounting under IFRS 9
5.5.1 Risk components
5.5.2 ‘All in one’ hedging
5.6 Overview of classification and measurement of non-derivative financial assets
PwC Contacts
Deanna Louth (CA)

Scott Bandura (CA)
5.1 Overview
The accounting for financial instruments can have a major impact on an oil and gas entity’s financial statements. Some
entities have specific energy trading activities and those are discussed in section 5.1.4. Many entities use a range of
derivatives to manage the commodity, currency and interest-rate risks to which they are operationally exposed. Other, less
obvious, sources of financial instrument issues arise through the interaction with the revenue and leasing standards and
from both the scope of IFRS 9 and the rules around accounting for embedded derivatives. Many entities that are solely
engaged in producing, refining and selling commodities might be party to commercial contracts that are either wholly
within the scope of IFRS 9 or contain embedded derivatives from pricing formulas or currency.
Oil and gas entities might enter into a variety of financial instruments, some of which are obvious (such as loan
arrangements) and others which are less apparent (for example, certain commodity contracts). An entity should carefully
evaluate whether contracts fall within the scope of IFRS 9.
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Some practical considerations for the own use assessment are included in section 5.1.4.
The ‘net settlement’ notion in paragraph 2.6 of IFRS 9 is quite broad. There are various ways in which a contract to buy
or sell a non-financial asset can be settled net in cash. One means of net settlement is where the underlying commodity
is readily convertible to cash. Certain commodities in nascent markets might not be considered readily convertible to
cash for a period of time, but such markets can evolve and should be carefully monitored (for example, biofuels, LNG
etc). Further guidance can be found in the PwC Manual of Accounting chapter 40 paragraph 83.
FAQ 40.83.1 - How is the scope of IFRS 9 evaluated for financial and non-financial contracts?
5.1.2 Application of ‘own use’
‘Own use’ applies to those contracts that were entered into, and continue to be held, for the purpose of the receipt or
delivery of a non-financial item.
PwC Observation
Sale and purchase contracts for commodities in locations where an active market exists must be accounted for as
financial instruments, unless ‘own use’ treatment can be evidenced. An entity’s policies, procedures and internal
controls are critical in determining the appropriate treatment of its commodity contracts. It is important to match the
own use contracts with the physical needs for a commodity by the entity. A well-managed process, both around
forecasting these physical levels and matching them to contracts, is very important.
FAQ 40.84.1 – What is the distinction between a contract meeting the ‘own use’ exception and a contract being treated
as a derivative?
FAQ 40.84.2 – What does ‘own-use’ mean in practice?
FAQ 40.84.3 – Is the ‘own use’ exemption met in a contract to sell copper where an entity has no history of net
settlement?
FAQ 40.84.5 – What factors should be considered when determining whether a contract meets the ‘own use’
exemption? Do both counterparties have to reach the same conclusion?
FAQ 40.84.7 – How does an entity measure a contract when IFRS 9 is first applied after the contract no longer meets the
scope exception for ‘own use’ contracts?
FAQ 40.84.4 – Is the ‘own use’ exemption met in a contract to purchase oil where an entity has an established pattern of
settling net before delivery?
FAQ 40.85.1 – How do you determine whether you have/do not have a written option?
FAQ 40.86.2 – Accounting for take or pay contract; do these violate the ‘own-use’ requirements?
FAQ 40.86.3 – Volume adjustment feature with a written option with no premium; is the ‘own-use’ exemption met?
5.1.3 The fair value option for own use contracts
Paragraph 2.5 of IFRS 9 provides an option to designate an ‘own use’ contract at fair value through profit or loss only if
this eliminates or reduces an accounting mismatch that would otherwise arise (for example, because there is an
offsetting contract that must be fair valued).
PwC Observation
Determining whether an ‘own use’ contract meets the criteria to be designated at fair value through profit or loss can
be complex, particularly for companies which refine/construct underlying commodities into more complex products.
This fair value option applies to contracts for which net cash settlement is permitted. If only physical settlement is
permitted under the contract, there must be a liquid market for the underlying commodity such that it is readily
convertible to cash. [IFRS 9 para 2.5].
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5.1.4 Centralised trading units
Many entities have established centralised trading or risk management units in response to the increasing volatility and
further sophistication of energy markets. The operation of such a central trading unit might be similar to the operation of
the trading units of banks.
The scale and scope of the unit’s activities might vary from market risk management through to dynamic profit
optimisation. An integrated entity with significant upstream and downstream operations is particularly exposed to
movements in the prices of commodities such as different oil grades, fuel products and gas (LNG). The trading unit’s
objectives and activities are indicative of how management of the company operates the business. The central trading
unit often operates as an internal market place in larger integrated businesses. The centralised trading function thus
‘acquires’ all of the entity’s exposure to the various commodity risks, and is then responsible for hedging those risks in
the external markets.
Industry Specific FAQs
IND FAQ 5.1.4.1 – How are centralised trading units considered under IFRS 9?
5.1.5 Presentation of derivatives in the income statement
Entities in the oil and gas industry frequently account for derivative contracts either because of failed own use or
because financial derivatives are being used for risk management purposes. This section focuses on the presentation of
derivatives income in the income statement, specifically presentation of derivative gains and losses and unrealised gains
and losses in cases where hedge accounting is or is not applied.
FAQ 4.114.3 – Can derivative gains and losses be included in 'revenue'?
FAQ 4.114.7 – Can realised gains and losses be presented separately from unrealised gains and losses for financially
settled non-interest-related derivatives?
FAQ 4.114.4 – How should an entity present fair value changes and sales proceeds from commodity contracts that are
accounted for as derivative financial instruments under IFRS 9 (or IAS 39)?
FAQ 4.114.6 – How should hedge ineffectiveness on cash flow hedge relationships be presented within the income
statement?
5.2 Measurement of long-term contracts that do not qualify for ‘own

use’
Long-term physical commodity purchase or sale contracts are common. Some of these contracts might be within the
scope of IFRS 9 if they contain net settlement provisions and do not qualify for ‘own use’ treatment.
IND FAQ 5.2.1 – How is fair value for long-term commodity contracts established?
5.2.1 ‘Day 1’ gains or losses
Commodity contracts that are measured at fair value have the potential to create ‘day 1’ gains or losses, particularly
where they are long-term contracts for which forecast pricing cannot be readily determined for the duration of the
contract. Further guidance on the recognition and measurement of ‘day 1’ gains or losses can be found in PwC Manual
of Accounting chapter 42 paragraphs 100–102.
IND FAQ 5.2.1.1 – Should an entity consider whether a ‘day 1’ gain or loss relates to factors unrelated to the commodity
contract?
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FAQ 42.101.1 – Can a ‘day 1’ gain or loss be recognised?
FAQ 42.101.2 – How should any ‘day 1’ gain or loss be subsequently measured?
FAQ 42.101.3 – What factors should be considered where there is a large apparent 'day 1' gain or loss?
5.3 Volume flexibility (optionality), including ‘take or pay’ arrangements
Long-term commodity contracts might offer the counterparty flexibility in relation to the quantity of the commodity to be
delivered under the contract. Volume flexibility, such that a party can choose not to take any volume and instead pay a
penalty, is referred to as a ‘take or pay’ contract. Such flexibility might prevent the supplier from claiming the ‘own use’
exemption. Further guidance can be found in the PwC Manual of Accounting chapter 40 paragraph 86.
5.4 Embedded derivatives
Long-term commodity purchase and sale contracts frequently contain a pricing clause (that is, indexation) based on a
commodity other than the commodity deliverable under the contract. Such contracts contain embedded derivatives that
might have to be separated and accounted for under IFRS 9 as a derivative. Examples are gas prices that are linked to the
price of oil or other products, or a pricing formula that includes an inflation component.
An embedded derivative is a derivative instrument that is combined with a non-derivative host contract (the ‘host’ contract)
to form a single hybrid instrument. An embedded derivative causes some or all of the cash flows of the host contract to be
modified, based on a specified variable. An embedded derivative can arise through market practices or common
contracting arrangements.
5.4.1 Assessing whether embedded derivatives are closely related
All embedded derivatives must be assessed to determine if they are ‘closely related’ to the host contract at the inception
of the contract. A key determinant in the ‘closely related’ assessment is risk. Further guidance can be found in the PwC
Manual of Accounting chapter 41 paragraphs 10–16.
PwC Observation
A pricing formula that is indexed to something other than the commodity delivered under the contract could
introduce a new risk to the contract. The assessment of whether an embedded derivative is closely related is both
qualitative and quantitative, and it requires an understanding of the economic characteristics and risks of both
instruments.
Management should consider how other contracts for that particular commodity are normally priced in the absence
of an active market price for that commodity. A pricing formula will often emerge as a commonly used proxy for
market prices. Where it can be demonstrated that a commodity contract is priced by reference to an identifiable
industry ‘norm’, and contracts are regularly priced in that market according to that norm, the pricing mechanism is
generally not considered an embedded derivative.
The application guidance to IFRS 9 provides examples of situations where the embedded derivative is, or is not, closely
related to the host contract. Further guidance can be found in the PwC Manual of Accounting chapter 41 paragraph 21.
FAQ 41.11.1 – Using both quantitative and qualitative factors to assess the closely related criteria
5.4.2 Timing of assessment of embedded derivatives
All contracts need to be assessed for embedded derivatives at the date when the entity first becomes a party to the
contract. Subsequent reassessment of embedded derivatives is required when there is a significant change in the terms
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of the contract, but it is prohibited in all other cases. More information on when to assess a contract for embedded
derivatives can be found in the PwC Manual of Accounting chapter 41 paragraphs 19–20.
5.5 Overview of hedge accounting under IFRS 9
Note that this chapter only covers hedge accounting under IFRS 9. Certain entities might have elected to continue to apply
IAS 39 for hedge accounting. The IAS 39 guidance is not covered in this guide.
This guidance is not intended to be a comprehensive summary of hedge accounting under IFRS 9, and entities applying
hedge accounting should consider seeking more detailed information.
Entities often manage exposure to financial risks (including commodity price risks) by deciding to which risk, and to what
extent, they should be exposed, by monitoring the actual exposure and taking steps to reduce risks to within agreed limits,
often through the use of derivatives.
As discussed in 5.1.3, in some cases it might also be possible to fair value ‘own use’ contracts under IFRS 9 and avoid
hedge accounting.
IFRS 9 defines three types of hedge: cash flow hedge; fair value hedge; and hedge of a net investment in a foreign
operation, as defined in paragraph 8 of IAS 21.
PwC Observation
Entities that buy or sell commodities (for example, energy companies) might designate hedge relationships between
hedging instruments, including commodity contracts that are not treated as ‘own use’ contracts, and hedged items. In
addition to hedges of foreign currency and interest rate risk, energy companies primarily hedge the exposure to
variability in cash flows arising from commodity price risk in forecast purchases and sales.
Further guidance can be found in the PwC Manual of Accounting chapter 46 paragraphs 5, 14 and 22.
General FAQs and EX of Particular Relevance to the Industry
FAQ 46.1.1 – What is hedge accounting?
EX 46.14.1 – Examples of cash flow hedges
FAQ 46.20.1 – Does IFRS 9 require debit balances in the cash flow hedge reserve to be tested for recoverability?
Further guidance on qualifying criteria for hedge accounting can be found in the PwC Manual of Accounting chapter 46
paragraphs 33–55.
General FAQs and EX of Particular Relevance to the Industry
FAQ 46.35.1 – Is a risk management strategy required to apply hedge accounting?
FAQ 46.35.2 – What is the difference between a risk management objective and a risk management strategy?
FAQ 46.35.3 – What are common examples of sources of ineffectiveness?
FAQ 46.35.4 – What information must be provided in the documentation of a hedge of a forecast transaction?
EX 46.35.7 – Hedge documentation
FAQ 46.39.1 – Is a quantitative effectiveness assessment required?
FAQ 46.39.2 – Can hedge accounting still be achieved if fair value movements on the hedged item and the hedging
instrument are outside the range of 80–125%?
FAQ 46.42.1 – Is a quantitative test sufficient to prove an economic relationship?
FAQ 46.45.1 – What factors should be considered when assessing whether credit risk dominates the economic
relationship?
FAQ 46.45.2 – Does IFRS 9 provide a definition of when credit risk dominates?
FAQ 46.45.3 – Is the credit risk assessment applicable for the hedging instrument only?
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FAQ 46.49.1 – How is the hedge ratio determined?
FAQ 46.49.2 – In which circumstances might an entity designate a hedge ratio that could create ineffectiveness?
FAQ 46.49.3 – How should an entity select the appropriate hedge ratio?
IFRS 9 introduces the concept of ‘cost of hedging’. Where a purchased option is designated as a hedging instrument,
IFRS 9 views the option as similar to purchasing insurance cover, with the time value being the associated cost. [IFRS 9
para BC6.299].
Further guidance can be found in the PwC Manual of Accounting chapter 46 paragraphs 117–122.
FAQ 46.110.1 – Can an entity use a purchased option as a hedging instrument in a cash flow hedge?
EX 46.119.1 – Example of separating the intrinsic and time value of the option, where the hedged item is a forecasted sale
of a commodity (transaction related)
EX 46.119.2 – Example of separating the intrinsic and time value of the option, where the hedged item is a firm
commitment to purchase a non-financial item (transaction related)
An aggregated exposure is a combination of an exposure that could qualify as a hedged item (in accordance with para
6.3.1 of IFRS 9) and a derivative. Aggregated exposures could be designated as hedged items. Further guidance can be
found in the PwC Manual of Accounting chapter 46 paragraph 64.
PwC Observation
Aggregated positions including a derivative might qualify as a hedged item. For example, an entity with a Sterling
functional currency might have forecast sales of oil in USD. The entity might choose initially to hedge the commodity
risk of such a purchase in USD (that is, to fix the sales price in USD) using a forward oil sale derivative contract.
Subsequently, the entity might choose to hedge the foreign currency risk associated with the fixed USD cash flows
using a Sterling/USD forward contract. The hedged item is the aggregated forecast sale plus the forward oil sale
contract.
FAQ 46.64.1 – Can an entity achieve hedge accounting if it adds an additional derivative to a pre-existing hedge
relationship?
FAQ 46.64.6 – Can an entity apply hedge accounting under IFRS 9 to hedge the exposure on an aggregate position not
already in a hedge relationship?
For cash flow hedges of a forecast transaction which subsequently results in the recognition of a non-financial item (such
as inventory), the carrying value of that item must be adjusted for the accumulated gains or losses recognised directly in
equity. This is often referred to as a ‘basis adjustment in a cash flow hedge’. This is not a reclassification adjustment, as
defined in IAS 1, and hence it does not affect other comprehensive income. Further guidance can be found in the PwC
Manual of Accounting chapter 46 paragraph 18.
In business combinations, an acquirer re-designates all hedge relationships of the acquired entity on the basis of the
pertinent conditions as they exist at the acquisition date (that is, as if the hedge relationship started at the acquisition
date). Further guidance can be found in PwC Manual of Accounting chapter 46 paragraph 144.
FAQ 46.105.1 – What is the effect of hedging with pre-existing derivatives?
FAQ 46.105.2 – What is the impact of hedging with a swap whose fair value is not nil at the inception of the hedge?
5.5.1 Risk components

IFRS 9 allows for hedging non-financial portions where they are separately identifiable and reliably measurable. Certain
risk components might be contractually specified (for example, Brent + $7). Further guidance can be found in the PwC
Manual of Accounting chapter 46 paragraph 66.
PwC Observation
Other risk components might not be contractually specified and would need to be evaluated in the context of the
particular market structure (such as evaluating whether the spot market pricing mechanism for a location is based
on a particular benchmark). Although this might allow more risk components to be eligible for hedge accounting,
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demonstrating that non-contractual risk components are separately identifiable and reliably measurable can be
challenging and sometimes will require modelling of historical data points.
5.5.2 ‘All-in-one’ hedging
An ‘all-in-one’ hedge is the designation of a gross-settled derivative (that is, an instrument which is settled gross by
delivery of the underlying asset and the payment of the price specified in the contract, rather than by net settlement of
the difference between the two legs) as the hedging instrument in a cash flow hedge of the variability of the
consideration to be paid or received in the future transaction that will occur on gross settlement of the derivative
contract itself, assuming that the other cash flow hedge accounting criteria are met.
IND FAQ 5.5.2.1 – Can a contract for which ‘own use’ is failed, but that is still expected to result in physical delivery (for
example, perhaps it fails ‘own use’ because of similar contracts that have been net settled in the past), qualify to be
designated in a cash flow hedging relationship of the expected purchase or sale under the contract?
FAQ 46.133.1 – Are ‘all-in-one’ hedges allowed under IFRS 9?
FAQ 46.133.2 – Can a gross settled derivative be designated as an ‘all-in-one’ hedge?
FAQ 46.133.3 – Is it possible to achieve an ‘all-in-one’ hedge where there is some variability in the contractual cash
flows for the reporting entity?
5.6 Overview of classification and measurement of non-derivative

financial assets
Non-derivative financial assets can be classified as either equity instruments or debt instruments under IFRS 9.
Classification as a debt instrument under IFRS 9 depends on:
a) the objective of the business model for the portfolio in which the instrument is held; and
b) the contractual cash flows under the instrument representing solely payments of principal and interest (SPPI).
Further guidance on classification can be found in the PwC Manual of Accounting chapter 42 paragraphs 9–14.
An entity’s business model refers to how an entity manages its financial assets in order to generate cash flows. IFRS 9
prescribes two business models: holding financial assets to collect contractual cash flows; and holding financial assets to
collect contractual cash flows and selling.
It should be noted that the ‘business model’ test is generally evaluated at a level of aggregation of multiple instruments (for
example, an investment portfolio). The level at which the business model is evaluated will often require significant
judgement. The second criteria is evaluated for each instrument. Further guidance on business model assessment can be
found in the PwC Manual of Accounting chapter 42 paragraphs 15–19.
FAQ 42.15.1 – Should an entity take stress case scenarios into account in its business model assessment?
FAQ 42.19.1 – What are useful indicators for assessing the business model for a portfolio?
The classification approach in IFRS 9 applies to all financial assets, including those with embedded derivatives. There is no
separation of embedded derivatives from a financial asset. Financial assets are classified at fair value through profit or loss
where the SPPI criterion is failed. Further guidance on classification can be found in the PwC Manual of Accounting
chapter 42 paragraphs 67–68.
PwC Observation
In practice, we expect that many contracts that would otherwise contain embedded derivatives would be measured at
fair value through profit or loss under IFRS 9. For example, convertible bonds owned by oil and gas entities would
generally fail the SPPI criterion discussed above, which would in turn require them to be carried at fair value through
profit and loss.
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FAQ 25.19.5 – How do IAS 2 and IFRS 9 apply where all variability in a payable arises from a market price?
FAQ 25.19.6 – How do IAS 2 and IFRS 9 apply where all variability in a payable arises from physical attributes (for
example, quantity of contained metals in concentrate)?
FAQ 25.19.7 – How do IAS 2 and IFRS 9 apply where variability in a payable arises from both market price and physical
attributes, and the two kinds of variability are not readily separable?
FAQ 11.295.3 – Does IFRS 15 or IFRS 9 apply where all variability in the receivable arises from a market price?
FAQ 11.295.4 – Does IFRS 15 or IFRS 9 apply where all variability in the consideration arises from physical attributes (for
example, quantity of contained metals in concentrate)?
FAQ 11.295.5 – Does IFRS 15 or IFRS 9 apply where variability arises from both market price and physical attributes (for
example, quantity of contained metals in concentrate), and the two kinds of variability are not readily separable?
FAQ 42.68.1 – How is SPPI assessed for financial assets which contain embedded derivatives?
IFRS 9 requires an ‘expected loss’ impairment model to be applied to most financial assets classified as debt instruments.
Many oil and gas entities will only have trade receivables or other short-term instruments, and often these are with highly
rated counterparties. A simplified model is used to account for expected credit losses for most trade receivables. More
information can be found in the PwC Manual of Accounting chapter 45 paragraph 11.
General EX and FAQs of Particular Relevance to the Industry
FAQ 45.12.2 – Impairment of receivables arising from executory contracts

FAQ 45.13.1 – Use of an impairment provision matrix
EX 45.13.2 – Example of a provision matrix for corporates
All equity investments should be measured at fair value under IFRS 9. However, management has an irrevocable option,
chosen at initial recognition, to present, in other comprehensive income, unrealised and realised fair value gains and losses
on equity investments that are not held for trading.
PwC Observation
For an oil and gas company, this might include an interest in a listed junior exploration company. Such designation is
available on an instrument-by-instrument basis and is irrevocable. There is no subsequent recycling to the income
statement of fair value gains and losses on disposal, nor any impairment requirements. Dividends from such
investments will continue to be recognised in the income statement unless they clearly represent a recovery of part of
the cost of an investment, in which case they directly reduce the carrying amount of the investment. This election
avoids downside losses being booked to the income statement, but it also prevents fair value gains from being
recorded in income, so entities should carefully weigh whether this election is appropriate for a particular instrument.
There is no blanket exemption to record investments in unquoted equity securities at cost. Under IFRS 9, all equity
instruments (public or private) would be carried at fair value but, in very limited circumstances, cost might be used as an
estimate of fair value. Further guidance on the classification and measurement of equity instruments can be found in the
PwC Manual of Accounting chapter 42 paragraphs 62–66.
IND FAQ 5.1.4.1 – How are centralised trading units considered under
IFRS 9?
Reference to standard: IFRS 9 para 2.5

Question
How are centralised trading units considered under IFRS 9?
Answer
Some centralised trading departments are also given the authority to enhance the returns obtained from the integrated
business by undertaking a degree of speculative trading. A pattern of speculative activity or trading directed to profit
maximisation is likely to result in many contracts failing to qualify for the ‘own use’ exemption.
A centralised trading unit therefore undertakes two classes of transaction:
a) Transactions that are non-speculative in nature; for example, the purchase of oil to meet the physical requirements of
the physical assets and the sale of any fuel produced by a refinery. Contracts for such an activity are sometimes held in
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a ‘physical book’.
b) Transactions that are speculative in nature, to achieve risk management returns from wholesale trading activities.
Contracts for such an activity are sometimes held in a ‘trading book’, and they often involve entering into offsetting sale
and purchase contracts that are settled on a net basis. Those contracts and all similar contracts (that is, all contracts in
the trading book) do not qualify for the ‘own use’ exemption and are accounted for as derivatives.
Entities that maintain separate physical and trading books need to maintain the integrity of the two books, to ensure that
the net settlement of contracts in the trading book does not ‘taint’ similar contracts in the physical book, thus preventing
the ‘own use’ exemption from applying to contracts in the physical book.
A contract must meet the ‘own use’ requirements to be included in the ‘own use’ or ‘physical’ book. Contracts must
meet the physical requirements of the business at inception and continue to do so for the duration of the contract, as
discussed in 5.1.2.
PwC Observation
Practical requirements for a contract to be ‘own use’ are:
At inception and throughout its life, the contract has to reduce the market demand or supply requirements of
the entity, by entering into a sale contract or a purchase contract respectively.
The market exposure is identified and measured following methodologies documented in the risk
management policies of production and distribution. These contracts should be easily identifiable and
recorded in separate books.
Own-use treatment should be applied at a gross level; that is, sale of the oil production does not have to be
offset against purchases of oil by the refinery in order to determine an ‘own use’ level.
The number of own-use contracts should be capped by reference to virtually certain production and
distribution volumes (‘confidence levels’), to avoid the risk of ‘own use’ contracts becoming surplus to the
inherent physical requirements. If, in exceptional circumstances, the confidence levels proved to be
insufficient, the contract might no longer qualify as own use.
If the contract fails to reduce the market demand or supply requirements of the entity or is used for a different
purpose, the contract will cease to be accounted for as a contract for ‘own use’ purposes.
In this example, assume that the only reason why physical delivery below 500 units would take place would be
unforeseen operational conditions beyond control of the management of the entity (such as a refinery closure due to
a technical fault). Entities would typically consider contracts that fall within the highest confidence level (with
volumes up to 500 in the above diagram) as ‘own use’ (subject to being able to distinguish these as not being
“similar” contracts failing ‘own use’, as discussed in FAQ 5.1.4.1). The entity might also designate certain physical
contracts failing own use – where physical delivery is highly probable (that is, non-own-use contracts for 300 units) –
as ‘all in one’ hedges, subject to meeting all of the necessary criteria to apply hedge accounting, as discussed in
5.5.2. Other contracts that are not qualified as own use, nor designated in a hedging relationship, would be
measured at fair value through profit and loss.
IND FAQ 5.2.1 – How is fair value for long-term commodity contracts
established?
Reference to standard: IFRS 9 para 2.4

Reference to standing text: IND 5.2, Manual para 40.81
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Question
How is fair value for long-term commodity contracts established?
Answer
These contracts are typically not traded on an exchange and are therefore measured at fair value as defined in IFRS 13
using valuation models. Typically, there will not be observable market prices for the entire period of the contract (for
example, there might only be observable prices available for the next three years but not for the remainder of the
contract). Valuation can therefore be complex and subject to estimation uncertainty, particularly where unobservable
inputs are used in establishing fair value.
Fair value is intended to establish the price that would be received to sell an asset, or paid to transfer a liability (an exit
price), by market participants at the measurement date under current market conditions.
The valuation of a contract should include:
(a) selecting inputs that market participants would consider in setting a price, making maximum use of relevant
observable inputs and relying as little as possible on unobservable or entity-specific inputs;
(b) identifying the principal or most advantageous market;
(c) being consistent with accepted economic methodologies for pricing financial instruments; and
(d) if using unobservable inputs, calibrating the valuation technique(s) to ensure that they reflect observable market data
(for example, by using prices from any observable current market transactions in the same instrument).
The assumptions used to value long-term contracts are updated at each balance sheet date to reflect changes in market
prices, the availability of additional market data, and changes in management’s estimates of prices for any remaining
illiquid periods of the contract. Clear disclosure of the policy and approach (including significant assumptions) is crucial,
to ensure that users understand the entity’s financial statements. There are a number of detailed disclosures required for
such contracts contained in paragraphs 91–99 of IFRS 13.
IND FAQ 5.2.1.1 – Should an entity consider whether a ‘day 1’ gain or

loss relates to factors unrelated to the commodity contract?
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Reference to standard: IFRS 9 App B para B5.1.2A

Question
Should an entity consider whether a ‘day 1’ gain or loss relates to factors unrelated to the commodity contract?
Answer
Yes. If a ‘day 1’ gain or loss is determined for a commodity contract, the entity should consider whether there are any
elements that are unrelated to the commodity contract itself. For example, were there any other transactions agreed to
at the same time with the counterparty (such as a favourable own-use purchase or sale contract or lease agreement)? If
there are other transactions with the counterparty, part of the consideration should be allocated to those transactions.
Assuming that there are no other transactions that drive the ‘day 1’ gain or loss, the entity should first consider whether
its valuation model and the assumptions used therein are appropriate. IFRS 13 requires the entity to calibrate its
valuation model (that is, make adjustments to the valuation model), and such calibration might eliminate a perceived
‘day 1’ gain or loss in many cases.
If there are no other transactions and calibration does not result in any adjustment, any ‘day 1’ gain or loss can only be
recognised if the fair value of the contract:
(a) is evidenced by a quoted price in an active market for an identical asset or liability; or
(b) is based on a valuation technique that uses only data from observable markets. [IFRS 9 App B para B5.1.2A].
PwC Observation
Commodity contracts include a volume component, and oil and gas entities are likely to recognise the deferred gain
or loss and release it to profit or loss on a systematic basis as the volumes are delivered, or as observable market
prices become available for the remaining delivery period.
IND FAQ 5.5.2.1 – Can a contract for which ‘own use’ is failed, but that
is still expected to result in physical delivery (for example, perhaps it
fails ‘own use’ because of similar contracts that have been net settled
in the past), qualify to be designated in a cash flow hedging
relationship of the expected purchase or sale under the contract?
Reference to standard: IAS 39 IG F2.5

Question
Can a contract for which ‘own use’ is failed, but that is still expected to result in physical delivery (for example,
perhaps it fails ‘own use’ because of similar contracts that have been net settled in the past), qualify to be designated
in a cash flow hedging relationship of the expected purchase or sale under the contract?
Answer
Yes. As discussed in 5.1.2, certain physically settled contracts might be required to be measured as financial
instruments because of failure to meet the conditions for ‘own use’. However, if it is highly probable that physical
delivery will occur, the entity could designate the contract as a hedging instrument in a cash flow hedging relationship
of the highly probable forecast purchase under the contract. Assuming that all other qualifying criteria for hedge
accounting are met, this will usually result in the fair value gains and losses during the life of the contract being
recorded in other comprehensive income and the net fair value gain/loss being recognised as an adjustment to the
cost of the inventory when purchased. Effectively, this would mean that the inventory will be recorded at the fixed
price in the contract rather than the market price on purchase.
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Illustrative text
IND EX 4.1.2.1 Acquisition of E&E assets and

producing properties

Oil and Gas Co acquires multiple working interests in contiguous properties located in a single field in a single formation for
CU10 million. The predominant resource is crude oil. No employees (or outsourced workforce) are transferred to Oil and Gas
Co. Oil and Gas Co has elected to apply the optional concentration test. The fair value of each working interest and the
reserve classification is as follows:
Fair value of assets acquired Reserve classification
Property 1 $500,000 Producing
Property 2 $8,500,000 E&E
Property 3 $1,000,000 E&E
Total $10,000,000
Question
Is the value of the acquisition considered to be concentrated in a group of similar assets for the purpose of the concentration
test?
Answer
Maybe. Oil and Gas Co determines that property 1 cannot be combined with properties 2 and 3, because a producing
property does not have the same risk characteristics as E&E assets.
Oil and Gas Co needs to perform an assessment of its E&E assets and to determine the classification between tangible and
intangible assets. If at least 90% of the fair value of the gross assets of the acquisition is concentrated in either similar
tangible or similar intangible assets, the concentration test would be met, and the transaction would be accounted for as an
asset acquisition.
If the concentration test is failed, the company would need to consider whether the definition of a business was met.
IND EX 4.1.2.2 – Acquisition of producing

properties

Oil and Gas Co acquires multiple working interests in contiguous properties located in a single field in a single formation for
$4 million. All of the properties are proved and some are producing crude oil. No employees or contracted workforce are
transferred to Oil and Gas Co. The assets acquired include mineral rights and infrastructure assets. The regime in which the
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properties are located does not transfer rights to land to Oil and Gas Co, but it provides the company with a licence to
explore for and produce hydrocarbons on land owned by others. The fair value of each working interest and the reserve
classification is as follows:
Fair value of assets acquired Reserve classification
Property 1 $1,500,000 Proved developed
Property 2 $400,000 Proved undeveloped
Property 3 $2,100,000 Proved developed
Total $4,000,000
Question
Is the value of the acquisition considered to be concentrated in a group of similar assets for the purpose of the concentration
test?
Answer
Unlikely.
Oil and Gas Co elects to apply the optional concentration test.Oil and Gas Co determines that the properties do not all have
similar risk characteristics: they are in a single oil and gas field, producing the same product, but they have different reserve
classifications. However, if properties 1 and 3 were considered similar, they would be assessed in aggregate.
Since the company does not own the underlying land and field, but merely has a right to explore and produce the
hydrocarbons, another consideration would be whether such rights are intangible and, therefore, a different nature than the
tangible infrastructure.
The company might also have undertaken significant seismic or other geological studies, which could be considered
intangible in nature.
The concentration test considers the following potential combinations:
1. Tangible assets can be combined with other tangible assets in circumstances where they are connected and separating would
incur significant cost.
2. Tangible capital assets can be combined with IFRS 16 ‘right of use’ assets if the tangible assets are attached to the underlying
leased assets and separating these two tangible assets would incur significant cost.
The first combination is not applicable where the licence is intangible and the infrastructure is tangible.
The second combination – of a tangible asset and the right of use of a tangible asset – is in circumstances in which the
tangible assets cannot be feasibly separated from the underlying tangible asset subject to the right of use, and the standard
provides the example of land and buildings. At first glance, this would seem helpful, because the infrastructure is closely
connected to the exploitation of the resources. However, the standard refers to ‘right of use’ assets under IFRS 16, and the
mineral ‘leases’ themselves are outside the scope of IFRS 16. Therefore, the exception granted by the standard might not
apply.
In practice, companies often disclose oil and gas properties without distinguishing between tangible and intangible aspects,
because the accounting for and depletion of such tangible and intangible assets would often be the same. However,
because the concentration test strictly prohibits the combination of tangible and intangible assets in assessing
concentration, this issue is now likely to be more significant in practice.
Additionally, because there are proved developed and undeveloped reserves, it is unlikely that existing infrastructure and
licences have similar useful lives, and therefore it is difficult to analogise to the nuclear power plant example provided in
paragraph B32(b) of IFRS 3 to combine the tangible and intangible assets as a single asset.
If the concentration test failed, the company would need to consider whether the definition of a business was met.
IND EX 4.1.2.3 – Acquisition of an exploration

entity
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Exploration Co acquires working interests in multiple unproved properties, geological and geophysical (G&G) data (such as
surveys, maps, seismic data), an at-market drilling services contract, and employees including petroleum engineers, landmen
and geologists who have gained significant expertise in the properties. The fair value of each of the unproved properties and
the G&G data is significant.
Question
Is the arrangement the acquisition of a business?
Answer
First, Exploration Co determines that it will not apply the concentration test, because the fair value of the properties and the
G&G data are each significant and are separate asset classes and so they cannot be combined.
Exploration Co would then analyse the transaction, referring to the framework without outputs.
The acquisition includes an input of the unproved properties. The G&G data would be considered critical to the extraction of
the resources. The contract gives access to an organised workforce. It is likely that the organised workforce would be
substantive. Finally, the drilling contract would be considered an economic resource that would be used to create outputs.
Based on the above, the arrangement would be considered the acquisition of a business and would be accounted for under
IFRS 3.
IND FAQ 4.1.4.1– How should an acquirer

measure the fair value of undeveloped
properties/resources?

Reference to standing text: Manual para 29.100, Manual para 5.8
Question
How should an acquirer measure the fair value of undeveloped properties/resources?
Answer
Undeveloped properties and resources or exploration potential can present challenges when ascribing fair value to individual
assets, particularly those properties still in the exploration phase for which proven or probable reserves have not yet been
determined. A significant portion of the consideration transferred might relate to the value of these undeveloped properties.
Management should consider similar recent transactions in the market and use market participant assumptions to develop
fair values. The specific characteristics of the properties also need to be taken into account, including the type and volume of
exploration and evaluation work on resource estimates previously carried out, the location of the deposits and expected
future commodity prices. The challenges associated with this are discussed further in section 4.1.7.
IND EX 4.1.9.1 – Accounting for purchase of an

interest in a non-producing field
Reference to standard: IFRS 3 App A, IFRS 11 paras B33A–B33D

Reference to standing text: Manual paras 29.6 to 13
There are three participants in a joint operation, Omega, that is in the early exploration phase. A production licence has not
yet been obtained. There are no proven reserves and no development plan in place. The ownership interest of the
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participants is as follows:
Entity A 40%
Entity B 40%
Entity C 20%
The terms of the joint operating agreement require unanimous approval of decisions relating to the exploration.Entity A
purchases entity C’s interest of 20% and now holds 60% of the participating interest.
Question
Should the acquisition of an interest in a non-producing field be accounted for as a business combination?
Answer
Since the acquired field does not have outputs, it requires a substantive process that is critical to the ability to develop or
convert an acquired input or inputs into outputs, and the inputs acquired must include an organised workforce that has the
necessary skills to perform that process and other inputs that the organised workforce could convert into outputs.
The field is in the early exploration phase, a production licence has not yet been obtained, there are no proven reserves and
there is no development plan in place. Based on this, there is no substantive process that is critical to the ability to develop
the field, and so the field is not a business.
Acquisition of an interest in a joint operation that is not a business represents an asset acquisition. The consideration for the
interest will be capitalised, and no deferred tax or goodwill will arise.
IND EX 4.1.9.2 - Accounting for purchase of an

interest in a producing field
Reference to standard: IFRS 11 App B 33A-C

Reference to standing text: IND 4.1.9, Manual paras 32.53 to 62
There are three participants in a joint operation, Infinity, that is a business. The ownership interest of the participants is as
follows:
Entity A 40%
Entity B 40%
Entity C 20%
The terms of the joint operating agreement require unanimous approval of decisions relating to the development. The
carrying value of the asset in entity A’s financial statements is C15 million.
Entity A purchases entity B’s interest of 40%. It has paid consideration equivalent to entity B’s fair value of C20 million. Entity
A now holds 80% of the participating interest.
Question
How should entity A account for the acquisition of the additional 40% interest purchased from entity B?
Answer
The producing field would represent a business. Acquisition of an interest in a joint operation that is a business is accounted
for using the principles of IFRS 3, ‘Business Combinations’.
A fair value assessment would be performed of the ‘business’, and the company would consolidate its 80% share of this. The
total fair value of the asset has been assessed as C50 million. Entity A will recognise an asset of C35 million, which consists
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of the C20 million paid for entity B’s share and C15 million for the carrying value of the 40% previously recognised. The
previously held interest is not remeasured, because the company retained joint control.
Deferred tax will also need to be considered.
1. Oil and gas value chain and significant

accounting issues
The objective of oil and gas operations is to find, extract, refine and sell oil and gas, refined products and related products. It
requires substantial capital investment and long lead times to find and extract the hydrocarbons in challenging environmental
conditions with uncertain outcomes. Exploration, development and production often take place in joint ventures or joint
activities to share the substantial capital costs.
The outputs often need to be transported significant distances through pipelines and tankers; gas volumes are increasingly
liquefied, transported by special carriers and then regasified on arrival at destination. Gas remains challenging to transport;
thus many producers and utilities look for long- term contracts to support the infrastructure required to develop a major field,
particularly off-shore.
The industry is exposed significantly to macroeconomic factors such as commodity prices, currency fluctuations, interest
rate risk and political developments. The assessment of commercial viability and technical feasibility to extract hydrocarbons
is complex, and includes a number of significant variables. The industry can have a significant impact on the environment
consequential to its operations and is often obligated to remediate any resulting damage. Despite all of these challenges,
taxation of oil and gas extractive activity and the resultant profits is a major source of revenue for many governments.
Governments are also increasingly sophisticated and looking to secure a significant share of any oil and gas produced on
their sovereign territory.
This publication examines the accounting issues that are most significant for the oil and gas industry. The issues are
addressed following the oil and gas value chain: exploration and development, production and sales of product, together
with issues that are pervasive to a typical oil and gas entity.
2.4 Development expenditures
Development expenditures are costs incurred to obtain access to proved reserves and to provide facilities for extracting,
treating, gathering and storing the oil and gas. An entity should develop an accounting policy for development expenditure
based on the guidance in IAS 16, IAS 38 and the Framework. Much development expenditure results in assets that meet the
recognition criteria in IFRS.
Development expenditures are capitalised to the extent that they are necessary to bring the property to commercial
production. Entities should also consider the extent to which abnormal costs have been incurred in developing the asset. IAS
16 requires that the cost of abnormal amounts of labour or other resources involved in constructing an asset should not be
included in the cost of that asset. Entities will sometimes encounter difficulties in their drilling plans and make adjustments to
these, with the side track issue discussed in section 2.3.8 being one example. There will be a cost associated with this, and
entities should develop a policy on how such costs are assessed as being normal or abnormal.
Expenditures incurred after the point at which commercial production has commenced should only be capitalised if the
expenditures meet the asset recognition criteria in IAS 16 or 38.
2.5 Borrowing costs
The cost of an item of property, plant and equipment may include borrowing costs incurred for the purpose of acquiring or
constructing it. IAS 23 Borrowing costs requires that borrowing costs be capitalised in respect of qualifying assets.
Qualifying assets are those assets which take a substantial period of time to get ready for their intended use.
Borrowing costs should be capitalised while acquisition or construction is actively underway. These costs include the costs
of specific borrowings for the purpose of financing the construction of the asset, and those general borrowings that would
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have been avoided if the expenditure on the qualifying asset had not been made. The general borrowing costs attributable to
an asset’s construction should be calculated by reference to the entity’s weighted average cost of general borrowings.
Borrowing costs incurred during the exploration and evaluation (E&E) phase may be capitalised under IFRS 6 as a cost of
E&E if they were capitalising borrowing costs under their previous GAAP. Borrowing costs may also be capitalised on any
E&E assets that meet the asset recognition criteria in their own right and are qualifying assets under IAS 23. E&E assets
which meet these criteria are expected to be rare.
Entities could develop an accounting policy under IFRS 6 to cease capitalisation of borrowing costs if these were previously
capitalised. However, the entity would then need to consider whether borrowing costs relate to a qualifying asset and would
therefore require capitalisation. The asset would have to meet the IASB framework definition of an asset and be probable of
generating future economic benefit. This definition will not be met for many assets. An exploration licence, for example,
would not meet the definition of a qualifying asset as it is available for use in the condition it is purchased and does not take
a substantial period of time to get ready for use. Additional exploration expenditure, although it can be capitalised under
IFRS 6, would not be considered probable of generating future economic benefit until sufficient reserves are located.
2.5.1 Foreign exchange gains and losses
When development is funded by borrowings in a foreign currency, IAS 21 The effects of changes in foreign exchange rates
requires any foreign exchange gain or loss to be recognised in the income statement unless they are regarded as
adjustments to interest costs, in which case they can be treated as borrowing costs in accordance with IAS 23.
The gains and losses that are an adjustment to interest costs include the interest rate differential between borrowing costs
that would be incurred if the entity borrowed funds in its functional currency and borrowing costs actually incurred on foreign
currency borrowings.
IAS 23 does not prescribe which method should be used to estimate the amount of foreign exchange differences that may
be included in borrowing costs. Two possible methods are:
The portion of the foreign exchange movement to capitalise may be estimated

based on forward currency rates at the inception of the loan.
The portion of the foreign currency movement to capitalise may be estimated

based on interest rates on similar borrowings in the entity’s functional currency.
Management must use judgement to assess which foreign exchange differences can be capitalised. The method used is a
policy choice which should be applied consistently to foreign exchange differences whether they are gains or losses.
Exchange differences on foreign currency borrowings
Background
An upstream oil and gas entity domiciled in the UK, with GBP functional currency, has a US$1 million foreign currency
loan at the beginning of the period. The interest rate on the loan is 4% and is paid at the end of the period. An equivalent
borrowing in sterling would carry an interest rate of 6%. The spot rate at the beginning of the year is £1 = US$1.55 and at
the end of the year it is £1 = US$1.50.
Question
What exchange difference could qualify as an adjustment to the interest cost?
Solution
The expected interest cost on a sterling borrowing would be £645,161 @ 6% = £38,710
The actual cost of the US$ loan is: £

Loan at the beginning of the year: US$1 million @ 1.55 645,161
Loan at the end of the year: US$1 million @ 1.50 666,667
Exchange loss 21,506
Interest paid: US$1 million @ 4% = $40,000 @ 1.5 26,667
Total 48,173
Interest on sterling equivalent 38,710
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Difference 9,463
The total actual cost of the loan exceeds the interest cost on a sterling equivalent loan by £9,463. Therefore, only
£12,043 (£21,506 - £9,463) of the exchange difference of £21,506 may be treated as interest eligible for capitalisation
under IAS 23.
The correlation between the exchange rate and interest rate differential should be demonstrable and remain consistent
over the life of the borrowing to continue to allow capitalisation of foreign exchange differences.
2.5.2 Hedging instruments
An entity may hedge the cost of purchasing property, plant and equipment or hedge borrowings incurred for the purpose of
acquiring or constructing it.
Gains and losses on derivative instruments not designated in an effective hedging relationship under IFRS 9 Financial
instruments should be recognised in income. Note that this chapter only covers hedge accounting under IFRS 9. Certain
entities might have elected to continue to apply IAS 39 for hedge accounting. The IAS 39 guidance is not covered in this
guide.
The effective portion of hedging gains/losses can only be capitalised as part of the cost of an asset when the hedging
instrument qualifies for hedge accounting in accordance with IFRS 9.
Section 5.5 discusses hedge accounting in further detail. Further guidance on hedging instruments can be found in the PwC
Manual of Accounting chapter 46.
2.7 Asset swaps
An entity may exchange part or all of its future production interest in a field for an interest in another field. The fields may be
in different stages of development, and depending on how advanced the development is it could be considered to be a
business exchange. The accounting requirements will be different if the transaction represents the exchange of assets or a
business combination. The properties exchanged may meet the definition of a business; if control is obtained over a property
that meets the definition of a business then a business combination has occurred.
An exchange of one non-monetary asset for another is accounted for at fair value unless (i) the exchange transaction lacks
commercial substance, or (ii) the fair value of neither of the assets exchanged can be determined reliably. There may be more
than one asset or a combination of cash and non-monetary assets. The acquired item is measured at the fair value of assets
relinquished unless the fair value of asset or assets received is more readily determinable. A gain or loss is recognised on the
difference between the carrying amount of the asset given up and fair value recognised for the asset received. It is expected
that the entity will be able to determine a fair value for the assets in many circumstances. There may be some situations
where a fair value is not available e.g. there is no market data of recent comparable transactions or exploration and
evaluation activity is at an early stage with no conclusive data on reserves and resources. If a fair value cannot be
determined the acquired item is measured at cost, which will be the carrying amount of the asset given up. There will be no
gain or loss.
An entity determines whether an exchange transaction has commercial substance by considering the extent to which its
future cash flows are expected to change as a result of the transaction. IAS 16 provides guidance to determine when an
exchange transaction has commercial substance.
If the transaction is determined to be a business combination, the more complex requirements of IFRS 3 apply. An entity
may also obtain joint control or significant influence when it acquires an interest in a property through a swap. IFRS 3
requirements apply if an entity acquires an interest in a joint venture that is a business. Otherwise the interest is initially
recognised at fair value as determined above and then the requirements of IAS 28 Investments in associates and joint
ventures apply (as further discussed in section 4.2.7). There can also be situations where entities which own assets or
exploration rights in adjacent areas enter into a contract to combine these into a larger area, effectively an exchange of a
share in a small asset for a share in a bigger asset. Section 4.2.11 explores this in more detail.
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2.8 Depletion, depreciation and amortisation

(DD&A)
2.8.1 Depletion, depreciation and amortisation

(DD&A)
This section focuses on the depreciation of upstream assets related to key issues in the oil and gas industry.
Further guidance on measurement subsequent to initial recognition can be found in the PwC Manual of Accounting chapter
22 paras 22.79 to 22.102.
The accumulated capitalised costs from the exploration and evaluation and development phases are amortised over the
expected total production using a units of production (‘UOP’) basis.
PwC Observation
UOP is the most appropriate amortisation method for depreciating upstream oil and gas assets because it reflects the
pattern of consumption of the reserves’ economic benefits. However, straight-line amortisation might be appropriate for
assets that are consumed more by the passage of time. For example, there might be circumstances where straight-line
depreciation does not produce a materially different result and can be used rather than UOP.
IND FAQ 2.8.1.1 – What basis should be used for the UOP calculation?
IND FAQ 2.8.1.2 – What class of reserves should be used for the UOP calculation?
IND FAQ 2.8.1.3 – Can an entity subsequently change the basis of reserves used in the UOP calculation?
IND EX 2.8.1.4 – ‘Component’ depreciation in the oil and gas industry

FAQ 22.94.2 – Can an entity change to a ‘units of production method’ for calculating depreciation?
EX 22.100.1 – Change in estimate of useful life
Illustrative text
IND FAQ 2.8.1.1 – What basis should be used

for the UOP calculation?

Reference to standing text: Manual para 22.79
Question
What basis should be used for the UOP calculation?
Answer
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IFRS does not prescribe what basis should be used for the UOP calculation. Many entities use only proved developed
reserves, while others use total proved or both proved and probable. Proved developed reserves are those that can be
extracted without further capital expenditure. The basis of the UOP calculation is an accounting policy choice, and it should
be applied consistently. If an entity does not use proved developed reserves, an adjustment is made to the calculation of the
amortisation charge to include the estimated future development costs to access the undeveloped reserves.
The estimated production used for DD&A of assets that are subject to a lease or licence should be restricted to the total
production expected to be produced during the licence/lease term. Renewals of the licence/lease are only assumed if there
is evidence to support probable renewal at the choice of the entity without significant cost.
IND FAQ 2.8.1.2 – What class of reserves

should be used for the UOP calculation?

Question
Entity D is preparing its first IFRS financial statements. D’s management has identified that it should amortise the carrying
amount of its producing properties on a UOP basis over the reserves present for each field.
However, D’s management is debating whether to use proved reserves or proved and probable reserves for the UOP
calculation.
What class of reserves should be used for the UOP calculation?
Answer
Entity D’s management could choose to use either proved reserves or proved and probable reserves for the UOP
amortisation calculation.
The IASB Framework identifies assets on the basis of probable future economic benefits, and so the use of probable
reserves is consistent with this approach. However, some national GAAPs have historically required only proved developed
reserves to be used for such calculations.
Whichever definition of ‘reserves’ D’s management chooses, it should disclose and apply this consistently to all similar types
of production property. For example, some entities use proved reserves for conventional oil and gas extraction, and proved
and probable for unconventional properties. If proved and probable reserves are used, an adjustment must be made to the
amortisation base to reflect the estimated future development costs required to access the undeveloped reserves.
IND FAQ 2.8.1.3 – Can an entity subsequently

change the basis of reserves used in the UOP
calculation?

Question
Can an entity subsequently change the basis of reserves used in the UOP calculation?
Answer
An entity might use one reserves basis for depreciation, and it might subsequently determine that an alternative base could
be more appropriate. It might be that the use of proved and probable would be more appropriate, since that is the basis that
management uses when assessing the entity’s business performance. A change in the basis of reserves from proved
reserves to proved and probable reserves (or from proved developed to total proved) is considered acceptable under IFRS.
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A change in the basis of reserves constitutes a change in accounting estimate under IAS 8. The entity’s policy of
depreciating its assets on a UOP basis is unchanged, since it has only changed its estimation technique. The effect of the
change is recognised prospectively from the period in which the change has been made. Entities which change their UOP
basis should ensure that any related changes (such as future capital expenditure to complete any undeveloped assets, or to
access probable reserves) are also incorporated into their depreciation calculation. Appropriate disclosure of the change
should be made.
IND EX 2.8.1.4 – ‘Component’ depreciation in

the oil and gas industry

property, plant and equipment is depreciated separately. [IAS 16 paras 43–44].
Significant parts of an asset that have similar useful lives and patterns of consumption can be grouped together. This
requirement can create complications for oil and gas entities, because there might be assets that include components with a
shorter useful life than the asset as a whole.
Productive assets are often large and complex installations. Assets are expensive to construct, they tend to be exposed to
harsh environmental or operating conditions, and they require periodic replacement or repair. The significant components of
these types of asset must be separately identified. Consideration should also be given to those components that are more
prone to technological obsolescence, corrosion or wear and tear than the other portions of the larger asset.
The components that have a shorter useful life than the remainder of the asset are depreciated to their recoverable amount
over that shorter useful life. The remaining carrying amount of the component is derecognised on replacement, and the cost
of the replacement part is capitalised. [IAS 16 paras 13–14].
2.9 Disclosure of reserves and resources
2.9.1 Overview
A key indicator for evaluating the performance of oil and gas entities is their existing reserves and the future production and
cash flows expected from them. Some national GAAPs and securities regulators require supplemental disclosure of reserve
information, most notably the FASB ASC 932 and Securities and Exchange Commission (SEC) regulations. There have also
been recommendations on accounting practices issued by industry bodies such as the UK Statements of Recommended
Practice (SORPs) – which cover Accounting for Oil and Gas Exploration, Development, Production and Decommissioning
Activities. However, there are no reserve disclosure requirements under IFRS.
IAS 1 Presentation of financial statements [IAS 1 para 17] requires that an entity’s financial statements should provide
additional information when compliance with specific requirements in IFRS is insufficient to enable an entity to achieve a fair
presentation.
An entity may consider the pronouncements of other standard-setting bodies and accepted industry practices when
developing accounting policies in the absence of specific IFRS guidance. Many entities provide supplemental information
with the financial statements because of the unique nature of the oil and gas industry and the clear desire of investors and
other users of the financial statements to receive information about reserves. The information is usually supplemental to the
financial statements, and is not covered by the auditor’s opinion.
Information about quantities of oil and gas reserves is essential for users to understand and compare oil and gas companies’
financial position and performance. Entities should consider presenting reserve quantities and changes on a reasonably
aggregated basis. Where certain reserves are subject to particular risks, those risks should be identified and communicated.
Reserve disclosures accompanying the financial statements should be consistent with those reserves used for financial
statement purposes. For example, proven and probable reserves or proved reserves might be used for depreciation,
depletion and amortisation calculations.
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The categories of reserves used and their definitions should be clearly described. Reporting a ‘value’ for reserves and a
common means of measuring that value have long been debated, and there is no consensus among national standard-
setters permitting or requiring value disclosure. There is, at present, no globally agreed method to prepare and present
‘value’ disclosures. However, there are globally accepted engineering definitions of reserves that take into account economic
factors. These definitions may be a useful benchmark for investors and other users of financial statements to evaluate.
The disclosure of key assumptions and key sources of estimation uncertainty at the balance sheet date is required by IAS 1.
Given that the reserves and resources have a pervasive impact, this normally results in entities providing disclosure about
hydrocarbon resource and reserve estimates, for example:
the methodology used and key assumptions made for hydrocarbon resource and
reserve estimates
the range of reasonably possible outcomes within the next financial year in respect
of the carrying amounts of the assets and liabilities affected
an explanation of changes made to past hydrocarbon resource and reserve
estimates, including changes to underlying key assumptions.
Other information such as the potential future costs to be incurred to acquire, develop and produce reserves may help users
of financial statements to assess the entity’s performance. Supplementary disclosure of such information with IFRS financial
statements is useful, but it should be consistently reported, and the underlying basis clearly disclosed and based on
common guidelines or practices, such as the Society of Petroleum Engineers definitions.
2.9.2 Disclosure of E&E and production

expenditure
Exploration and development costs that are capitalised should be classified as non-current assets in the balance sheet. They
should be separately disclosed in the financial statements and distinguished from producing assets where material [IFRS 6
para 23]. The classification as tangible or intangible established during the exploration phase should be continued through to
the development and production phases. Details of the amounts capitalised and the amounts recognised as an expense
from exploration, development and production activities should be disclosed.
2.9.3 SEC rules on disclosure of resources
SEC guidance on the disclosure of reserves is viewed by the industry as a best practice approach to disclosure. Oil and gas
entities may prepare their reserves disclosures based on this guidance even where they are not SEC-listed. The SEC
amended its guidance on disclosure requirements (The Final Rule) and this has been in effect since December 2009.
The main disclosure requirements of the Final Rule are:
Disclosure of estimates of proved developed reserves, proved undeveloped

reserves and total proved reserves. This is to be presented by geographical area
and for each country representing 15% or more of a company’s overall proved
reserves
Disclosure of reserves from non-traditional sources (i.e. bitumen, shale, coalbed
methane) as oil and gas reserves
Optional disclosure of probable and possible reserves
Optional disclosure of the sensitivity of reserve numbers to price
Disclosure of the company’s progress in converting proved undeveloped reserves
into proved developed reserves. This is to include those that are held for five years
or more and an explanation of why they should continue to be considered proved.
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Disclosure of technologies used to establish reserves in a company’s initial filing

with the SEC and in filings which include material additions to reserve estimates.
The company’s internal controls over reserve estimates and the qualifications of
the technical person primarily responsible for overseeing the preparation or audit of
the reserves estimates.
If a company represents that disclosure is based on the authority of a third party
that prepared the reserves estimates or conducted a reserves audit or process
review, they should also file a report prepared by the third party.
‘Oil and gas producing activities’ include sources of oil and gas from unconventional sources, including bitumen, oil sands
and hydrocarbons extracted from coalbeds and oil shale. Reserve definitions are aligned with those from the Petroleum
Resources Management System (PRMS) approved by the Society for Petroleum Engineers (SPE).
The definition of ‘proved oil and gas reserves’ is “the estimated quantities of crude oil, natural gas, and natural gas liquids
which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known
reservoirs under existing economic and operating conditions” [Rule 4-10a].
Key criteria to meet this definition are:
There must be at least a 90% probability that the quantities actually recovered will
equal or exceed the stated volume (consistent with PRMS) to achieve the definition
of ‘Reasonable certainty’.
The reserves must be ‘Economically producible’ and this requires the use of
average prices during the prior 12-month period.
To extract the reserves there must be ‘Reliable technology’: this refers to
technology that has been field tested and demonstrated consistency and
repeatability in the formation being evaluated or in an analogous formation.
Probable and possible reserve estimates allow the use of deterministic and probabilistic methods.
The Final Rule is silent with respect to the treatment of the reserves of an equity method investment. The ASU, however,
requires entities to separately disclose the significant oil and gas producing activities of their equity method investments at
the same level of detail as consolidated investments (i.e. including Topic ASC 932 supplemental disclosures).
Financial reporting in the power and utilities

industry
This publication is part of a series that takes a sector-by-sector look at IFRS in practice. In this edition, we look at the issues
faced by power and utilities companies. We draw on our considerable experience of helping power and utilities companies
apply IFRS effectively and we include a number of real-life examples to show how companies are responding to the various
challenges along the value chain.
Power and utilities value chain and significant

accounting issues
Overview
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A traditional integrated power entity (utility) generates electricity and sends it around the country or region via high-voltage
transmission lines, finally delivering it to customers through a retail distribution network. Some utilities also – or exclusively –
transport water and/or gas. As the industry continues to evolve, many operational and regulatory models have emerged.
Generators continue to diversify supplies; fossil fuels still dominate, but there is an increasing focus on bio-fuels, co-
generation and renewable sources such as wind, solar and wave power. Some governments are supporting the construction
of new nuclear power plants and, in some countries, construction has already started; other governments are reconsidering
or reversing their support in response to the Fukushima event.
The regulatory environment can be complex and challenging, and it may differ between geographies or even within a
country. Pressure to introduce and increase competition and to diversify supply is apparent, as well as schemes that create
financial incentives to reduce emissions and increase the use of renewable sources. Previously integrated businesses might
be split by regulation into generation, transmission, distribution and retail businesses. Competition might then be introduced
for the generation and retail segments. Generators will look to compete on price and secure long-term fuel supplies,
balancing this against potentially volatile market prices for wholesale power. The distribution business might see the
incumbent operator forced to grant access to its network to other suppliers. Power customers are beginning to behave like
any other group of retail customers: exercising choice, developing brand loyalty, shopping for the best rates, or looking for
an attractive bundle of services that might include gas, telephone, water and internet as well as power.
The power and utilities industry is highly regulated, with continuing government involvement in pricing, security of supply and
pressure to reduce greenhouse gas emissions and other pollutants. Add this to a background of increased competition, and
a challenging financial environment and difficult accounting issues result. This publication examines the accounting issues
that are most significant for the utilities industry. The issues are addressed in the order of the utilities value chain: generation,
transmission and distribution, and issues that affect the entire entity.
Power and utilities value chain and significant accounting issues
 View image
Generation
Generating assets are often large and complex installations. They are expensive to construct, tend to be exposed to harsh
operating conditions and require periodic replacement or repair. This environment leads to specific accounting issues.
Fixed assets and components
IFRS has a specific requirement for ‘component’ depreciation, as described in IAS 16, Property, Plant and Equipment. Each
significant part of an item of property, plant and equipment is depreciated separately. Significant parts of an asset that have
similar useful lives and patterns of consumption can be grouped together. This requirement can create complications for
utility entities, because many assets include components with a shorter useful life than the asset as a whole.
Identifying components of an asset
Generating assets might comprise a significant number of components, many of which will have differing useful lives. The
significant components of these types of assets must be separately identified. This can be a complex process, particularly on
transition to IFRS, because the detailed recordkeeping needed for componentisation might not have been required in order
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to comply with national generally accepted accounting principles (GAAP). This can particularly be an issue for older power
plants. However, some regulators require detailed asset records, which can be useful for IFRS component identification
purposes.
An entity might look to its operating data if the necessary information for components is not readily identified by the
accounting records. Some components can be identified by considering the routine shutdown or overhaul schedules for
power stations and the associated replacement and maintenance routines. Consideration should also be given to those
components that are prone to technological obsolescence, corrosion or wear and tear that is more severe than that of the
other portions of the larger asset.
First-time IFRS adopters can benefit from an exemption under IFRS 1, First-time Adoption of International Financial
Reporting Standards. This exemption allows entities to use a value that is not depreciated cost in accordance with IAS 16,
and IAS 23, Borrowing Costs, as deemed cost on transition to IFRS. It is not necessary to apply the exemption to all assets
or to a group of assets.
IFRS 14, Regulatory Deferral Accounts, was issued in January 2014 as an interim standard on rate-regulated activities. IFRS
14 permits first-time adopters to continue to recognise amounts related to rate regulation in accordance with their previous
GAAP accounting policies on adoption of IFRS. However, IFRS 14 requires the effect of rate regulation to be presented
separately from other items to enhance comparability with entities that already apply IFRS (and therefore do not recognise
such amounts). An entity that already presents IFRS financial statements is not eligible to apply the new guidance.
Depreciation of components
All components should be depreciated to their recoverable amount over their useful lives, which might differ among
components. The remaining carrying amount of the component is derecognised on replacement, and the cost of the
replacement part is capitalised.
The costs of performing major maintenance/overhaul are capitalised as a component of the plant, where this provides future
economic benefits. Turnaround/ overhaul costs that do not relate to the replacement of components or the installation of
new assets should be expensed when incurred. Turnaround/overhaul costs should not be accrued over the period between
the turnarounds/overhauls, because there is no legal or constructive obligation to perform the turnaround/ overhaul; the
entity could choose to cease operations at the plant and hence avoid the turnaround/overhaul costs.
Borrowing costs
The cost of an item of property, plant and equipment might include borrowing costs incurred for the purpose of acquiring or
constructing it. IAS 23 (revised) requires such borrowing costs to be capitalised if the asset takes a substantial period of time
to be prepared for its intended use. Examples of borrowing costs given by the standard are: interest expense calculated
using the effective interest method (described in IFRS 9, Financial Instruments: Recognition and Measurement); finance
charges in respect of finance leases recognised in accordance with IFRS 16, Leases; and exchange differences arising from
foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.
of specific funds borrowed for the purpose of financing the construction of the asset, and those general borrowings that
would have been avoided if the expenditure on the qualifying asset had not been made. The general borrowing costs
attributable to an asset’s construction should be calculated by reference to the entity’s weighted-average cost of general
borrowings.
Example
A utility commences construction on a new power plant on 1 September 201X, which continues without interruption until
after the year end 31 December 201X. Directly attributable expenditure on this asset is C100 million in September 201X
and C250 million in each of the months of October to December 201X. Therefore, the weighted-average carrying amount
of the asset during the period is C475 million – that is, (100 million + 350 million + 600 million + 850 million)/4.
The entity has not taken out any specific borrowings to finance the construction of the plant, but it has incurred finance
costs on its general borrowings during the construction period. During the year, the entity had 10% debentures in issue,
with a face value of C2 billion; and it had an overdraft of C500 million, which increased to C750 million in December 201X
and on which interest was paid at 15% until 1 October 201X, when the rate was increased to 16%. The capitalisation rate
of the general borrowings of the entity during the period of construction is calculated as follows:
Weighted-average borrowings during period:
((2b × 4)+(500 million × 3)+(750 million × 1))/4

=
C2,562,500,000
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Capitalisation rate (total finance costs in period/ weighted-average borrowings

during period)
=
96,250,000/2,562,500,000
= 3.756%
The capitalisation rate, therefore, reflects the weighted-average cost of borrowings for the four- month period that the
asset was under construction. On an annualised basis, 3.756% for the four-month period gives a capitalisation rate of
11.268% per annum, which is what would be expected on the borrowings profile.
Therefore, the total amount of borrowing costs to be capitalised is the weighted-

average carrying amount of asset × capitalisation rate
= C475
million ×
11.268% ×
4/12
=
C17,841,000
C (x1,000)
Finance cost on C2 billion 10% debentures during 66,667
September–December 201X
Interest at 15% on overdraft of C500 million in September 6,250

201X
Interest at 16% on overdraft of C500 million in October 13,333

and November 201X
Interest at 16% on overdraft of C750 million in December 10,000

201X
Total finance costs in September–December 201X 96,250
Example
A utility uses general borrowings and cash from operating activities to finance its qualifying assets. It has a capital
structure of 20% equity and 80% current and non-current liabilities, including interest-bearing debt from general
borrowings. The borrowing rate is applied to the full carrying amount of the qualifying asset, rather than to the 80% of the
qualifying assets that are financed with borrowings.
Utilities will sometimes use operating cash flows to finance capital expenditure during a period when there is also general
financing. The borrowing rate is applied to the full carrying amount of the qualifying asset. This is the case even where the
cash flows from operating activities are sufficient to finance the capital expenditure. IAS 23 (revised) does not deal with the
actual or imputed cost of capital.
A utility might contract for a power plant on a turnkey basis. Progress payments will be made by the utility over the
construction period of a power plant. The borrowing costs incurred by an entity to finance prepayments made to a third party
to acquire the qualifying asset are capitalised in accordance with IAS 23 (revised) on the same basis as the borrowing costs
incurred on an asset that is constructed by the entity. Capitalisation starts when all three conditions are met: expenditures
are incurred, borrowing costs are incurred, and the activities necessary to prepare the asset for its intended use or sale are in
progress. Expenditures on the asset are incurred when the prepayments are made (that is, payments of the instalments).
Borrowing costs are incurred when borrowing is obtained. The last condition – the activities necessary to prepare the asset
for its intended use or sale – is considered to be met when the manufacturer has started the construction process.
Determining whether the construction is in progress requires information directly from the turnkey supplier.
A utility might hedge its borrowings. The effects of cash flow or fair value hedge relationships on borrowing costs are
capitalised (this applies to both specific and general borrowings). The hedging relationship modifies the borrowing costs of
the utility related to the debt; IAS 23 requires the effective interest rate to be used as the basis for interest capitalisation. A
hedge that modifies the amount of borrowing costs should be included in determining the effective interest rate.
Ineffectiveness on such hedging relationships should be recognised in profit or loss.
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Decommissioning obligations
The power and utilities industry can have a significant impact on the environment. Decommissioning (or environmental
restoration work) at the end of the useful life of a plant or other installation might be required by law, the terms of operating
licences or an entity’s stated policy and past practice. An entity that promises to remediate damage, even where there is no
legal requirement, might have created a constructive obligation and thus a liability under IFRS. There might also be
environmental clean-up obligations for contamination of land that arises during the operating life of a power plant or other
installation. The associated costs of remediation/restoration can be significant; so the accounting treatment for
decommissioning costs is critical.
Decommissioning provisions
A provision is recognised where an obligation exists to remediate or restore. The local legal regulations should be taken into
account when determining the existence and extent of the obligation. Obligations to decommission or remove an asset are
created when the asset is placed in service. Entities recognise decommissioning provisions at the present value of the
expected future cash flows that will be required to perform the decommissioning. The cost of the provision is recognised as
part of the cost of the asset when it is placed in service, and it is depreciated over the asset’s useful life. The total cost of the
fixed asset, including the cost of decommissioning, is depreciated on the basis that best reflects the consumption of the
economic benefits of the asset.
Provisions for decommissioning and restoration are recognised even if the decommissioning is not expected to be
performed for a long time (perhaps 80 to 100 years). The effect of the time to expected decommissioning is reflected in the
discounting of the provision. The discount rate used is the pre-tax rate that reflects current market assessments of the time
value of money. Entities also need to reflect the specific risks associated with the decommissioning liability. Naturally,
different decommissioning obligations have different inherent risks (for example, different uncertainties associated with the
methods, and the costs and the timing of decommissioning). The risks specific to the liability can be reflected either in the
pre-tax cash flow forecasts prepared or in the discount rate used.
A similar accounting approach is taken for nuclear fuel rods. These rods are classified as inventory, and an obligation to
reprocess them is triggered when the rods are placed into the reactor. A liability is recognised for the reprocessing obligation
when the rods are placed into the reactor, and the cost of reprocessing is added to the cost of the fuel rods.
Revisions to decommissioning provisions
Decommissioning provisions are updated at each balance sheet date for changes in the estimates of the amount or timing of
future cash flows and changes in the discount rate. Changes to provisions that relate to the removal of an asset are added to
or deducted from the carrying amount of the related asset in the current period. Changes to provisions that relate to the
removal of an asset no longer used are recognised immediately in the income statement. However, the adjustments to the
asset are restricted:
The asset cannot decrease below zero and cannot increase above its recoverable
amount.
If the decrease to the provision exceeds the carrying amount of the asset, the
excess is recognised immediately in profit or loss.
Adjustments that result in an addition to the cost of the asset are assessed to
determine if the new carrying amount is fully recoverable. An impairment test is
required if there is an indication that the asset might not be fully recoverable.
The accretion of the discount on a decommissioning liability is recognised as part of finance cost in the income statement.
Decommissioning funds
Power and utilities companies that operate nuclear power plants might, at times, be obliged to contribute to a separate fund
established to ensure that decommissioning obligations will be met in the future.
range of assets, usually debt and sometimes also equity securities. The trustees determine how contributions are invested,
within the constraints set by the fund’s governing documents and any applicable legislation or other regulations. The power
and utilities entity then obtains reimbursement of actual decommissioning costs from the fund as they are incurred. However,
the power and utilities entity might only have restricted access or no access to any surplus of assets of the fund over those
used to meet eligible decommissioning costs.
IFRIC 5, Rights to Interests arising from Decommissioning, Restoration and Environmental Rehabilitation Funds, provides
guidance on the accounting treatment for these funds in the financial statements of the power and utilities entity.
Management must recognise its interest in the fund separately from the liability to pay decommissioning costs. Offsetting is
not appropriate.
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fund accordingly. In the absence of some level of control or influence, the fund is accounted for as a reimbursement of the
entity’s closure and environmental obligation; the fund is measured at the lower of the amount of the decommissioning
obligation recognised and the entity’s share of the fair value of the net assets of the fund.
The movements in the fund (based on the IFRIC 5 measurement) are assessed separately from the measurement of the
provision (under IAS 37). Any movements in a fund accounted for as a reimbursement asset are recognised in the income
statement as finance income/expense.
Impairment
The utility industry is distinguished by the significant capital investment required, exposure to commodity prices and heavy
regulation. The required investment in fixed assets leaves the industry exposed to adverse economic conditions and,
therefore, impairment charges. Utilities’ assets should be tested for impairment whenever indicators of impairment exist. The
normal measurement rules for impairment apply.
Impairment indicators
Examples of external impairment triggers relevant for the utilities industry include falling retail prices, rising fuel costs,
overcapacity and increased or adverse regulation or tax changes.
Impairment indicators can also be internal in nature. Evidence that an asset or cash-generating unit (CGU) has been
damaged or has become obsolete is an impairment indicator; for example, a power plant destroyed by fire is, in accounting
terms, an impaired asset. Other indicators of impairment are a decision to sell or restructure a CGU, or evidence that
business performance is less than expected. Performance of an asset or group of assets that is below that expected by
management in operational and financial plans is also an indicator of impairment.
Management should be alert to indicators of impairment on a CGU basis; for example, a fire at an individual generating
station would be an indicator of impairment for that station as a separate CGU.
Management might also identify impairment indicators on a regional, country or other asset-grouping basis, reflective of how
it manages its business. Once an impairment indicator has been identified, the impairment test must be performed at the
individual CGU level, even if the indicator was identified at a regional level.
Cash-generating units
A CGU is the smallest group of assets that generates cash inflows largely independently of other assets or groups of assets.
In identifying whether cash inflows from an asset or groups of assets are largely independent of the cash inflows from other
assets (or groups of assets), CGUs should be identified on a consistent basis from one period to the next for the same
assets or types of asset, unless a change is justified. (If an asset is moved to a different CGU, or the types of asset that are
aggregated for the asset’s CGU have changed and a material impairment is recognised or reversed, the entity should
describe the current and former way of aggregating assets and the reasons for the change.)
Determining the CGU and assessing the recoverable amount for an individual CGU is difficult in situations where
management has multiple assets and has the ability to choose the assets that are used. If there is an active market for the
output produced by an asset or group of assets, that asset or group of assets should be identified as a CGU.
Determination of what is a CGU can be an area of significant judgement but is not an accounting policy choice. The exercise
of such judgement might result in multiple assets being grouped to form a single CGU or being considered as individual
CGUs. If this judgement has an impact on whether an impairment is recognised, the judgement and related assumptions
might be significant enough to be disclosed as critical judgements under IAS 1.
Calculation of recoverable amount
Impairments are recognised if the carrying amount of a CGU exceeds its recoverable amount; the recoverable amount is the
higher of fair value less costs of disposal (FVLCOD) and value in use (VIU).
Fair value less costs of disposal
Fair value less costs of disposal is the amount that a market participant would pay for the asset or CGU, less the costs of
selling the asset. The use of discounted cash flows to determine FVLCOD is permitted in the following situations: where there
is no readily available market price for the asset; or where there are no recent market transactions for the fair value to be
determined through a comparison between the asset being tested for impairment and a recent market transaction. However,
where discounted cash flows are used, the inputs must be based on external, market-based data.
So, the projected cash flows for FVLCOD include the assumptions that a potential purchaser would include in determining
the price of the asset. Industry expectations for the development of the asset can therefore be taken into account, which
might not be permitted under VIU. However, the assumptions and resulting value must be based on recent market data and
transactions.
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Post-tax cash flows are used when calculating FVLCOD using a discounted cash flow model. The discount rate applied in
FVLCOD is a post-tax market rate based on a typical industry participant’s cost of capital.
Value in use (VIU)
VIU is the present value of the future cash flows expected to be derived from an asset or CGU in its current condition.
Determination of VIU is subject to the explicit requirements of IAS 36, Impairment of Assets. The cash flows are based on the
asset that the entity has now; they must exclude any plans to enhance the asset or its output in the future, but include
expenditure necessary to maintain the current performance of the asset. The VIU cash flows for assets under construction
and not yet complete should include the cash flows necessary for their completion and the associated additional cash
inflows or reduced cash outflows.
Any foreign currency cash flows are projected in the currency in which they are earned and discounted at a rate appropriate
for that currency. The resulting value is translated to the entity’s functional currency using the spot rate at the date of the
impairment test.
The discount rate used for VIU is always pre-tax and applied to pre-tax cash flows. This is often one of the most challenging
elements of the impairment test, because pre-tax rates are not available in the marketplace, and arriving at the correct pre-
tax rate is a complex mathematical exercise. Computational shortcuts are available if there is a significant amount of
headroom in the VIU calculation. However, grossing up the post-tax rate seldom, if ever, gives an accurate estimate of the
pre-tax rate.
Contracted cash flows in VIU
The cash flows prepared for a VIU calculation should reflect management’s best estimate of the future cash flows expected
to be generated from the assets concerned. Purchases and sales of commodities are included in the VIU calculation at the
spot price at the date of the impairment test or, if appropriate, prices obtained from the forward price curve at the date of the
impairment test.
There might be commodities – both fuel and the resultant electricity output – covered by purchase and sales contracts.
Management should use the contracted price in its VIU calculation for any commodities unless the contract is already on the
balance sheet at fair value. Including the contracted prices of such a contract would be to double count the effects of the
contract. Impairment of financial instruments that are within the scope of IFRS 9, Financial Instruments: Recognition and
Measurement, is addressed by IFRS 9 and not IAS 36
The cash flow effects of hedging instruments, such as caps and collars, for commodity purchases and sales are also
excluded from the VIU cash flows. These contracts are also accounted for in accordance with IFRS 9.
Emission trading schemes and certified

emission reductions


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obligations
FAQ 33.21.3 – How does the ability to generate carbon credits affect a forest's fair
value?
Emissions Trading Systems: The Opportunities ahead.
Transmission and distribution
Transmission and distribution activities in the power and utilities industry include the transmission of power and the
transportation of water or gas, as well as the distribution of these resources. This part of the value chain is also dependent
on significant capital investment in electric grid facilities and pipeline networks.
Fixed assets and components
Network assets, such as an electricity transmission system or a gas pipeline, comprise many separate components. A
network must be broken down into its significant parts that have different useful lives. The determination of the number and
breakdown of parts is specific to the entity’s circumstances. A number of factors should be considered in this analysis: the
cost of different parts; how the asset is split for operational purposes; physical location of the asset; and technical design
considerations.
Many individual components might not be significant. A practical approach to identifying components is to consider the
entity’s mid- to long-term capital budget, which should identify significant capital expenditures and pinpoint major
components of the network that will need replacement over the next few years. The entity’s engineering staff should also be
involved in identifying components based on repairs and maintenance schedules and planned major renovations or
replacements.
Some network companies apply renewals accounting for expenditure related to their networks under national GAAP.
Expenditure is fully expensed, and no depreciation is charged against the network assets. This accounting treatment is not
acceptable under IFRS, because the normal fixed asset accounting and depreciation requirements apply. This might be a
significant change for network companies and introduces some application challenges.
An entity with a history of expensing all current expenditure might struggle initially to reinstate what should have been
capitalised and what should have been expensed. Materiality is a useful guide; if replacement costs are material to the asset,
these costs should be capitalised where recognition criteria are met (that is, where costs can be reliably measured and future
economic benefits are probable). First-time IFRS adopters can benefit from an exemption according to IFRS 1, First-time
Adoption of International Financial Reporting Standards. This exemption allows entities to use a value that is not depreciated
cost in accordance with IAS 16, Property, Plant and Equipment, and IAS 23, Borrowing Costs, as deemed cost on transition
to IFRS. It is not necessary to apply the exemption to all assets or to a group of assets.
Network companies might be accustomed to a working assumption that assets have an indefinite useful life. All significant
assets have a finite life, to be determined under IAS 16, being the time remaining before the asset needs to be replaced.
Maintenance and repair activities might extend this life, but ultimately the asset will need to be replaced.
A residual value must be determined for all significant components. In many cases, this value is likely to be scrap only or nil,
because IAS 16 defines ‘residual value’ as the disposal proceeds if the asset were already of an age and in the condition
expected at the end of its useful life. An entity is required to allocate costs at initial recognition to its significant parts. Each
part is then depreciated separately over its useful life. Separate parts that have the same useful life and depreciation method
can be grouped together to determine the depreciation charge.
Regulatory assets and liabilities
Complete liberalisation of utilities is not practical, because of the physical infrastructure required for the transmission and
distribution of the commodity – a monopoly of the infrastructure’s owner is created. Therefore, privatisation and the
introduction of competition are often balanced by price regulation. Some utilities continue as monopoly suppliers, with prices
limited to a version of cost plus margin overseen by the regulator.
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The regulatory regime is often unique to each country. The two most common types of regulation are incentive-based
regulation and cost-based regulation. The regulator governing an incentive-based regulatory regime usually sets the
‘allowable revenues’ for a period, with the intention of encouraging cost efficiency from the utility. A utility entity operating
under cost-based regulation is typically permitted to recover an agreed level of operating costs, together with a return on
assets employed.
An entity’s accounting policies should consider the regulatory regime and the requirements of IFRS. Any asset or liability
arising from regulation to be recognised under IFRS should be evaluated based on applicable IFRSs or the Framework, as
there is no specific standard for the accounting for such assets or liabilities under IFRS.
IFRS 14 was issued in January 2014 as an interim standard on rate-regulated activities. IFRS 14 permits first-time adopters
to continue to recognise amounts related to rate regulation in accordance with their previous GAAP accounting policies on
adoption of IFRS. However, IFRS 14 requires the effect of rate regulation to be presented separately from other items to
enhance comparability with entities that already apply IFRS (and therefore do not recognise such amounts). An entity that
already presents IFRS financial statements is not eligible to apply the new guidance.
In January 2021 the IASB issued their exposure draft Regulatory Assets and Regulatory Liabilities to replace IFRS 14. As of
January 2023 the final standard has not yet been issued.
Line fill and cushion gas
Some items of property, plant and equipment (PPE), such as pipelines and gas storage, require a minimum level of product
to be maintained in them in order for them to operate efficiently. This product is usually classified as part of the PPE because
it is necessary to bring the PPE to its required operating condition. The product is therefore recognised as a component of
the PPE at cost, and is subject to depreciation to estimated residual value.
However, product owned by an entity that is stored in PPE owned by a third party continues to be classified as inventory.
This includes, for example, all gas in a rented storage facility. It does not represent a component of the third party’s PPE or a
component of PPE owned by the entity. Such product should therefore be measured at first-in, first-out (FIFO) or weighted-
average cost.
Example – Cushion gas
Entity A has purchased salt caverns to use as underground gas storage. The salt cavern storage is reconditioned to
prepare it for injection of gas. The natural gas is injected and, as the volume of gas injected increases, so does the
pressure. The salt cavern therefore acts as a pressurised container. The pressure established within the salt cavern is
used to push out the gas when it needs to be extracted. When the pressure drops below a certain threshold, there is no
pressure differential to push out the remaining natural gas. This remaining gas within the cavern is therefore physically
unrecoverable until the storage facility is decommissioned. This remaining gas is known as ‘cushion gas’.
Should entity A’s management account for the cushion gas as PPE or as inventory?
Entity A’s management should classify and account for the cushion gas as PPE. The cushion gas is necessary for the
cavern to perform its function as a gas storage facility. It is therefore part of the storage facility and should be capitalised
as a component of the storage facility PPE asset.
The cushion gas should be depreciated to its residual value over the life of the storage facility in accordance with
paragraph 43 of IAS 16. However, if the cushion gas is recoverable in full when the storage facility is decommissioned,
depreciation is recorded against the cushion gas component only if the estimated residual value of the gas decreases
below cost during the life of the facility.
When the storage facility is decommissioned and the cushion gas extracted and sold, the sale of the cushion gas is
accounted for as the disposal of an item of PPE in accordance with paragraph 68 of IAS 16. Accordingly, the gain/loss
on disposal is recognised in profit or loss. The natural gas in excess of the cushion gas that is injected into the cavern
should be classified and accounted for as inventory in accordance with IAS 2.
Net realisable value of gas inventories
Gas purchased for use by a utility is valued at the lower of cost and net realisable value if it will be used as a fuel.
Determining net realisable value requires consideration of the estimated selling price in the ordinary course of business, less
the estimated costs to complete processing and to sell the inventories. An entity determines the estimated selling price of
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the gas product using the market price at the balance sheet date.
Movements in the gas price after the balance sheet date typically reflect changes in the market conditions after that date,
and so they should not be reflected in the calculation of net realisable value.
Network operation arrangements
Rights to use public ground for constructing and operating electricity grids are often limited in time. Municipalities might
decide to not prolong these rights once they have expired, but operate the grids on their own or enter into co-operation
agreements with network-operating companies or other municipalities. The arrangements might take various forms, such as:
leasing the grid assets directly to network operating entities;

establishing (together with a network operator) network-holding companies, which
lease the grid assets out to the network operator; or
joint arrangements with other municipalities or entities, which can comprise
numerous collaboration and service contracts.
Usually the arrangements are rather complex, because they comprise a multitude of contracts between the parties, such as
contracts regulating the rights and obligations between the shareholders of the network holding companies, lease contracts
and service contracts. All entities involved in these arrangements have to analyse all facts and circumstances in order to
conclude the appropriate accounting treatment. The contracts could also give rise to a concession service agreement, which
is discussed in section 1.5.1.
Entity-wide issues
Service concession arrangements
Public/private partnerships are one method whereby governments attract private sector participation in the provision of
infrastructure services. These services might include toll roads, prisons, hospitals, public transportation facilities, and water
and power distribution. These types of arrangement are often described as ‘concessions’, and many fall within the scope of
IFRIC 12, Service Concession Arrangements. Arrangements within the scope of the standard are those where a private
sector entity might construct the infrastructure, maintain and provide the service to the public. The provider might be paid for
its services in different ways. Many concessions require the related infrastructure assets to be returned or transferred to the
government at the end of the concession.
IFRIC 12 applies to arrangements where the grantor (that is, the government or its agent) controls or regulates what services
the operator provides with the infrastructure, to whom it must provide them and at what price. The grantor also controls any
significant residual interest in the infrastructure at the end of the term of the arrangement.
Water distribution facilities and energy supply networks are examples of infrastructure that might be the subject of service
concession arrangements. For example, the government might have authorised the building of a new town. It might grant a
concession to a power distribution entity to construct the distribution network, maintain it and operate it for a period of 25
years. The distribution network is transferred to the government at the end of the concession period, with a specified level of
functionality for no consideration. The national regulator sets prices on a cost-plus basis. The concession arrangement has
baseline service commitments that trigger substantial penalties if service is interrupted. The government requires the power
entity to provide universal access to the electricity network for all residents of the town.
This arrangement would fall within the scope of IFRIC 12, because it has many of the common features of a service
concession arrangement, including:
The grantor of the service arrangement is a public sector entity or a private sector
entity to which the responsibility for the service is delegated (in this case, the
government has authorised the new town and granted the licence).
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The operator is not an agent acting on behalf of the grantor, but is responsible for
at least some of the management of the infrastructure (the operator has an
obligation to maintain the network).
The arrangement is governed by a contract (or by the local law, as applicable) that
sets out performance standards, mechanisms for adjusting prices and
arrangements for arbitrating disputes (there are financial penalties for poor
operating performance and cost-plus tariff).
The operator is obliged to hand over the infrastructure to the grantor in a specified
condition at the end of the period of the arrangement (transfer with no
consideration from the government at the end of the concession period).
The two accounting models under IFRIC 12 that an operator applies to recognise the rights received under a service
concession arrangement are:
Financial asset – An operator with a contractual and unconditional right to receive

specified or determinable amounts of cash (or other financial assets) from the
grantor recognises a financial asset. The financial asset is within the scope of IAS
32, Financial Instruments: Presentation, IFRS 9, Financial instruments and IFRS 7,
Financial Instruments: Disclosures.
Intangible asset – An operator with a right to charge the users of the public service
recognises an intangible asset. There is no contractual right to receive cash when
payments are contingent on usage. The licence is within the scope of IAS 38.
Arrangements between governments and service providers are complex, and the conclusions are seldom as obvious as the
example above. Detailed analysis of the specific arrangement is necessary to determine whether it is in the scope of IFRIC
12 and whether the ‘financial asset’ or ‘intangible asset’ model should be applied. Some complex arrangements might have
elements of both models for the different phases, so it might be appropriate to account separately for each element of the
consideration.
Joint arrangements
Joint arrangements are frequently used by power and utilities companies as a way to share risks and costs, or as a way of
bringing in specialist skills to a particular project. The legal basis for a joint arrangement can take various forms: a joint
arrangement might be established through a formal contract; or the governance arrangements set out in a company’s
formation documents might provide the framework for a joint arrangement. The feature that distinguishes a joint arrangement
from other forms of cooperation between parties is the presence of joint control. An arrangement without joint control is not a
joint arrangement.
Joint control
IFRS 11 defines ‘joint control’ as:
‘the contractually agreed sharing of an arrangement, which exists only when decisions about the relevant activities require
the unanimous consent of the parties sharing control.’
For many investees, a range of operating and financing activities significantly affect their returns. Examples of decisions
about relevant activities in the power and utilities industry include:
establishing operating and capital decisions of the investee about running a power
plant, including budgets; and
appointing and remunerating an investee’s key management personnel or service
providers and terminating their services or employment.
The assessment of joint control focuses on whether the investors (or a specific sub-set of investors) must agree on all
decisions over relevant activities.
Consideration of joint control would consist of, but not be limited to, the following:
the composition of the Board (or other decision- making body);
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whether each Board member’s vote is required to align with the interest of the
shareholder represented;
ability to change Board members once appointed; and
how disputes are resolved.
Joint control might be present even if one of the investors acts as operator of the joint arrangement.
The operator’s powers are usually limited to day-to-day operational decisions; key strategic financial and operating decisions
(that is, decisions about the significant relevant activities) remain with the joint arrangement investors as a group, with
unanimous consent required.
In contrast, joint control might not be present even if an arrangement is described as a ‘joint venture’. Financial and
operating decisions that are made by ‘simple majority’ rather than by unanimous consent could mean that joint control is not
present, even in situations where two parties hold the majority of shares (for example, three parties to an arrangement with
holdings of 45%, 45% and 10% respectively).
Classification of joint arrangements
The classification of the joint arrangement is based on the rights and obligations of the parties to the arrangement.
Determination of the type of joint arrangement can be a complex decision under IFRS 11.
Determining the classification of a joint arrangement is a four-step process, as shown below.
In summary, a joint arrangement that is not structured through a separate vehicle is a joint operation. However, not all joint
arrangements in separate vehicles are joint ventures. A joint arrangement in a separate vehicle can still be a joint operation;
classification depends on the rights and obligations of the investors.
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Separate vehicles
The first step in determining the classification is to assess whether the arrangement is structured through a separate vehicle.
A ‘separate vehicle’ is a separately identifiable financial structure, including separate legal entities or entities recognised by
statute, regardless of whether those entities have a legal personality. There are many different types of vehicle used for joint
arrangements, including partnerships, unincorporated entities, limited companies and unlimited liability companies. Local
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laws and regulations also need consideration before determining whether a particular structure meets the definition of a
‘separate vehicle’.
Joint arrangements structured through a separate vehicle
A joint arrangement that is structured through a separate vehicle can be either a joint venture or a joint operation, depending
on the investors’ rights and obligations relating to the arrangement.
The investors need to assess whether the legal form of the separate vehicle, the terms of the contractual arrangement and
(where relevant) any other facts and circumstances give them:
rights to the assets and obligations for the liabilities relating to the arrangement
(that is, joint operation); or
rights to net assets of the arrangement (that is, joint venture).
Local laws and regulations play a key role in the assessment of the rights and obligations conferred by the separate vehicle.
It is possible that the same legal form in different territories could give different rights and obligations, depending on the local
laws and regulations (for example, general partnerships).
Rights to assets and obligations for liabilities given by contractual terms
In most cases, the rights and obligations agreed to by the investors in their contractual terms are consistent with the rights
and obligations conferred on the investors by the legal form of the separate vehicle. This is because the selection of a
particular legal form is, in many cases, driven by the intended economic substance that the particular legal form delivers.
However, investors might choose a particular legal form to respond to tax consequences, regulatory requirements or for
other reasons. This can alter the intended economic substance initially sought by the investors to the arrangement. In such
cases, the investors might enter into contractual arrangements that modify the effects that the legal form of the arrangement
would otherwise have on their rights and obligations.
In addition, the local law of a territory might require an arrangement in a particular industry to be set up only in a limited
liability company. This means that the legal structure of the separate vehicle will create a separation between the investors
and the arrangement. However, the investors might have the intention of setting up a joint operation.
In such cases, the investors could enter into contractual terms which modify or reverse the rights and obligations conferred
by the legal form of the separate vehicle. The contractual terms of the arrangement might be such that each investor has an
interest in the assets of the company, and each investor has an obligation for the liabilities of the company in a specified
proportion.
The contractual terms have to be assessed carefully to ensure that they are, in fact, robust enough to modify or reverse the
rights and obligations conferred by the legal structure.
Effect of guarantees on classification of a joint arrangement
Investors in joint arrangements often provide guarantees to third parties on behalf of the arrangement where the arrangement
is purchasing goods, receiving services or obtaining financing.
The question that commonly arises is whether provision of such guarantees (or commitment by the investors to pay in case
the arrangement fails to pay or meet its obligations) indicates that the investors have obligations for liabilities of the
arrangement and so the arrangement is a joint operation.
All relevant facts and circumstances should be considered in determining the classification. Rights and obligations are
assessed as they exist in the normal course of business. It is not appropriate to make a presumption that the arrangement
will not settle its obligations and that the investors will be obligated to settle those liabilities because of the guarantee issued.
This would not be seen as a normal course of business. Therefore, issuing a guarantee does not, on its own, mean that the
arrangement is a joint operation.
'Other facts and circumstances’
This is the final step in determining the classification of a joint arrangement. Where arrangements are incorporated in limited
liability companies, classifying them as joint operations on the basis of ‘other facts and circumstances’ is considered a high
hurdle to cross.
If the arrangement was primarily designed to provide output to the investors, it might indicate that the investors’ objective
was to have rights to substantially all of the economic benefits of the arrangement’s assets.
The effect of an arrangement with such a design is that the liabilities incurred by the arrangement are, in substance, satisfied
by the cash flows received from the investors through their purchases of the output. It also means that the investors are
effectively the only source of cash flows for the continuity of the arrangement’s operations. This indicates that the investors
have an obligation for the liabilities relating to the arrangement.
This type of design must be supported by contractual terms that bind the investors. This is generally achieved by a formal
agreement between the investors requiring each to take their proportionate share of output and/ or preventing the
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arrangement from selling to third parties. An arrangement that provides the investors with the right, but not the obligation, to
take all of the output would not be viewed as joint operation; this is because the investors would not have a direct obligation.
‘Other facts and circumstances’ scenarios
Each of the scenarios considered on pages 31 and 32 has the following assumptions:
joint control exists in each of the arrangements; and

the arrangement is contained in a separate vehicle; the legal structure of the
separate vehicle and the contractual terms do not give the investors rights to
assets and obligations for liabilities.
The initial indicators are that the arrangements are joint ventures; however, the ‘other facts and circumstances’ are analysed
as to how they might affect the classification of the arrangement.
Scenario Classification Analysis

The arrangement (an offshore wind Depends on the The parties do not need to set up a
park located in the UK) produces contractual terms over joint arrangement for an interest in the
two products – electricity and output. same product. They might have an
renewable energy certificates interest in different products, but
(RECs). might set up a joint arrangement for
reasons such as cost savings or
100% of the power generated is similar manufacturing processes.
taken by one party, and 100% of the
RECs is taken by the other party at In this case, the facts suggest that
market value. one party has operations in physical
proximity to the wind farm, enabling
Since these are purchased by the that party to take 100% of the power
parties at market value, there is a directly. The other party takes 100%
residual profit or loss left in the of the RECs, resulting in all of the
arrangement which is distributed by output of the wind farm being
way of dividends to the parties in consumed by the investors of the
proportion to their shareholding. arrangement. As such, the
arrangement appears dependent on
the parties for cash flows (that is, the
parties ‘fund operations’ through their
purchase of the output). A contractual
requirement for the parties to take
substantially all of the output would
result in classification as a ‘joint
operation’; the lack of such
requirement would likely result in ‘joint
venture’ classification.
Parties have the right of first refusal Likely to be a joint The following factors indicate that the
to buy the output, but they are not venture. arrangement is most likely a joint
obligated to take the output. venture:
The arrangement was set up three

years ago. In the first year, the There is no obligation
parties take all of the output in the
ratio of their shareholding.
on the arrangement
to sell its output to
In the second year, the product is the parties. This
sold to third parties.
indicates that the
In the third year, the purpose and design
parties take all of the of the arrangement
output, but in a different
ratio from their was not to provide all
shareholding. of the output to the
parties.
In the past, output
has been sold to
third parties. This
proves that the
arrangement is not
substantially
dependent on the
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parties for its cash

flows.
Parties have a contractual Likely to be a joint The binding commitment

agreement to take all of operation. of the parties to take all of
the output in proportion to the output provides the
their ownership interest. parties with the rights to
The arrangement is the economic benefits of
prohibited from selling the assets and creates an
output to third parties. All obligation for the liabilities.
output must be purchased The agreement means that
at cost plus a defined the investors are
margin. substantially the only
source of cash flows for
the operations to continue.
Two parties set up an arrangement Likely to be a joint In this case, it is clear that the
to construct and operate a power venture. arrangement is not designed to
plant. The power generated is sold provide all of its output to the parties.
to third parties.
The arrangement is selling the product
As per the contractual terms: to third parties and is generating its
own cash flows.
a. all of the gross cash
proceeds from The transfer of gross proceeds of
revenue of the revenues to the parties, and
arrangement are reimbursement for costs incurred, do
transferred to the not indicate that the parties have
parties on a monthly rights to assets and obligations for
basis in proportion liabilities of the arrangement. It is
to their merely a funding mechanism. It is no
shareholding; and different from the parties having an
b. the parties agree to interest in the net results of the
reimburse the arrangement.
arrangement for all
its costs in
proportion to their
shareholding.
Reassessment of classification
The rights and obligations of parties to joint arrangements might change over time. Consequently, the assessment of the
type of joint arrangement needs to be a continuous process, to the extent that facts and circumstances change.
Accounting for joint operations
Investors in joint operations are required to recognise the following:

its expenses, including its share of any expenses incurred jointly.
‘Share of assets and liabilities’ is not necessarily the same as proportionate consolidation. ‘Share of assets and liabilities’
means that the investor should consider their interest or obligation in each underlying asset and liability under the terms of
the arrangement – it will not necessarily be the case that they have a single, standard percentage interest in all assets and
liabilities.
Accounting for joint ventures (‘JVs’)
IFRS 11 requires equity accounting for all joint arrangements classified as joint ventures.
The key principles of the equity method of accounting are described in IAS 28 as follows:
investment in the JV is initially recognised at cost;

changes in the carrying amount of investment are recognised based on the
the venturer only reflects their share of the profit or loss of the JV; and
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distributions received from a JV reduce the carrying amount of the investment.

The results of the joint venture are incorporated by the venturer on the same basis as the venturer’s own results (that is,
using the same GAAP (IFRS) and the same accounting policy choices). The growing use of IFRS and convergence with US
GAAP have helped in this regard, but the basis of accounting should be set out in the formation documents of the joint
venture.
Example – Joint venture uses a different GAAP
An entity uses IFRS. Are accounting adjustments required before it can incorporate the results of a joint venture that
reports under US GAAP?
Background
Entity J is a joint venture that prepares its accounts under US GAAP, as prescribed in the joint venture agreement. One
of the venturers, entity C, prepares its consolidated financial statements under IFRS. C’s management believes that, for
the purpose of applying the equity method, the US GAAP financial statements of entity J can be used.
Must entity C’s management adjust entity J’s US GAAP results, to comply with IFRS, before applying the equity
method?
Solution
Yes, the results must be adjusted for all material differences. IAS 28 requires all information contained in IFRS financial
statements to be prepared according to IFRS. Entity C’s management must therefore make appropriate adjustments to
entity J’s US GAAP results to make them compliant with IFRS requirements. There is no exemption in IFRS for
impracticability.
The same requirement would exist if entity J was a joint operation. Adjustments to conform accounting policies are also
required where both entities use IFRS.
Contributions to joint arrangements

It is common for participants to contribute assets (such as cash, non-monetary assets or a business) to a joint arrangement
on formation. Contributions of assets are a partial disposal by the contributing party. Accordingly, the contributor should
recognise a gain or loss on the partial disposal.
However, there is an inconsistency between IAS 28 and IFRS 10 relating to gain or loss recognition where the contribution to
the joint venture is considered to represent a business.
IAS 28 requires the participant to recognise the gain or loss on the contribution, up to the share of the other investors in the
arrangement.
In contrast, IFRS 10 states that any investment that a parent has in the former subsidiary, after control is lost, is measured at
fair value at the date that control is lost, and any resulting gain or loss is recognised in full in profit or loss.
effective date of the amendment indefinitely, pending finalisation of its research project on the equity method. [IAS 28 paras
31A and 45C].
FAQ 31.29.1 – Accounting for monetary and non-monetary assets exchanged on formation of an associate or joint venture or
subsequently
FAQ 31.29.2 – Methods by which an associate can arise from the disposal of a subsidiary
Investments with less than joint control
Public/private partnerships are one method whereby Some co-operative arrangements might appear to be joint
arrangements but fail on the basis that unanimous agreement between investors over relevant activities is not required. This
might arise where a super majority (for example, 80%) is required but the threshold can be achieved with a variety of
combinations of shareholders and no sub-set of investors are able to make all decisions together. Accounting for these
arrangements will depend on the way in which they are structured and the rights of each investor.
If an entity does not qualify as a joint arrangement, each investor will account for its investment, either using equity
accounting in accordance with IAS 28 (if it has significant influence) or at fair value as a financial asset in accordance with
IFRS 9.
An investor might also participate in a joint operation but not have joint control. The investor should account for its rights to
assets and obligations for liabilities. If it does not have rights to assets or obligations for liabilities, it should account for its
interest in accordance with the IFRS applicable to that interest.
Investors might also have an undivided interest in a tangible or intangible asset where there is no joint control and the
investors have a right to use a share of the operating capacity of that asset. An example is where a number of investors have
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invested in a shared road network, and an investor with a 20% interest has the right to use the network. Industry practice is
for an investor to recognise its undivided interest at cost less accumulated depreciation and any impairment charges.
operating and maintenance costs. These costs should be recognised as expenses in the income statement when incurred,
and they should be classified in the same way as equivalent costs for wholly owned assets.
Example – Identifying a joint venture
Is an entity automatically a joint arrangement if more than two parties hold equal shares in an entity?
Background
Entities A, B, C and D (investors) each hold 25% in entity J, which owns a power plant. Decisions in entity J need to be
approved by a 75% vote of the investors.
Entity A’s management wants to account for its interest in entity J using share of revenue and assets in its IFRS
consolidated financial statements, because entity J is a joint operation. Can entity A’s management account for entity J
in this way?
Solution
No, entity A cannot account for entity J using share of revenue and assets, because entity J is not jointly controlled. The
voting arrangements would require unanimous agreement between those sharing the joint control of entity J to qualify as
a joint arrangement. The voting arrangements of entity J allow agreement of any combination of three of the four partners
to make decisions (typically referred to as ‘collective control’).
Each investor must therefore account for its interest in entity J as an associate, since they each have significant influence
but they do not have joint control. Equity accounting must therefore be applied.
Changes in ownership in a joint arrangement

A participant in a joint arrangement can increase or decrease its interest in the arrangement. The appropriate accounting for
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Control
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IFRS 10 confirms that consolidation is required where control exists. The standard defines ‘control’ in the relevant activities,
exposure to variable returns, and the ability to use its power to affect its returns. Previously, control through voting rights was
addressed by IAS 27, while exposure to variable returns was an important consideration within the SIC 12 framework.
However, the relationship between these two approaches to control was not always clear. IFRS 10 links power and returns
by introducing an additional requirement that the investor is capable of using that power to influence its returns.
Key factors to be assessed by power and utilities entities, to determine control under the new standard, include:
the purpose and design of an investee;

whether rights are substantive or protective in nature;
existing and potential voting rights;
whether the investor is a principal or agent; and
relationships between investors and how they affect control.
Purpose and design of an investee
The purpose and design of an investee could impact the assessment of what the relevant activities are, how those activities
are decided, who can direct those activities, and who can receive returns from those activities. The consideration of purpose
and design might make it clear that the entity is controlled by voting rights or potential voting rights. Voting rights in some
cases might not significantly impact an investee’s return. The investee might be on ‘auto-pilot’ through contractual
arrangements. In those cases, the following should be considered in assessing the purpose and design of an entity:
a. downside risks and upside potential that the investee was designed to create;
b. downside risks and upside potential that the investee was designed to pass on to other parties in the transaction; and
c. whether the investor is exposed to those risks and upside potential.
Substantive or protective rights
Only substantive rights are considered in the assessment of power; protective rights (that is, rights designed only to protect
an investor’s interest without giving power over the entity and which can only be exercised under specified conditions) are
not relevant in the determination of control.
Potential voting rights
Potential voting rights are defined as ‘rights to obtain voting rights of an investee, such as those within an option or
convertible instrument’. Potential voting rights with substance should be considered when determining control. This is a
change from the previous standard, where only presently exercisable rights were considered in the determination of control.
Principal or agent
The ‘principal vs. agent’ determination is also important. Parties in power plant arrangements will often be appointed to
operate the project on behalf of the investors. A principal might delegate some of its decision authority to the agent, but the
agent would not be viewed as having control where it exercises such powers on behalf of the principal.
Relationships between investors and how they affect control
Economic dependence in an arrangement, such as a coal-fired power plant which relies on coal to be mined by a specific
supplier, is not uncommon, but is not a priority indicator. If the supplier has no influence over management or decision-
making processes, dependence would be insufficient to constitute power.
Example – Can an option provide power if it is out of the money?
Investors X and Y hold 30% and 70% respectively of a company (‘investee’) that is
controlled by voting rights. X has a currently exercisable, out-of-the-money call option
over the shares held by Y. Can the option provide X with power over the investee?
Solution
Yes, such an option can provide X with power if it is determined to be substantive. This will require judgement based on
all of the facts and circumstances: X must benefit from the exercise of the option in order for it to be substantive. The
option is out of the money, which might indicate that the potential voting rights are not substantive. However, X might
benefit from exercising the option, even though it is out of the money. X might achieve other benefits − such as synergies
or the elimination of a competitor – and might, overall, benefit from exercising the option. The option is likely to be
substantive in those circumstances.
De facto control
This is one of the significant changes introduced by IFRS 10 - the standard includes guidance on de facto control for the first
time. An investor with less than a majority of the voting rights might hold the largest block of voting rights, with the remaining
voting rights widely dispersed. The investor might have the power to unilaterally direct the investee unless a sufficient
number of the remaining dispersed investors act in concert to oppose the influential investor. However, such concerted
action might be hard to organise if it requires the collective action of a large number of unrelated investors.
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Structured entities
Voting rights might not have a significant effect on an investee’s returns. For example, voting rights might relate to
administrative tasks only, and contractual arrangements dictate how the investee should carry out its activities. These
entities are described as ‘structured entities’. Previously, SIC 12 used the term ‘special purpose entities’ (SPEs) to mean
those entities that are created to accomplish a narrow and well-defined objective, and it stipulated separate consolidation
criteria for these entities. This term is no longer used under IFRS 10. However, a narrow and well-defined objective might be
an identification characteristic for structured entities. This suggests that a subset of former SPEs might qualify to be
classified as ‘structured entities’. ‘Auto-pilot’ entities under SIC 12 are a key candidate for classification as ‘structured
entities’. All substantive powers in such entities might appear to have been surrendered to contracts that impose rigid control
over the entities’ activities. None of the parties might appear to have power. However, entities might be indirectly controlled
by one of the parties involved. Further analysis is required to determine if there is a party with control.
De facto agent
An agent need not be bound to the principal by a contract. IFRS 10 uses the term ‘de facto agents’ to describe agents who
might be acting on behalf of principals even where there is no contractual arrangement in place. Identification of such
relationships is expected to be highly judgemental.
Consideration should be given to the nature of relationships between the investor and various parties, and how they interact
with each other.
The standard identifies a number of possible de facto agent/principal relationships, including:
IAS 24 related parties of the principal;

parties that received interests in the investee as a contribution or loan from the
principal;
parties that agreed not to sell, transfer or encumber their interests in the investee
without the principal’s approval;
parties that cannot finance operations without subordinated financial support from
the principal;
parties that have largely similar governing body members or key management
personnel as the principal; and
parties that have close business relationships with the principal.
An investor with a de facto agent should consider the de facto agent’s decision-making rights, as well as its indirect
exposure to variable returns through the de facto agent, when assessing control of the investee.
Frequency of reassessment
Reassessment of control is required if facts and circumstances indicate changes to the elements of control. IFRS 10
highlights that control can change where:
decision-making mechanisms change (for example, change from a substantive

voting system to an ‘auto-pilot’ mechanism);
events occur, even if they do not involve the investor (for example, lapse of
decision-making rights by another party);
an investor’s exposure or rights to variable returns change; and
the relationship between an agent and a principal changes.
However, a change in market conditions on its own will not result in a reassessment of control, unless it changes one of the
three elements of control.
Revenue recognition
Entities in the power and utilities industry sometimes enter into complex contractual arrangements relating to the sale of
products or services. These transactions include partnerships with other entities, arrangements for which the consideration is
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based on future production, agency arrangements, transportation services, and long-term take-or-pay arrangements.
Power and utilities entities should first assess whether the arrangements represent or contain financial instruments (or
contain non-closely related embedded derivatives) and whether the arrangements convey the right to use a specific asset,
and therefore constitute a lease under the leasing standards.
IFRS 15 requires power and utilities entities to apply judgement in identifying the performance obligations, as well as the
reasons for any price changes over the term of the arrangement. Where contracts contain variable consideration, entities
need to take into account the risk of significant reversal when measuring revenue. Entities also have to consider whether the
arrangements include a significant financing component that will have to be accounted for separately.
1. Overview
Entities in the power and utilities industry sometimes enter into complex contractual arrangements relating to the sale of
products or services. These transactions include partnerships with other entities, arrangements for which the consideration is
based on future production, agency arrangements, transportation services, and long-term take-or-pay arrangements.
Power and utilities entities should first assess whether the arrangements represent or contain financial instruments (or
contain non-closely related embedded derivatives) and whether the arrangements convey the right to use a specific asset,
and therefore constitute a lease under the leasing standards.
IFRS 15 requires power and utilities entities to apply judgement in identifying the performance obligations, as well as the
reasons for any price changes over the term of the arrangement. Where contracts contain variable consideration, entities
need to take into account the risk of significant reversal when measuring revenue. Entities also have to consider whether the
arrangements include a significant financing component that will have to be accounted for separately.
IFRS 15 requires increased disclosures.
2. Scope
IFRS 15 applies to contracts with customers. Power and utilities entities will need to use judgement as they evaluate whether
or not the parties to the transaction have a vendor-customer relationship, and therefore fall within the scope of IFRS 15.
2.1 Identifying a contract with a customer
A contract can be implied by customary business practice. This is relevant to tariff-based sales to regulated customers.
Specifically, there is an implied contract between a customer and a utility for the purchase, delivery and sale of electricity,
gas or water, despite the role that the regulator plays in establishing the rates and terms of service. Tariff-based sales to
regulated customers are within the scope of IFRS 15.
The following list summarises certain common contractual arrangements in the power and utilities industry and identifies
whether they are expected to be within the scope of IFRS 15:
Power sales agreements (this includes arrangements where the ‘own use’
exemption applies). An independent power producer that sells electricity into the
merchant market would likely apply IFRS 15. A generator that enters into a power
sales agreement would likely apply IFRS 15 to those elements in the contract that
are not accounted for under other accounting guidance.
Revenue based on a regulated tariff. There is an implied contract between a
customer and a utility for the purchase, delivery and sale of electricity, gas or
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water, despite the role that the regulator plays in establishing the rates and terms of
service.
Home services, including installation and maintenance of energy efficiency
equipment. Contracts for home services, such as water heater or energy efficiency
installations or electronic home repairs and protection, are generally within the
scope of IFRS 15. These are commonly contracted services with specifically
defined obligations that are enforceable.
2.2 Identifying performance obligations in a

contract
It is common for customer contracts within the power and utilities industry to contain multiple performance obligations. It is
essential that power and utilities entities evaluate their portfolio of customer contracts in order to identify explicit and implicit
promises to transfer a distinct good or service to a customer.
A promise to transfer a series of distinct goods that are substantially the same and that have the same pattern of transfer to
the customer is a performance obligation known as a ‘series’. Contracts for the sale of electricity, and many contracts for the
sale of gas to residential and small commercial and industry clients, would represent such a promise.
Sometimes, two products (such as gas and electricity) are sold together. Where multiple products are sold simultaneously,
generally:
1. Gas and electricity are distinct, because (a) a customer can benefit from either gas or electricity on its own (that is, the customer
can sell gas and electricity, on a stand-alone basis, into the marketplace, etc.), and (b) the promise to transfer gas or electricity is
separately identifiable from other promises in the contract.
2. The performance obligation to deliver gas and electricity, in many cases, is satisfied over time, since the customer simultaneously
receives and consumes the benefits provided by the entity’s performance as the entity performs. This conclusion might not be
applicable for gas or other commodity contracts, where the customer has storage facilities and does not consume the benefits of
the commodity immediately as it is delivered.
3. Each delivery of gas or electricity in the series, that the entity promises to transfer to the customer, meets the criteria to be a
performance obligation satisfied over time, and the same method will be used to measure the entity’s progress towards complete
satisfaction of the performance obligation to transfer each distinct delivery of gas or electricity in the series to the customer.
Judgement is required to identify performance obligations in power and utilities contracts. In some jurisdictions, distribution
and energy might be distinct performance obligations; while, in others, energy and distribution might be a single integrated
performance obligation. This will depend on a number of factors, including whether the customer can choose amongst
retailers and the relationships between the providers of distribution, the retailer and the end customer. Reporting entities
commonly execute arrangements for the purchase and sale of multiple products, including electricity, capacity and ancillary
services. In evaluating these contracts, reporting entities should consider whether or not each promise to transfer a good or
service to the customer is distinct.
Example – Identify the performance obligations (power purchase agreement

(‘PPA’))
Background
Solar Sun Power Co (‘Solar’) sells electricity and renewable energy credits (‘RECs’) to Power Buyer Co (‘Buyer’) pursuant to a
three-year PPA. The PPA does not contain a lease. The electricity element qualifies for the ‘own use’ scope exception and is
not accounted for as a derivative. The RECs element of this PPA is also not accounted for as a derivative (for example, the
net settlement characteristic is not met). As such, each element of this agreement is within the scope of IFRS 15.
Control, including title and risk of loss related to the electricity, transfers to Buyer on delivery of the electricity at a single
point within the electricity grid. Control, including title and risk of loss related to the RECs, transfers to Buyer when the
associated electricity is delivered. Solar and Buyer frequently execute contracts for the purchase and sale of electricity and
RECs on a stand-alone basis.
How many performance obligations are included in the PPA between Solar and Buyer?
Discussion
The electricity represents a promise to transfer to the customer a series of distinct goods that are substantially the same and
that have the same pattern of transfer to the customer. The basis for the conclusion that the electricity represents one
performance obligation that is satisfied over time is as follows:
1. Buyer can benefit from the electricity on its own (that is, Buyer can sell electricity, on a stand-alone basis, into the marketplace, so
the electricity is capable of being distinct).
2. The promise to transfer electricity is separately identifiable within the PPA (that is, the electricity is distinct within the context of
the contract).
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3. Electricity is not generally considered to be storable by the customer, and the performance obligation to deliver electricity is
satisfied over time, since Buyer simultaneously receives and consumes the benefits of the electricity provided by Solar’s
performance as Solar performs.
4. Each distinct transfer of electricity in the series that Solar promises to transfer to Buyer meets the criteria to be a performance
obligation satisfied over time, and the same method will be used to measure Solar’s progress towards complete satisfaction of
the performance obligation to transfer electricity in the series to Buyer.
The monthly promise to transfer RECs to the customer during the term of the three-year PPA (36 deliveries) represents
goods that are distinct, based on the following:
1. Buyer can benefit from the RECs on their own (that is, Buyer can sell RECs, on a stand-alone basis, into the marketplace, so the
RECs are capable of being distinct).
2. The promise to transfer RECs is separately identifiable within the PPA (that is, the RECs are distinct within the context of the
contract).
Each monthly promise to deliver RECs (36 deliveries) is a separate performance obligation. Based on facts and
circumstances, Solar assumed that this performance obligation is satisfied at a point in time, because none of the criteria are
met to account for such promises as performance obligations satisfied over time. The point at which the performance
obligation for the RECs is satisfied can be subject to significant judgement is some cases.
Note: In some circumstances, the entity will register the REC with the local authority and transfer that registration to
the customer. An entity needs to make a judgement about whether that process is substantive and, therefore, has an
impact on the assessment of when control transfers.
Example – Identify the performance obligations (gas supply agreement)

Background
Gas Supply Co (‘Supplier’) sells gas to Power Buyer Co (‘Buyer’) pursuant to a three-year agreement with a daily stated
delivery quantity. The arrangement does not contain a lease. The gas element of this agreement qualifies for the ‘own use’
scope exception and is not accounted for as a derivative. The gas element of this agreement is within the scope of IFRS 15.
Control, including title and risk of loss related to gas, transfers to Buyer on delivery of gas at the outlet of the gas pipeline.
Buyer has access to gas storage facilities.
How many performance obligations are in the contract?
Discussion
The daily promise to transfer gas to the customer during the term of the three-year agreement (1,095 daily deliveries)
represents goods that are distinct, based on the following:
1. Buyer can benefit from gas on its own (that is, Buyer can sell gas, on a stand-alone basis, into the marketplace, so gas is capable
of being distinct).
2. The promise to transfer gas is separately identifiable within the agreement.
3. Gas is considered to be storable by Buyer, and the performance obligation to deliver gas is satisfied at a point of time, because
Buyer receives the benefits of gas provided by Supplier’s performance as Supplier performs.
Arrangements to sell other commodities, including natural gas and physical capacity, over a contractual term might
represent a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to
the customer. Arrangements that meet these criteria are required to be accounted for as a single performance obligation,
even though the contract contains distinct goods or services.
Example – Identify the performance obligations (gas supply agreement to a retail

customer)
Background
Gas Supply Co (‘Supplier’) sells gas to retail customers. Supplier offers a free grill if a new customer concludes an agreement
for three years at fixed price. The arrangement does not contain a lease. The gas element of this agreement qualifies for the
‘own use’ scope exception and thus is not accounted for as a derivative instrument. The gas element of this agreement is
within the scope of IFRS 15.
Control, including title and risk of loss related to the gas, transfers to a customer on delivery of the gas at a single point at a
customer’s household.
Discussion
The gas represents a promise to transfer to the customer a series of distinct goods that are substantially the same and that
have the same pattern of transfer to the customer. The basis for the conclusion that gas represents one performance
obligation that is satisfied over time is as follows:
1. The customer can benefit from the gas, together with other resources readily available to the customer (that is, gas oven or gas
heater).
2. The promise to transfer gas is separately identifiable within the agreement (that is, the gas is distinct within the context of the
contract).
3. Gas is not generally considered to be storable by retail customers, and the performance obligation to deliver gas is satisfied over
time, because the customer simultaneously receives and consumes the benefits of gas provided by Supplier’s performance as
Supplier performs.
4. Each distinct transfer of gas in the series that Supplier promises to transfer to the customer meets the criteria to be a
performance obligation satisfied over time, and the same method will be used to measure Supplier’s progress towards complete
satisfaction of the performance obligation to transfer gas in the series to a customer.
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The promise to transfer a grill to a new customer, on concluding a three-year contract, represents goods that are distinct,
based on the following:
1. The customer can benefit from the grill on its own (that is, the customer can use the grill or sell it, so the grill is capable of being
distinct).
2. The promise to transfer the grill is separately identifiable within the agreement (that is, the grill is distinct within the context of the
agreement).
The promise to deliver a grill is a separate performance obligation.
Example – Identify the performance obligations (design and build a power plant)
Background
Plant Builder Co (‘Builder’) enters into a contract to design and build a power plant for its customer, Facility Owner Co
(‘Owner’). Builder is responsible for the overall management of the project, and it identifies various goods and services that
are provided, including architectural design, site preparation, electrical services, and turbine construction. Builder regularly
sells these goods and services individually to customers.
Discussion
The bundle of goods and services is combined into a single performance obligation. The promised goods and services are
individually capable of being distinct, because Owner could benefit from the goods or services either on their own or
together with other readily available resources. The goods and services are capable of being distinct, because Builder
regularly sells the goods or services separately to other market participants, and Owner could generate economic benefit
from the individual goods and services by using, consuming or selling them.
The goods and services are not distinct within the context of the contract, because they are not separately identifiable from
other promises in the contract. Builder provides a significant service of integrating the various goods and services into the
power plant that Owner has contracted to purchase; therefore, the promised goods and services are not distinct.
2.3 Interaction with other standards
Contracts that are within the scope of other guidance under IFRS, such as financial instruments, are outside the scope of
IFRS 15.
Elements of contracts within the scope of IAS 17 or IFRS 16, ‘Leases’, are also outside the scope of the revenue standard.
However, a contract might contain both lease elements within the scope of IAS 17 or IFRS 16 and other non-lease elements
that are within the scope of IFRS 15.
An entity applies the separation and/or measurement guidance in other standards first, if they specify how to separate. An
entity applies the separation and measurement guidance in IFRS 15 if other standards do not specify how to separate or
measure the remaining portion of the contract.
IFRS 15 provides application guidance for evaluating contracts with repurchase arrangements that will assist power and
utilities entities in determining whether the arrangement is a sale to a customer, a financing arrangement or a lease.
2.4 Product exchanges
Certain non-monetary exchanges, specifically ‘non-monetary exchanges between entities in the same line of business
to facilitate sales to customers other than the parties to the exchange (for example an exchange of oil to fulfil
demand on a timely basis in a specified location)’, are outside the scope of IFRS 15. Such non-monetary exchanges are
accounted for based on other guidance (para 24 of IAS 16 is relevant for non-monetary exchanges of property, plant or
equipment).
2.5 Take-or-pay and similar long-term supply

agreements
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Long-term sales contracts are common in the power and utilities industry. Producers and buyers might enter into sales
contracts that are often a year or longer in duration to secure supply and reasonable pricing arrangements. Such contracts
are often fundamental to supporting the business case or to finance, develop or continue activity at a particular location.
Contracts will typically stipulate the sale of a set volume of product over the period at an agreed price. There are often
clauses within the contract relating to price adjustment or escalation over the course of the contract to protect the producer
and/or the seller from significant changes to the underlying assumptions in place at the time when the contract was signed.
Long-term commodity contracts frequently offer the counterparty flexibility and options in relation to the quantity of the
commodity to be delivered under the contract.
Power and utilities entities should continue to first assess whether these arrangements convey the right to use a specific
asset, and therefore constitute a lease under the leasing standards.
Only the minimum amount specified would generally be considered a contract, because this is the only enforceable part of
the agreement. Options in the contract to acquire additional volumes will likely be considered a separate contract at the time
when the customer exercises the option, unless such options provide the customer with a material right. Where there is a
material right, the option should be accounted for as a separate performance obligation in the original contract. A practical
expedient is available to simplify the accounting for certain material rights in paragraph B43 of IFRS 15.
2.6 Failed ‘own use’ on trading contracts
Power and utilities entities might enter into contracts to supply the commodities. Contracts to buy or sell non-financial assets
(such as commodities) that can be settled net are within the scope of IFRS 9, unless the ‘own use’ exemption is met.
Contracts that fail the ‘own use’ exemption and are within the scope of IFRS 9 meet the definition of derivative financial
instruments, and they should be accounted for at fair value through profit or loss.
Commodity contracts could fail the ‘own use’ exemption even though they eventually result in a physical delivery of goods
(for example, if the entity has a practice of settling similar contracts net in cash). IFRS 9 also permits an election not to apply
the ‘own use’ exception to certain contracts in certain circumstances, which is discussed further in the Financial Instrument
chapter of this guide.
Where the contract is accounted for as a derivative, it would be recorded at fair value through profit or loss, with fair value
changes recognised in other income/expense until delivery of the commodity. The entity should then generally recognise
revenue for the sale of the commodity under IFRS 15, on control transferring to the customer, where such sales are an
output of the entity’s ordinary activities in exchange for consideration.
An alternative approach is that the contract continues to be accounted for as a derivative financial instrument within the
scope of IFRS 9 (or IAS 39) and not within the scope of IFRS 15 (see para 5(c) of IFRS 15), and therefore it does not give rise
to ‘revenue from contracts with customers’ or related cost of sales.
Example – Failed ‘own use’ in trading contract (IFRS 15 revenue approach)
Background
On 1 August 20X6, entity A enters into a contract with a customer to sell 100 Mt of fuel oil with physical delivery of $300 per
Mt. Although entity A intends to settle the contract physically, the contract is assumed to fail the ‘own use’ exemption and
thus to fall within the scope of IFRS 9.
Entity A’s reporting period ends on 30 September 20X6. The sales contract is settled on 1 November 20X6. Entity A delivers
fuel oil in return for cash of $30,000. Entity A measures inventory at fair value.
Forward price Fair value

changes
1 August 20X6 300 -
30 September 20X6 310 (1,000)
1 November 20X6 325 (2,500)
How should entity A measure its revenue?
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Discussion
Until delivery of the commodity, the contract is accounted for under IFRS 9 as a derivative, with fair value changes
recognised in other income/expense. At delivery, entity A recognised the consideration received for the sale of the
commodity (including the settlement of the fair value of the derivative contract) as revenue under IFRS 15.
The following journal entries illustrate this approach:
On 30 September 20X6
Dr Other expense 1,000
Cr Derivative 1,000
On 31 October 20X6
Dr Other expense 1,500
Cr Derivative 1,500
On 1 November 20X6
Dr Cash 30,000
Dr Derivative 2,500
Cr Revenue 32,500
2.7 Sale of non-financial assets
Power and utilities entities that sell non-financial assets (for example, real estate) will have to evaluate all facts and
circumstances in determining whether or not such sales are within the scope of IFRS 15. IFRS 15 applies to transfers of non-
financial assets, which do not constitute a business, to a customer in the ordinary course of business. Transfers that are not
an output of an entity’s ordinary activities are outside the scope of IFRS 15. Power and utilities entities should consider this
guidance when evaluating sales of gas pipelines, power plants, and wind farms. The appropriate recognition model to apply
to these sales of real estate depends on several factors, as illustrated in the table below.
Scenario Revenue/Gain recognition model
Scenario 1: Sales of non-financial Apply IFRS 15 to the entire transaction.

assets as part of the entity’s ordinary
activities to customers Sales of non-
financial assets to customers in the
ordinary course of business (for example,
an entity routinely constructing
generation facilities for sale sells a
constructed facility, etc.)
Scenario 2: Sales of non-financial Apply IAS 16, IAS 38 or IAS 40, which requires entities to
assets outside the ordinary course of apply certain aspects of IFRS 15 to determine:
business Sales of non-financial assets
such as property, plant and equipment
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(for example, the sale of a generator if an enforceable contract exists,
where the entity is in the business of
selling electricity but not generating if control of the asset has
assets).
transferred to the buyer, and
the amount of gain or loss to
recognise when the asset is
derecognised, considering any
constraint on income due to
variable consideration.
The gain or loss on sale will likely be
shown in other income/expense. These
sales might also be subject to the
guidance for assets held for
sale/discontinued operations in IFRS 5.
Scenario 3: Sales of subsidiary Apply the derecognition model within the

businesses to non-customers Sales of consolidation guidance (IFRS 10) to sales
businesses, including real estate, to non- of subsidiary businesses, including real
customers estate, to non-customers. The guidance
in IFRS 5 regarding assets held for
sale/discontinued operations might also
apply.
3. Practical application
3.1 Combination of contracts
Power and utilities entities might need to evaluate whether they should account for two or more contracts with the same
customer as a single contract. Combining contracts, where appropriate, helps to ensure that the unit of accounting is
properly identified and the model is properly applied. Separate agreements to sell electricity and capacity to an individual
counterparty that were executed on the same day might have a single commercial objective if, for example, either of the
individual contracts would be loss-making without taking into account the consideration received under the other contract.
3.2 Contract modifications
One of the most judgemental aspects of implementing IFRS 15 for power and utilities entities is applying the contract
modifications guidance to arrangements, such as ‘blend and extend’ arrangements. Blend and extend arrangements are
common in the power and utilities industry. In a blend and extend arrangement, the buyer and seller negotiate amended
pricing of an existing contractual arrangement, including extending the term of the existing arrangement. It is common for the
buyer to benefit from a lower blended price (original price blended with the extension period price which is at a lower rate per
unit) and for the seller to benefit from an extended term (original term plus the extension period term). Management will need
to evaluate these types of modifications in order to determine how and when they will be accounted for under the contract
modification provisions in IFRS 15.
Blend and extend modifications will typically fall into one of the following scenarios:
1. The modification creates a separate contract from the existing arrangement. This would be the case if the modification results in
an increase in the amount of distinct goods (such as units of electricity to be delivered), and the additional consideration reflects
the reporting entity’s stand-alone selling price of the additional promised goods.
2. The modification represents a termination of the existing agreement and the creation of a new agreement, to be accounted for
prospectively. This would be the case if the modification results in an increase in the amount of distinct goods (such as units of
electricity to be delivered), but the additional consideration does not reflect the reporting entity’s stand-alone selling price of the
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additional promised goods (for example, the price per unit of the new distinct goods is different from the market due to the
blended price).
Energy-related blend and extend arrangements would generally not require a cumulative catch-up adjustment to revenue,
because the electricity to be delivered in the extension period will usually represent additional distinct goods. However, a
cumulative catch-up adjustment might be required for some contract modifications (for example, a modification to a
construction services arrangement that represents a single performance obligation).
Example – Contract modification (prospective basis)
Background
Power Sale Co (‘Seller’) and Electric Buy Co (‘Buyer’) are parties to an existing arrangement for the purchase and sale of
electricity. The contract term began on 1 January 20X0 and ends on 31 December 20X7, and the contract price and annual
contract quantities were $50/MWh and 87,600 MWh (10 MW per hour * 24 [hours per day] * 365 [days per year]),
respectively.
Seller concluded that its obligation to sell electricity represents a single performance obligation that is satisfied over time
(that is, the sale of electricity over the term of the agreement represents a series of distinct goods that are substantially the
same and that have the same pattern of transfer to the customer). See the section titled ‘Identifying performance obligations’
for more information on identifying performance obligations, and the section titled ‘Recognise revenue when (or as) the entity
satisfies a performance obligation’ for more information regarding the concepts of satisfying performance obligations and
measuring progress towards complete satisfaction of a performance obligation.
On 1 January 20X2, two years into the agreement, Seller and Buyer negotiate a modification (that is, a blend and extend
arrangement) to the existing arrangement, which extended the contract term by two additional years. The contract price and
annual contract quantities for the purchase and sale of electricity during the additional two years is $40/MWh and 87,600
MWh, respectively.
How should Seller account for the transaction?
Discussion
The blend and extend arrangement would be accounted for as a separate agreement if Seller concludes, at the date of the
contract modification, that:
1. the additional electricity to be delivered represents distinct goods; and

2. the additional consideration of $7,008,000 (($40 * 87,600 MWh) [year 9] + ($40 * 87,600 MWh) [year 10]) reflects the stand-alone
selling price of the additional promised goods.
Accounting for this contract modification as a separate arrangement reflects the fact that there is no economic difference
between the entities entering into a separate contract and agreeing to the modification to the existing arrangement. Seller
would continue to recognise revenue at $50/MWh until 31 December 20X7 and then recognise revenue at $40/MWh in 20X8
and 20X9.
The blend and extend arrangement would be accounted for as a termination of the existing contract and the creation of a
new contract on a prospective basis if Seller concludes, at the date of the contract modification, that the additional electricity
to be delivered represents distinct goods, but that the additional consideration of $7,008,000 (($40 * 87,600 MWh) [year 9] +
($40 * 87,600 MWh) [year 10]) does not reflect the stand-alone selling price of the additional promised goods. In this case,
the amount of total consideration to be recognised in the final six years of the existing arrangement (1 January 20X2 – 31
December 20X7) and the additional two years (1 January 20X8 – 31 December 20X9) is $33,288,000 (($50 * 87,600 * 6) + ($40
* 87,600 * 2)), or $4,161,000 per year. Accounting for this contract modification on a prospective basis reflects the effective
termination of the existing arrangement and the execution of a new arrangement.
Example – Contract modification: construction services arrangement: cumulative

catch-up adjustment
Background
Gas Pipeline Co (‘Seller’) contracts with Energy Co (‘Buyer’) to construct a natural gas pipeline to transport natural gas from
delivery point A to delivery point B. The contract requires Seller to construct the natural gas pipeline over a 24-month period
at a fixed price of $150,000,000, with construction beginning on 1 January 20X0 and ending on 31 December 20X1. Total
expected costs to construct the pipeline are $110,000,000. The construction of the natural gas pipeline is a single
performance obligation. At the end of the first year, Seller has incurred total costs of $50,000,000, and Seller and Buyer
agree to modify the grade of the steel used to construct the remainder of the natural gas pipeline, which will increase the
transaction price and expected cost by $10,000,000 and $7,500,000, respectively.
How should Seller account for the modification?
Discussion
Seller should account for the modification as if it were part of the existing contract. The modification does not create a
performance obligation, because the remaining goods and services to be provided under the modified contract are not
distinct. Seller should update its estimate of the transaction price and its measure of progress, to account for the effect of
the modification. This will result in a cumulative catch-up adjustment at the date of the contract modification.
Assuming that Seller has (1) accounted for its obligation to construct the gas pipeline to connect delivery point A to delivery
point B as a single performance obligation that is satisfied over time, and (2) measured its progress towards complete
satisfaction of its performance obligation via a cost-based input method, Seller would recognise cumulative revenue of
$68,085,106 ($160,000,000 [$150,000,000 + $10,000,000] * ($50,000,000/$117,500,000 [$110,000,000 + $7,500,000])) for the
year ended 31 December 20X0. See the section titled ‘Recognise revenue when (or as) the entity satisfies a performance
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obligation’ for more information regarding the concepts of satisfying performance obligations and measuring progress
towards complete satisfaction of a performance obligation.
3.3 Agency relationships
IFRS 15 provides indicators to help entities determine if they obtain control of the goods or services before transferring
control of those goods or services to the customer. The complexity of judgements in determining whether the entity is acting
as principal or agent appears to be increasing within the industry, particularly in relation to entities that provide value-added
services to power and utilities entities, such as transportation and distribution.
3.4 Principal versus agent considerations
To determine whether an entity is acting as principal or agent, the following should be considered:
an entity must first identify the specified good or service being provided to the
customer, based on the performance obligations identified in the contract;
an entity should assess whether it controls these goods or services before they are
transferred to a customer.
An entity is the principal in an arrangement if it obtains control of the goods or services of another party in advance of
transferring control of those goods or services to the customer.
Obtaining title momentarily before transferring a good or service to a customer does not necessarily constitute control (which
might be relevant in certain ‘flash title’ arrangements).
An entity is an agent if its performance obligation is to arrange for another party to provide the goods or services.
Indicators that the entity is an agent include:
The other party is primarily responsible for delivering goods or services;

The entity does not have inventory risk;
The entity does not have latitude in establishing prices.
An agent recognises revenue for the fee earned for facilitating the transfer of goods or services. Its consideration is the ‘net’
amount retained after paying the principal for the goods or services that the principal provided to the customer.
3.5 Determining the transaction price
The determination of the transaction price in many power and utilities contracts will be fairly straightforward, particularly
where the contract pricing and contract quantities are fixed; however, in practice, reporting entities often enter into contracts
that contain index-based pricing, variable volume, or both.
For example, Seller might enter into a requirements contract to sell electricity to Buyer at predetermined prices, but volumes
are not known at contract inception. Uncertainty exists with respect to the total consideration to be received by Seller over
the term of the contract. Seller might be able to elect a practical expedient to recognise revenue based on the amount
invoiced, if it directly corresponds with the value to the customer of Seller’s performance completed to date.
Contracts that contain forms of variable consideration, significant financing components, non-cash consideration and/or
consideration payable to a customer are likely to be more complex and will require judgement.
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3.6 Variable consideration
Variable consideration should be estimated using the expected value method or the most likely amount method. This is not a
‘free choice’. An entity needs to consider which method it expects to better predict the amount of consideration to which it
will be entitled and apply that method consistently for similar types of contract.
A performance bonus is a form of variable consideration commonly included in service contracts in the power and utilities
industry (for example, plant operations and maintenance service arrangements). When determining the transaction price, a
reporting entity should estimate the amount of consideration to which it will be entitled in exchange for transferring the
promised services to a customer.
Example – Variable consideration: performance bonus
Background
Electric Company (‘ElecCo’) and Rosemary Gas and Electric Company (‘GasCo’) are party to an operations and maintenance
service agreement whereby ElecCo is responsible for all operations and maintenance at GasCo’s generation facility. The
contract term is for one year, beginning on 1 January 20X1 and ending on 31 December 20X1. Under the terms of the
agreement, ElecCo receives a fixed fee of $10,000,000 for its services, and it is entitled to a progressive performance bonus
of $250,000 if annual operations and maintenance costs, on a per MW basis (‘costs per MW’), are at least 10% lower than
the prior year, $500,000 if costs per MW are 12% lower than the prior year, and $1,000,000 if costs per MW are 15% lower
than the prior year.
ElecCo’s service agreement with GasCo is similar to its other service agreements, and management believes that its
experience enables it to accurately predict the amount to which it will be entitled for its services, including amounts
associated with the contractual performance bonuses. ElecCo concludes that the expected value method is most predictive
in this case.
How should ElecCo determine the transaction price?
Discussion
The transaction price should include ElecCo’s estimate of the amount of consideration to which it will be entitled for the work
performed. Since ElecCo has determined that the expected value approach is more predictive, the transaction price would
be calculated as follows:
Probability-weighted consideration
$11,000,000 (fixed fee plus $1,000,000 performance $2,200,000

bonus) *
20% probability
$10,500,000 (fixed fee plus $500,000 performance $4,200,000

bonus) *
40% probability
$10,250,000 (fixed fee plus $250,000 performance $4,100,000

bonus) *
40% probability
Total probability-weighted consideration $10,500,000
ElecCo assigned probabilities to the scenarios above based on its significant experience with similar contracts. The total
transaction price of $10,500,000 is reflective of the probability-weighted estimate. ElecCo will need to update its estimate at
each reporting date. Based on ElecCo’s experience with similar contracts, management concluded that it was highly
probable that a significant reversal in the amount of cumulative revenue recognised would not occur if a $500,000 estimate
of variable consideration were included in the transaction price; therefore, the variable consideration was not constrained.
However, if ElecCo concluded that it was not highly probable that a significant reversal of cumulative revenue recognised
would not occur, ElecCo might have concluded that none (or only a portion) of the variable consideration associated with the
progressive performance bonus should be included in the transaction price.
Example – Price protection if competitor subsequently lowers price

Background
A retailer sells a product to customer A for C100 on 1 January, and it agrees to reimburse customer A for the difference
between the purchase price and any lower price offered by a certain direct competitor during the three-month period
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following the sale. The retailer has recent experience with similar promotions of similar products. On a probability-weighted
basis, the retailer estimates that it will reimburse the customer C5. How does the retailer account for the potential refund?
Discussion
The consideration expected to be repaid to the customer is excluded from revenue and recorded as a liability at the time of
sale. Management concludes, based on its recent experience that it is highly probable that recognising C95 would not result
in significant reversal of cumulative revenue on resolution of the uncertainty. Therefore, the retailer recognises revenue of
C95 and a refund liability of C5.
3.7 Provisional pricing arrangements
Certain commodity contracts are ‘provisionally priced’ on delivery. The transaction price might be variable, or contingent on
the outcome of future events, which could include provisional pricing arrangements. Management should understand the
sources of variability, which will help to establish an appropriate accounting method.
Example – Variability arises from market price only
On 1 January 20X1, entity A enters into a contract to supply power (electricity) to a customer for delivery on 31 January
20X1. Electricity is supplied, and control transfers, at 31 January 20X1. The consideration is payable at 30 April 20X1, based
on the spot electricity price at that date. There is no other variability associated with the consideration.
Question
Does IFRS 15 or IFRS 9 apply where all variability in the receivable arises from a market price?
Discussion
The IASB discussed this topic at its December 2015 meeting and observed that the variable consideration constraint in IFRS
15 would not apply to variability arising solely from changes in market price. At 31 January 20X1 the entity will recognise a
receivable and measure it in accordance with IFRS 9.
The receivable would fail the solely payments of principal and interest (‘SPPI’) test, due to the variability associated with the
commodity price. The receivable would be classified as fair value through profit or loss.
Example – Variability arises from physical attributes only

On 1 January 20X1, entity B enters into a contract to sell wet gas (that is, natural gas containing natural gas liquids (‘NGLs’))
to a customer for delivery on 31 January 20X1. The pricing will be based on the dry gas and NGL content of the gas. The
quantity of dry gas and NGLs will not be known until further measurement and assessment by the purchaser at the delivery
point. Gas is supplied, and control transfers, at 31 January 20X1.
The consideration is payable at 30 April 20X1. Prices for the dry gas and NGLs are fixed in the contract. The consideration is
derived from these fixed prices, based on the final amount of NGLs determined after the further processing and assessment.
No adjustments are made for changes in market prices.
Question
Does IFRS 15 or IFRS 9 apply where all variability in the receivable arises from physical attributes?
Discussion
The IASB discussed this topic at its December 2015 meeting and suggested that IFRS 15 applies, and the contract is subject
to the variable consideration guidance in paragraphs 56 to 58 of IFRS 15. This is because the entity’s right to consideration is
contingent on the physical attributes of the product delivered, as confirmed by the customer.
There is no embedded derivative to be separated at delivery under paragraph 4.3.1 of IFRS 9. This is because the underlying
is a non-financial variable specific to a party to the contract (being the physical attributes of the commodity delivered).
Example – Variability arises from both market price and physical attributes
Entity C enters into a contract to sell wet gas (that is, natural gas containing NGLs) to a customer on 1 January 20X1. Wet
gas is delivered, and control transfers, at 31 January 20X1. The quantity of dry gas and NGLs will not be known until further
processing and assessment by the purchaser at the delivery point. The consideration is payable at 30 April 20X1, based on
the spot gas price per unit at that date. The price is also subject to adjustment for the final quantity of gas determined after
the further processing and assessment.
Question
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Does IFRS 15 or IFRS 9 apply where variability in the receivable arises from both market price and physical attributes, and
the two kinds of variability are not readily separable?
Discussion
The variability would be considered on a combined basis in accordance with paragraph 4.3.2 of IFRS 9. The IASB discussion
at their December 2015 meeting suggests that the entity should apply IFRS 9 to the variability.
Variable consideration within the scope of IFRS 15 is subject to a constraint. The objective of the constraint is that an entity
should recognise revenue as performance obligations are satisfied, to the extent that it is ‘highly probable’ that a significant
revenue reversal will not occur in future periods. Such a reversal would occur if there is a significant downward adjustment of
the cumulative amount of revenue recognised for that performance obligation. This might be particularly relevant where the
final quality of product being delivered will not be known until assessment at its destination. This is more likely to be variable
consideration if the price is conditional solely on the quality of the product.
Judgement will be required to determine if there is an amount that is variable consideration and, if so, whether it is subject to
a significant reversal. IFRS 15 has a list of factors that could increase the likelihood or magnitude of a revenue reversal.
Judgement is required to identify the point at which the variable consideration becomes unconditional and is then
considered a financial asset within the scope of IFRS 9/IAS 39.
Management’s estimate of the transaction price will be reassessed in each reporting period.
Power and utilities entities would be required to continue to separate provisional pricing features that represent embedded
derivatives, and to recognise and measure them in accordance with financial instrument guidance.
3.8 Retrospective price adjustment
A volume incentive is a form of variable consideration commonly included in supply contracts in the power and utilities
industry (for example, power supply arrangements). In these arrangements, the price per unit will be adjusted retroactively
once the customer reaches a certain sales volume.
When determining the transaction price, reporting entities should estimate the amount of consideration to which it will be
entitled in exchange for transferring the promised services to a customer. Reporting entities should consider their experience
(or other evidence) with similar types of contract and whether this experience has predictive value.
Retroactive adjustments to the transaction price, allocated to satisfied performance obligations, are recognised as revenue
immediately on a cumulative catch-up basis. [IFRS 15 para 88]. A change in the amount allocated to a performance
obligation that is satisfied over time is also adjusted on a cumulative catch-up basis. This will result in less revenue or more
revenue in the period of change for the satisfied portion of the performance obligation.
Example – Volume discount incentive
Background
Power Sale Co (‘Seller’) and Electric Buy Co (‘Buyer’) are parties to an existing arrangement for the purchase and sale of
electricity. The contract price is $50/MWh. The price will be retrospectively reduced to $48/MWh if Buyer consumes more
than 90,000 MWh in a calendar year.
Seller estimates that the total sales volume for the year will be 82,000 MWh, based on its prior experience with, and forecast
sales to, Buyer. Seller considers that it is highly probable that there would be no significant reversals based on this assessed
volume.
In the first quarter ended 31 March, Buyer consumes 19,000 MWh, which fell within the range of Seller’s expectations. Buyer
recognised revenue of $950,000.
In May, Buyer starts an unanticipated new project that increases Buyer’s needs for power. In the second quarter ended 30
June, Buyer consumes 25,000 MWh.
In light of the new project, Seller revises its sales forecast and now estimates that Buyer will exceed the 90,000 MWh
threshold. As a result, Buyer will need to retroactively adjust the selling price to $48/MWh.
How does Seller account for this change in estimate?
Discussion
Seller should update its calculation of the transaction price to reflect the change in estimate. The updated transaction price is
$48/MWh, based on the new estimate of total sales volume. Consequently, Seller recognises revenue of $1,162,000 for the
quarter ended 30 June, calculated as follows:
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$48 * 25,000 MWh $1,200,000

consumed in 2Q
Less: $2 * 19,000 MWh (38,000)

consumed in 1Q
1,162,000
The cumulative catch-up adjustment reflects the amount of revenue that Seller would have recognised if, at contract
inception, it had had the information that is now available. Seller will continue to update its estimate of the total sales volume
at each reporting date until the uncertainty is resolved.
3.9 Significant financing elements
Power and utilities contracts will occasionally contain a significant financing component, the identification of which might be
complex. If a long-term contract contains an implicit financing element, the transaction price should be adjusted for the
effects of time value of money.
An indicator of a significant financing component is a situation where revenue is expected to be deferred for a long period of
time (for example, where consideration is received significantly in advance of performance). However, the facts and
circumstances giving rise to such conditions need to be analysed carefully, to determine if there are reasons other than
financing that led to the advance payment (for example, certain customer contributions required by regulation to be made in
advance of performance).
A practical expedient is available for the entity not to recognise a significant financing component if it expects, at contract
inception, that the period between when it transfers a promised good or service to the customer and when the customer
pays for that good or service will be one year or less.
3.10 Allocating the transaction price to

performance obligations in the contract
Reporting entities within the power and utilities industry commonly execute agreements for the purchase and sale of
electricity and other energy-related products, including capacity, ancillary services, and RECs. It is common for these types
of agreement, which are often referred to as ‘bundled arrangements’, to contain a fixed bundled price. When it is determined
that a bundled arrangement contains multiple performance obligations, reporting entities will be required to allocate the
transaction price to each separate performance obligation, so that revenue is recorded at the right time and amounts.
The price at which a reporting entity would sell electricity, capacity, RECs, or any other product included in bundled
arrangements, separately to a customer is usually known.
The transaction price is allocated to distinct performance obligations, based on the relative stand-alone selling price of the
performance obligations in the contract. The stand-alone selling price for items not sold separately should be estimated. This
method is generally used to allocate the transaction price to each performance obligation within a bundled arrangement.
A residual approach could be used as a method to estimate the stand-alone selling price in certain situations where the
selling price for a good or service is highly variable or not yet established (that is, the selling price is uncertain).
Some elements of the transaction price, such as variable consideration or discounts, might affect only one performance
obligation rather than all performance obligations in the contract. Variable consideration can be allocated to specific
performance obligations if certain conditions are met, namely that the terms of the variable consideration relate specifically
to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome
from satisfying the performance obligation or transferring the distinct good or service).
A discount is allocated to one or more, but not all, specific performance obligations if all of the following criteria are met:
The entity regularly sells each distinct good or service in the contract on a stand-
alone basis.
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The entity regularly sells, on a stand-alone basis, a bundle of some of those distinct
goods or services at a discount.
The discount attributable to the bundle of distinct goods or services is substantially
the same as the discount in the contract, and an analysis of the goods or services
in each bundle provides observable evidence of the performance obligation to
which the entire discount in the contract belongs.
An entity is required to allocate any subsequent changes in the transaction price on the same basis as at contract inception.
Consequently, an entity should not reallocate the transaction price to reflect changes in stand-alone selling prices after
contract inception.
Example – Allocating the transaction price: stand-alone selling prices are directly
observable
Background
On 1 January 20X0, Power Seller Co (‘Seller’) agrees to sell 10 MW of electricity during each hour and the associated RECs
(one REC for each MWh) to Power Buyer Co (‘Buyer’) during the month of June 20X0 at a bundled price of $200/MWh. The
total transaction price equals $1,440,000 (10 MW per hour * 24 (hours per day) * 30 (days in June) * $200/MWh). Seller sells
electricity and RECs to customers on a stand-alone basis for $60/MWh and $180/REC, respectively, which reflects the
forward market prices at contract inception. Seller sells these products separately and they are separately identified within
the agreement; therefore, they are distinct and accounted for as distinct performance obligations.
How should Seller allocate the transaction price of $1,440,000 to the performance obligations?
Discussion
Seller should allocate the transaction price of $1,440,000 to the electricity and RECs based on their relative stand-alone
selling prices as follows:
Electricity $360,000 ($1,440,000 * ($432,000

[7,200 (MWh in June
20X0) x
$60/MWh]/$1,728,000))
RECs $1,080,000 ($1,440,000 *

($1,296,000 [7,200
(RECs in June 20X0) x
$180/REC]/$1,728,000))
Although the transaction price is $1,440,000, on a stand-alone basis the electricity and RECs would have been sold for a
combined $1,728,000 (($60 * 7,200) + ($180 * 7,200)). The allocation, based on relative fair value, results in the $288,000
discount being allocated proportionately to the two performance obligations. There is an expectation that the discount will be
applied proportionately between performance obligations unless there is evidence to the contrary in the arrangement.
Example – Allocating the transaction price: estimating the stand-alone selling

price
Background
Home Maintenance Co (‘Seller’) enters into a contract to install, maintain and verify energy efficiency equipment with
Customer Co (‘Buyer’) for a transaction price of $100,000. Seller regularly sells its installation and maintenance services on a
stand-alone basis for $25,000 and $45,000, respectively. The verification service is a new service offering that Seller has not
previously sold, and it does not have an established price; however, verification services are routinely sold by competitors of
Seller for $52,000. Given its position in the market of providing verification services (that is, small market share), Seller
determines that it would be required to sell verification services for $55,000 in order to achieve margins that would make its
verification service a sustainable business offering. Seller concludes that the installation, maintenance and verification
services represent distinct performance obligations.
How should Seller allocate the transaction price of $100,000 to the performance obligations?
Discussion
Seller should allocate the transaction price of $100,000 to the installation, maintenance and verification services, based on
their relative stand-alone selling prices (or estimate thereof), as follows:
Installation services $20,000 ($100,000 *

($25,000/$125,000)
Maintenance services $36,000 ($100,000 *

($45,000/$125,000)
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Verification services $44,000 ($100,000 *

($55,000/$125,000)
Although the consideration is $100,000, on a stand-alone basis the services would have been sold for a combined $125,000.
The allocation, based on relative fair value, results in the $25,000 discount being allocated proportionately to the three
performance obligations.
3.11 Recognise revenue when (or as) the entity

satisfies a performance obligation
The obligation to purchase and sell electricity under a PPA generally will be viewed as a single performance obligation that is
satisfied over time. A power and utilities entity will be required to measure its progress towards complete satisfaction of its
performance obligation to deliver electricity. The objective, when measuring progress, is to depict the seller’s performance in
transferring control of the electricity to the customer.
Arrangements to sell other commodities, including natural gas and physical capacity, over a contractual term, could be
viewed as a single performance obligation, as discussed in section 3.1. More judgement might be required to determine if
such arrangements meet the definition of a performance obligation satisfied over time.
3.12 Different pricing conventions
Some types of sales contract are not impacted by price or volume variability but they do have different fixed pricing
conventions (for example, prices per unit might be stated, but they might change over the life of the contract). Under a
particular arrangement, the price per unit might step up over time, to reflect expected costs to produce or an expectation of
increased market pricing over time. Alternatively, the prices might be different to reflect seasonal or time of day pricing (such
as peak versus off-peak).
A contract with stated, but changing, prices for a fixed quantity delivered does not contain variable consideration, because
the transaction price for the contract is known at inception and does not change. It is important for the power and utility
entity to understand what is giving rise to the pricing convention. For example, the escalations might be intended to reflect
the expected market price of power in the future periods which a customer would expect to pay.
The total transaction price should be recognised as revenue over time by measuring progress towards complete satisfaction
of the performance obligation. The seller applies a permissible form of the ‘output’ or ‘input’ method.
The seller might determine that an output method (such as KWh delivered) would appropriately depict the entity’s progress
towards complete satisfaction of the performance obligation, for a contract with stated but changing prices for a fixed
quantity delivered, which would result in a recognition pattern that reflects proportional performance of the seller at the fixed
price per unit. For example, assuming that power is delivered rateably (that is, equal volumes in each reporting period) over
the term of the contract, this would result in a rateable revenue recognition pattern.
It might also be appropriate to use input methods for measuring progress towards complete satisfaction of a performance
obligation for a contract with stated but changing prices for a fixed quantity delivered. The underlying economics and the
contractual terms of the PPA, including the pricing and volume provisions, will influence the method to be selected by
reporting entities.
The method of measuring progress towards complete satisfaction of a performance obligation will directly impact the
revenue recognised in each reporting period. A reporting entity will need to ensure that the selected method faithfully depicts
its performance towards complete satisfaction of a performance obligation. The selected method for measuring progress
should be applied consistently for a particular performance obligation, and also across contracts that have performance
obligations with similar characteristics.
A practical expedient allows entities to recognise revenue in the amount at which the entity has a right to invoice, if that
amount corresponds directly with the value to the customer of the entity’s performance to date. [IFRS 15 para B16]. This
would typically be the case where an entity bills a customer a fixed amount for each hour of service or for each unit provided.
It might require judgement to determine whether the invoiced amount corresponds directly with the value to the customer,
particularly if a contract contains variable pricing (for example, escalating pricing over the contract period). Particular care
needs to be taken where the pricing in the contract is not indicative of the value to a customer and not consistent with
expected costs or market pricing. For example, if a contract’s pricing decreases over time where both market prices and
input costs are expected to rise, this would be an indicator that it is not appropriate to recognise the revenue at the unit
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prices stated in the contract, and that some revenue should be deferred as units earlier in the life of the contract are
delivered.
Example – Recognise revenue: measuring progress towards complete

satisfaction of a performance obligation
Background
Power Seller Co (‘Seller’) and Power Buyer Co (‘Buyer’) executed a PPA for the purchase and sale of electricity over a six-
year term. Buyer is obligated to purchase 10 MW of electricity per hour for each hour during the contract term (87,600 MWh
per annual period) at prices that reflect the forward market price of electricity at contract inception. The contract prices are
as follows:
Years 1 and 2: $50/MWh

The transaction price, which represents the amount of consideration to which the seller expects to be entitled in exchange
for transferring electricity to the buyer, is $28,908,000 (annual contract prices per MWh multiplied by annual contract
quantities). Seller concludes that the promise to sell electricity represents one performance obligation that will be satisfied
over time.
How should Seller recognise revenue under its PPA?
Discussion
Since the performance obligation will be settled over time, Seller must select the method to be used to measure its progress
towards complete satisfaction of its obligation to deliver electricity during the term of the PPA.
IFRS 15 includes a practical expedient that allows an entity to recognise revenue in the amount at which the entity has a right
to invoice if that amount corresponds directly with the value to the customer of the entity’s performance to date. Judgement
might be required to conclude whether invoiced amounts correspond directly with the value to the customer. If Seller
concludes that application of the practical expedient is appropriate, revenue would be calculated as follows:
Contract year Revenue recognised Computation
Years 1 and 2 $4,380,000 per year 87,600 MWh * $50/MWh [contract price
in years 1 and 2]
in years 3 and 4]
in years 5 and 6]
Note: Seller might measure progress, for revenue recognition purposes, based on the ‘units delivered’ method if
Seller concludes that the price escalation included in the contract does not reflect the value to be delivered to the
customer in each year. This method would result in the recognition of revenue on a consistent basis over the term of
the contract based on progress towards complete satisfaction of the performance obligation. This might be an
average price per unit, based on total transaction price over the contract and the total expected units.
3.13 Contracts with volume variability
Power and utilities entities often enter into variable-volume contracts. Some of these contracts are structured as
‘requirements contracts’, which provide for delivery of as much electricity or gas as the customer needs. These contracts are
necessary and typical for various reasons, including: to secure a source of supply sufficient to cover anticipated needs; due
to limited storage ability and/or capacity; or because consumption in many cases occurs immediately on delivery.
Power and utilities entities that enter into requirements and similar contracts with variable volumes should first consider
whether the arrangement contains a lease within the scope of IAS 17/IFRS 16, or whether it is a financial instrument
accounted for under IFRS 9. The following analysis assumes that the arrangement does not contain a lease and is not
accounted for as a financial instrument.
The pricing for such contracts is generally known at the time when the contract is executed. While such contracts might take
different forms, including a single price for all deliveries, or different but specified prices depending on the time of day and/or
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season of the year, the primary unknown at the time of contract execution is generally the ultimate quantity to be delivered.
The contract provides a right to choose the quantity of additional distinct goods. An entity is not legally obligated to provide
or deliver additional goods, and it does not have a contractual right to consideration until the customer exercises its option.
That is, customer purchases under the variable-volume contract represent the customer contracting for a specific number of
distinct goods in which each order creates a new performance obligation. This new performance obligation arises at the time
when the customer exercises the option, unless such options provide the customer with a material right. Where there is a
material right, the option should be accounted for as a separate performance obligation in the original contract. A practical
expedient is available in paragraph B43 of IFRS 15 to simplify the accounting for certain material rights.
A power and utilities entity might have an obligation to stand ready to deliver additional volumes. Judgement is needed to
determine if a separate ‘stand ready’ performance obligation exists and to determine the appropriate revenue attribution
method.
3.14 Take-or-pay and similar long-term supply

agreements: breakage
Identifying performance obligations
A take-or-pay contract might contain renewal or extension options. These options also need to be considered in the context
of whether they provide a material right to the customer. Where such a material right exists, it is accounted for as a separate
performance obligation, or an entity might elect a practical expedient to assume the renewal term in the period over which
revenue is recognised. [IFRS 15 para B43].
Breakage
Customers might not exercise all of their contractual rights to receive a good or service in the future. Unexercised rights are
often referred to as ‘breakage’.
An entity should recognise estimated breakage as revenue in proportion to the pattern of exercised rights. Management
might not be able to conclude whether there will be any breakage, or the extent of such breakage. In this case, it should
consider the constraint on variable consideration, including the need to record any minimum amounts of breakage. Breakage
that is not expected to occur should be recognised as revenue when the likelihood of the customer exercising its remaining
rights becomes remote. The assessment should be updated at each reporting period.
In take-or-pay arrangements, this could mean that an entity might be able to recognise revenue in relation to breakage
amounts in a period earlier than when the breakage occurs, provided that it can demonstrate that it expects that the
customer will not exercise these rights. Given the nature of these arrangements and the inherent uncertainty in being able to
predict a customer’s behaviour, it might be difficult to obtain sufficient evidence to meet this requirement.
3.15 Customer contributions and connection

fees
Power and utilities entities often charge a fee to a customer when connecting that customer to the transmission/distribution
network. The ‘fee’ might be monetary or involve the contribution of a non-financial customer asset. The fee might vary based
on the level of work required to complete the connection, but it is often governed by regulation. The fee could be fixed and
would not directly compensate the entity for the costs of building out the network to connect the customer (that is, it might
be higher or lower). This is because regulation is designed to ensure that all customers have access to the service, and it is
based on a cost-sharing mechanism across all users of the network over the life of the network.
Where an entity provides both connection to a network and ongoing access to goods or services, management should
determine whether these services are separate performance obligations of the arrangement for the purposes of revenue
recognition. Facts and circumstances might differ between legal jurisdictions or based on the terms of different
arrangements. Entities need to consider the following:
If the payment is received from a developer, who is the customer (for example, the
developer or the homeowners)?
Could the connection be a stand-alone service?

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Does the utility company that charges the connection fee have an explicit or
implicit ongoing obligation to the ultimate purchasers of energy (for example, to
maintain the equipment or provide an ongoing connection)?
A non-refundable upfront fee might relate to an activity undertaken at or near contract inception. However, no revenue is
recognised unless that activity results in the satisfaction of a separate performance obligation. If there is no distinct
performance obligation, the upfront fee is recognised as revenue when goods or services are provided to the customer in the
future. The period of revenue recognition could extend beyond the relationship with the initial customer, depending on the
nature of the ongoing obligation. For example, if the obligation is to provide an ongoing connection to the owner of a home
for the life of the home, this obligation might survive the transfer of the home to a subsequent buyer.
3.16 Customer renewal options and

cancellation rights
Power and utilities entities might allow customers to renew their existing contracts. A cancellation option that allows a
customer to cancel a multi-year contract after each year might effectively be the same as a renewal option, because a
decision is made annually whether to continue under the contract. Management should assess a renewal or cancellation
option, to determine if it provides a material right similar to other types of customer option.
Example – Customer renewal option
Background
Provider Co enters into an arrangement with a customer to supply electricity at US$0.15 per KW per hour for 12 months. The
customer has the option, at the end of the year, to renew the contract once for an additional 12 months. The contract
renewal will be under the same terms as the original contract. Provider Co typically increases its prices by 5% each year.
Provider Co charges the customer a non-refundable upfront connection fee of US$50, and it has an obligation to maintain
the connection until the contract terminates.
How should Provider Co account for the renewal option?
Discussion
The renewal option represents a material right to the customer, because the customer will be charged a lower price for the
electricity than similar customers if it renews the contract.
Provider Co is not required to determine a stand-alone selling price for the renewal option, because both criteria for the use
of the practical expedient associated with material rights have been met. Provider Co could instead elect to include the
estimated total electricity consumption at US$0.15 per KW per hour for 24 months (the initial period and the renewal period)
in the initial measurement of the transaction price. In this case, the upfront connection fee should also be included in the
amount to be recognised as revenue over 24 months.
3.17 Gifts, vouchers, cash bonuses, bonuses in

kind
An entity might grant to a customer the option to acquire additional goods or services free of charge or at a discount. These
options might include customer vouchers, or other sales incentives and discounts, that will give rise to a separate
performance obligation if the option provides a material right that the customer would not receive without entering into the
contract. The entity should recognise revenue allocated to the option when the option expires or when the additional goods
or services are transferred to the customer.
An option to acquire an additional good or service at a price that is within the range of prices typically charged for those
goods or services does not provide a material right, even if the option can be exercised only because of entering into the
previous contract.
Consideration payable to a customer
An entity needs to determine the transaction price, which is the amount of consideration it expects to be entitled to in
exchange for transferring promised goods or services to a customer. Consideration payable by an entity to a customer is
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accounted for as a reduction of the transaction price, unless the payment is for a distinct good or service that the customer
transfers to the entity.
Example – Provider-issued coupons
Background
Provider Co supplies utilities to customers and, at the same time, it provides a coupon for a 3% discount off a furnace
inspection during the next year. Provider Co intends to offer a 1% discount on all inspections as part of a promotional
campaign during the same period. Provider Co estimates that 75% of customers that receive the coupon will exercise the
option for the purchase of, on average, C80,000 of discounted additional services. How should Provider Co account for the
option provided by the coupon?
Discussion
Provider Co should account for the option as a distinct performance obligation, since the discount represents a material
right. It is a material right, because it is incremental to the discount offered to a similar class of customers during the period
(only a 1% discount is offered more widely). The stand-alone selling price of the option is C1,200, calculated as the estimated
average purchase price of additional inspection services (C80,000) multiplied by the incremental discount (2%) multiplied by
the likelihood of exercise (75%). The transaction price for the contract is allocated between utility supply and the discount
based on the relative stand-alone selling price of each performance obligation. The consideration allocated to the discount
will be recognised on exercise (that is, on purchase of the additional service) or expiry.
An entity should consider whether it needs to assume 100% redemption of the options if it does not have sufficient history to
estimate the extent of redemption.
4. Presentation
4.1 Contract assets and liabilities
The entity should present either a contract asset or a receivable, depending on the nature of the entity’s right for its
performance, if an entity recognises revenue before the customer pays consideration. In making this distinction, it is
important to consider that:
a. a contract asset is an entity’s right to payment in exchange for goods or services that the entity has transferred to a customer,
where that right is conditional on something other than the passage of time (for example, the entity’s future performance); and
b. a receivable is an entity’s right to payment that is unconditional.
Both contract assets and receivables are subject to IFRS 9’s expected credit loss model, as explained further in the Financial
Instruments chapter.
The entity should present, as a contract liability, an amount of non-refundable payment received from a customer or an
amount of payment that is due before the performance obligations were satisfied. A contract liability is an entity’s obligation
to transfer goods or services to a customer for which the entity has received payment from the customer.
Example – Contract assets and liabilities (supplying power to households)
Background
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Provider Co (‘Provider’) provides electricity to households. Household customers receive a meter reading only once a year.
During the year, customers pay equal instalments. Revenue is based on a standard load profile, taking seasonality into
account. Each individual contract could result in either a contract asset (if revenue exceeds instalments received since the
last meter reading) or a liability (if revenue is lower than instalments since the last meter reading).
Could Provider Co book only one asset or liability for all contracts?
Discussion
Each contract should be accounted for individually. The portfolio approach can only be used if the result does not differ
materially.
An impairment provision will be required for contract assets based on an expected credit loss model. [IFRS 9]. [IFRS 15 para
107].
Offsetting overall contract assets and liabilities on a portfolio basis would generally not be appropriate.
4.2 Revenue from non-customers
Revenue from sources other than from contracts with customers should be presented separately in the income statement.
Other sources of revenue include revenue from interest and leases.
Collaboration agreements or partnership agreements (for example, a network operation arrangement, as discussed in section
1.3.6) should be understood to identify whether all or a portion of the contract is, in substance, a contract with a customer. A
portion of the contract might be the sharing of risks and benefits of an activity that is outside the scope of IFRS 15.
5. Disclosures
IFRS 15 includes a number of extensive disclosure requirements intended to enable users of financial statements to
understand the amount, timing, and judgements related to revenue recognition and corresponding cash flows arising from
contracts with customers. Some of the more significant disclosure requirements are highlighted below, but the list is not all-
inclusive.
The disclosures include qualitative and quantitative information about:
contracts with customers;

the significant judgements, and changes in judgements, made in applying the
guidance to those contracts; and
assets recognised from the costs to obtain or fulfil contracts with customers.
IFRS 15 requires disclosures that disaggregate revenue into categories that depict how the nature, amount, timing and
uncertainty of revenue and cash flows are affected by economic factors. The standard contains guidance on how to
determine the required disaggregation. In some cases, disaggregation might already be present in segment information
disclosure presented under IFRS 8; but, in other cases, further disaggregation is required.
The disclosure requirements are more detailed than those under previous GAAP, and they focus significantly on the
judgements made by management. For example, they include specific disclosures of the estimates used and judgements
made in determining the amount and timing of revenue recognition.
IFRS 15 also requires an entity to disclose the amount of its remaining performance obligations, and the expected timing of
the satisfaction of those performance obligations, for contracts with durations of greater than one year, and both quantitative
and qualitative explanations of when amounts will be recognised as revenue. This requirement could have a significant
impact on utilities, where long-term contracts are a significant portion of an entity’s business. Certain practical expedients
are available for this disclosure where revenue is being recognised on a ‘right to invoice’ basis or for short-term contracts.
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6. Transaction
IFRS 15 permits entities to apply one of two transition methods: retrospective or modified retrospective. Retrospective
application requires applying the new guidance to each prior reporting period presented; however, entities can elect to apply
certain practical expedients. Entities electing the modified retrospective transition approach would apply the new guidance
only to contracts that are not completed at the adoption date, and they would not adjust prior reporting periods.
The modified retrospective transition approach is intended to be simpler than full retrospective application; however, there
are still challenges associated with that approach, including additional disclosure requirements in the year of adoption. These
additional disclosures effectively require an entity to apply both the new revenue standard and the previous revenue
guidance in the year of initial application. Entities should consider the needs of investors and other users of the financial
statements when deciding which transition method to follow.
7. Comprehensive example
7.1 Application of the five-step model
Facts: Bundle Seller Co (‘Seller’) and Bundle Buyer Co (‘Buyer’) executed an agreement for the purchase and sale of 1oMW
of electricity per hour and the associated RECs (one REC for each MWh) at a fixed bundled price (‘the agreement’ or ‘the
PPA’). The contract term begins on 1 January 20X1 and ends on 31 December 20X4, and the fixed bundled price during
each of those respective years is $200, $205, $210 and $215. The increase in the bundled price represents the increase in
the forward price of electricity and RECs over the term of the agreement as of the acquisition date. Control, including title to
and risk of loss related to the electricity, will pass and transfer on delivery at a single point on the electricity grid. Control,
including title to and risk of loss related to RECs, will pass and transfer when the associated electricity is delivered.
Seller and other market participants frequently execute contracts for the purchase and sale of electricity and RECs on a
stand-alone basis.
Seller concluded that this arrangement does not contain a lease (that is, no property, plant or equipment is explicitly or
implicitly identified). The electricity element of this arrangement qualifies for the ‘own use’ exception and thus is not
accounted for as a derivative. The REC element has no net settlement characteristics. As such, each element of this
agreement is within the scope of IFRS 15.
Discussion
Step 1 – Identify the contract with a customer
This agreement, including each of its elements (that is, electricity and RECs), is within the scope of the standard, and
collection of the contract consideration is considered probable.
Step 2 – Identify the performance obligations
The electricity element represents a promise to transfer a series of distinct goods that are substantially the same and that
have the same pattern of transfer to the customer; therefore, the electricity represents one performance obligation that is
satisfied over time. This conclusion is based on the following factors:
1. The electricity is distinct, because (a) Buyer can benefit from the electricity on its own (that is, Buyer can sell electricity, on a
stand-alone basis, into the marketplace), and (b) the promise to transfer electricity is separately identifiable from other promises in
the contract (that is, the electricity is not an input to produce or deliver a combined output to Buyer, the electricity does not
significantly modify or customise another promise in the contract, and the electricity is not highly dependent on, or highly
interrelated with, other promised goods in the agreement).
2. The performance obligations to deliver electricity are satisfied over time, since Buyer simultaneously receives and consumes the
benefits provided by Seller’s performance as Seller performs.
3. Each distinct transfer of electricity in the series that Seller promises to transfer to Buyer meets the criteria to be a performance
obligation satisfied over time, and the same method will be used to measure Seller’s progress towards complete satisfaction of
the performance obligation to transfer each distinct good in the series to Buyer.
The monthly promise to transfer RECs to the customer during the term of the PPA (48 deliveries) represents goods that are
distinct, based on the following:
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1. Buyer can benefit from the RECs on its own (that is, Buyer can sell RECs, on a stand-alone basis, into the marketplace, so the
RECs are capable of being distinct); and
2. the promise to transfer RECs is separately identifiable within the PPA (that is, the RECs are distinct within the context of the
contract).
Each promise to deliver RECs is a separate performance obligation that is satisfied at a point in time, because none of the
criteria are met to account for such promises as performance obligations satisfied over time.
Step 3 – Determine the transaction price
The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring
promised goods to a customer. Under the terms of the arrangement, Seller will sell 10 MW per hour during each hour of the
four-year contract term at fixed bundled prices, which escalate during each year of the contract term. The transaction price
is $72,708,000. The table below illustrates the computation to arrive at the transaction price.
Contract year Contract price Contract quantity Amount

(a)
1 $200/MWh 87,600 MWh $17,520,000
2 $205/MWh 87,600 MWh $17,958,000
3 $210/MWh 87,600 MWh $18,936,000
4 $215/MWh 87,600 MWh $18,834,000
Total 350,400 MWh $72,708,000
(a) Annual contract quantities were calculated as follows: 10 [MW per hour] * 24 [hours per day] * 365 [days per year].
Step 4 – Allocate transaction price to the performance obligations in the contract
The promise to transfer electricity to the customer represents one performance obligation that is satisfied over time; the
monthly promise to transfer RECs to the customer represents individual performance obligations that are satisfied at a point
in time. The transaction price should be allocated to each performance obligation, based on the relative stand-alone selling
prices of the goods being provided to the customer. To do so, Seller should determine the stand-alone selling price (‘SSP’)
at contract inception of the distinct good underlying each performance obligation in the bundled arrangement and allocate
the transaction price in proportion to those SSPs.
Since Seller frequently sells electricity and RECs on a stand-alone basis in the normal course of its operations, the price that
it charges for electricity and RECs when it sells them separately to similar customers is the best evidence of the SSP. As a
result, Seller is not required to estimate or derive the SSP of either electricity or RECs; rather, it will use those SSPs for the
purposes of allocating the transaction price, which reflects the forward prices as of the date when the contract was
executed.
The SSP for the electricity and RECs was calculated as follows:
Year SSP – SSP – Quantity Total SSP – Total SSP – Total SSP
electricity REC (a) electricity REC
(a)
20X1 $41/MWh $162/REC 87,600 $3,591,600 $14,191,200 $17,782,80
20X2 $43/MWh $165/REC 87,600 $3,766,800 $14,454,000 $18,220,80
20X3 $45/MWh $168/REC 87,600 $3,942,000 $14,716,800 $18,658,80
20X4 $47/MWh $171/REC 87,600 $4,117,200 $14,979,600 $19,096,80
Total $15,417,600 $58,341,600 $73,759,20
(a) In this fact pattern, Seller has determined that the SSP for electricity and RECs represents the forward prices for
electricity and RECs as of the date when the contract was executed. The allocation is not updated for changes in the SSP of
electricity and RECs subsequent to contract inception.
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Seller would allocate the transaction price to the electricity, which represents one performance obligation satisfied over time,
as follows:
Electricity: $15,197,872 ($72,708,000 *

($15,417,600
[SSP]/$73,759,200
[total SSP]))
Seller would allocate the transaction price to the RECs, which represent individual performance obligations that are satisfied
at a point in time, as follows:
Year Annual amounts Computation

(a)
20X1 $13,988,950 $72,708,000 * ($14,191,200 [SSP]/$73,759,200

[total SSP])
20X2 $14,248,005 $72,708,000 * ($14,454,000 [SSP]/$73,759,200

[total SSP])
20X3 $14,507,059 $72,708,000 * ($14,716,800 [SSP]/$73,759,200

[total SSP])
20X4 $14,766,114 $72,708,000 * ($14,979,600 [SSP]/$73,759,200

[total SSP])
Total $57,510,128
(a) Immaterial difference might arise due to rounding.
The excess of the sum of the SSPs of the electricity and RECs ($73,759,200) over the promised consideration ($72,708,000)
represents a discount that Buyer is receiving from Seller for purchasing a bundle of goods. By allocating based on the
relative SSPs, the discount of $1,051,200 is allocated proportionately to each performance obligation. The discount allocated
to electricity is $219,728 ($1,051,200 * ($15,417,600/$73,759,200)). The discount allocated to the performance obligations to
deliver RECs in January and February 20X1 is $17,177 ($1,051,200 * ($14,191,200 * (31/365))/$73,759,200) and $15,515
($1,051,200 * ($14,191,200 * (28/365))/$73,759,200), respectively. The aggregate discount attributable to the 48 performance
obligations to deliver RECs is $831,472 ($1,051,200 * ($58,341,600/$73,759,200)).
Step 5 – Recognise revenue when (or as) the entity satisfies a performance obligation
Seller should recognise revenue when (or as) it satisfies a performance obligation by transferring a promised good (that is, an
asset) to Buyer. An asset is transferred when (or as) Buyer obtains control of that asset. Buyer obtains control of a good if it
has the ability to direct the use of and obtain substantially all of the remaining benefits from that good.
Seller transfers control of the electricity over time, and Buyer simultaneously receives and consumes the benefits provided
by Seller’s performance as it performs; therefore, Seller would satisfy its performance obligations and would recognise
revenue on sales of electricity over time by measuring the progress towards complete satisfaction of its performance
obligation to deliver electricity. The objective when measuring progress is to depict Seller’s performance in transferring
control of the electricity to Buyer. Seller transfers control of the RECs at a point in time; therefore, Seller recognises revenue
in the month in which the associated electricity is delivered.
IFRS 15 includes a practical expedient that allows an entity to recognise revenue in the amount at which the entity has a right
to invoice if that amount corresponds directly with the value to the customer of the entity’s performance to date. Judgement
might be required to conclude whether invoiced amounts correspond directly with the value to the customer, and application
of the practical expedient might not be appropriate in this fact pattern.
Revenue should be recognised when control is transferred for each performance obligation (that is, electricity and RECs on
delivery to the electricity grid). If Seller concludes that application of the practical expedient is appropriate, Seller would
recognise revenue on the first three monthly deliveries of electricity and RECs as follows:
Performance obligation January February March Total

20X1 20X1 20X1
Electricity revenue1 $300,502 $271,421 $300,502 $872,425
REC revenue2 $1,187,498 $1,072,579 $1,187,498 $3,447,575

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Total $1,488,000 $1,344,000 $1,488,000 $4,320,000
1
transaction
($3,591,600/$17,782,800).
Calculatedprice
as the
of product
$40.39/MWh.
of fixed
The
quantities
allocateddelivered
per unit (7,440,
transaction
6,720price
and is7,440
the fixed
MWhbundled
in January,
priceFebruary
($200.00)
and
multiplied
March, respectively)
by the proportionate
and the allocated
share of the
perrelative
unit SSP
2
transaction
the
Calculated
relative SSP
price
as the
($14,191,200/$17,782,800).
of product
$159.61/REC.
of fixedThe
quantities
allocated
Note
delivered
per
that
unit
revenue
(7,440,
transaction
is6,720
recognised
price
and is
7,440
calculated
in the
RECs
period
inasJanuary,
when
the fixed
theFebruary
bundled
associated
and
price
electricity
March,
($200.00)
respectively)
is multiplied
delivered.and
by the proportionate
allocated per unit
share of
The total amount of revenue recognised by Seller for the first three monthly deliveries of electricity and RECs ($4,320,000) is
equal to the sum of the three monthly invoices billed to Buyer in January, February and March 20X1 of $1,488,000 (10 [MW
per hour] * 24 [hours per day] * 31 [days in January] * $200 [bundled price]), $1,344,000 (10 [MW per hour] * 24 [hours per
day] * 28 [days in February] * $200 [bundled price]), and $1,488,000 (10 [MW per hour] * 24 [hours per day] * 31 [days in
March] * $200 [bundled price]), respectively.
Note: In practice, a reporting entity’s conclusions might differ from the above on similar bundled arrangements, based on,
among other factors: (1) the underlying economics of the arrangement, including the conclusion on whether the contractual
pricing corresponds directly with the value to the customer over the contractual term; (2) the market constructs (for example,
RECs might not represent a separate performance obligation in all markets); (3) the composition of its sales portfolios (for
example, electricity or RECs might not be sold on a stand-alone basis, so it might be necessary to estimate SSPs); and (4)
conclusions regarding when control is transferred (for example, a reporting entity might conclude, in certain facts and
circumstances, that transfer of control of RECs occurs on the transfer of RECs into Buyer’s accounts).
Future developments
Rate-regulated activities
In January of 2021 the IASB issued an exposure draft (ED) Regulatory Assets and Regulatory Liabilities to replace IFRS 14.
The IASB is proposing an accounting model to supplement the information that an entity already provides by applying IFRS
Standards. The proposed model is based on the principle that an entity should reflect the total allowed compensation for
goods or services supplied in a period as part of its reported financial performance for that period.
The comment period is closed and the IASB is currently redeliberating certain aspects of the model. The timing of a final
standard remains unconfirmed at this time.
Financial reporting in the mining industry
One of the major challenges of any reporting framework is how best to implement it in the context of a specific company or
industry. IFRS is a principles based framework and short on industry guidance. PwC looks at how IFRS is applied in practice
by mining companies.
This publication identifies the issues that are unique to the mining industry and includes a number of real life examples to
demonstrate how companies are responding to the various accounting challenges along the value chain.
1. Mining value chain
Mining activities begin with the exploration and evaluation of an area of interest. If the exploration and evaluation is
successful, a mine can be developed, and commercial mining production can commence.
The phases before production begins can be prolonged and expensive. The appropriate accounting treatment for this
investment is essential. However, before we examine the accounting implications of the phases of operations, we need to
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define the phases. There are five terms in common use that describe the different phases of a mine’s operations, although
other terms are sometimes used.
1.1 Phases of operations
 View image
1.2 Distinguishing between the phases
The points at which one phase ends and another begins are important when accounting for the costs of each phase. The
phases often overlap, and sometimes several phases may occur simultaneously. It is not always easy, therefore, to
determine the cut-off points for costs between the various phases.
1.2.1 Phases 1 & 2— exploration and

evaluation
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The costs of exploration are for discovering mineral resources; the costs of evaluation are for proving the technical feasibility
and commercial viability of any resources found.
1.2.2 Phases 2 & 3— evaluation and

development
The cut-off between evaluation and development is often critical when making capitalisation decisions (see sections 2.3.2
and 3.1). Development commences once the technical feasibility and commercial viability of extracting the mineral resource
has been determined. Management will usually make a decision to develop based on receipt of a feasibility study
(sometimes know as a ‘bankable’, ‘definitive’ or ‘final’ feasibility study).
The feasibility study:
establishes the commercial viability of the project;

establishes the availability of financing;
identifies the existence of markets or long-term contracts for the product; and
decides whether or not the mine should be developed.
1.2.3 Phases 3 & 4— development and

production
Determining the cut-off point between the development and production phases is rarely simple.
Assets must be ‘available for use’ before they can be depreciated. For mining entities, assets are ‘available for use’ when
commercial levels of production are achieved.
The decision on commercial production is usually made after discussions between the accountants, engineers and
metallurgists, and may be based on a range of criteria, such as:
a nominated percentage of design capacity for the mine and mill;

mineral recoveries at or near expected levels; and
the achievement of continuous production or other output.
The percentages and levels of recovery are nominated well before they occur. These factors need to be reconsidered in the
event of any significant delays in development or if pre-determined commercial levels of production are not achieved.
Development may continue after production has begun, such as:
stripping costs where removal of overburden occurs before production in additional

pits; and
stripping activity which benefits both current and future activity.
Similar examples occur in underground mining operations with the extension of a shaft or major underground excavations.
1.2.4 Phases 4 & 5—production and closure
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A mine’s operational life is considered to end either when the ore body is depleted or when the mine is closed for other
reasons and the normal ore feed to the plant stops or production ceases. The likely costs of the closure phase include
employee severance costs, restoration and rehabilitation and environmental expenditure.
2. Exploration and evaluation activities
2.1 Overview
Mining activities comprise the exploration for and discovery of mineral reserves. They also include the evaluation and
development of these reserves and resources, and their subsequent extraction (production).
2.2 Reserves and resources
Mineral reserves and resources are the most significant source of value for mining entities. They are the most important
economic asset for a mining entity. The reserves and resources, along with the ability of management to successfully
transform reserves and
resources into cash inflows, are the key drivers of value. Reserves and resources also provide the basis for acquiring funds
through borrowings and equity financing.
IAS 16 “Property, Plant and Equipment” and IAS 38 “Intangible assets” exclude mineral reserves from their scope.
Traditionally, the accounting standard setters (including the IASB) have concluded that development of reserve and resource
definitions are outside their technical expertise. Resource and reserve definitions are normally established by professional
bodies of engineers and geologists. Capital markets regulators will often specify which set of definitions should be used and
often prescribe separate disclosures of reserve information. This information usually accompanies the financial statements
but is not formally part of the financial statements.
Most mining entities recognise the cost incurred to find and develop mineral reserve and resource assets on the balance
sheet at historical cost. Reserves and resources acquired in a business combination or an asset transaction are also
recognised at the cost of acquisition. However, the finding and proving of reserves does not have an immediate accounting
impact.
Reserves and resources have a pervasive impact on a mining entity’s financial statements, namely the:
charge for depreciation and amortisation;

calculation of stripping adjustments;
determination of impairment charges;
expected timing of future decommissioning and restoration, termination and
pension benefit cash flows (which impacts on discounted value of those
obligations);
allocation of the purchase price in business combinations;
capitalisation of exploration and evaluation costs; and
accounting for financial instruments.
2.2.1 Defining a mineral resource
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Deposits of minerals are often located deep beneath the earth’s surface and are often irregular in shape, making them
difficult to measure. The relative quality or percentage of metal content of ore may also vary throughout a single deposit.
Estimating mineral reserves and resources is therefore a matter of considerable technical difficulty and uncertainty. It
typically involves an assessment of the geological confidence of the deposit and the economic viability of extraction of the
ore.
Geologists measure and classify the resources. There is currently no global standard used by geologists for the
measurement and classification of reserves and resources. The IASB’s Extractiveactivities discussion paper released in April
2010 assessed some of the more prominently used sets of definitions to consider whether one framework could serve as a
consistent set of rules for the mining industry. It concluded that the Committee for Mineral Reserves International Reporting
Standards (‘CRIRSCO’) had developed an appropriate international reporting template that could be used to promote greater
consistency under IFRS. The CRIRSCO template was considered the preferred option by the IASB’s project team as it:
is a comprehensive classification system that is broad in scope to cover all types of

minerals;
has kept pace with industry developments and generally accepted current
practices; and
has wide acceptance and consistency with a number of national codes.
Regulators often require the use of their own reserves standards for the purposes of capital market disclosures. However,
given the absence of specific guidance in IFRS until the discussion paper progresses, entities must consider the application
and disclosure of accounting policies that are dependent on reserves and resources. These definitions and measures should
be clearly disclosed and applied consistently.
2.2.2 Resources vs reserves
Mineral reserves and resources are categorised based on the level of geological confidence. See the diagram below, taken
from the CRIRSCO international reporting template. The distinction between mineral reserves and resources is based on the
economic viability of extraction (as opposed to geological confidence):
resources are an identified mineral occurrence with reasonable prospects for

eventual economic extraction;
reserves are the economically mineable part of a resource—appropriate
assessments demonstrate that economic extraction can reasonably be justified.
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In this publication we use the CRIRSCO definitions of reserves and resources.
The concept of “economically mineable” does not take into account the intention of entities to develop their mineral deposits
within a reasonable time-frame. Another way of saying this is that reserves can be “economically mineable” without a
company having any intention of proceeding to development in the near future.
Most national codes take some or all of the following matters into account in their measurement and classification of
reserves and resources.
the grade (the relative quality or percentage of metal content) in various parts of the
mineral resource;
continuity of geology between samples;

the proportion of the mineral resource that will be extracted (allowing for the
partially offsetting factors of dilution and non-recovery);
future commodity prices;
future exchange rates;
future production costs;
future capital expenditure; and
technological changes.
All assumptions are important if there is any doubt about operating at profitable levels.
Information about the characteristics of mineral reserves and resources tends to expand as the development progresses.
Expectations of future mineral prices and production costs also vary as a result of changes in economic and technological
factors. Estimates of reserves and resources may therefore fluctuate during the life of a mine. Some securities regulators
require entities to update the estimations at least annually.
2.2.3 Assumptions and estimates
Assumptions play a critical part in the estimation of reserves and resources and in their use in financial reporting. There are
many variables both financial and non-financial that a mining entity must take into consideration when developing reserve
estimates including:
the location of the commodity to be mined and its impact on pricing of the minerals
to be sold;
the quality and grade of minerals to be produced;
the cost of capital, operating costs and refining / treatment costs;
timing of cash flows and production quantities; and
other external financial conditions including views on commodity prices, costs of

labour, materials a nd equipment, foreign exchange rates and discount rates.
The combination of the many variables and the required pure geological interpretation can explain why two co- venturers can
record quite different reserve estimates for the same mineral deposit.
Reserves and resources are often used as the basis for estimates of fair value to be used in purchase price allocations in a
business combination. An entity is expected to use as many observable inputs as possible when estimating fair value to be
used in financial reporting.
2.2.4 Extractive activities project
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As mentioned in section 2.2.1, the Extractive activities discussion paper released in April 2010 made recommendations on
the use of the CRIRSCO template for the classification of reserves and resources.
Proposals were included for a significant increase in the level of disclosure to be provided, including various reserve
quantities, value-based information and revenue and cash flow information.
The paper also proposed that mineral assets be recognised when the entity acquired a legal right to explore. Information
gained from exploration and evaluation activities, as well as development activities, would represent an enhancement of the
exploration / reserves and resources asset. The asset’s unit of account would initially be the geographical area of the
exploration right. This would be refined as exploration and development plans are developed, resulting in one or more
smaller units of account, generally at the level of the individual mine. Costs incurred outside this mine would be considered
separately for impairment and potential derecognition. These proposals would change how many entities currently account
for exploration activity (discussed in the following sections), leading to earlier capitalisation of costs.
The IASB is currently considering its agenda for 2013 and beyond. This will include deciding whether extractive activities
should be added to the active agenda for future projects.
2.3 Exploration and evaluation
Exploration costs are incurred to discover mineral resources. Evaluation costs are incurred to assess the technical feasibility
and commercial viability of the resources found. Exploration, as defined in IFRS 6 “Exploration and Evaluation of Mineral
Resources”, starts when the legal rights to explore have been obtained. Expenditure incurred before obtaining the legal right
to explore is generally expensed; an exception to this would be separately acquired intangible assets such as payment for an
option to obtain legal rights.
The accounting treatment of exploration and evaluation (“E&E”) expenditures (capitalising or expensing) can have a
significant impact on the financial statements and reported financial results, particularly for entities at the exploration stage
with no production activities.
2.3.1 Accounting for E&E under IFRS 6
An entity accounts for its E&E expenditure by developing an accounting policy that complies with the IFRS Framework or in
accordance with the exemption permitted by IFRS 6 [IFRS 6 para 7]. IFRS 6 allows an entity to carry forward a pre-existing
policy under national GAAP with certain limitations.
An entity may have a past practice of deferring all exploration and evaluation expenditure as an asset even if the outcome is
highly uncertain. This policy is common among junior mining companies with no major producing assets where exploration
and evaluation expenditure is ongoing and for which an outcome has not yet been determined. Other entities may have a
past practice of expensing all exploration and evaluation expenditure until the technical feasibility and commercial viability of
extracting a mineral resource has been established. Expenditure from this point is development expenditure (see section 3).
There are a variety of policies that can be adopted between these two extremes.
Practice also varies in relation to the treatment of the amounts payable to third parties to acquire exploration licences. Some
entities capitalise these costs even if the subsequent expenditure incurred in relation to those licences is expensed, on the
basis that they can expect to recover the acquisition cost through resale. Others treat such acquisition costs on the same
basis as any other exploration and evaluation expenditure on the same area of interest (see 2.3.2 below)—costs are
expensed if the viability of the mine has not yet been established and other expenditure is expensed as incurred.
IFRS 6 allows an entity to continue to apply its existing accounting policy under national GAAP for E&E. The policy need not
be in full compliance with the IFRS Framework [IFRS 6 para 6–7]. An entity can change its accounting policy for E&E only if
the change results in an accounting policy that is closer to the principles of the Framework [IFRS 6 para 13]. The change
must result in a new policy that is more relevant and no less reliable or more reliable and no less relevant than the previous
policy. The policy, in short, can move closer to the Framework but not further away. This restriction on changes to the
accounting policy includes changes implemented on adoption of IFRS 6.
The criteria used to determine if a policy is relevant and reliable are those set out in paragraph 10 of IAS 8 “Accounting
Policies, Changes in Accounting Estimates and Errors”. That is, it must be:
Relevant to decision making needs of users;

Provide a faithful representation;
Reflect the economic substance;

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Neutral (free from bias);

Prudent; and
Complete.
Changes to accounting policy when IFRS 6 first applied
Can an entity make changes to its policy for capitalising exploration and evaluation expenditures when it first adopts
IFRS?
Background
Entity A has been operating in the gold mining sector for many years. It is transitioning to IFRS in 20X5 with a transition
date of 1 January 20X4. Management has decided to adopt IFRS 6 to take advantage of the relief it offers for
capitalisation of exploration costs and the impairment testing applied.
Entity A has followed a policy of expensing geological study costs under its previous GAAP. The geological studies that
entity A has performed do not meet the Framework definition of an asset in their own right, however management has
noted that IFRS 6 permits the capitalisation of such costs [IFRS 6 para 9(b)].
Can entity A’s management change A’s accounting policy on transition to IFRS to capitalise geological and geotechnical
costs?
Solution
No. IFRS 6 restricts changes in accounting policy to those which make the policy more reliable and no less relevant or
more relevant and no less reliable. One of the qualities of relevance is prudence. Capitalising more costs than under the
previous accounting policy is less prudent and therefore is not more relevant. Entity A’s management should therefore
not make the proposed change to the accounting policy.
The above solution is based on entity A being a standalone entity. However, if entity A was a group adopting IFRS and at
least one entity in the group had been capitalising exploration and evaluation expenditures, entity A as a group could
adopt a policy of capitalisation.
A new entity that has not reported under a previous GAAP and is preparing its initial set of financial statements can choose a
policy for exploration cost. Management can choose to adopt the provisions of IFRS 6 and capitalise such costs. This is
subject to the requirement to test capitalised E&E for impairment if there are indications that the carrying amount of any
assets will not be recoverable. The mine-by-mine approach to impairment and depreciation is applied when the asset moves
out of the exploration phase.
2.3.2 Initial recognition
2.3.2.1 Initial recognition of E&E under the IFRS 6 exemption
As exploration expenditure is often made in the hope (rather than the expectation) that there will be future economic benefits
and success rates tend to be low it is difficult for an entity to demonstrate that the recovery of exploration expenditure is
probable.
Most entities transitioning to IFRS have chosen to use the IFRS 6 shelter rather than develop a policy under the Framework.
The exemption in IFRS 6 allows an entity to continue to apply the same accounting policy to exploration and evaluation
expenditures as it did before the application of IFRS 6. The costs capitalised under this policy might not meet the IFRS
Framework definition of an asset, as the probability of future economic benefits has not yet been demonstrated. However,
IFRS 6 deems these costs to be assets. E&E expenditures might therefore be capitalised earlier than would otherwise be the
case under the Framework.
In practice, the policies previously adopted by many entities are specific to the location and nature of an operation and will
reflect a different approach to the activity based on mineral deposits already found in the surrounding area:
‘Greenfield’ site—this is an area where the entity does not have any mineral
deposits that are already being mined or developed. Expenditure will often be
expensed as incurred until a feasibility study has been performed.
‘Brownfield site’—this is an area around an existing mine, where the entity has
substantial knowledge about the mineral deposit and has constructed the
infrastructure and/or processing facilities needed to exploit the additional resources
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that it expects to find. There may also be a proven history of return on amounts
spent. Expenditure is normally capitalised at an earlier point.
As noted in section 6.4, resources acquired in a business combination or an asset transaction are recognised at the cost of
acquisition.
After recognition has been deemed appropriate, an entity must determine the ‘unit’ to which exploration and evaluation
expenditures should be allocated. The most common approach in the mining industry is to allocate costs between areas of
interest. This involves identifying the different geological areas that are being examined and tracking separately the costs
incurred for each area. An area of interest normally contracts in size over time as work progresses towards the identification
of individual mineral deposits.
An area of interest will normally comprise a single mine or deposit when economic viability is established.
The shelter of IFRS 6 only covers the exploration and evaluation phase, until the point at which the commercial viability of the
property has been established.
2.3.2.2 Initial recognition under the Framework
Expenditures incurred in exploration activities should be expensed unless they meet the definition of an asset. An entity
recognises an asset when it is probable that economic benefits will flow to the entity as a result of the expenditure [F4.44].
The economic benefits might be available through commercial exploitation of mineral reserves or sales of exploration
findings or further development rights. It is often difficult for an entity to demonstrate that the recovery of exploration
expenditure is probable. Where entities do not adopt IFRS 6 and instead develop a policy under the Framework,
expenditures on an exploration property are normally expensed until:
i. the point at which the fair value less costs to sell of the property can be reliably determined as higher than the total of the
expenses incurred and costs already capitalised (such as licence acquisition costs); and
ii. an assessment of the property demonstrates that commercially viable reserves are present and hence there are probable future
economic benefits from the continued development and production of the resource.
Cost of survey that provide evidence of unproductive areas but result in an increase in the fair value of the
licence—Should they be capitalised?
Background
Entity B operates in the copper mining sector and has chosen to develop accounting policies for exploration and
evaluation expenditures that are fully compliant with the requirements of the IFRS Framework rather than continue with
its previous accounting policies. It also chooses not to group exploration and evaluation assets with producing assets for
the purposes of impairment testing.
Entity B has acquired a transferable interest in an exploration licence. Initial surveys of the licence area already
completed indicate that there are mineral deposits present but further surveys are required in order to establish the
extent of the deposits and whether they will be commercially viable.
Management are aware that third parties are willing to pay a premium for an interest in an exploration licence if additional
geological and geotechnical information is available. This includes licences where the additional information provides
evidence of where further surveys would be unproductive.
Question
Can entity B capitalise the costs of a survey if it is probable before the survey is undertaken that the results of the survey
will increase the fair value of the licence interest regardless of the survey outcome?
Solution
Yes. Entity B may capitalise the costs of the survey provided that the carrying amount does not exceed recoverable
amount. Entity B’s management are confident before the survey is undertaken that the increase in the fair value less
costs to sell of the licence interest will exceed the cost of the additional survey.
Capitalisation of the costs of the survey therefore meets the accounting policy criteria set out by the entity.
2.3.2.3 Tangible / Intangible classification

Exploration and evaluation assets recognised should be classified as either tangible or intangible according to their nature
[IFRS 6 para 15].
Industry practice varies and some entities take the view that exploration and evaluation assets form part of property, plant
and equipment because the underlying asset is a tangible asset (i.e., the mineral deposit). Others have concluded that any
assets recognised in respect of exploration and evaluation expenditure must be attributed to the relevant exploration/mining
licence(s) and recognised as an intangible asset.
Clear disclosure of the accounting policy chosen and consistent application of the policy chosen are important to allow users
to understand the entity’s financial statements. In practice, most entities classify E&E assets as intangible unless it is a
physical asset e.g. drilling rig.
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2.3.3 Evaluation
Evaluation activities are further advanced than exploration and hence are more likely to meet the criteria for recognising an
asset. However, each project needs to be considered on its merits. The amount of evaluation work required to conclude that
a viable mine exists will vary for each area of interest.
Factors to be considered include:
the entity’s existing level of knowledge about the area of interest and the extent to
which the infrastructure assets and processing facilities needed to exploit the
mineral deposit already exist. This will depend on whether the evaluation activity
relates to a greenfield site, a brownfield site or extension drilling for a mineral
deposit that is already being mined or developed;
the scale of the project’s estimated net present value and the sensitivity of the net
present value to changes in the key assumptions. This will depend on the nature
and quality of the mineral deposit, and also the extent of the up-front capital costs
needed to develop the mine;
the level of risk associated with the project, including political risk and operational
risk;
the existence of any barriers that might prevent the project from proceeding (such
as securing water supplies, obtaining environmental approvals or developing the
required technology); and
management’s experience and track record.
The studies that are produced during the evaluation phase (such as pre-feasibility studies and final feasibility studies)
typically include an estimated net present value (based on the projected future cash flows) and a risk assessment setting out:
the potential range of any key parameters (including metal price, production grade,
production rate, capital costs, operating costs, metal recoveries, currency
exchange rates and development schedule);
the impact of fluctuations in these parameters on the economic viability of the
project (as measured by the net present value); and
other key parameters such as legal, permitting and environmental risks.
Typically each successive study generally costs more to produce and generates more detailed and reliable technical and
financial data.
A feasibility study (sometimes known as a ‘bankable’, ‘definitive’ or ‘final’ study as noted in section 1.2.2) may be needed
before the entity can demonstrate that future economic benefits are probable. Some mining entities have adopted a policy
under which all expenditure on individual exploration and evaluation projects is expensed until a final feasibility study has
been completed.
There are also many situations where a final feasibility study is not required to demonstrate economic feasibility; the entity
may, in these situations, capitalise all (or some) of the costs incurred in compiling the final study. Many Codes in use around
the world do not require the preparation of final feasibility study before resources can be designated as proved and probable
reserves.
Management needs to develop a consistent and transparent accounting policy that is applied through the various phases of
exploration and evaluation activity, highlighting the cut-off point before capitalisation of costs commences.
Costs incurred after probability of economic feasibility is established are capitalised only if the costs are necessary to bring
the resource to commercial production. Subsequent expenditures should not be capitalised after commercial production
commences, unless they meet the asset recognition criteria.
2.3.4 Subsequent measurement of E&E assets

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Exploration and evaluation assets can be measured using either the cost model or the revaluation model as described in IAS
16 and IAS 38 after initial recognition [IFRS 6 para 12]. In practice, most companies use the cost model.
Depreciation and amortisation of E&E assets usually does not commence until the assets are placed in service.
The classification of E&E assets as tangible or intangible has a particular consequence if the revaluation model is used for
subsequent measurement (although this is rare) or if the fair value as deemed cost exemption in IFRS 1 “First-time Adoption
of International Financial Reporting Standards” is used on first-time adoption of IFRS.
The revaluation model can only be applied to intangible assets if there is an active market in the relevant intangible assets.
This criterion is rarely met and would never be met for E&E assets as they are not homogeneous. The ‘fair value as deemed
cost’ exemption in IFRS only applies to tangible fixed assets and thus is not available for intangible assets. Classification as
tangible or intangible may therefore be important in certain circumstances.
2.3.5 Borrowing costs during the E&E phase
Borrowing costs incurred during the exploration and evaluation (“E&E”) phase may be capitalised under IFRS 6 as a cost of
E&E if they were capitalising borrowing costs under their previous GAAP. Borrowing costs may also be capitalised on any
E&E assets that meet the asset recognition criteria in their own right and are qualifying assets under IAS 23 “Borrowing
Costs” (revised 2007). E&E assets which meet these criteria are expected to be rare, for example during the assembly of
exploration facilities.
Entities could develop an accounting policy under IFRS 6 to cease capitalisation of borrowing costs if these were previously
capitalised. However the entity would then need to consider whether borrowing costs relate to a qualifying asset and would
therefore require capitalisation. The asset would have to meet the IASB framework definition of an asset and be probable of
generating future economic benefit. This definition will not be met for many assets. An exploration licence, for example,
would not meet the definition of a qualifying asset as it is available for use in the condition it is purchased and does not take
a substantial period of time to get ready for use. Additional exploration expenditure, although it can be capitalised under
IFRS 6, would not be considered probable of generating future economic benefit until sufficient reserves are located.
2.3.6 Reclassification out of E&E under IFRS 6
E&E assets are reclassified from Exploration and Evaluation when evaluation procedures have been completed [IFRS 6 para
17]. E&E assets for which commercially-viable reserves have been identified are reclassified to development assets. E&E
assets are tested for impairment immediately prior to reclassification out of E&E [IFRS 6 para 17]. The impairment testing
requirements are described below.
Once an E&E asset has been reclassified from E&E, it is subject to the normal IFRS requirements. This includes impairment
testing at the CGU level and depreciation on a component basis. The relief provided by IFRS applies only to the point of
evaluation (IFRIC Update November 2005).
An E&E asset for which no commercially-viable reserves have been identified should be written down to its fair value less
costs to sell. The E&E asset can no longer be grouped with other producing properties.
2.3.7 Impairment of E&E assets
IFRS 6 introduces an alternative impairment-testing regime for E&E assets. An entity assesses E&E assets for impairment
only when there are indicators that impairment exists. Indicators of impairment include, but are not limited to:
Rights to explore in an area have expired or will expire in the near future without
renewal;
No further exploration or evaluation is planned or budgeted;
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A decision to discontinue exploration and evaluation in an area because of the

absence of commercial reserves; and
Sufficient data exists to indicate that the book value will not be fully recovered from
future development and production.
The affected E&E assets are tested for impairment once indicators have been identified. IFRS introduces a notion of larger
cash generating units (CGUs) for E&E assets. Entities are allowed to group E&E assets with producing assets, as long as the
policy is applied consistently and is clearly disclosed. Each CGU or group of CGUs cannot be larger than an operating
segment (before aggregation). The grouping of E&E assets with producing assets might therefore enable an impairment to be
avoided for a period of time.
Although IFRS provides this allowance to group E&E assets with producing assets it is rarely used in practice.
Identification of level at which to test for impairment
Background
A mining entity has operations in Africa and South America. The operations in South America are all at the exploration
stage.
Within the Africa operating segment there are two producing mines (A and B), which are separate cash-generating units,
and two exploration sites (C and D). Management receives a geological survey showing significant downward revisions
to the resource estimates at site C.
Question
What policies may be established for the level at which E&E assets are tested for impairment?
Solution
Management could have a policy of testing each E&E site separately, (in which case it may be fully impaired).
Alternatively, management could have established a policy that groups an exploration site with the producing mines, in
which case there may be no impairment at all.
The sites which are grouped must all be within the same operating segment. In this example, were exploration site C to
have been in the South America operating segment it could not be grouped with the assets from the Africa operating
segment. In the absence of a producing mine within the South America operating segment, no shelter for impairment
would be available.
When a policy on grouping has been established it should be followed consistently for all future indications of
impairment. Common practice in the mining industry is to test E&E assets for impairment without grouping them with
producing mines, except where an E&E site would share infrastructure assets and/or processing facilities with the
producing mine.
The lack of certainty over the existence of reserves at the E&E stage means that Fair Value Less Costs to Sell (“FVLCTS” -
see section 9.5) is likely to be the appropriate approach to the impairment test. Fair value is usually established through other
methods such as on an acreage basis or using similar transactions.
Once the decision on commercial viability has been reached E&E assets are reclassified from the E&E category. They are
tested for impairment under the IFRS 6 policy adopted by the entity immediately prior to reclassification. Subsequent to
reclassification the normal impairment testing guidelines of IAS 36 “Impairment” apply. Successful E&E will be reclassified to
development and unsuccessful E&E is written down to the higher of fair value less costs to sell or value in use.
Assets reclassified from E&E are subject to the normal IFRS requirements of impairment testing at the CGU level and
depreciation on a component basis. As explained in section 2.3.6 the shelter provided by IFRS 6 only applies until the point
of reclassification. After reclassification impairment testing and depreciation on a pool basis is not acceptable.
2.3.8 Post balance sheet events
2.3.8.1 Identification of unsuccessful properties
A exploration project at the reporting date may be found to be unsuccessful subsequent to the balance sheet date. If this is
identified before the issuance of the financial statements, a question arises whether this is an adjusting or non-adjusting
event. IAS 10 “Events after the Reporting Period” requires an entity to recognise adjusting events after the reporting period in
its financial statements for the period.
Adjusting events are those that provide evidence of conditions that existed at the end of the reporting period. If the condition
arose after the reporting period, this would result in a non-adjusting event. An exploration project at period end which is
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determined to be unsuccessful subsequent to the balance sheet date based on substantive evidence obtained during the
drilling process in that subsequent period suggests a non- adjusting event. These conditions should be carefully evaluated
based on the facts and circumstances.
2.3.8.2 Licence relinquishment
Licences for exploration (and development) usually cover a specified period of time. They may also contain conditions
relating to achieving certain milestones on agreed deadlines. Often, the terms of the licence specify that if the entity does not
meet these deadlines, the licence can be withdrawn. Sometimes, entities fail to achieve these deadlines, resulting in
relinquishment of the licence. A relinquishment that occurs subsequent to the balance sheet date but before the issuance of
the financial statements must be assessed as an adjusting or non-adjusting event.
If the entity was continuing to evaluate the results of their exploration activity at the end of the reporting period and had not
yet decided if they would meet the terms of the licence, the relinquishment is a non- adjusting event. The event did not
confirm a condition that existed at the balance sheet date. The decision after the period end created the relinquishment
event.
If the entity had made the decision before the end of the period that they would not meet the terms of the licence or the
remaining term of the licence would not allow sufficient time to meet the requirements then the subsequent relinquishment is
an adjusting event and the assets are impaired at the period end. Appropriate disclosures should be made in the financial
statements under either scenario.
2.3.9 Exploration and evaluation disclosures
Typical exploration and evaluation disclosures include:
the accounting policy applied in respect of exploration and evaluation expenditure,

including the policy for allocating exploration and evaluation assets to cash-
generating units for impairment purposes;
the amounts recognised in the financial statements in respect of exploration and
evaluation activities (including the amounts of assets, liabilities, income, expense,
operating cash flows and investing cash flows); and
a reconciliation of the amounts carried forward as exploration and evaluation
assets at the beginning and end of the period—including expenditure capitalised
during the period, transfers to development, amounts written off and impairments.
The policy followed in respect of exploration and evaluation expenditure will require significant judgement for many entities.
They will need to determine whether expenditure should be carried forward as an asset or evaluate whether an impairment
loss has arisen or both. The financial statements must also disclose the judgements that have been applied.
Cash flows from exploration and evaluation costs that are capitalised as assets are disclosed as investing activities in the
cash flow statement. If the exploration and evaluations costs are expensed, then the related cash flows are shown as
operating activities in the cash flow statement. Cash flows from exploration and evaluation costs may be separately
disclosed in operating activities.
2.4 Disclosure of reserves and resources
A key indicator for evaluating the performance of mining entities are their existing reserves and the future production and
cash flows expected from them. Disclosures of reserves and resources often accompany financial statements but are
presented outside of them and are not covered by the auditor’s opinion. Some national securities regulators require
supplemental disclosure of reserve information. There are also recommendations on accounting practices issued by industry
bodies which are required by some stock exchanges. However, there are no reserve disclosure requirements under IFRS and
it is not mandatory to provide disclosures in all jurisdictions although some entities may still do so on a voluntary basis.
IAS 1 “Presentation of Financial Statements” [IAS 1 para 17] requires that an entity’s financial statements should provide
additional information when compliance with specific requirements in IFRS is insufficient to enable an entity to achieve a fair
presentation.
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An entity may consider the pronouncements of other standard-setting bodies and accepted industry practices when
developing accounting policies in the absence of specific IFRS guidance. Many entities provide supplemental information
with the financial statements because of the unique nature of the mining industry and the clear desire of investors and other
users of the financial statements to receive information about reserves. The information is usually supplemental to the
financial statements and, as noted above, is not covered by the auditor’s opinion.
Information about quantities of mineral reserves and changes therein is essential for users to understand and compare
mining companies’ financial position and performance. Entities should consider presenting reserve quantities and changes
on a reasonably aggregated basis. Reserve disclosures accompanying the financial statements should be consistent with
those reserves used for financial statement purposes. For example, proved and probable reserves might be used for
depreciation and amortisation calculations.
The categories of reserves used and their definitions should be clearly described. Reporting a ‘value’ for reserves and a
common means of measuring that value have long been debated, and there is no consensus among national standard-
setters permitting or requiring value disclosure. There is, at present, no globally agreed method to prepare and present
‘value’ disclosures. However, there are globally accepted engineering definitions of reserves that take into account economic
factors. These definitions may be a useful benchmark for investors and other users of financial statements to evaluate. The
disclosure of key assumptions and key sources of estimation uncertainty at the balance sheet date is required by IAS 1.
Given that the reserves and resources have a pervasive impact, this can result in entities providing disclosure about mineral
resource and reserve estimates, for example:
the methodology used and key assumptions made for mineral resource and reserve
estimates;
the sensitivity of carrying amounts of assets and liabilities to the mineral resource
and reserve estimates used;
the range of reasonably possible outcomes within the next financial year in respect
of the carrying amounts of the assets and liabilities affected; and
an explanation of changes made to past mineral resource and reserve estimates,
including changes to underlying key assumptions.
Other information such as the potential future costs to be incurred to acquire, develop and produce reserves may help users
of financial statements to assess the entity’s performance. Supplementary disclosure of such information with IFRS financial
statements is useful, but it should be consistently reported, the underlying basis clearly disclosed and based on common
guidelines or practices, such as the CRIRSCO definitions.
Companies already presenting supplementary information regarding reserves under their local GAAP may want to continue
providing information in the same format under IFRS.
3. Development activities
3.1 Development expenditures
Development expenditures are costs incurred to obtain access to proved and probable reserves and to provide facilities for
extracting, treating, gathering, transporting and storing the minerals. An entity should develop an accounting policy for
development expenditure based on the guidance in IAS 16, IAS 38 and the Framework. Much development expenditure
results in assets that meet the recognition criteria in IFRS.
Development expenditures are capitalised to the extent that they are necessary to bring the property to commercial
production. They should be directly attributable to an area of interest or capable of being reasonably allocated to an area of
interest. Costs which could meet these criteria include:
the purchase price for development assets, including any duties and any non-
refundable taxes;
costs directly related to bringing the asset to the location and condition for
intended use such as drilling costs or removal of overburden to establish access to
the ore reserve; and
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the present value of the initial estimate of the future costs of dismantling and
removing the item and restoring the site on which it is located, where such
obligations arise when the asset is acquired or constructed.
Allocation of expenditure includes direct and indirect costs. Indirect costs are included only if they can be directly attributed
with the area of interest. These may include items such as road construction costs and costs to ensure conformity with
environmental regulations. Costs associated with re-working engineering design errors or those attributed to inefficiencies in
development should not be capitalised.
General or administrative overheads relating to the whole entity, rather than to specific phases of operations, are expensed
as incurred. Time charges from head office staff may be capitalised where there is a clear and direct allocation of their time
to development specific activities.
Entities should also consider the extent to which “abnormal costs” have been incurred in developing the asset. IAS 16
requires that the cost of abnormal amounts of labour or other resources involved in constructing an asset should not be
included in the cost of that asset. Entities will sometimes encounter difficulties in their mining plans and make adjustments to
these. There will be a cost associated with this, and entities should develop a policy on how such costs are assessed as
being normal or abnormal.
Expenditures incurred after the point at which commercial production has commenced should only be capitalised if the
expenditures meet the asset recognition criteria in IAS 16 or 38.
3.2 Borrowing costs in the development phase
The cost of an item of property, plant and equipment may include borrowing costs incurred for the purpose of acquiring or
constructing it. IAS 23 requires that borrowing costs be capitalised in respect of qualifying assets. Qualifying assets are
those assets which take a substantial period of time to get ready for their intended use.
of specific borrowings for the purpose of financing the construction of the asset, and those general borrowings that would
have been avoided if the expenditure on the qualifying asset had not been made. The general borrowing costs attributable to
an asset’s construction should be calculated by reference to the entity’s weighted average cost of general borrowings.
3.3 Foreign exchange gains and losses
When development is funded by borrowings in a foreign currency, IAS 21 “The Effects of Changes in Foreign Exchange
Rates” requires any foreign exchange gain or loss to be recognised in the income statement unless they are regarded as
adjustments to interest costs, in which case they can be capitalised as borrowing costs in accordance with IAS 23.
The gains and losses that are an adjustment to interest costs include the interest rate differential between borrowing costs
that would be incurred if the entity borrowed funds in its functional currency and borrowing costs actually incurred on foreign
currency borrowings.
IAS 23 does not prescribe which method should be used to estimate the amount of foreign exchange differences that may
be included in borrowing costs. Two possible methods are:
The portion of the foreign exchange movement may be estimated based on

forward currency rates at the inception of the loan; or
The portion of the foreign currency movement may be estimated based on interest
rates on similar borrowings in the entity’s functional currency.
Management must use judgement to assess which foreign exchange differences can be capitalised. The method used is a
policy choice which should be applied consistently to foreign exchange differences whether they are gains or losses.
Exchange differences on foreign currency borrowings Background
At the beginning of the year a mining entity domiciled in the UK has a US$1 million foreign currency loan. The interest
rate on the loan is 4% and is paid at the end of the period. An equivalent borrowing in sterling would carry an interest rate
of 6%. The spot rate at the beginning of the year is £1 = US$1.55 and at the end of the year it is £1 = US$1.50
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Question
What exchange difference could qualify as an adjustment to the interest cost?
Solution
The expected interest cost on a sterling borrowing would be £645,161 @ 6% = £38,710
The actual cost of the US$ loan is: £

Loan at the beginning of the year: US$1 million @ 1.55 645,161
Loan at the end of the year: US$1 million @ 1.50 666,667
Exchange loss 21,506
Interest paid: US$1 million @ 4% = $40,000 @ 1.5 26,667
Total 48,173
Interest on sterling equivalent 38,710
Difference 9,463
The total actual cost of the loan exceeds the interest cost on a sterling equivalent loan
by £9,463. Therefore, only £12,043 (£21,506 - £9,463) of the exchange difference of
£21,506 may be treated as interest eligible for capitalisation under IAS 23.
In order to continue capitalisation of the exchange difference, the correlation between the exchange rate and interest
rate differential should be demonstrable and remain consistent over the life of the borrowing.
3.5 Development disclosures
Development expenditure disclosures include:
accounting policy, including treatment of development expenditure after

commercial production has commenced;
balance of development and construction expenditure capitalised;
amounts capitalised on projects yet to reach commercial production; and
reconciliation of costs to prior year, including expenditure incurred during the
period, transfers and impairments.
3.4 Pre-production sales
This section focuses on how to account for pre-production income generated before an item of PP&E is ready for its
intended use.
Output might be generated when a mine is still in the development phase (for example, when resources are extracted from
the ground while the mine shaft is being sunk, or when the mine is being tested and output is produced as a result of
testing). This income is generally referred to as ‘pre-production income’.
The cost of output generated before the item of PP&E is ready for its intended use should be measured in accordance with
the principles of IAS 2. Once the output has been sold, pre-production income earned and the cost of the output generated
are required to be recognised in the statement of comprehensive income.
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PwC Observation
Accounting for pre-production income will have a significant impact on entities that construct material items of PP&E
and, as part of the construction, there is a ramp-up period to test whether the asset is operating as it should; similarly,
where resources are extracted from the earth during the development of a mine which is above a body of resource (for
example, where a shaft is sunk and resource is extracted in the development process). The mining industry is expected
to be significantly impacted by the requirement to account for pre-production proceeds. Management might need to
develop processes to track the cost of output generated during the development phase and to account for an asset as
ready for its intended use earlier than before.
Further guidance on measurement of cost can be found in the PwC Manual of Accounting chapter 22 paras 22.20 to 20.20.3.
IND FAQ 3.4.1 – How does the amendment to IAS 16 impact accounting for stockpiles?
IND FAQ 3.4.2 – Should depreciation of the mine, or components of a mine, that are still being developed be included in the
costs allocated to the pre-production output?
IND FAQ 3.4.3 – How is a loss on the write-down of inventory during the development phase accounted for?IND FAQ 3.4.4 –
Does the amendment impact the value of and accounting for exploration and evaluation activities?
IND FAQ 3.4.5 – What is the accounting treatment for the capitalisation of borrowing costs during the testing phase of an
item of PP&E?
IND FAQ 3.4.6 – Does the amendment impact how entities should perform their unit of account assessment to determine
when an asset is ready for its intended use?

FAQ 22.20.1.1 – How are costs allocated to output generated before an item of PP&E is ready for its intended use
measured?
FAQ 22.20.5 – What factors should entities consider in determining when an item of PP&E is ready for its intended use if the
entity is generating output during the development phase?
FAQ 22.20.3.1 – What retrospective adjustments are required at the date when the amendment to IAS 16 becomes effective
(that is, annual reporting periods beginning on or after 1 January 2022)?
4. Production activites
Determining when development ends and production starts can be complex. This is a key determination for mining entities
as the change to production activity means that certain costs are no longer capitalised, and depreciation of assets
commences. It is also the stage at which the entity will commence production of inventory and recognising revenue.
As explained in section 1.2.3, a conclusion on whether an asset is ‘available for use’ and in the production phase is usually
reached after discussions between the engineers, metallurgists, operators and those in financial role).
This section explores the accounting issues which can occur once the decision is made that the mine is at the production
stage:
Revenue recognition — how is it determined when of the transfer of ownership

has occurred and how are provisional pricing arrangements recognised?
Depreciation and amortisation — what is the appropriate basis of depreciation
for assets used in mining activities and how is the requirement to depreciate on a
component basis met?
Deferred stripping costs — can deferred stripping costs at the production phase
be capitalised and how should these be measured and amortised?
Renewal and reconditioning costs — should these costs be capitalised?
Inventory valuation — what costs should be included in the measurement of
inventory and how should long term stock piles be valued?
4.1 Revenue recognition
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4.1.1 Overview
The core principle of IFRS 15 is that an entity is required to recognise revenue to depict the transfer of promised goods and
services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for
those goods or services.
PwC Observation
Revenue recognition in the mining industry might appear to be simple. Revenue is generated through the supply of
commodities in exchange for consideration. Complexities can arise, however, from certain types of contractual
arrangement that are common to the industry, including: partnerships with other entities (section 4.1.2.1); arrangements
for which the consideration is based on future production; agency arrangements (section 4.1.7.1); transportation
services (section 4.1.4); provisionally-priced commodity sales contracts (section 4.1.2.2); and long-term take-or-pay
arrangements (sections 4.1.2 and 4.1.3). The complexities in these areas can make the decision of when to recognise
revenue, and how to measure it, challenging.
4.1.2 Scope
Further guidance on IFRS 15’s scope can be found in the PwC Manual of Accounting chapter 11 paras 6 to 17.
Transactions should be accounted for within the scope of IFRS 15 if the counterparty to the contract is a customer. IFRS 15
does, however, exclude the following from its scope: lease contracts within the scope of IFRS 16 ‘Leases’; financial
instruments and other contractual rights and obligations within the scope of IFRS 9, ‘Financial Instruments’; and non-
monetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers.
Paragraph 7 of IFRS 15 states that a contract can be partially within the scope of IFRS 15 and partially within the scope of
another standard. If the other standard specifies how to separate and/or initially measure the contract (or some parts of the
contract), the entity applies the separation and/or measurement requirements in the other standard. An entity applies the
separation and measurement guidance in IFRS 15 if other standards do not specify how to separate or measure the
remaining portion of the contract. Since IFRS 15 is a residual standard, entities should first assess whether the contract (or
part of the contract) is within the scope of other standards before applying IFRS 15.
PwC Observation
Long-term sales contracts are common in the mining industry. These contracts will typically stipulate the sale of a set
volume of product over the period at an agreed price. Long-term commodity contracts frequently offer the counterparty
flexibility and options in relation to the quantity of the commodity to be delivered under the contract.
Mining entities should first assess whether these arrangements (1) convey the right to control the use of an identified
asset and therefore constitute a lease, or (2) represent financial instruments or contain embedded derivatives that should
be accounted for under the financial instruments standards (for example, where a contract with volume flexibility
contains a written option that can be settled net in cash or another financial instrument).
PwC Observation
Mineral exploration and development is a capital intensive process and different financing methods have arisen.
Streaming transactions are a common means of obtaining financing.
In a streaming transaction, an investor/customer makes an upfront payment to a resource company in return for the
right to purchase a fixed percentage of future production of a commodity, often at a price below market value. The
arrangement typically provides for ongoing payments for each unit of commodity as they are delivered under the
streaming agreement. Streaming arrangements are usually long term and frequently span the life of the related
producing asset.
This is a complex area. There will be very specific facts for each arrangement. These must be understood and analysed,
because different accounting treatments might be applicable in certain circumstances. Often, judgement is applied in
determining the accounting treatment.
Arrangements of this type are different from derivative forward contracts that would protect the entity against
fluctuations in commodity prices (that is, to buy or sell mineral ores at a specified future time at a price agreed in the
present).
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PwC Observation
These types of transactions typically result in one of four accounting outcomes based on the facts and circumstances:
the sale of an interest in the mining property (with potentially an extraction

service contract within the scope of IFRS 15);
a long term purchase contract within the scope of IFRS 15, which might result in
a contract liability;
a derivative within the scope of IFRS 9; and
a loan with an embedded derivative within the scope of IFRS 9.
FAQ 11.8.1 – Are non-monetary exchanges in the scope of the revenue standard?
EX 11.11.1 – Accounting for contracts partially in scope of the revenue standard
FAQ 40.84.1 – What is the distinction between a contract meeting the ‘own use’ exception and a contract being treated as a
derivative?
FAQ 40.86.4 – Electricity supply contracts containing a written option; is the ‘own use’ exemption met?
FAQ 40.79.1 – How should an entity account for a prepayment of a commodity?
4.1.2.1 Definition of a customer
A customer is a party that contracts with an entity to obtain goods or services that are the output of that entity’s ordinary
activities. The scope includes transactions with collaborators or partners if the collaborator or partner obtains goods or
services that are the output of the entity’s ordinary activities. It excludes transactions arising from arrangements where the
parties are participating in an activity together and share the risks and benefits of that activity.
FAQ 11.16.1 – Is a collaborative arrangement in the scope of the revenue standard?
4.1.2.2 Provisionally priced arrangements
Sales contracts for certain commodities (such as platinum, copper, and iron ore) often incorporate provisional pricing. At the
date of delivery of the mineral ore to the customer, a provisional price might be charged. Quite often, the final price is an
average market price for a particular future period. At the date of making the sale, there is variability in the transaction price,
in that changes in the commodity price and/or the quantity or quality of the commodity can occur.
Provisional pricing might arise for a variety of reasons:
the time taken to transport the product might mean that the customer wishes to
pay the market price at the date of eventual delivery at the final destination; or
the product is being transported in concentrate form, and the final quality and
volume of component commodities will not be known until further processing at its
final destination.
Since a sale is made to a customer, the transaction will fall within the scope of IFRS 15. However, a variability arising solely
from changes in market price will fall into IFRS 9. The receivable recognised from the sale would fail the solely payments of
principal and interest (‘SPPI’) test, due to the variability associated with the commodity price, and it would be measured at
fair value through profit or loss.
PwC Observation
Fair value movements in receivables resulting from provisional pricing arrangements do not meet the definition of
‘revenue from contracts with customers’; however, presentation as part of revenue in the primary statement, with the
amount disclosed as another type of revenue in the notes, would be acceptable.
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FAQ 11.295.3 – Does IFRS 15 or IAS 39/IFRS 9 apply where all variability in the receivable arises from a market price?
FAQ 11.295.4 – Does IFRS 15 or IAS 39/IFRS 9 apply where all variability in the consideration arises from physical attributes
(for example, quality of contained metals in concentrate)?
FAQ 11.295.5 – Does IFRS 15 or IAS 39/IFRS 9 apply where variability arises from both market price and physical attributes
(for example, quality of contained metals in concentrate) and the two kinds of variability are not readily separable?
FAQ 11.299.1 – Does the seller adjust revenue if the fair value of the separated embedded derivative or the receivable
changes?
EX 11.11.1 – Accounting for contracts partially in scope of the revenue standard
4.1.3 Identifying the contract
Further guidance on identifying the contract can be found in the PwC Manual of Accounting chapter 11 paras 18 to 55.
A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. Criteria
that must be met before an entity accounts for a contact with a customer can be found in paragraph 9 of IFRS 15.
PwC Observation
In order for a long-term supply contract to be considered to be a contract in terms of IFRS 15, each party’s rights
regarding the goods and services to be transferred need to be able to be identified. In addition, the payment terms for
the goods and services to be transferred need to be identified.
It is unlikely that long-term supply contracts that do not include a minimum quantity to be delivered will be within the
scope of IFRS 15, because each party's rights regarding the goods and services to be transferred are not identifiable.
Only when the quantities (or minimum quantities) to be delivered are agreed to and the payment terms can be identified
will these contracts be considered to be contracts within the scope of IFRS 15.
Where long-term supply contracts within the scope of IFRS 15 offer the counterparty flexibility and options in relation to
the quantity of the commodity to be delivered under the contract, only the minimum amount specified would generally
be considered a contract, because this is the only enforceable part of the agreement. Options in the contract to acquire
additional volumes will likely be considered a separate contract at the time when the customer exercises the option,
unless such options are embedded derivatives under IFRS 9 (section 4.1.2) or provide the customer with a material right
(section 4.1.4.1).
4.1.4 Identifying performance obligations in

the contract
Further guidance on identifying performance obligations in the contract can be found in the PwC Manual of Accounting
chapter 11 paras 56 to 71.
At contract inception, an entity should assess the goods or services promised explicitly or implicitly in the contract. A
performance obligation is each promise to transfer to the customer either (a) a good or service that is distinct, or (b) a series
of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. In
terms of IFRS 15, a series of distinct goods or services will be considered to have the same pattern of transfer to the
customer only if each distinct good or service in the series meets the criteria to recognise revenue over time.
PwC Observation
In a long-term supply contract, where the contract is identified as a contract within the scope of IFRS 15, each unit of
commodity delivered will be considered to be a separate performance obligation, because each unit delivered is distinct.
PwC Observation
Mineral resources are often extracted from remote locations and can require transportation over great distances.
Transportation might occur via sea, rail or road. Arrangements that involve the transport of goods to a customer might
include promises related to freight and handling activities that give rise to a performance obligation. Management should
assess the explicit shipping terms to determine when control of the goods transfers to the customer and whether the
freight and handling activities are a separate performance obligation.
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PwC Observation
Freight and handling activities that occur before the customer obtains control of the related goods are generally
fulfilment activities and are not considered to be a separate performance obligation. However, if control of a good has
been transferred to a customer (before shipment), and freight and handling activities are provided in relation to the
customer’s goods, the entity is providing a service to the customer. In this case, freight and handling activities are
usually considered to be a separate performance obligation. This is often the case for goods shipped on a standard
‘cost, insurance, and freight’ (CIF) or ‘cost and freight’ (CFR) basis. A full understanding of the terms of trade is required
in order to reach this conclusion. Management should then assess whether it acts as a principal or agent in providing
the shipping services to the customer. See section 4.1.7.1 for further discussion.
IND FAQ 4.1.7.2 – How many performance obligations exist in the refining arrangement?
FAQ 11.58.2 – How many performance obligations are in an arrangement that involves shipment of goods to a customer?
4.1.4.1 Material right
A material right is a right that the customer would not receive without having entered into the contract – for example a
discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in
that geographical area or market. Paragraph 26(j) of IFRS 15 lists options to purchase additional goods or services when
those options provide a customer with a material right as a distinct good or service.
Purchase options for commodities should first be assessed as to whether they are embedded derivatives under IFRS 9
(section 4.1.2). If the option is not an embedded derivative and provides a customer with a material right under IFRS 15, the
customer is purchasing two things in the arrangement – the good or service originally purchased, and the right to a free or
discounted good or service in the future – and is effectively paying in advance for future goods or services. Where there is a
material right, the option should be accounted for as a separate performance obligation in the original contract.
A practical expedient is available to simplify the accounting for certain material rights, details can be found in Paragraph B43
of IFRS 15.
FAQ 11.200.2 – How should an entity account for the exercise of a customer option?
FAQ 11.205.2 – How should an entity account for a renewal option that provides a material right?
4.1.5 Determining the transaction price
Further guidance on determining the transaction price can be found in the PwC Manual of Accounting chapter 11 paras 72 to
123.
The transaction price in a contract reflects the amount of consideration to which an entity expects to be entitled in exchange
for goods or services transferred. The transaction price promised in a contract with a customer might include fixed amounts,
variable amounts or both. When determining the transaction price, management must take into account consideration that is
fixed, variable and non-cash, and amounts payable to a customer.
Variable consideration included in the transaction price is subject to a constraint. An entity should recognise revenue as
performance obligations are satisfied only if it is highly probable that a change in the estimate of the variable consideration
would not result in a significant reversal of the cumulative revenue recognised. This assessment will often require judgement.
In addition, management needs to assess whether a significant financing component exists in contracts with customers,
because this should be taken into account in the determination of the transaction price.
PwC Observation
Normally, assays (whereby the concentrate is analysed to determine the composition and quality) are performed prior to
delivery to a customer. As a result, it is unlikely that the variable consideration estimates will need to be constrained for
provisionally priced arrangements where variability relates to physical attributes.
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IND FAQ 4.1.7.3 – How should the refiner account for metal gains?
4.1.5.1 Significant financing component
Further guidance on identifying a significant financing component can be found in the PwC Manual of Accounting chapter 11
paras 100 to 102.
Some contracts might contain a significant financing component because payment by a customer occurs either significantly
before or significantly after performance. The facts and circumstances giving rise to the timing difference need to be
analysed carefully, to determine if there are reasons other than financing that led to the timing difference. The amount of
revenue recognised will be different from the amount of cash received from the customer where an entity determines that a
significant financing component exists. Revenue recognised will be less than cash received for payments that are received in
arrears of performance, since a portion of the consideration will be recognised as interest income. Revenue recognised will
exceed the cash received for payments that are received in advance of the performance, because an interest expense will be
recorded and increase the amount of revenue recognised.
However, there is a practical expedient available for an entity not to have to account for the significant financing component
if it expects, at contract inception, that the period between when the entity transfers a promised good or service to a
customer and when the customer pays for that good or service will be one year or less.
PwC Observation
For long-term purchase contracts including streaming transactions and similar arrangements accounted for as long-term
purchase contracts within the scope of IFRS 15 (see section 4.1.2), it is likely that each unit of commodity to be
delivered will be considered to be a separate performance obligation. Due to the upfront payment and the long-term
nature of these transactions, these transactions will likely be considered to contain significant financing. Revenue
recognised will thus exceed the cash received for payments that are received in advance of performance, because
interest expense recorded will increase the amount of revenue recognised.
4.1.6 Allocation of transaction price to separate

performance obligations
Further guidance on allocating the transaction price to separate performance obligations in the contract can be found in the
PwC Manual of Accounting chapter 11 paras 124 to 152.
The transaction price is allocated to each distinct performance obligation, based on the relative stand-alone selling price of
the performance obligation in the contract.
Some elements of the transaction price might affect only one performance obligation, rather than all performance
obligations, in the contract. Additionally, variable consideration can be allocated to specific performance obligations if certain
conditions are met, namely that the terms of the variable consideration relate specifically to the entity’s efforts to satisfy the
performance obligation or to transfer the distinct good or service.
PwC Observation
There are often clauses within a long-term supply contract relating to price adjustment or escalation over the course of
the contract to protect the producer and/or the seller from significant changes to the underlying assumptions in place at
the time the contract was signed. If the formulas used are to reflect the expected increase in the relative stand alone
selling price of the commodity, the price increase would be allocated to the deliveries to which the increase relates. For
example: where platinum is supplied on a monthly basis to a customer for a period of 20 years, and the price charged
per delivery is the spot price at the date of delivery, the transaction price allocated to each delivery would be the spot
price at the date of the respective delivery. Another example could be where annual contractual price increases are
based on cost price increases or some form of inflation index that is closely linked to the supply contract. If these
increases are intended to represent the relative stand alone selling price, the increase would be allocated to the year in
which the increase is expected to occur.
A long-term contract to supply coal to a customer might contain a number of price adjustment factors in respect of the
quality of the coal (such as moisture content, ash content or abrasiveness index). Because these adjustment factors
relate to a separate performance obligation (that is, each unit of coal delivered), they would not be allocated to all of the
performance obligations under the contract but to the specific performance obligation to which they relate.
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PwC Observation
4.1.7 Recognising revenue when (or as) a

performance obligation is satisfied
Further guidance on recognising revenue when (or as) a performance obligation is satisfied can be found in the PwC Manual
of Accounting chapter 11 paras 153 to 197.
An entity is required to recognise revenue when (or as) it satisfies a performance obligation by transferring control of the
good or service to a customer. Control either transfers over time or at a point in time, which affects the timing of when
revenue is recorded.
IND FAQ 4.1.7.4 – Should the refiner account for the revenue generated from refining services at a point in time or over time?
IND FAQ 4.1.7.5 – How is revenue recognised in a take-or-pay arrangement?
4.1.7.1 Agent versus principal
Further guidance on agent versus principal considerations can be found in the PwC Manual of Accounting chapter 11 paras
264 to 272.
Where another party is involved in providing goods or services to a customer, the entity should determine whether the nature
of its promise is a performance obligation to provide the specified goods or services itself (that is, the entity is a principal) or
to arrange for those goods or services to be provided by the other party (that is, the entity is an agent). An entity determines
whether it is a principal or an agent for each specified good or service promised to the customer.
If a contract with a customer includes more than one specified good or service, an entity could be a principal for some
specified goods or services and an agent for others.
To determine whether an entity is acting as principal or agent, the following should be considered:
the entity must first identify the specified good or service being provided to the
customer, based on the performance obligations identified in the contract; and
the entity should assess whether it controls these goods or services before they are
transferred to a customer. Indicators that an entity controls the specified good or
service can be found in paragraph B37 of IFRS 15.
The decision as to whether the entity is acting as an agent or principal in a transaction will impact the amount of revenue
recognised. An agent recognises revenue for the fee earned for facilitating the transfer of goods or services (that is, on a net
basis). The principal recognises as revenue the ‘gross’ amount paid by the customer for the specified good or service, and it
will recognise a corresponding expense for the commission or fee that it has to pay to any agent in addition to the direct
costs of satisfying the contract. In addition, the timing of revenue recognition (that is, over time or at a point in time) could
also be impacted by whether the entity is considered to be an agent or principal.
Determining whether an entity is the principal or an agent is not an accounting policy choice. It is a judgement that must be
supported based on the facts and circumstances of each arrangement.
IND FAQ 4.1.7.1 – Is a refiner acting as agent or principal for the sale of goods to a customer?
FAQ 11.271.5 – Should an entity recognise shipping and handling fees gross or net of the amount paid to a shipping
provider?
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4.2 Deprication & Amortisation
4.2.1 Deprecation of mining assets
The accumulated capitalised costs from E&E and development phases are amortised over the expected total production
using a units of production (“UoP”) basis. UoP is the most appropriate amortisation method because it reflects the pattern of
consumption of the reserves’ economic benefits. However, straight-line amortisation may be appropriate for assets that are
consumed more by the passage of time. Also, there may be circumstances when straight line depreciation does not produce
a materially different result and can be used as a proxy for UoP.
4.2.2 UoP basis
IFRSs do not prescribe what basis should be used for the UoP calculation. There are several methods commonly used:
total quantity of material extracted from the mine (including waste): this is
appropriate for depreciating equipment such as shovels and draglines where the
level of wear and tear is based on the volume extracted from the mine, irrespective
of whether it represents ore or waste;
total quantity of ore extracted from the mine: this is appropriate for depreciating the
cost of the mineral property itself. It might also be suitable for depreciating
equipment that is used in the early stages of processing, such as crushers and
conveyors where wear and tear is linked to the ore throughput;
total output: this is appropriate for depreciating plant and equipment that is
involved in the latter stages of processing (such as smelters and refineries) where
the volume of throughput (and hence wear and tear) is closely linked to the quantity
of valuable output.
For assets with an economic life that is shorter than the mine life, these calculations need to be performed using the
estimated productive capacity of the individual asset (or component), not the estimated capacity of the mine as a whole.
4.2.3 Determining the reserve/resource base
The life of the mine for depreciation purposes is based on an estimate of mineable mineral reserves and resources. The
reserve/resource base selected needs to be considered in conjunction with the actual mine plan and any necessary costs to
be incurred in order to extract part of those reserves/resources in determining the amortisation charge for the period.
The following reserve and resource bases are commonly used by a mining entity:
Proved and probable reserves; or

Reserves and a portion of resources expected to be converted into reserves.
Entities should only include those reserves or resources which they plan to mine.
4.2.3.1 Proved and probable reserves
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The use of proved and probable reserves for the calculation of depreciation is common as it is often the best estimate of the
life of the mine. All inferred resources are excluded, together with any indicated and measured resources that have not yet
been deemed economically recoverable.
This approach may be appropriate in situations where proved and probable reserves provide the best indication of the useful
life of the assets and the related costs that have been capitalised. However, in other situations, proved and probable
reserves alone may not provide a realistic indication of the useful life of the mine and related assets. Management may be
confident that further resources will be converted into reserves and are approaching economic decisions affecting the mine
on this basis, but has chosen to delay the work required to designate them formally as reserves.
4.2.3.2 Reserves and a portion of resources expected to be converted into reserves
Some mining entities adopt a different policy. The reserve/resource base is assessed for each mine and will depend on the
type of mineral and the characteristics of the deposit. It is difficult to justify including inferred mineral resources in the
depreciation base if the tonnage, grade and mineral content can only be estimated with a low level of confidence. For some
deposits, however, it may be considered reasonable to take account of indicated and measured mineral resources that have
not yet been classified as reserves. This might help to ensure the depreciation charges reflect management’s best estimate
of the useful life of the assets.
This can be particularly important where a mineral property has been acquired as part of a business combination and a
significant amount has been attributed to the fair value of resources not yet designated as reserves. Use of only proved and
probable reserves in those circumstances would probably result in a significant acceleration of depreciation expense.
4.2.3.3 Basis of UoP calculation
The basis of the UoP calculation is a choice, and should be applied consistently for similar fact patterns. As noted in section
2.3.2, the type of site which is being operated may be a factor which the entity considers when evaluating the likely activity
on a mine and could be a factor in deciding which basis to use for the UoP calculation. A brownfield site may provide more
confidence in selecting reserves and a portion of resources which they expect to convert to reserves.
If an entity includes more than just proved and probable reserves in its UoP calculation, an adjustment is generally made to
the calculation of the amortisation charge to include the estimated future development costs to access the portion of
resources expected to be converted into reserves. There are different approaches to the inclusion of future development
costs and these are discussed in 4.2.3.4 below.
The estimated production used for depreciation of assets that are subject to a lease or licence should be restricted to the
total production expected to be produced during the licence/lease term. Renewals of the licence/ lease are only assumed if
there is evidence to support probable renewal at the choice of the entity without significant cost.
Unit of production calculation—classes of reserves
What class of reserves should be used for the UoP calculation?
Background
Entity D is preparing its first IFRS financial statements. D’s management has identified that it should amortise the
carrying amount of its producing mines on a unit of production basis over the reserves present for each mine.
However, D’s management is debating whether to use proved and probable reserves or reserves and a portion of
resources expected to be converted into reserves for the unit of production calculation.
Solution
Entity D’s management may choose to use either proved and probable reserves or reserves and a portion of resources
expected to be converted into reserves for the unit of production amortisation calculation.
The IASB Framework identifies assets on the basis of probable future economic benefits. An appropriate basis for
assessing these would be the reserves used by management when assessing their business performance and the use of
probable reserves may be consistent with this approach. In some limited circumstances it may be appropriate to include
resources which form an integral part of management’s mine plan.
Whichever reserves definition D’s management chooses it should disclose and apply this consistently to all similar types
of production properties.
Unit of production calculation—future mine plans
Can resources not yet designated as reserves be used as a basis for the UoP calculation?
Background
Entity C has been operating a producing mine for the last 30 years. The mine area contains narrow deep veins of
precious metals.
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At the year end there are proved reserves remaining equivalent to two years of production remaining. However, the entity
expects to convert further resources not yet designated as reserves and believes that these will be sufficient for activity
to continue for an additional 20 years.
Solution
Where the entity has a track record of proving up additional reserves every year, has evidence to indicate that there are
additional resources which may be proved up in future and has demonstrated an intention to continue activity at the site,
it may be appropriate to include resources expected to be converted into reserves.
4.2.3.4 Future development costs

Substantial costs are incurred up-front when a new mine is established but before production commences. However, it may
be apparent that further future development costs will be necessary to extract all of the reserve/resource base from the mine.
For example, it may be necessary to expand the tailings facilities or remove more overburden or, in the case of an
underground mine, it may be necessary to construct new levels and cross-cuts.
Where substantial future development costs are required to extract the entire reserve/resource base, one approach is to split
the costs attributed to the mineral property between those that can:
be attributed to the entire ore body (such as the property acquisition costs and
transfers from exploration and evaluation), which should be depreciated over the
full reserve/resource base; and
only be attributed to part of the ore body (such as the overburden removal costs or
the cost of constructing the first tailings facility), which should be depreciated over
the relevant portion of the reserve/resource base.
This might result in the use of several different reserve/ resource bases for different components of the mine development
costs. These costs are then depreciated as and when additional development costs are incurred over the part of the ore
body to which they relate.
Any amounts capitalised in respect of the future dismantlement, removal and restoration of the mine site are depreciated on
a basis consistent with the mine development activity to which they relate. This approach is consistent with the requirement
that each part of an asset with a cost that is significant to the total cost of the item should be depreciated separately.
Where costs are attributed to the entire ore body and depreciation is calculated over reserves and resources, future
development costs may need to be taken into account when determining the pattern of depreciation charges on the existing
asset.
4.2.4 Change in the basis of reserves
An entity should use the reserve base which is in line with their mine plan and the level of reserves they expect to extract. As
expectations can change the entity may subsequently determine that an alternative base may be more appropriate. A
change in the basis of reserves from proved and probable reserves to reserves and a portion of resources expected to be
converted into reserves is considered acceptable under IFRS.
A change in the basis of reserves constitutes a change in accounting estimate under IAS 8. The entity’s policy of
depreciating their assets on a UoP basis is unchanged; they have only changed their estimation technique. The effect of the
change is recognised prospectively from the period in which the change has been made. Entities which change their UoP
basis should ensure that any related changes (such as future capital expenditure to complete any assets or access
resources) are also incorporated into their depreciation calculation. Appropriate disclosure of the change should be made.
4.2.5 Deprecation of other assets
Non-mining assets are depreciated using a method that reflects the pattern in which the asset’s future economic benefits are
expected to be consumed. The depreciation is allocated on a systematic basis over an asset’s useful life. The residual value
and the useful lives of the assets are reviewed at least at each financial year-end and, if expectations differ from previous
estimates the changes are accounted for as a change in an accounting estimate in accordance with IAS 8. Depreciation on a
straight line basis over the expected useful lives of the assets is a common approach.
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4.2.6 Components
property, plant and equipment is depreciated separately [IAS 16 para 43-44].
Significant parts of an asset that have similar useful lives and patterns of consumption can be grouped together. This
requirement can create complications for mining entities, as there may be assets that include components with a shorter
useful life than the asset as a whole.
Productive assets are often large and complex installations. Assets are expensive to construct, tend to be exposed to harsh
environmental or operating conditions and require periodic replacement or repair. The significant components of these types
of assets must be separately identified. Consideration should also be given to those components that are prone to
technological obsolescence, corrosion or wear and tear more severe than that of the other portions of the larger asset.
The components that have a shorter useful life than the remainder of the asset, such as mill liners, are depreciated to their
recoverable amount over that shorter useful life. The remaining carrying amount of the component is derecognised on
replacement and the cost of the replacement part is capitalised [IAS 16 para 13-14].
4.3 Deferred stripping costs
Stripping costs incurred during the development phase of a mine, often referred to as overburden removal costs, are usually
capitalised as part of the depreciable cost of building, developing and constructing the mine. Once production begins, those
capitalised costs are depreciated over the life of the mine using the UoP method.
A mining entity may continue to incur overburden removal costs as the perimeter of the pit grows during the production
phase. However, in addition, large amounts of waste will also need to be removed from the pit as part of regular mining
activities. Such production stripping costs incurred may benefit both future and current period production. There is diversity
in practice in accounting for such costs. Some entities recognise the production stripping costs as an expense (a cost of
production). Other entities capitalise some or all of the costs in recognition of the future economic benefit created from this
activity as ore becomes more accessible in future periods.
IFRIC 20 “Stripping Costs in the Production Phase of a Surface Mine” was issued in September 2011. and is applicable for
annual periods beginning on or after 1 January 2013. and it applies to stripping costs incurred during the production phase
of a mine and does not cover the overburden removal costs incurred during the development phase. It only applies to
surface mining activities and does not cover the underground mining activities.
The IFRIC applies to all types of natural resources extracted using surface mining. Where reference is made to ‘extraction of
mineral ore’ in the IFRIC it also applies to extraction of other natural resources that are not embedded in an ore deposit (for
example coal) provided they are extracted using surface mining activity. However, IFRIC 20 does not apply to oil and natural
gas extraction.
The question of whether oil sands extraction is a surface mining activity has not been addressed by the Committee. Entities
carrying out oil sands extraction using processes similar to surface mining should exercise caution in using the principles of
this interpretation.
The interpretation does not give guidance on differentiating the development phase from the production phase of a mine. As
explained in section 1.2.3, this can be very complex requiring significant management judgement especially in cases where
the mines are large and portions of the mine are accessed in discrete phases.
The following flow chart summarises the decision process for capitalisation of production stripping costs under IFRIC 20.
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4.3.1 Recognition
An entity usually obtains two kinds of benefits from its stripping activity. These are extraction of ore in the current period in
the form of inventory and improved access to the ore body for a future period. As a result, two different kinds of assets are
created. If the stripping activity in the current period does not provide an identifiable benefit, the associated costs are
expensed in the current period.
To the extent that the benefits from the stripping activity are realised in the form of inventory produced, the associated costs
are recorded in accordance with the principles of IAS 2 Inventories.
To the extent that the benefits are realised in the form of improved access to the ore body in the future, the associated costs
are recognised as a ‘stripping activity asset’ if all of the following conditions are met:
a. it is probable that the future economic benefit associated with the stripping activity will flow to the entity;
Assume that this diagram is the shape of a mine.

The mine plan of the entity identifies four components of the ore body
(A,B,C & D) which will be accessed separately on a phased basis over a
period of 10 years.
b. the entity can identify the component of the ore body for which access has been improved; and
c. the costs relating to the stripping activity associated with that component can be measured reliably.
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The benefit in the form of improved access to ore in the future may relate to ore expected to be accessed in more than just
one year in the future within the identified component or components of the ore body.
‘Component of the ore body’ in para (b) above refers to a specific volume of the ore body that is made more accessible as a
result of the stripping activity. This would typically be a subset of the total ore body of the mine. An entity usually identifies
the components of mines during the mine planning stage.
Identifying components of the ore body requires management judgement. Mine plans may provide the information required
to allow these judgements to be made with reasonable consistency.
The recognition criteria of IFRIC 20 requires that the entity should identify the
specific component of the ore body i.e. A, B, C or D towards which the stripping
costs have been incurred.
If the entity is unable to do so, a stripping activity asset cannot be recognised.
In practice the ore bodies vary in shapes and sizes are much more haphazard than shown in the diagram. Hence,
identification of components of an ore body becomes a complex process requiring significant management judgement. In
practice management could identify the components in a number of ways such as identifying discrete phases in the mine
plan, annual production plans or plans for push back campaigns. Whatever approach is adopted, it is important that the
components are recognisable to those responsible for mine planning within the company given the need to continue to track
progress as ore is removed and update the assessment of components should the mine plan change.
Accordingly, for ongoing production stripping activities management will need to establish systems, controls and processes
to ensure that the components are identified consistently and stripping costs that benefit future periods are allocated to such
components.
The stripping activity asset is accounted for as an addition to or enhancement of the existing asset. It is more like a part of an
existing asset rather than an asset in its own right. The classification of the stripping activity asset as a tangible or intangible
asset would depend on the classification of the existing asset to which it relates.
Componentisation—Pit by pit or mining complex basis
Entity A has a producing iron ore mining complex. In its mine plan it has identified 12 pits from which the ore is planned
to be extracted, some in the current period and others in later phases. For the purpose of accounting the stripping costs,
Entity A has identified components of ore body for the mine as a whole rather than on a pit by pit basis.
Can Entity A do this?
Solution
Entity A should identify the components within each pit to which the access has been improved by the stripping activity.
In other words each pit should be treated as a unit of account.
IFRIC 20 states that a component refers to the specific volume of the ore body that is made more accessible by the
stripping activity. Hence, for each pit, Entity A will identify the component of ore bodies that are accessed and allocate
stripping costs to those components within the pit. If Entity A cannot identify the component of ore body within a pit for
which the stripping costs have been incurred, the stripping costs should not be capitalised as a stripping activity asset.
Capitalisation of stripping costs (1)
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Entity B operates a producing coal mine. It has incurred costs during the year which have resulted in both access to a
certain amount of ore in the current period and also improved access to other parts of the mine for future extraction. In
the past Entity B has been expensing stripping costs in the period in which they were incurred.
Can Entity B adopt a policy to continue to expense its stripping costs in the period in which they are incurred?
Solution
Entity B can no longer adopt this approach under IFRIC 20. Since the stripping costs incurred have provided access to
inventory and have provided improved access to future ore, Entity B will have to allocate the costs incurred to the
inventory (to the extent remaining unsold) and stripping activity asset (if the recognition criteria are met) and recognise
these assets in the balance sheet subject to the normal materiality thresholds.
Capitalisation of stripping costs (2)
Entity C has incurred C30 million towards stripping activities which they believe has benefitted the company by providing
access to inventory as well as improving access to various portions of the ore. The company has not precisely allocated
the costs to identified components of the mine. However, the company intends to capitalise these stripping costs by
allocating them to the whole mine rather than any component.
Can Entity C do this?
Solution
Entity C cannot adopt this approach under IFRIC 20. A stripping activity asset can only be recognised if it can be
identified with a component of the ore body for which access has been improved [para 9(b)]. In this case, Entity C will
have to allocate the costs towards obtaining access to inventory and record that portion in accordance with IAS 2. The
remaining costs which cannot be identified with a specific component of the mine will be treated as a period production
cost. In practice there would be limited circumstances where a mine would be a single component and management
should attempt to identify those parts of the ore body that became more accessible in the future from the stripping
activity.
4.3.2 Initial measurement
A stripping activity asset is initially measured at cost. Cost includes those that are directly attributable to performing the
stripping activity that improves access to the identified component of the ore and an allocation of directly attributable
overhead costs.
Costs associated with incidental operations that are not necessary for the production stripping activity to continue as
planned should not be included in the stripping activity asset. Incidental operations may often take place at the same time as
the production stripping activity—for example building an access road in the area in which the stripping activity is taking
place.
Management should be guided by the principles laid out in IAS 16 and IAS 38 while determining the costs that are eligible for
capitalisation.
The cost of an item of property, plant and equipment includes any costs directly attributable to bringing the asset to the
location and condition necessary for it to be capable of operating in the manner intended by management. Examples of the
types of costs that would be expected to be included as directly attributable overhead costs would include an allocation of
salary costs of the mine supervisor overseeing that component of the mine, and an allocation of contractor costs for mining
extraction and haulage services specifically related to performing the stripping activity.
4.3.3 Allocation of costs
It may be difficult in practice to measure the cost of each benefit separately when production and development type
stripping activity take place at the same time. Costs are allocated between the inventory produced and the stripping activity
asset by using an allocation basis that is based on a relevant production measure.
A production measure is considered to be a good indicator of the nature of benefits that are generated for the activity taking
place in the mine. The production measure basis requires an entity to identify when a level of activity has taken place beyond
what would otherwise be expected for the inventory production in the period, and that may have given rise to a future access
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benefit. The production measure is calculated for the identified component of the ore body and is used as a benchmark to
identify the extent to which the additional activity of creating a future benefit has taken place.
Examples of production measures are:
Cost of inventory produced compared to expected cost;

Volume of waste extracted compared with expected volume, for a given volume of
ore production; and
Mineral content of the ore extracted compared with expected mineral content to be
extracted, for a given quantity of ore produced.
Allocation of costs cannot be based on sales values. This is because sales values are not closely linked to the stripping
activity. Companies which currently allocate costs on the basis of sales value or sales prices will see a change in the
allocation of costs.
Allocation of costs between inventory and stripping activity asset
Entity E’s stripping activity for a single identified component of the mine (the “current mining phase”) for the current
period had the following cost and extraction information:
Direct costs incurred for the mining activity—C10,550,000

Directly attributable overhead costs—C3,450,000
Total = C14,000,000
Ore extracted—765 tonnes
Waste extracted—5,980 tonnes
How should the company allocate the costs incurred between the inventory produced and the stripping activity asset?
Note:This simplified example does not consider the relationship between this component and other components of the
mine. In practice, management should consider this relationship.
Solution
Step 1—Can the company identify the costs separately for each of the benefits?
The Company has determined that it is not practically possible to separately determine the costs incurred for each
benefit because the inventory and the stripping activity asset are produced simultaneously as there are multiple shovels
in operation on multiple faces and a single haulage fleet.
Step 2—Determine a production measure that can be used to allocate costs
The Company has determined that they will allocate costs based on the volume of waste and ore extracted (the current
strip ratio) in the period compared with expected volume over that phase of operations (life of phase ratio).
A different production-measure based allocation of costs can be performed. In situations where the mineral content
fluctuates significantly and the cost of production is a more reliable measure, that basis can be chosen to allocate costs
if that gives the most relevant and reliable information
Step 3—Determine the expected volume of waste extracted for a given volume of ore production
The Company has forecast the following mining and stripping activity during the current mining phase which will span a
number of periods:
Expected volume of ore to be extracted—4,590

Expected volume of waste to be extracted for the above volume of ore—28,750
IFRIC 20 requires that stripping activity assets can be recognised if the stripping costs can be attached to a specific
component of the ore body. Hence, to arrive at the right value of asset to be capitalised, the above information needs to
be computed for the specific component of the ore body and not for the mine as a whole.
Step 4—Determine the additional waste extracted compared to expected volume of waste for the actual volume
of ore extracted
Average expected waste per unit of ore = Expected volume of waste to be

produced extracted
Expected volume of ore to be extracted
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= 28,750/4,590 = 6.26 (Current mining

phase stripping ratio)
Average expected volume of waste for the actual volume of ore produced in period = 765*6.26 = 4,792 tonnes
Actual volume of waste extracted in period = 5,980 tonnes Additional waste extracted in period = 5,980—4,792 = 1,188
tonnes
Step 5—Determine the ratio for allocating costs to the stripping activity asset
Ratio = Additional volume of waste extracted/(Actual volume of waste +

ore extracted)
= 1,188 / (5,980 + 765)
= 17.62%
As mentioned above, in this simplified example the ratios at Step 4 and 5 have to be computed for a specific component
of the ore body, in this case the current mining phase, and not the mine as a whole.
Step 6—Determine the amount to be allocated to the stripping activity asset and inventory
Amount allocated to stripping activity asset = 14,000,000 * 17.62% = C2,466,800

Amount allocated to inventory = 14,000,000—2,466,800 = C11,533,200
Where the pit wall is being pushed back during a sustained stripping campaign (i.e. a lay back), it is possible that most of the
stripping activities are directed towards obtaining access to ore in future periods and negligible quantities of ore may actually
be extracted during the push back period. In such cases it is possible that substantial amounts of the stripping activity costs
in those periods should be capitalised as a part of the stripping activity asset relating to the components of ore body that
have become more accessible. Management should identify whether the costs associated with the push back can be
separately identified from other production costs. Where those costs can be separately identified, management should ring
fence the push back activity and consider the allocation of costs separately from the wider mining and stripping operations.
If the costs cannot be separately identified, then a relevant production measure should be used to allocate the total costs to
the inventory produced and the stripping asset.
4.3.4 Subsequent measurement
Subsequent to initial recognition, the stripping activity asset is carried at its cost less depreciation, amortisation and
impairment losses, in the same way as the existing asset of which it is a part.
While rare in practice, the stripping activity asset may also be carried at re-valued amounts if the existing asset of which it is
a part is carried at revalued amounts.
The stripping activity asset is depreciated or amortised on a systematic basis, over the expected useful life of the identified
component of the ore body. This best reflects the consumption of the economic benefits from the stripping activity. The UoP
method is applied unless another method is more appropriate.
The expected useful life of the identified component of the ore body will differ from the expected useful life used to
depreciate or amortise the mine itself and related life- of-mine assets. The exception to this are those limited circumstances
when the stripping activity provides improved access to the whole of the remaining ore body. For example, if the identified
component represents the final part of the ore body at the end of the mine’s useful life.
The basis of subsequent measurement of the stripping activity asset should follow that of the existing asset of which it is a
part.
Impairment of stripping activity assets is determined based on the principles in IAS 36. The stripping activity asset is tested
as part of the relevant cash generating unit and not on a standalone basis.
Impairment of stripping activity asset
Entity F has a producing gold mine. It has identified 7 pits in the mine to extract gold. Presently it is working on Pit 1 for
which it has capitalised a stripping activity asset of C12,500,000. During the current year, there was a cyclone which
caused a pit wall slide which covered the previously exposed ore. The entity has carried out an impairment test for the
CGU to which Pit 1 relates and identified that there is no impairment. Hence, it decides not to write down any part of the
stripping activity asset.
Can Entity F do this?
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Solution
No—Entity F should write down the value of the stripping activity asset to the extent the future economic benefits
relating to the stripping will no longer be realised. This is because when an asset has become obsolete or has been
physically damaged, affecting the use of the asset, it needs to be written down even if the CGU to which it relates may
not be impaired. In this case, the stripping activity asset should be written down to its recoverable value because of the
pit wall slide and the entity will have to carry out further stripping activity to regain access to the ore.
4.4 Inventory valuation
Inventories of mine product include:
run-of-mine ore;
work in progress (crushed ore, ore in-circuit); and
finished goods (concentrate, metal).

Inventory is usually measured at cost, where cost does not exceed net realisable value as determined under IAS 2. Various
cost methods are available and can be used under IFRS; specific identification, weighted average or first-in first-out (FIFO).
Issues commonly faced by companies in the mining industry include:
Point of recognition for inventory.

Cost absorption in the measurement of inventory.
Method of allocation of costs to inventories, such as FIFO or weighted average

cost.
Determination of joint and by-products and the measurement consequences.
Accounting for long term low grade stock piles.
Inventory is recognised when it is probable that the future economic benefits will flow to the entity and the asset has a cost
or value than can be measured reliably. Ore is recognised as inventory as soon as it is extracted, the reliable assessment of
mineral content is possible and the cost of production can be reliably determined.
Inventory may be recognised in an underground mine, for example, when it is broken underground or when it is hoisted to
the surface, depending on the specific circumstances.
This section addresses specific measurement challenges which can arise in the mining industry.
4.4.1.1 Measurement challenges — Work in progress
Measurement issues can arise in the work in progress stage in concentrators, smelters and refineries—where materials may
be enclosed in pipes or vessels, with no uniformity of grade. Work in progress inventories may also be in stockpiles,
particularly underground, where it is more difficult to measure quantities.
Processing varies in extent, duration and complexity from mineral to mineral, and different production and processing
techniques may be used in the production of a specific mineral. The point at which work-in-progress inventory is first
recognised and measured—rather than continuing to be treated as part of the mineral reserves —is when a reliable
assessment of mineral content is possible and the cost of production can reliably be determined. Practice varies in this area,
reflecting the genuine differences in the ability to assess mineral content and predict production costs.
4.4.1.2 Measurement challenges — Stockpiles
Quantities are normally based on physical measurements from weightometers or truck loads. For example, when large
amounts of material are held in stockpiles, aerial surveys are sometimes used to determine the contours of the material.
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In other cases, a multiple stockpile technique is often used when storage facilities permit its application. Individual stockpile
volumes are separately recorded, and physical volumes of each stockpile are regularly cleared to zero.
Quantities are usually determined on a net dry-weight basis. Bulk density and other conversion factors are used and are
subject to regular review. Grade is generally determined through assay testing, and block reconciliations are done. Surveys
are used as a test of the reasonableness of these measures, but the densities and grades make them variable.
Stockpile measurement is an inherently inaccurate science. It is common industry practice to use at least two measurement
methods so that the results of the two can be compared and contrasted.
Inventory is generally a current asset as it is consumed within the normal business cycle. However, where some long term
stock piles have been recognised in inventory, it is essential to split out these stock piles from the current inventory and
classify them as non-current on the face of the balance sheet.
4.4.1.3 Measurement challenges — Long-term stock piles
High grade ore extracted from a mine is usually prioritised for further processing. Low grade ore may be stockpiled to
maximise the volume of saleable production by prioritising the processing of high grade ore. Low grade ore stockpiles may
only be processed many years later when mining operations are winding down or have ceased altogether.
Low grade ore material—the mineral content of which is below what is currently economically viable—is not recognised as
an asset when extracted because it is unlikely that future cash flows will flow to the entity. The cost of extracting the low
grade material (measured using the principles described in section 4.4.2) is normally classified as a waste removal cost and
treated as a production cost.
The inventory of low grade ore material may be recognised as an asset only when future cash flows are expected from the
sale of the product processed from low grade ore stock piles. The inventory should be assessed to ensure that the carrying
value is recoverable, including the timing of cash flows and application of an appropriate discount rate.
4.4.1.4 Measurement challenges - Heap leaching
Heap leaching is a process which may be used in the recovery of metals from low grade or certain types of ore. Heap
leaching brings its own measurement challenges around the assessment of product quantities and estimation of realisable
values. The metal recovery factor is difficult to determine because of the varying physical attributes of material in the heap
leach pads. The ultimate recovery is therefore unknown until leaching is completed.
However, ore loaded on heap leach pads is usually recognised as inventory despite these estimation and measurement
problems. One of the key decisions is whether pads are measured separately, in groups or in total. The preferred approach is
to consider each pad separately (as far as possible) because this reduces the expected variability in ore type to more
manageable levels.
4.4.1.5 Measurement challenges - Ore in circuit
Ore in circuit at period end can be very difficult to measure as it is generally not easily accessible. The value of materials
being processed should therefore be estimated based on inputs, throughput time and ore grade.
The significance of the value of ore in circuit will depend on the commodity being processed - precious metal producers may
have a material value in process.
4.4.2 Cost and net realisable value
IAS 2 requires inventories to be measured at the lower of cost or net realisable value. This section addresses the
components of cost, how costs are allocated to inventory and the assessment of net realisable value.
4.4.2.1 Determination of costs
The absorption method is used to determine the cost of inventories. This means that the cost of inventory consists of:
all costs of purchase;

costs of conversion; and
other costs incurred in bringing the inventories to their present location and
condition.
Costs of conversion include costs that directly relate to production and an allocation of fixed and variable production
overheads. Variable production overheads are allocated to the cost of inventory on the basis of the actual level of
production; fixed overheads are allocated by reference to the ‘normal capacity’ of a facility. Normal capacity does not refer to
the facility’s maximum capacity; it relates to the capacity that is expected to be achieved on average over several periods
and not in periods of abnormally high production. The range of normal capacity will vary based on process and business-
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specific factors. Judgement is required to determine when a production level is abnormally low (outside range of normal
capacity). Examples of factors that may result in an abnormally low production level include significantly reduced demand,
labour and materials shortages, and unplanned facility or equipment downtime.
Administrative overheads that do not contribute to bringing inventories to their present location and condition are excluded
from the cost of inventories. There are some functions which only partially contribute to the production process. Judgement
is required in establishing whether overheads should be attributed to production. For example, the finance department in a
production plant will normally support the following functions:
production—by paying direct and indirect production wages and salaries,

controlling purchases and related payments, and preparing periodic financial
statements for the production units;
marketing and distribution—by analysing sales and controlling the sales ledger;
and
general administration—by preparing management accounts and annual financial
statements and budgets, controlling cash resources and planning investments.
Overheads are allocated to inventory on a systematic basis such as head count or cost centre costs.
Storage costs that are not a necessary stage of the production process are also excluded from the cost of inventories.
However, storage costs are included when these are necessary for production, such as the costs of storing mineral
solutions/suspensions for drying and settling.
Overhead costs incurred during periods of idle capacity, due to breakdowns or scheduled maintenance, are excluded from
the cost of inventories and expensed as incurred.
The following table highlights some of the key costs incurred in the production of inventory:
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4.4.2.2 Assigning costs to inventories
Costs are normally allocated to mining inventories on weighted average cost or using first-in, first-out (FIFO) formulae.
The same method should be used for all inventories of a similar nature. A difference in geographical location of inventories or
in the respective tax rules is not sufficient to justify the use of a different cost methodology.
4.4.2.3 Net realisable value
Inventory is carried at the lower of cost and net realisable value. Net realisable value is estimated by calculating the net
selling price less all costs still to be incurred in converting the relevant inventory to saleable product, and delivering it to the
customer. The selling price of mine products is generally determined by reference to mineral content; management must
determine the grade of the material as well as the physical quantities.
Net realisable value is determined on the basis of conditions that existed at balance sheet date; subsequent price
movements are also considered to determine whether they provide more information about the conditions that were present
at balance sheet date. The net realisable value should be determined using the most reliable estimate of the amounts the
inventories are expected to realise. Both the year-end spot price and the market forward commodity price may provide
unbiased and reliable estimates of the amount the inventories are expected to realise. The spot price at period end will often
provide the best evidence of the value which the inventories could realise, however, where the inventory is to be sold at a
future date and the entity has an executory contract for this the use of the forward price curve would be appropriate.
Movements in the ore price after the balance sheet date typically reflect changes in the market conditions after that date and
therefore should not be reflected in the calculation of the net realisable value. A consistent approach to different
commodities will need to be applied and this approach should be consistent from one year to another.
The forward sales contract price may be used to estimate the net realisable value of a quantity of inventory held unless the
contract is recognised as a separate asset or liability on the balance sheet in accordance with IAS 39 or an onerous non-
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derivative contract recognised as a provision in accordance with IAS 37 “Provisions, Contingent Liabilities and Contingent
Assets”.
A further complexity may arise where the forward contract prices are denominated in a foreign currency. The use of the spot
exchange rate at the balance sheet date or forward exchange rates for the translation of the selling price into the functional
currency are both seen in practice. The appropriate rate to use depends on the overall approach adopted in determining the
net realisable value.
If circumstances which caused a previous write-down of inventories from cost to net realisable value have reversed or
changed (for example, a metal price decline has been reversed) the write-down is reversed and the effect on the current
period profit is disclosed.
4.4.2.4 Net realisable value for long-term stock piles
Management must consider carefully the determination of net realisable value in situations where low grade stockpiles are
recognised as a separate asset.
Net realisable value for long-term stockpiles
Background
Entity A is a coal mining company and sells its coal on the spot market. It has low grade stockpiles included in
inventories at the balance sheet date. The company does not plan nor have the capacity to process the stockpiles until
the end of the mine life which is currently estimated to occur in five years. The cost of the low grade stockpiles is $90 per
tonne. Valuing these stock piles using the current market prices for coal the current processing costs, the value is $87
per tonne. Based on market information, management has determined the 5-year forecast price of coal to be 20% lower
than the current market price. If valued using the 5-year forecast price of coal and the forecast production costs,
adjusted for the time value of money, the value of these long term stock piles is $70 per tonne.
Question
Should entity A calculate the net realisable value for these stock piles using the market value at the balance sheet date
($87 per tonne) or using the 5-year forecast price ($70 per tonne)?
Solution
Entity A should calculate the net realisable value of these low grade and long term stockpiles using the forecast market
price for when the inventory is expected to be processed and realised. As the market price of coal changes daily in
response to the status of the global economy, future changes in the forecast price or the planned scheduling of
processing and sales may result in additional or reversal of net realisable value adjustments. These will be changes in
estimates; as such, the gains and losses will be recognised in the income statement in the period in which they arise.
The assumptions about the long term commodity prices used in the estimate of the sales proceeds and the expected timing
of realisation should generally be consistent with those used in the Life of Mine Plan and other models that would be used for
valuation and impairment purposes.
The estimate of the costs necessary to convert the low grade ore into saleable product must take into account any expected
difference between future inflation factors applicable to revenue and costs. The sales proceeds may not be sufficient to
recover the costs of the inventory if costs are expected to grow at rates in excess of revenue.
Application of a discount factor to the future cash flows associated with the sales proceeds and conversion costs may be
appropriate to reflect the time value of money. The net realisable value of the stock which is not expected to be sold for a
very long period of time, determined based on the discounted future cash flows, will typically be very low.
4.4.3 Joint products and by-products
More than one metal is commonly produced by the same mining and refining processes. For example, base metals such as
lead and zinc are often found together; silver is often found with gold. The decision as to whether these are joint products or
one is only a by-product is important as it may affect the allocation of costs.
Joint products are two or more products produced simultaneously from a common raw material source, with each product
having a significant relative sales value. One joint product cannot be produced without the other and the products cannot be
identified separately until a certain production stage, often called the ‘split-off point’, is reached.
By-products are secondary products obtained during the course of production or processing, having relatively small
importance when compared with the principal product or products.
4.4.3.1 Joint products or by-products?
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Products produced at the same time are classified as joint products or by-products; usually driven by the importance of the
different products to the viability of the mine. The same metal may be treated differently based on differing grades and
quantities of products.
A systematic and rational basis of cost allocation should be applied when the conversion costs of a product are not
separately identifiable. There are different practices in use but all look to allocate costs to joint and by-products.
4.4.3.2 Valuing joint products
The most common method used is to allocate joint production costs to joint products at the split-off point, based upon
either:
net realisable value at the split off point or relative sales value at the end of
production; or
the volume of production, where the realisable value of each unit of production is
similar.
Cost allocation based on the volume of production may be inappropriate if there is a significant difference between the
relative sales values of the joint products, such as in a mine producing lead and silver. The costs allocated to the lower value
product may exceed its net realisable value whilst the higher value product would result in ‘super’ profits.
The allocation method should be applied consistently, using reliable production and revenue data.
Costs of production after separation are charged directly to the product to which they relate.
4.4.3.3 Valuing by-products
By-products are often valued at estimated net realisable value, with a corresponding credit to the cost of production of the
main product. When inventories are measured at net realisable value, any subsequent changes in that value are recognised
in the income statement.
Some mining entities attribute only the costs of processing after the split-off point to by-products.
Both methods are acceptable and the method chosen is applied consistently.
4.4.3.4 Sale of joint products and by-products
The decision as to whether a metal is a joint product or a by-product will also affect the classification of sales of the metal.
Sales of joint products are recognised as revenue in the income statement. Sales of by-products are recognised as a
negative cost.
4.4.4 Insurance and capital spares
Spare parts and servicing equipment are usually carried as inventory and recognised as an expense when consumed.
Entities often keep additional spare parts for key pieces of equipment to ensure that downtime is minimised in the event of
equipment failure, due to the specialised nature of the equipment used by mining operations and the remote locations in
which they are typically located.
There are two main categories of spare parts:
insurance spares, which the entity only expects to use if there is an unexpected
breakdown or equipment failure; and
capital spares, which the entity anticipates will eventually be used as replacement
parts.
4.4.4.1 Insurance spares
Insurance spares are major items and parts kept on hand to ensure the uninterrupted operation of production equipment if
there is an unexpected breakdown or equipment failure. They do not include items that are generally consumed or replaced
during the regular maintenance cycle. Insurance spares are normally used only because of a breakdown, and are not
generally expected to be used.
Insurance spares are capitalised within property, plant and equipment and depreciated over the same period as the
component they are associated with. This reflects the fact that they are ‘available for use’ immediately. The residual value
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used to calculate the depreciation charges reflects the expected resale value of ’unused’ equipment; this should be changed
if the spares have to be used and as a consequence have no future resale value.
4.4.4.2 Capital spares
Capital spares (or ‘circulating spares’) are spare parts that are regularly replaced, usually as part of a general replacement
programme. The parts removed are often repaired or overhauled and used in the next replacement cycle.
IAS 16 states that spare parts and servicing equipment that are capital spares are usually carried as inventory and
recognised as an expense when consumed. However, it also states that:
major spare parts and stand-by equipment qualify as property, plant and
equipment when an entity expects to use them during more than one period; and
if spare parts and servicing equipment can be used only in connection with an item
of property, plant and equipment, they are accounted for as property, plant and
equipment.
Depreciation of spares that are capitalised commences when the asset has been installed and is capable of being used. The
depreciation charge is based on the expected useful life of the spare while it is being used, which may be shorter than the
useful life of the asset to which it relates. When the spare is itself replaced, the asset is derecognised.
4.4.5 Consumable stores and other spare parts
Mining entities often hold significant consumable stores and spare parts for the continuity of their operations that are in
remote locations. Inventories of consumable stores and spare parts are carried at the lower of cost and net realisable value.
Consumable stores and spare parts are carried at cost, if the entity expects that they will be used in operations and their
cost will be recoverable through the sale of the final product at above its final cost.
Damaged and obsolete consumable stores and spare parts are written down to net realisable value as soon as they are
identified.
Surplus consumable stores and spare parts need to be identified on a timely basis. Any losses to be incurred as a result of
their subsequent return to suppliers, sale or other means of disposal are provided for as soon as management considers that
such losses are likely. The issue of net realisable value of consumables becomes more important towards the end of the life
of the mine, in anticipation of any potential loss on disposal of consumable stores that may be unused.
4.5 Renewal and reconditioning costs
The costs of performing a major renewal or reconditioning are capitalised if it gives access to future economic benefits. Such
costs will include the labour and materials costs of performing the renewal or reconditioning. However, costs that do not
relate to the replacement of components or the installation of new assets should be expensed as incurred [IAS16 para 12].
Renewal and reconditioning costs should not be accrued over the period between the renewal and reconditioning because
there is no legal or constructive obligation to perform the renewal/reconditioning—the entity could choose to cease
operations at the plant and hence avoid the renewal/reconditioning costs.
Reconditioning of equipment
How should reconditioning of equipment be accounted for?
Background
Entity Y operates a major mine. Management estimates that reconditioning of the equipment is required every 30
months. The costs of reconditioning are approximately C500,000; C300,000 for parts and equipment and C200,000 for
labour to be supplied by employees of Entity Y.
Management proposed to accrue the cost of the reconditioning over the 30 months of operations between
reconditioning and create a provision for the expenditure.
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Is management’s proposal acceptable?
Solution
No. It is not acceptable to accrue the costs of reconditioning equipment. Management has no constructive obligation to
undertake the reconditioning. The cost of the reconditioning should be identified as a separate component of the mine
asset at initial recognition and depreciated over a period of thirty months. This will result in the same amount of expense
being recognised in the income statement over the same period as the proposal to create a provision.
4.6 Care and maintenance
Mining operations are sometimes suspended because a change in circumstances—such as a contraction of global demand
for the commodity, higher costs or changes in exchange rates—has made production or further development uneconomical.
Instead of shutting down and abandoning the property, operations and development are curtailed and the mine is placed on
a ‘care-and-maintenance’ basis. This can happen in the development phase or after production has started.
Putting a mine on ‘care and maintenance’ (also known as ‘mothballing’ the mine) is an impairment indicator (see section 9
Impairment). An impairment test should be carried out and an impairment loss recognised if the carrying amount of the cash-
generating unit exceeds the recoverable amount.
During the period of care and maintenance, expenditures are still incurred but usually at a lower rate than when the mine is
operating. A lower rate of depreciation for tangible non-current assets is also usually appropriate due to reduced wear and
tear. Movable plant and machinery would generally be depreciated over its useful life. Management should consider
depreciation to allow for deterioration. Where depreciation for movable plant and machinery is determined on a UoP basis,
this would no longer normally be appropriate.
Management should also ensure that any assets which have become redundant are written off.
The length of the closure and the associated care and maintenance expenditure may be estimated for depreciation and
impairment purposes. However, it is not appropriate to establish a provision for the entire estimated expenditure of the care
and maintenance period; all care and maintenance expenditure is expensed as incurred.
Development costs amortised or depreciated on the units of production method would no longer be depreciated. Holding
costs should be expensed to the income statement in the period they are incurred—these may be costs such as security
costs and site property maintenance costs.
Costs associated with restarting a mine which has previously been ‘mothballed’ should only be capitalised if they improve
the mine beyond its original operating capabilities. Entities should exercise caution when performing this assessment.
4.7 Emissions trading schemes


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obligations
FAQ 33.21.3 – How do emissions trading schemes affect a forest's fair value?
Emissions Trading Systems: The Opportunities ahead.
4.8 Production disclosures
Management should disclose the following items for activities in the production phase:
Revenue disclosures:
the accounting policy adopted for the recognition of revenue including all aspects
—for example, shipment terms and provisional pricing;
the amount of each significant category of revenue recognised during the period
including revenue arising from:
the sale of goods;
the rendering of services;
interest;
royalties; and
dividends.
the amount of revenue arising from exchanges of goods or services included in
each significant category of revenue;
critical accounting judgements where specific judgements are made in relation to
the application of the revenue accounting policy—for example, prices used in the
assessment of provisional pricing arrangements; and
revenue information about products and services, geographical areas and major
customers if required (see section 13 Operating segments).
Production costs disclosures:
how the entity determines whether assets are ‘available for use’;
cost of product sold and operating expenses;
selling, general, administrative and other expenses;
depreciation and amortisation;
finance costs; and
royalty expenditure.
Stripping costs disclosures:
accounting policy; and

movements in any ‘deferred stripping’ asset.
Disclosures relating to property, plant and equipment temporarily idle or under care and maintenance:
accounting policy; and
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carrying amounts of assets temporarily idle / under care and maintenance.

Depreciation and amortisation disclosures (for each class of property, plant and equipment and each class of intangible
asset):
the depreciation/amortisation methods adopted;
the useful lives or depreciation/amortisation rates used. These should include an

explanation of:
the reserve/resource base used to determine depreciation/amortisation
charges and, where non-reserve material is included, the basis for
determining how and when such material is included; and
the treatment of future development costs, where they are expected to be
significant;
the total depreciation/amortisation charge for the period (and, for amortisation, the
line item(s) in the income statement where it is included);
the accumulated depreciation/amortisation (aggregated with accumulated
impairment losses) at the beginning and end of the period;
the nature and effect of any change in accounting estimate that has an effect in the
current period or is expected to have an effect in future periods This would include
changes to:
useful lives, including changes to the reserve/ resource base (even if they
will only impact future depreciation/amortisation charges);
residual values; and
depreciation/amortisation methods; and
where relevant, an explanation as to why the straight-line method is being used to
depreciate/ amortise assets for which the consumption of future economic benefits
is linked to the volume of production.
Inventory disclosures:
the basis of valuation of production inventories;

the composition of inventories under their relevant headings in a separate note on
inventories, including the split of production inventory and stores; and
amounts of inventories in final form and awaiting shipment, materials in the course
of processing (for example, concentrate in the mill circuit or concentrates awaiting
smelting or refining), raw materials, consumable stores and other inventories.
5. Consolidation
5.1 Overview
Cooperative working arrangements are common in the mining industry and the determination of the type of control that
exists is important. The rights of investors to make decisions over relevant activities (now defined as those which significantly
affect the investee’s returns) are critical in this determination.
This section focuses on IFRS 10, in particular the definition and guidance with regard to “control” IFRS 11 on joint control
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and joint arrangements is separately examined in Section 7.
5.2 Control
IFRS 10 confirms consolidation is required where control exists. The standard redefines control: where an investor has the
power and exposure to variable returns and the ability to use that power it controls the investee.
Factors to be assessed by mining entities to determine control under the new standard include:
The purpose and design of an investee;

Whether rights are substantive or protective in nature;
Existing and potential voting rights;
Whether the investor is a principal or agent; and
Relationships between investors and how they affect control.
Only substantive rights are considered in the assessment of power—protective rights, designed only to protect an investor’s
interest without giving power over the entity and which may only be exercised under certain conditions, are not relevant in
the determination of control.
Potential voting rights are defined as ‘rights to obtain voting rights of an investee, such as those within an option or
convertible instrument.’ Potential voting rights with substance should be considered when determining control. This is a
change from the previous standard where all and only presently exercisable rights were considered in the determination of
control.
The “principal vs. agent” determination is also important. Parties in mining arrangements will often be appointed to operate
the project on behalf of the investors. A principal may delegate some of its decision authority to the agent, but the agent
would not be viewed as having control when it exercises such powers on behalf of the principal.
Economic dependence in an arrangement, such as a smelter which relies on copper concentrate to be provided by a specific
supplier, is not uncommon, but is not a priority indicator. If the supplier has no influence over management or decision-
making processes, dependence would be insufficient to constitute power.
7. Joint arrangements
7.1 Overview
Joint ventures and other similar arrangements (“joint arrangements”) are frequently used by mining companies as a way to
share the higher risks and costs associated with the industry or as a way of bringing in specialist skills to a particular project.
The legal basis for a joint arrangement may take various forms: establishing a joint venture might be achieved through a
formal joint venture contract, or the governance arrangements set out in a company’s formation documents might provide
the framework for a joint arrangement The feature that distinguishes a joint arrangement from other forms of cooperation
between parties is the presence of joint control. An arrangement without joint control is not a joint arrangement.
7.2 Joint control
Joint control is the contractually-agreed sharing of control over an economic activity. An identified group of venturers must
unanimously agree on all decisions over “relevant activities”, which IFRS 10 defines as the activities which significantly affect
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an investee’s returns. Each of the parties that share joint control has a veto right: they can block key decisions if they do not
agree.
Not all parties to the joint venture need to share joint control. Some participants may share joint control and other investors
participate in the activity but not in the joint control. Section 7.7 discusses the accounting for those participants.
Similarly, joint control may not be present even if an arrangement is described as a ‘joint venture’. Decisions over financial
and operating decisions that are made by “simple majority” rather than by unanimous consent could mean that joint control
is not present even in situations where there are only two shareholders but each has appointed a number of directors to the
Board or relevant decision-making body.
Joint control will only exist if decisions require the unanimous consent of the parties sharing control. If decisions are made by
simple majority, the following factors may undermine the joint control assertion:
the directors are not agents or employees of the shareholders

the shareholders have not retained veto rights
there are no side agreements requiring directors vote together

a quorum of Board members can be achieved without all members being in
attendance
If it is possible that a number of combinations of the directors would be able to reach a decision, it may be that joint control
does not exist. This is a complex area which will require careful analysis of the facts and circumstances. If joint control does
not exist, the arrangement would not be a joint venture. Investments with less than joint control are considered further in
section 7.7.
A key test when identifying if joint control exists is to identify how disputes between ventures are resolved. If joint control
exists, resolution of disputes will usually require eventual agreement between the venturers, independent arbitration or,
dissolution of the joint venture.
One of the venturers acting as operator of the joint venture does not prevent joint control. The operator’s powers are usually
limited to day-to-day operational decisions; key strategic financial and operating decisions (i.e. decisions about the relevant
activities) remain with the joint venture partners collectively.
7.3 Classification of joint arrangements
“Joint arrangement” is the term for all cooperative working arrangements where two or more parties have joint control.
IFRS 11 definition
Joint operation Parties have rights to the assets and obligations for
the liabilities relating to the arrangement
Joint operation Parties have rights to the assets and obligations for
the liabilities relating to the arrangement
Joint venture Parties have rights to the net assets of the
arrangement
Jointly controlled entities could meet the definition of a joint operation or a joint venture. The classification of the joint
arrangement is based on the rights and obligations of the parties to the arrangements.
Determination of the type of joint arrangement can be a complex decision under IFRS 11. Legal form remains relevant for
determining the type of joint arrangement but is less important than under the previous standard.
A joint arrangement that is not structured through a separate vehicle is a joint operation. However, not all joint arrangements
in separate vehicles are joint ventures. A joint arrangement in a separate vehicle can still be a joint operation; classification
depends on the rights and obligations of the venturers and is further influenced by the economic purpose of the joint
arrangement.
Determining the classification of joint arrangements is a four step process as shown below.
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7.3.1 Separate vehicles
The first step in determining the classification is to assess whether the arrangement is structured through a separate vehicle.
A separate vehicle is a separately identifiable financial structure, including separate legal entities or entities recognised by
statute, regardless of whether those entities have a legal personality.
There are many different types of vehicles used for joint arrangements including partnerships, unincorporated entities, limited
companies and unlimited liability companies. Each of these are generally separately identifiable financial structures having
separately identifiable assets, liabilities, revenues, expenses, financial arrangements, financial records, etc. These would
generally be separate vehicles.
The definition of a ‘separate vehicle’ is, however, quite broad. It does not necessarily need to have a legal personality as in
the above mentioned examples. This means that a contractual arrangement between two parties may also be a separate
vehicle even if not established through an entity having a legal personality provided it has the features of a separate vehicle.
Local laws and regulations also need consideration before determining whether a particular structure meets the definition of
a ‘separate vehicle’.
7.3.1.1 Joint arrangements not structured through a separate vehicle
When an arrangement is not structured through a separate vehicle, it is a joint operation. This is because in such cases the
parties determine in the contractual arrangements their rights to the assets, and their obligations for the liabilities, relating to
the arrangement. These are classified as joint operations. Mining joint working arrangements often do not operate through
separate vehicles and so are classified as joint operations.
7.3.1.2 Joint arrangements structured through a separate vehicle
A joint arrangement that is structured through a separate vehicle can be either a joint venture or a joint operation depending
on the parties’ rights and obligations relating to the arrangement.
The parties need to assess whether the legal form of the separate vehicle, the terms of the contractual arrangement and,
when relevant, any other facts and circumstances give them:
rights to the assets and obligations for the liabilities relating to the arrangement (i.e.
joint operation); or
rights to net assets of the arrangement (i.e. joint venture)
7.3.2 Rights to assets and obligations given by

legal firm
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The second step in determining the classification of a joint arrangement is to assess the rights and obligations arising from
the legal form of the separate vehicle.
Joint arrangements are established through many different legal structures, including limited liability companies, unlimited
liability companies, limited liability partnerships, general partnerships and unincorporated entities. Each of these legal
structures exposes the parties to a different set of rights and obligations.
If the legal structure of the arrangement is such that the parties have rights to assets and are obligated for the liabilities of the
arrangement, then it is a joint operation. In order to ascertain this, the local laws and regulations need to be carefully
assessed.
The key question is whether the separate vehicle can be considered in its own right i.e. are the assets and liabilities held in
the separate vehicle those of the separate vehicle or are they the assets and liabilities of the parties?
Types of separate vehicle
Partnerships — in most cases general partnerships cannot be considered in their own right i.e. the partners have
obligations for the liabilities and have rights to the assets of the partnership in the normal course of business. On the
other hand a limited liability partnership (LLP) may be considered in its own right since the partners are not obligated for
the liabilities of the LLP and the assets of the LLP are its own assets.
Limited liability companies — in most jurisdictions these can be considered in their own right i.e. the assets and
liabilities of the company are its own assets and liabilities. The creditors and lenders of the company do not have a right
to claim payments from the shareholders. However, unlimited liability companies may sometimes provide direct rights to
assets and obligations for liabilities to the parties depending on the relevant facts and circumstances.
Unincorporated entities — When an arrangement is operated through this type of vehicle, in most cases the parties will
have the right to assets and have obligations for the liabilities of the arrangement.
Local laws and regulations play a key role in the assessment of the rights and obligations conferred by the separate vehicle.
It is possible that the same legal form (such as a partnership) in different territories could give different rights and obligations
depending on the local laws and regulations.
Associations, trusts and corporations are some other forms of vehicles used to establish joint arrangements. The rights and
obligations arising from these structures vary significantly depending on jurisdictional laws and regulations. Hence, these
have to be assessed based on the specific facts and circumstances.
When the legal form of the separate vehicle does not give the parties rights to assets and obligations for liabilities relating to
the arrangement, it means that the legal form indicates that the arrangement is a joint venture. However, the contractual
terms between the parties and when relevant, other facts and circumstances can override the assessment of the rights and
obligations conferred by the legal form.
7.3.3 Rights to assets and obligations given by

contractual terms
In most cases, the rights and obligations agreed to by the parties in their contractual terms are consistent with the rights and
obligations conferred on the parties by the legal form of the separate vehicle. This is because the selection of a particular
legal form is in many cases driven by the intended economic substance that the particular legal form delivers.
However, sometimes parties choose a particular legal form to respond to tax, regulatory requirements or other reasons. This
can alter the intended economic substance initially sought by the parties to the arrangement. In such cases, the parties
might enter into contractual arrangements that modify the effects that the legal form of the arrangement would otherwise
have on their rights and obligations.
The local law of a territory may require an arrangement in a particular industry to be set up only in a limited liability company.
This means that the legal structure of the separate vehicle will create a separation between the parties and the arrangement.
However, the parties may have the intention of setting up a joint operation.
In such cases, the parties may enter into contractual terms which modify or reverse the rights and obligations conferred by
the legal form of the separate vehicle. The contractual terms of the arrangement may be such that each party has an interest
in the assets of the company and each party has an obligation for the liabilities of the company in a specified proportion.
However, in such cases the contractual terms have to be carefully assessed to ensure that they are in fact robust enough to
modify/reverse the rights and obligations conferred by the legal structure.
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Indicators of a joint operation in contractual arrangements
Rights to assets
The parties share all interests (e.g. rights, title or ownership) in the assets in a specified proportion (e.g. in proportion to
the parties’ ownership interest in the arrangement or in proportion to the activity carried out through the arrangement
that is directly attributed to them).
Obligations for liabilities
The parties share all liabilities, obligations, costs and expenses in a specified proportion as in the case of rights to
assets.
Revenues and expenses
The contractual arrangement usually establishes the allocation of revenues and expenses on the basis of the relative
performance of each party to the joint arrangement. For example, the contractual arrangement might establish that
revenues and expenses are allocated on the basis of the capacity that each party uses in a refinery or smelter operated
jointly, which could differ from their ownership interest in the joint arrangement.
In other instances, the parties may agree to share the profit or loss relating to the arrangement on the basis of a specified
proportion such as the parties’ ownership interest in the arrangement. This would not prevent the arrangement from
being a joint operation if the parties have rights to the assets, and obligations for the liabilities, relating to the
arrangement.
Indicators of a joint venture in contractual arrangements
Rights to assets
Generally the contractual terms establish that the assets bought by the arrangement are those of the arrangement and
the parties do not have any direct interests in the title or ownership of these assets.
Obligations for liabilities
The contractual terms establish that the arrangement is liable for the debts and obligations of the arrangement and that
the parties are only liable to the extent of unpaid capital. Further the creditors of the joint arrangement do not have a
right of recourse against the investing parties.
Revenues and expenses
The contractual arrangement establishes each party’s share in the net profit or loss relating to the activities of the
arrangement.
The assessment of rights and obligations should be carried out as they exist in the ‘normal course of business’ (para B14 of
IFRS 11) i.e. the rights and obligations as they exist during the day to day operation of the company. Legal rights and
obligations arising in circumstances which are other than in the ‘normal course of business’ such as liquidation and
bankruptcy are much less relevant.
For example, in a liquidation or bankruptcy of a limited liability company, secured and unsecured creditors generally have the
first right to the assets of the company and the shareholders only have rights in the net assets remaining after settlement of
the third party liabilities. If this is considered while assessing the classification, it would suggest that a limited liability
company can never be a joint operation since the shareholders have rights only to the residual assets. However, this is not
the intention of IFRS 11 since it requires rights and obligations to be assessed in the normal course of business.
If the contractual terms give the parties rights to assets and obligations for liabilities, then the arrangement is a joint
operation. If the contractual terms give the parties rights to net assets, then the legal form of the separate vehicle and the
contractual terms indicate that the arrangement is likely to be a joint venture.
However, before finally concluding on the classification of the arrangement, ‘other facts and circumstances’ should be
assessed as these can sometimes affect the rights and obligations conferred upon by the legal form and the contractual
terms. ‘Other facts and circumstances’ are discussed in more detail in 7.3.4 below.
7.3.3.1 Effect of guarantees on classification of a joint arrangement
Parties to joint arrangements often provide guarantees to third parties on behalf of the arrangement when the arrangement is
purchasing goods, receiving services or obtaining financing.
The question that commonly arises is whether provision of such guarantees (or commitment by the parties to pay in case the
arrangement fails to pay or meet its obligations) indicates that the parties have obligations for liabilities of the arrangement
and therefore the arrangement is a joint operation.
The provision of guarantees or commitments does not by itself determine that the arrangement is a joint operation. The
feature that determines whether the joint arrangement is a joint operation or a joint venture is whether the parties have
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obligations for the liabilities relating to the arrangement (for some of which the parties might or might not have provided a
guarantee).
All relevant facts and circumstances should be considered in determining the classification. Rights and obligations are
assessed as they exist in the normal course of business. It is not appropriate to make a presumption that the arrangement
will not settle its obligations and that the parties will be obligated to settle those liabilities because of the guarantee issued.
This would not be seen as a normal course of business. Therefore issuing a guarantee does not on its own mean that the
arrangement is a joint operation.
7.3.4 'Other facts and circumstances'
This is the final step in determining the classification of a joint arrangement. Assessing ‘other facts and circumstances’
essentially means assessing the purpose and design of setting up the arrangement i.e. what was the objective or intent of
the parties in setting up the arrangement?
If the arrangement was primarily designed for provision of output to the parties it may indicate that the objective of the
parties was to have rights to substantially all the economic benefits of the assets of the arrangement.
The effect of an arrangement with such a design is that the liabilities incurred by the arrangement are in substance satisfied
by the cash flows received from the parties through their purchases of the output. It also means that the parties are
substantially the only source of cash flows for the continuity of the arrangement’s operations. This indicates that the parties
have an obligation for the liabilities relating to the arrangement.
Assessment of ‘other facts and circumstances’ grows more challenging as the arrangements between parties become
increasingly complex. When arrangements are incorporated in limited liability companies, classifying them as joint operations
on the basis of ‘other facts and circumstances’ is not easy and is a high hurdle to cross. This is because classifying them as
joint operations means that the corporate veil has to be pierced. The parties will then record assets and liabilities relating to
the arrangement although legally they neither have rights to the assets nor the obligation for the liabilities. Therefore
consideration should be given to all facts and circumstances before reaching a conclusion.
Listed below are some of the general characteristics of an arrangement with the purpose and design of a joint operation:
Parties generally restrict the arrangement from selling the output to third parties to
ensure that they have uninterrupted access to the output.
There is generally a binding obligation on the parties to purchase substantially all of
the output—if the parties did not have an obligation to take the output, the
arrangement may sell the output to third parties, indicating that the purpose and
design of the arrangement was not to provide all of its output to the parties.
The demand, inventory and credit risks relating to the activities of the arrangement
are passed on to the parties and do not rest with the arrangement.
Generally, the parties ensure that the output is purchased from the arrangement at
a price that covers all the costs of the arrangement and it operates at a break-even
level. It may not be necessary for the arrangement to operate at a break-even level
- the key is to assess the purpose and design of the arrangement. If the
arrangement is designed to provide all the output to the parties, the price at which
the output is purchased by the parties may become a less relevant factor in
determining the classification.
The arrangement does not generally have any borrowings and the parties are
substantially the only source of cash flows. Sometimes arrangements may have
borrowings for financing their working capital requirements or for capital
expansion. However, as long as the arrangement is designed to provide all the
output to the parties, it means that the arrangement will not be able to make the
interest payments and the principal repayments without receiving funds from the
parties. This may indicate that the arrangement continues to be a joint operation.
“Other facts and circumstances” scenarios
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Each of the scenario’s considered below have the following assumptions:
a. Joint control exists in each of the arrangements; and

b. the legal structure of the separate vehicle and the contractual terms do not give
the parties rights to assets and obligations for liabilities.
The initial indicators are that the arrangements are joint ventures, however, the ‘other facts and circumstances’ are
analysed as to how they may affect the classification of the arrangement.
Scenarios Classification Analysis

The arrangement produces a product and Joint operation The design of the arrangement
the parties are obligated to take all of the is to provide all its output to the
output in the ratio of their shareholding. parties. It is dependent on the
parties for its cash flows to
The price of output is set by the parties at a ensure continuity of operations.
level such that the arrangement operates at The parties get substantially all
break-even level. the economic benefits from the
assets of the arrangement. As
The arrangement is prohibited discussed above, it is a joint
from selling the output to third operation.
parties.
Same facts as above except Joint operation For the reasons stated above, it
that the product is a is a joint operation. The fact
commodity like gold which is that the product is readily
readily saleable in the market saleable becomes less relevant
i.e. if the parties do not buy it because there is an obligation
can be easily sold to a third on the arrangement to sell all of
party. its output to the parties.
The arrangement produces two products— Likely to be a The parties don’t necessarily have to set up
gold doré and copper concentrate. joint operation a joint arrangement for interest in the same
product. They may have interest in different
100% of gold doré is taken by one party and products but may set up a joint arrangement
100% of copper concentrate is taken by the for reasons like costs saving, similar
other party at market value. manufacturing processes, etc.
Since these are purchased by In this case it appears that the arrangement
the parties at market value is dependent on the parties for cash flows
there is a residual profit or loss and the parties take all output. This is a
left in the arrangement which is strong indicator that the arrangement may
distributed by way of dividends be a joint operation.
to the parties in the proportion
of their shareholding. However, before determining the
classification, consideration should be given
to all facts and circumstances. Certain other
factors may impact classification, including:
whether the parties have

a contractual obligation to
take all of the output—if
so, then it is a joint
operation.
the relative values of the
products purchased
compared to the
proportion of investments
made by the parties.
the value of one of the
products may be
relatively lower and the
investor who purchases
that product may get
compensated in some
other way such as share
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of profits made from sales

to the other party.
Parties have the right of first refusal to buy Likely to be a The following factors indicate that the
the output but they are not obligated to take joint venture. arrangement is most likely a joint venture.
the output.
The arrangement was set up three years There is no obligation on

ago. In the first year the parties take all of
the arrangement to sell its
the output in the ratio of their shareholding.
output to the parties. This
In the second year, the product is sold to indicates that the purpose
third parties.
and design of the
In the third year, the parties arrangement was not to
take all of the output but in a provide all of the output
ratio different from their
shareholding. to the parties;
In the past output has
been sold to third parties.
This proves that the
arrangement is not
substantially dependent
on the parties for its cash
flows.
However, all facts and circumstances
should be considered before determining
the classification. In some circumstances
the design of the arrangement may be to
provide all of the output to the parties.
However in a particular year, due to certain
practical considerations, the arrangement
sells output to third parties or the parties
take varying level of outputs. From the next
year they may revert to taking their share of
outputs. In such cases, emphasis should be
given to the purpose and design of the
arrangement.
Two parties set up an arrangement to mine Likely to be a In this case, it is clear that the purpose and
for zinc. The mined ore is sold to third joint venture design of the arrangement is not to provide
parties. all of its output to the parties.
As per the contractual terms: The arrangement is selling the product to

third parties and generating its own cash
a. all the gross cash flows.
proceeds from revenue of
the arrangement are Transferring gross proceeds of revenues to
transferred to the parties the parties and making cash calls for
on a monthly basis in incurring its costs does not indicate that the
proportion of their parties have rights to assets and obligations
shareholding; for liabilities of the arrangement. It is merely
b. The parties agree to a funding mechanism. It is no different from
reimburse the the parties having an interest in the net
arrangement for all its results of the arrangement.
costs in proportion of
their shareholding based
on cash calls.
Two parties set up a joint Judgment All facts and circumstances have to be
arrangement. One of the parties required considered before determining the
takes 100% of the silver classification. Assessment of the economic
produced at market prices and rationale behind such an arrangement might
the other party only takes its give an indication of the purpose and design
share of the profits/loss made of the arrangement.
by the entity.
An assessment should be made of whether
one of the parties actually controls the
arrangement or if there is an IFRIC 4
arrangement involved.
If it is concluded that there is

joint control, it seems that the
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arrangement has some
indicators of a joint operation.
This is because the
arrangement does not sell to
third parties and is dependent
on one of the parties for its
continuous cash flows.
However, one of the parties
does not consume any output.
7.3.5 Re-assessment of classification
The rights and obligations of parties to joint arrangements might change over time. This might happen, for example, as a
result of a change in the purpose of the arrangement that might trigger a reconsideration of the terms of the contractual
arrangements. Consequently, the assessment of the type of joint arrangement needs to be a continuous process, to the
extent that facts and circumstances change.
7.4 Accounting for joint operations ("JOs")
Investors in joint operations are required to recognise the following:

its expenses, including its share of any expenses incurred jointly
It should be noted that the share of assets and liabilities is not the same as proportionate consolidation. “Share of assets and
liabilities” means that the investor should consider their interest or obligation in each underlying asset and liability under the
terms of the arrangement— it will not necessarily be the case that they have a single, standard percentage interest in all
assets and liabilities.
7.5 Accounting for joint ventures ("JVs")
IFRS 11 requires equity-accounting for all joint arrangements classified as joint ventures. Investors who previously had a
choice between equity accounting and proportionate consolidation for a jointly controlled entity will no longer have that
choice.
The key principles of the equity method of accounting are described in IAS 28 “Investments in Associates and Joint
Ventures”:
Investment in the JV is initially recognised at cost;

Changes in the carrying amount of investment are recognised based on the
The venturer only reflects their share of the profit or loss of the JV; and
Distributions received from a JV reduce the carrying amount of the investment.
The results of the joint venture are incorporated by the venturer on the same basis as the venturer’s own results—i.e., using
the same GAAP (IFRS) and the same accounting policy choices. The growing use of IFRS and convergence with US GAAP
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has helped in this regard but the basis of accounting should be set out in the formation documents of the joint venture.
Joint venture uses a different GAAP
An entity uses IFRS. Are accounting adjustments required before it can incorporate the results of a joint venture that
reports under US GAAP?
Background
Entity J is a joint venture that prepares its accounts under US GAAP as prescribed in the joint venture agreement. One of
the venturers, entity C, prepares its consolidated financial statements under IFRS. C’s management believes that for the
purpose of applying the equity method, the US GAAP financial statements of J can be used.
Must C’s management adjust entity J’s US GAAP results to comply with IFRS before applying the equity method?
Solution
Yes the results must be adjusted for all material differences. IAS 28 paragraph 35 requires that all information contained
in IFRS financial statements should be prepared according to IFRS. C’s management must therefore make appropriate
adjustments to J’s US GAAP results to make them compliant with IFRS requirements. There is no exemption in IFRS for
impracticability.
The same requirement would exist if entity J was a joint operation. Adjustments to conform accounting policies are also
required where both entities use IFRS.
7.6 Contributions to joint arrangements
It is common for participants to contribute assets such as cash, non-monetary assets or a business to a joint arrangement
on formation. Contributions of assets are a partial disposal by the contributing party. Accordingly, the contributor should
recognise a gain or loss on the partial disposal.
However, there is an inconsistency between IAS 28 and IFRS 10 relating to gain or loss recognition where the contribution to
the joint venture is considered to represent a business.
IAS 28 requires the participant to recognise the gain or loss on the contribution, up to the share of the other investors in the
arrangement.
In contrast, IFRS 10 states that any investment that a parent has in the former subsidiary, after control is lost, is measured at
fair value at the date that control is lost, and any resulting gain or loss is recognised in full in profit or loss.
effective date of the amendment indefinitely, pending finalisation of its research project on the equity method. [IAS 28
paras 31A and 45C].
FAQ 31.29.1 – Accounting for monetary and non-monetary assets exchanged on formation of an associate or joint venture or
subsequently
FAQ 31.29.2 – Methods by which an associate can arise from the disposal of a subsidiary
Contributions to a joint venture
If a joint venture uses the fair values of all contributed assets in its own financial statements, can this be reflected in the
venturer’s own financial statements through equity accounting?
Background
Entities A and B have combined their mineral ore processing facilities in a certain region in order to reduce costs. They
established entity J. Entity A contributed a smelter and entity B a refinery to J. The smelter and refinery both met the
definition of a business. A receives 60% of the shares in J, and entity B receives 40%.
Entity J has recognised the contribution of the processing facilities from entities A and B at fair value. Entity J is
compelled to do this by local company law as shares issued must be backed by the fair value of assets recognised.
Effectively, J follows the “fresh start” method of accounting for its formation.
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Entity A’s accounts for jointly controlled entities using the equity method. A’s management wants to include its share of
J’s net assets and profits and losses on the same basis on which they are accounted for in entity J, without adjustment.
They point out that Entity J has used an acceptable method under IFRS of accounting for its formation.
Can A’s management do this?
Solution
Yes, there is a policy choice available to A in certain circumstances because of the conflict in the accounting standards
described below. A can choose partial recognition of the gain or loss being the difference between 40% of the carrying
amount of the asset contributed by A and 60% of the fair value of the refinery contributed by B. This is the approach set
out in IAS 28. A may also recognise 100% of the gain arising on its disposal of its smelter following IFRS 10—see
narrative below.
The example above is based on guidance provided within IAS 28. There is an inconsistency between IAS 28 and IFRS 10
when the contribution to the jointly controlled entity is considered to represent a business.
IFRS 10 has different guidance on the loss of control of a business. Any investment a parent has in the former subsidiary
after control is lost is measured at fair value at the date that control is lost and any resulting gain or loss is recognised in
profit or loss in full.
The IFRS Interpretations Committee have undertaken a project to clarify whether a business meets the definition of a ‘non-
monetary’ asset and eliminate the inconsistency between IAS 28 and IFRS 10. Initial indications are that an IFRS 10
approach would be adopted for all contributions of assets which constitute a business and the IAS 28 approach would be
used for all other contributions. Readers should check the progress of this recommendation before finalising their
accounting.
7.7 Investments with less than joint control
Some co-operative arrangements may appear to be joint arrangements but fail on the basis that unanimous agreement
between venturers is not required for key strategic decisions. This may arise when a super majority, for example an 80%
majority is required but where the threshold can be achieved with a variety of combinations of shareholders and no venturers
are able to individually veto the decisions of others. Accounting for these arrangements will depend on the way they are
structured and the rights of each venturer.
Identifying a joint venture
Is an entity automatically a joint venture if more than two parties hold equal shares in an entity?
Background
Entity A, B, C and D (venturers) each hold 25% in entity J, which owns a mineral property. Decisions in J need to be
approved by a 75% vote of the venturers.
Entity A’s management wants to account for its interest in J using share of revenue and assets in its IFRS consolidated
financial statements because J is a joint venture. Can A’s management account for J in this way?
Solution
No. A cannot account for J using share of revenue and assets because J is not jointly controlled. The voting
arrangements would require unanimous agreement between those sharing the joint control of J to qualify as a joint
venture. The voting arrangements of J allow agreement of any combination of three of the four partners to make
decisions.
Each investor must therefore account for its interest in J as an associate since they each have significant influence but
they do not have joint control. Equity accounting must therefore be applied.
If an entity doesn’t qualify as a joint venture, each investor will account for its investment either using equity accounting in
accordance with IAS 28 (if it has significant influence) or at fair value as a financial asset in accordance with IFRS 9.
An investor may also participate in a joint operation but not have joint control. The investor should account for their rights to
assets and obligations for liabilities. If they do not have rights to assets or obligations for liabilities they should account for
their interest in accordance with the IFRS applicable to that interest.
Investors may also have an undivided interest in a tangible or intangible asset where there is no joint control and the
investors have a right to use a share of the operative capacity of that asset. An example is when a number of investors have
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invested in shared road network and an investor with a 20% interest has the right to use the network. Industry practice is for
an investor to recognise its undivided interest at cost less accumulated depreciation and any impairment charges.
operating and maintenance costs. These costs should be recognised as expenses in the income statement when incurred
and classified in the same way as equivalent costs for wholly-owned assets.
7.8 Changes in ownership in a joint

arrangement
A participant in a joint arrangement may increase or decrease its interest in the arrangement. The appropriate accounting for
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7.8.1 Changes in ownership — Joint operations
The accounting for a change in the ownership will depend on whether the assets under the arrangement represent a
business and the level of control which exists after the change in ownership. If the arrangement meets the definition of a
business and control is obtained, this represents a business combination. The accounting for business combinations is
discussed in section 6.4. If control is not obtained and the asset remains jointly controlled, the consideration paid for any
additional interest is capitalised as the cost of that interest. As noted in section 7.6, the IFRS Interpretations Committee has
made a recommendation to the IASB on an amendment to IFRS 11 in relation to the acquisition of interests in joint
operations which may change the accounting.
Reductions in the interest in jointly controlled assets will result in derecognising an amount of carrying value equivalent to the
proportionate share disposed, regardless of whether joint control remains or not.
7.8.2 Changes in ownership — Joint ventures
Accounting for increases in interest in a joint venture will depend on the level of control post acquisition. Where control is
obtained, a business combination has taken place. The carrying amount previously recognised under equity accounting or
share of assets and liabilities would be derecognised, acquisition accounting applies and the entity would be fully
consolidated. This would require a fair value exercise, remeasurement of the previously held interest and measurement of
non-controlling interest and goodwill. There may also be a gain or loss to recognise in the income statement.
A partial disposal of an equity accounted interest that results in no change in joint control or a change to significant influence
results in the entity derecognising a proportion of the carrying amount of the investment. It will recognise any gain or loss
arising on the disposal in the income statement. The entity does not remeasure the retained interest.
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7.9 Accounting by the joint arrangement
The preceding paragraphs describe the accounting by the investor in a joint arrangement. A joint venture itself will normally
prepare its own financial statements for reporting to the joint venture partners and for statutory and regulatory purposes. It is
increasingly common for these financial statements to be prepared in accordance with IFRS. Joint ventures are typically
created by the venturers contributing assets or businesses to the joint venture in exchange for their equity interest in the JV.
An asset contributed to a joint venture in exchange for issuing shares to a venturer is a transaction within the scope of IFRS
2. These assets are recognised at fair value in the financial statements of the joint arrangement. However, the accounting for
the receipt of a business contributed by a venturer is not specifically addressed in IFRS as it is outside the scope of IFRS 2
and IFRS 3.
Two approaches have developed in practice. One is to recognise the assets and liabilities of the business, including
goodwill, at fair value, similar to the accounting for an asset contribution and the accounting for a business combination. The
second is to recognise the assets and liabilities of the business at the same book values as used in the contributing party’s
IFRS financial statements.
7.10 Farm outs
A “farm out” occurs when a venturer (the “farmor”) assigns an interest in the reserves and future production of a mine to
another party (the “farmee”). This is often in exchange for an agreement by the farmee to pay for both its own share of the
future mine development costs and those of the farmor. There may also be a cash payment made by the farmee to the
farmor. This is a “farm in” when considered from the farmee’s perspective. This typically occurs during the exploration or
development stage and is a common method entities use to share the cost and risk of developing properties. The farmee
hopes that their share of future production will generate sufficient revenue to compensate them for performing the
exploration or development activity.
7.10.1 Accounting by the farmor
Farm out agreements are largely non-monetary transactions at the point of signature for which there is no specific guidance
in IFRS. Different accounting treatments have evolved as a response. The accounting depends on the specific facts and
circumstances of the arrangement, particularly the stage of development of the underlying asset.
Assets with reserves
If there are reserves associated with the property, the farm-in should be accounted for in accordance with the principles of
IAS 16. The farm out will be viewed as an economic event, as the farmor has relinquished its interest in part of the asset in
return for the farmee delivering a developed asset in the future. There is sufficient information for there to be a reliable
estimate of fair value of both the asset surrendered and the commitment given to pay cash in the future.
The rights and obligations of the parties need to be understood while determining the accounting treatment.
The consideration received by the farmor in exchange for the disposal of their interest is the value of the work performed by
the farmee plus any cash received. This is presumed to represent the fair value of the interest disposed of in an arm’s length
transaction.
The farmor should de-recognise the carrying value of the asset attributable to the proportion given up, and then recognise
the “new” asset to be received at the expected value of the work to be performed by the farmee. After also recording any
cash received as part of the transaction, a gain or loss is recognised in the income statement. The asset to be received is
normally recognised as an intangible asset or “other receivable”. When the asset is constructed, it is transferred to property,
plant and equipment.
Assessing the value of the asset to be received may be difficult, given the unique nature of each development. Most farm out
agreements will specify the expected level of expenditure to be incurred on the project (based on the overall budget
approved by all participants in the mine development). The agreement may contain a cap on the level of expenditure the
farmee will actually incur. The value recognised for the asset will often be based on this budget. A consequence is that the
value of the asset will be subject to change as the actual expenditure is incurred, with the resulting adjustments affecting the
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gain or loss previously recognised. The stage of development of the asset and the reliability of budgeting will impact the
volatility of subsequent accounting.
Assets with no proved reserves
The accounting is not as clear where the mineral asset is still in the exploration or evaluation stage. The asset would still be
subject to IFRS 6 ‘Exploration for and Evaluation of Mineral Resources’ rather than IAS 16. The reliable measurement test in
IAS 16 for non-cash exchanges may not be met. Neither IFRS 6 nor IFRS 11 gives specific guidance on the appropriate
accounting for farm outs.
Several approaches have developed in practice by farmors:
recognise only any cash payments received and do not recognise any
consideration in respect of the value of the work to be performed by the farmee
and instead carry the remaining interest at the previous cost of the full interest
reduced by the amount of any cash consideration received for entering the
agreement. The effect will be that there is no gain recognised on the disposal
unless the cash consideration received exceeds the carrying value of the entire
asset held;
follow an approach similar to that for assets with proved reserves, recognising both
cash payments received and value of future asset to be received, but only
recognise the future asset when it is completed and put into operation, deferring
gain recognition until that point; or
follow an approach similar to that for assets with proved resources, recognising
both cash payments received and value of future asset to be received, and
recognise future asset receivable when the agreement is signed with an
accompanying gain in the income statement for the portion of reserves disposed
of.
All three approaches are used today under current IFRS. There can be volatility associated with determining the value of the
asset to be received as consideration for a disposal in a farm out of assets with proved resources. This volatility is
exacerbated for assets which are still in the exploration phase. Prevalent industry practice follows the first approach outlined
above.
7.10.2 Accounting by the farmee
The farmee will only recognise costs as incurred, regardless of the stage of development of the asset. The farmee is required
to disclose their contractual obligations to construct the asset and meet the farmor’s share of costs. The farmee should
follow its normal accounting policies for capitalisation, and also apply them to those costs incurred to build the farmor’s
share.
Accounting for a farm out
Background
Company N and company P participate jointly in the exploration and development of a copper deposit located in Peru.
Company N has an 18% share in the arrangement, and Company B has an 82% share. Companies N and P have signed
a joint arrangement agreement that establishes the manner in which the area should operate. N and P have a joint
operation under IFRS 11. The joint operation comprises the mine area, machinery and equipment. There are no proved
reserves.
The companies have entered into purchase and sale agreements to each sell 45% of their participation to a new investor
—Company R. Company N receives cash of C4 million and company P receives cash of C20 million. The three
companies entered into a revised ‘joint development agreement’ to establish the rights and obligations of all three parties
in connection with the funding, development and operations of the asset. The composition of the interests of the three
companies is presented in the table below:
Company N Company P Company R Total

Before 18% 82% - 100%
transaction
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After 10% 45% 45% 100%

transaction
Cash C4 million C20 million - C24 million
received
Each party to the joint development agreement is liable in proportion to their interest
for costs subsequent to the date of the agreement. However, 75% of the exploration
and development costs attributable to companies N and P must be paid by company
R on their behalf. The total capital budget for the exploration and development of the
asset is C200 million. Company N’s share of this based on their participant interest
would be C20 million, however, Company R will be required to pay C15 million of this
on behalf of Company N.
The carrying value of the asset in Company N’s financial statements prior to the transaction was C3 million.
Question: How should company N account for such transaction?
Solution
This transaction has all the characteristics of a farm out agreement. The cash payments and the subsequent obligation of
company R to pay for development costs on behalf of companies N and P appear to be part of the same transaction.
Companies N and P act as farmors and company R acts as the farmee. The structure described also meets the definition
of a joint operation per IFRS 11. Therefore company N should account for its share of the assets and liabilities and share
of the revenue and expenses.
The gain on disposal could be accounted for by company N using one of three approaches, as follows:
1. Recognise only cash payments received.

Company N will reduce the carrying value of the mining asset by the C4 million
cash received. The C1 million excess over the carrying amount is credited to the
income statement as a gain. The C15 million of future expenditure to be paid by
Company R on behalf of Company N is not recognised as an asset. As noted
above, this approach would be consistent with common industry practice.
2. Recognise cash payments plus the value of the future assets at the
agreement date.
Company N will recognise the C4 million as above. In addition, they will
recognise a “receivable” or intangible asset for the future expenditure to be
incurred by company R on company N’s behalf, with a further gain of this
amount recognised in the income statement. Company N would have to assess
the expected value of the future expenditure. Although one method to estimate
this would be the budgeted expenditure of C15 million, Company N would need
to assess whether this would be the actual expenditure incurred. Any difference
in the final amount would require revision to the asset recognised and also the
gain, creating volatility in the income statement.
3. Recognise cash payment plus the value of future assets received when
construction is completed.
Company N will recognise the C4 million cash received as in ‘1.’ above. When
the future assets are completed, these are recognised in the balance sheet, and
a gain of the same amount recognised in the income statement. This approach
would avoid the volatility issue associated with approach 2.
8. Closure and rehabilitation liabilities
The mining industry can have a significant impact on the environment. Closure or environmental rehabilitation work at the
end of the useful life of a mine or installation may be required by law, the terms of operating licences or an entity’s stated
policy and past practice.
An entity that promises to remediate damage or has done so in the past, even when there is no legal requirement, may have
created a constructive obligation and thus a liability under IFRS. There may also be environmental clean-up obligations for
contamination of land that arises during the operating life of the mine or installation. The associated costs of remediation/
restoration can be significant. The accounting treatment for closure and rehabilitation costs is therefore critical.
8.1 Closure and rehabilitation provisions
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A provision is recognised when an obligation exists to perform the rehabilitation. The local legal regulations should be taken
into account when determining the existence and extent of the obligation. An obligation might arise if an entity has a policy
and past practice of performing rehabilitation activity. A provision is recorded if others have a reasonable expectation that
the entity will undertake the restoration.
Obligations to decommission or remove an asset are created at the time the asset is put in place. Mining infrastructure, for
example, must be removed at the end of its useful life, typically on closure of the mine. The obligation to remove plant arises
from its placement. However, there is some diversity in practice as to whether the entire expected liability is recognised
when activity begins, or whether it is recognised in increments as the disturbance occurs. For example, in open cast mining
some obligating events might arise over time as the reserves are extracted. The environmental disturbance occurs as the top
soil is removed and mineral ore extracted. It may be more appropriate to recognise a provision for the rectification work
progressively as the disturbance occurs.
There is also diversity in whether closure liabilities are recognised during the exploration phase of a project. If an obligation to
restore the site arises as and when the disturbance occurs, a liability should be recognised at the time of such disturbance
even though the entity may be in the exploration phase of the project. The asset and liability recognised at any particular
point in time needs to reflect the specific facts and circumstances of the project and the entity’s obligations.
Closure provisions are measured at the present value of the expected future cash flows that will be required to perform the
decommissioning. The ‘best estimate’ may be determined by taking into account all possible outcomes and using
probabilities to weight these outcomes. There are various tools that can be used to determine the best estimate including the
Monte Carlo method.
The cost of the provision is recognised as part of the cost of the asset when it is put in place and depreciated over the
asset’s useful life. The total cost of the fixed asset, including the cost of closure, is depreciated on the basis that best reflects
the consumption of the economic benefits of the asset (typically UoP). Provisions for closure and restoration are recognised
even if the closure is not expected to be performed for a long time, for example more than 50 years.
The effect of the time to expected closure will be reflected in the discounting of the provision. The discount rate used is the
pre-tax rate that reflects current market assessments of the time value of money. Miners with multi-national operations
should select an appropriate discount rate for locations with materially different risks.
Different closure obligations will, naturally, have different inherent risks, for example different uncertainties associated with
the methods, the costs and the timing of closure. This is a complex area and careful consideration needs to be given to how
to appropriately reflect risks in the cash flow and discount rate.
8.2 Capitalise vs expense
The costs of a closure and environmental obligation that arises from mine development activities are capitalised as a cost of
the associated asset. The costs are allocated to the related asset and then depreciated over the useful life of that asset. The
cost associated with the initial obligation and any adjustments should be correctly allocated and subsequently depreciated.
The costs of closure and environmental obligations that arise from mine production activities are a current cost of production
and are included in inventory costs.
It can be challenging to distinguish between obligations that arise from production and those attributable to mine
development.
Restoration obligations, for example, that arise from moving material to waste dumps before the mine enters production are
generally capitalised as mine development costs. When those same activities occur during the production phase, they may
be related to both current period production and mine development. The treatment of the restoration obligations should be
consistent with the treatment of the associated waste removal costs.
8.3 Revisions to closure and rehabilitation

provisions
Closure provisions are updated at each balance sheet date for changes in the estimates of the amount or timing of future
cash flows and changes in the discount rate. This includes changes in the exchange rate when some or all of the expected
future cash flows are denominated in a foreign currency. Changes to provisions that relate to the removal of an asset are
added to or deducted from the carrying amount of the related asset in the current period [IFRIC 1 “Changes in
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Decommissioning, Restoration and Similar Liabilities” para 5]. However, the adjustments to the asset are restricted. The
asset cannot decrease below zero and cannot increase above its recoverable amount [IFRIC 1 para 5]:
if the decrease in provision exceeds the carrying amount of the asset, the excess is
recognised immediately in profit or loss;
adjustments that result in an addition to the cost of the asset are assessed to
determine if the new carrying amount is fully recoverable or not. An impairment test
is required if there is an indication that the asset may not be fully recoverable.
The accretion of the discount on a closure liability is recognised as part of finance expense in the income statement.
8.4 Deferred tax on closure and rehabilitation

provisions
There are two principal acceptable approaches for determining the tax bases of closure assets and liabilities:
One approach is to allocate the future tax deductions to the asset. On initial
recognition, the asset’s tax base is the future tax consequence of recovering the
asset at its carrying amount and no temporary difference arises. There is no
deduction associated with the liability; leading to its tax base equal to its carrying
amount. As there is no temporary difference on the asset and liability at initial
recognition, the initial recognition exemption under IAS 12 (para 15 and 24) is not
relevant.
The alternative approach is to allocate the future tax deductions to the liability. The
asset’s tax base is nil as there are no associated tax deductions, so there is a
temporary difference equal to the asset’s carrying amount at initial recognition. The
liability’s tax base is also nil, so there is a temporary difference equal to the
liability’s carrying amount at initial recognition. For closure obligations arising
outside of a business combination and which do not affect accounting profit or
taxable profit on initial recognition, these temporary differences will be covered by
the initial recognition exemption; therefore, no deferred taxes arises on initial
recognition.
For subsequent changes to the closure assets and liabilities, it will be necessary to determine how these are accounted for
under the relevant approach. Given that different approaches are acceptable, an entity should make clear its accounting
policy for deferred tax in closure obligations if this is material and apply it on a consistent basis.
8.5 Closure and rehabilitation funds
Many mining entities contribute to a separate fund established to help fund closure and environmental obligations. These
funds may be required by regulation or law or may be voluntary.
range of assets, usually debt and equity securities. The trustees determine how contributions are invested, within the
constraints set by the fund’s governing documents, and any applicable legislation or other regulations. The mining entity
then obtains reimbursement of actual decommissioning costs from the fund as they are incurred. However, the mining entity
may only have restricted access or no access to any surplus of assets of the fund over those used to meet eligible
decommissioning costs.
IFRIC 5 “Rights to Interests arising from Decommissioning, Restoration and Environmental Rehabilitation Funds” provides
guidance on the accounting treatment for these funds in the financial statements of the mining entity. Management must
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recognise its interest in the fund separately from the liability to pay closure and environmental costs. Offsetting is not
appropriate.
fund accordingly. In the absence of these, the fund is accounted for as a reimbursement of the entity’s closure and
environmental obligation, at the lower of the amount of the decommissioning obligation recognised and the entity’s share of
the fair value of the net assets of the fund.
Any movements in a fund accounted for as a reimbursement are recognised in the income statement as finance
income/expense. The movements in the fund (based on the IFRIC 5 measurement) are assessed separately from the
measurement of the provision (under IAS 37).
Accounting for guarantees
Background
In Australia, mining entity A has created a closure and rehabilitation provision in respect of the abandonment liability for
the mine.
A has also been required by law to place a performance guarantee equivalent to the estimated total amount required to
fulfil the abandonment liabilities at the end of the life of the mine it operates.
How should entity A account for this performance guarantee?
Solution
The performance guarantee should be disclosed in the financial statements as a contingent liability as the related liability
has already been accounted for under IAS 37.
8.6 Termination benefits
Payments made to employees in connection with the closure of a mine must be accounted for under IAS 19 “Employee
Benefits”.
It is certain that a mine’s ore reserves will be exhausted at the end of the life of mine, and it often follows from this that
redundancy costs will arise. In this respect, redundancy obligations are very similar to decommissioning obligations.
However, IAS 19 restricts when termination benefits can be recognised, with a liability only recognised when the entity is
demonstrably committed to the redundancies by having:
a detailed formal plan for the terminations; and

no realistic possibility of withdrawal.
Termination benefits can therefore only be recognised when the closure date has been announced and other recognition
criteria are met.
8.7 Disclosure
For each class of provision IAS 37 requires disclosure of:
the nature of the obligation;

the factors relevant in determining the timing of the expenditure where there is
significant uncertainty;
the amount provided and methods used to determine the amount;
a statement of whether the amount is discounted, where applicable; and
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any actual or potential offsets to the liability.

Although not required by the standard it is also good practice to disclose the discount rates used to determine the net
present value of the liability.
For recognised provisions management must also disclose the movements in each material class of provisions, showing
separately:
additional provisions;
adjustments to existing provisions;
amounts used during the year;
amounts released unused; and
the interest accrued during the year, if provisions were discounted.
For funds, management must disclose:
a description of the nature of any interest in a fund; and

any restrictions on access to the assets of the fund.
9. Impairment of mining assets
9.1 Overview
The mining industry is distinguished by the significant capital investment required and volatile commodity prices. The heavy
investment in fixed assets leaves the industry exposed to adverse economic conditions and therefore impairment charges.
Mining assets should be tested for impairment whenever indicators of impairment exist [IAS 36 para 9]. The normal
measurement rules for impairment apply to assets with the exception of the grouping of E&E assets with existing producing
cash generating units (“CGUs”) as described in section 2.3.7
Impairments are recognised if a CGU’s carrying amount exceeds its recoverable amount [IAS 36 para 6]. Recoverable
amount is the higher of fair value less costs to sell (“FVLCTS”) and value in use (“VIU”).
9.2 Impairment indicators
Entities must use judgement in order to assess whether an impairment indicator has occurred. If an impairment indicator is
concluded to exist, IAS 36 requires that the entity perform an impairment test.
What are some common potential indicators of impairment in the mining industry?
Solution
a significant decline in the market capitalisation of the entity or other entities

producing the same commodity;
a significant deterioration in expected future commodity prices;
a significant adverse movement in foreign exchange rates;
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a significant increase in production costs;

a large cost overrun on a capital project such as an overrun during the
development and construction of a new mine;
a significant increase in the expected cost of dismantling assets and restoring
the site, particularly towards the end of a mine’s life;
a significant revision of the life of mine plan;

higher cut-off grades leading to lower reserves;
production cut backs;
serious mine accidents, such as a pit wall failure or underground collapse; and
adverse changes in government regulations and environmental law, including a
significant increase in the tax or royalty burden payable by the mine.
Would a decline in the spot market price of copper be an indicator of impairment for a copper mine?
Background
An entity has a producing copper mine. There has been a significant decline in the spot price of copper during the last
six months.
Is such decline in the spot price of mineral ore an indicator of impairment of the mine?
Solution
Not automatically. The nature of mining assets is that they often have a long useful life. Commodity price movements
can be volatile and move between troughs and spikes.
Downward price movements can assume more significance if these are expected to persist for longer periods. This
might be evidenced by a decline in forward prices throughout the liquid period. If a decline in prices is expected to be
prolonged and for a significant proportion of the remaining expected life of the mine, this is more likely to be an
impairment indicator.
Short term market fluctuations may not be impairment indicators if spot prices are expected to return to higher levels
within the near future. Such assessments can be difficult to make, with price forecasts becoming difficult where a longer
view is taken.
Entities should approach this area with care. The process of defining the level of spot price movement as an indicator of
impairment should, in particular, consider the relevant cost base. Downward price movements would be more significant
for mines which are high cost producers.
Might a change in government be an indicator of impairment?
Background
A mining company has a mining licence in a developing country. The company’s investment in the mining assets is
substantial. There is a coup in the country and the democratically elected government is replaced by a military regime
who have indicated they will introduce a new mineral tax and review the terms of all existing mining licenses.
Does the change in government constitute an indicator of impairment?
Solution
Yes. The change in government is a change in the legal and economic environment that may have a substantial negative
impact on expected cash flows. The mining assets should be tested for impairment.
Impairment indicators can also be internal in nature. Evidence that an asset or CGU has been damaged or become obsolete
is likely to be an impairment indicator; for example a refinery destroyed by fire is, in accounting terms, an impaired asset.
Changes in development costs, such as budget overruns may also be potential impairment indicators. Other common
indicators are a decision to sell or restructure a CGU or evidence that business performance is less than expected.
Management should be alert to indicators that individual components within a CGU may be impaired; for example learning of
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a fire at an individual smelter facility would be an indicator of impairment for that smelter as a separate CGU.
9.3 Cash generating units
Few assets can be tested in isolation, as nearly all assets are used in integrated groups to generate cash flows for the entity.
A ‘cash generating unit’ or CGU is ‘the smallest identifiable group of assets that generates cash inflows that are largely
independent of the cash inflows generated from other assets or groups of assets’.
Most mining assets are grouped into CGUs. Each CGU should represent the smallest group of assets that could generate
largely independent cash flows.
The determination of CGUs will often be straightforward for the mining industry because an individual mine with its
supporting infrastructure will often be a single CGU.
The determination of CGUs can be more complex when a mining entity is involved in processing the output from its mines,
including activities such as refining or smelting of metals. If an ‘active market’ exists for any of the intermediate products in
an integrated value chain then each activity would form a separate CGU. This is required even if all of the intermediate
products are used internally.
An active market is a market in which all of the following conditions exist:
the items traded within the market are homogeneous;

willing buyers and sellers can normally be found at any time; and
prices are available to the public.
Grouping of assets into CGUs
Background
The owner of a copper mine also owns a smelter and refinery associated with the mine.
The copper concentrate produced by the smelter and refinery is of a consistent quality and there is an active local
market.
For impairment testing would the smelter and refinery represent a separate CGU from the mine?
Solution
Yes. The presence of an active market for copper concentrate means that there smelter and refinery can generate cash
flows independent of the mine and therefore represents a CGU.
9.4 Shared assets
Several mines located in the same region may share assets (for example, port and rail facilities or processing plant). This is
common in the coal industry where, for example, an entity might own several mines in the same region and share a common
washing plant.
Judgement is involved in determining how such shared assets should be treated for impairment purposes. Factors to
consider include:
whether the shared assets generate substantial cash flows from third parties as
well as the entity’s own mines—if so, they may represent a separate CGU
how the operations are managed
Any shared assets that do not belong to a single CGU but relate to more than one CGU still need to be considered for
impairment purposes. There are two ways to do this and management should use the method most appropriate for the
entity. Shared assets can be allocated to individual CGUs or the CGUs can be grouped together to test the shared assets.
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Under the first approach, the assets should be allocated to each individual CGU or group of CGUs on a reasonable and
consistent basis. The cash flows associated with the shared assets, such as fees from other users and expenditure, forms
part of the cash flows of the individual CGU.
The second approach has the group of CGUs that benefit from the shared assets grouped together to test the shared assets.
The allocation of any impairment identified to individual CGUs should be possible for shared assets used in the processing or
transportation of the output from several mines and, for example, could be allocated between the mines according to their
current production and mine plans.
9.5 Fair value less costs to sell (“FVLCTS”)
Fair value less costs to sell is the amount that a market participant would pay for the asset or CGU, less the costs of sale.
The use of discounted cash flows (“DCF”) for FVLCTS is permitted where there is no readily available market price for the
asset or where there are no recent market transactions for the fair value to be determined through a comparison between the
asset being tested for impairment and a recent market transaction.
FVLCTS is less restrictive in its application than VIU and can be easier to work with. It is more commonly used in practice,
particularly for recently-acquired assets. The underlying assumptions in a FVLCTS model are usually, but not always, closer
to those that management have employed in their own forecasting process. The output of a FVLCTS calculation may feel
intuitively more correct to management.
The assumptions and other inputs used in a DCF model for FVLCTS should incorporate observable market inputs as much
as possible. The assumptions should be both realistic and consistent with what a typical market participant would assume.
Assumptions relating to forecast capital expenditures that enhance the productive capacity of a CGU can therefore be
included in the DCF model, but only to the extent that a typical market participant would take a consistent view.
The amount calculated for FVLCTS is a post-tax recoverable amount. The discount rate applied in FVLCTS should be a post-
tax market rate based on a market participant’s weighted average cost of capital. As discussed in the Business
Combinations section 6.4.6, an asset’s fair value reflects the price which would be paid for the individual asset if it were to be
acquired separately. Accordingly, any Tax Amortisation Benefit (TAB) that would be available if the asset were acquired
separately should be reflected in the fair value of the asset.
The FVLCTS is compared against the carrying amount of the CGU on an after-tax basis; that is, after deducting deferred tax
liabilities relating to the CGU/group of CGUs. This is particularly relevant when testing goodwill for impairment. A major driver
of goodwill in mining acquisitions is the calculation of deferred tax on the reserves and resources acquired. With relatively
high marginal tax rates, the amount of goodwill can be substantial. The use of FVLCTS can alleviate the tension of
substantial goodwill associated with depleting assets.
9.6 Value in use (“VIU”)
VIU is the present value of the future cash flows expected to be derived from an asset or CGU in its current condition [IAS 36
para 6]. Determination of VIU is subject to the explicit requirements of IAS 36. The cash flows are based on the asset that the
entity has now and must exclude any plans to enhance the asset or its output in the future but include expenditure necessary
to maintain the current performance of the asset [IAS 36 para 44]. The VIU cash flows for assets that are under construction
and not yet complete (e.g., mine that is part-developed) should include the cash flows necessary for their completion.
The cash flows used in the VIU calculation are based on management’s most recent approved financial budgets/ forecasts.
The assumptions used to prepare the cash flows should be based on reasonable and supportable assumptions. Assessing
whether the assumptions are reasonable and supportable is best achieved by benchmarking against market data or
performance against previous budgets.
The discount rate used for VIU is pre-tax and applied to pre-tax cash flows [IAS 36 par 55]. This is often the most difficult
element of the impairment test, as pre-tax rates are not available in the market place. Arriving at the correct pre-tax rate is a
complex mathematical exercise. Computational short cuts are available if there is a significant amount of headroom in the
VIU calculation. However, grossing up the post tax rate seldom gives an accurate estimate of the pre-tax rate.
9.6.1 Period of projections
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The cash flow projections used to determine VIU can include specific projections for a maximum period of five years, unless
a longer period can be justified. A longer period may be appropriate for mining assets based on the proved and probable
reserves and expected annual production levels. Assumptions on the level of reserves expected to be produced should be
consistent with the latest estimates by reserve engineers, annual production rates should be consistent with those for the
preceding five years, and price and cost assumptions should be consistent with the final period of specific assumptions.
Some assets, such as smelters, may not have a finite life.
9.6.2 Commodity prices in VIU
Estimates of future commodity prices will need to be included in the cash flows prepared for the VIU calculation.
Management usually takes a longer term approach to the commodity price; this is not always consistent with the VIU rules.
Spot prices are used unless there is a forecast price available as at the impairment test date. In the mining industry, for
actively traded commodities there are typically forward price curves available and in such circumstances these provide a
reference point for forecast price assumptions. Those forecast prices should be used for the future periods covered by the
VIU calculation. Where the forward price curve does not extend far enough into the future, the price at the end of the forward
curve is generally held steady, unless there is a compelling reason to adjust it.
The future cash flows relating to the purchase or sale of commodities might be known from forward purchase or sales
contracts. Use of these contracted prices in place of the spot price or forward curve price for the contracted quantities will
generally be appropriate. However, some forward purchase and sales contracts will be accounted for as derivative contracts
at fair value in accordance with IFRS 9 and are recognised as current assets or liabilities. They are therefore excluded from
the IAS 36 impairment test. The cash flow projections used for the VIU calculation should exclude the pricing terms of the
sales and purchase contracts accounted for in accordance with IFRS 9.
9.6.3 Foreign currencies in VIU
Foreign currencies may be relevant to impairment testing for two reasons:
a. When all the cash flows of a CGU are denominated a single currency that is not the reporting entity’s functional currency; and
b. When the cash flows of the CGU are denominated in more than one currency.
a. CGU cash flows differ from entity’s functional currency
All future cash flows of a CGU may be denominated in a single currency, but one that is different from the reporting entity’s
functional currency. The cash flows used to determine the recoverable amount are forecast in the foreign currency and
discounted using a discount rate appropriate for that currency. The resulting recoverable amount is translated into the entity’s
functional currency at the spot exchange rate at the date of the impairment test [IAS 36.54].
b. CGU cash flows are denominated in more than one currency
Some of the forecast cash flows may arise in different currencies. For example, cash inflows may be denominated in a different
currency from cash outflows. Impairment testing involving multiple currency cash flows can be complex and may require
consultation with specialists.
The currency cash flows for each year for which the forecasts are prepared should be translated into a single currency using
an appropriate exchange rate for the time period. The spot rate may not be appropriate when there is a significant expected
inflation differential between the currencies. The forecast net cash flows for each year are discounted using an appropriate
discount rate for the currency to determine the net present value. If the net present value has been calculated in a currency
different from the reporting entity’s functional currency, it is translated into the entity’s functional currency at the spot rate at
the date of the impairment test [IAS 36.54].
The use of the spot rate, however, can generate an inconsistency, to the extent that future commodity prices denominated in
a foreign currency reflect long-term price assumptions but these are translated into the functional currency using a spot rate.
This is likely to have the greatest impact for operations in countries for which the strength of the local currency is significantly
affected by commodity prices. Where this inconsistency has a pronounced effect, the use of FVLCTS may be necessary.
FVLCTS does not impose the same specific restrictions.
9.6.4 Assets under construction in VIU
The VIU cash flows for assets that are under construction and not yet complete should include the cash flows necessary for
their completion and the associated additional cash inflows or reduced cash outflows. A mine in development is an example
of a part-constructed asset. The VIU cash flows should therefore include the cash flows to complete the development to the
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extent that they are included in the original development plan and the associated cash inflows from the expected sale of the
mineral ore.
9.7 Interaction of closure and rehabilitation

provisions and impairment testing
Closure and rehabilitation provisions and the associated cash flows can be either included or excluded from the impairment
test, provided the carrying amount of the asset and the cash flows are treated consistently. IAS 36 requires the carrying
amount of a liability to be excluded from the carrying amount of a CGU unless the recoverable amount of the CGU cannot be
determined without consideration of that liability [IAS 36.76, 78].
This typically applies when the asset/CGU cannot be separated from the associated liability. Closure and rehabilitation
obligations are closely linked to the asset that needs to be closed, although the cash flows associated with the asset may be
independent of the cash flows of the closure liability. If the carrying value of the closure provision is included in the carrying
amount of the CGU, the estimated future cash outflows are included in the DCF model used to determine recoverable
amount. However, if the carrying amount is excluded, the cash flows should also be excluded.
Interaction of closure provision and impairment testing
How is a closure provision included in an impairment test?
Background
Entity A incurs expenditure of C100 constructing a mine. The present value of the closure obligation at the date on which
the platform is put into service is C25. The present value of the future cash inflows from expected production is C180.
The present value of the future cash outflows from operating the mine is C50, and the present value of the future cash
outflows from performing the closure of the plant is C25.
Solution
The following example illustrates the results of both the inclusion and exclusion of the closure liability in the carrying
amount of the CGU and the cash flow projections.
The net present value of future cash flows associated with operating the mine is as follows:
VIU Including Excluding

calculation
Cash inflows 180 180

from sale of
commodities
produced
Operating (50) (50)

cash outflows
Cash outflows (25) (-)

from closure
at end of mine
life
Net present 105 130

value of cash
flows
(recoverable
amount)
Carrying 125 125

amount of
PPE
(including
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cost of future
closure)
Carrying (25) (-)

amount of
closure
provision
Net carrying 100 125

amount of
CGU
The recoverable amount in both cases exceeds the carrying amount of the assets and
hence, no impairment charge is required. However, if the discount rate used for
arriving at the cash outflows from decommissioning is different from that used for the
9.8 Goodwill impairment testing
IAS 36 requires goodwill to be tested for impairment at least annually and tested at the lowest level at which management
monitors it. The lowest level cannot be higher than the operating segment to which goodwill belongs to under IFRS 8
“Operating Segments”.
The grouping of CGUs for impairment testing should reflect the lowest level at which management monitors the goodwill. If
that is on an individual CGU basis, testing goodwill for impairment should be performed on that individual basis. However,
when management monitors goodwill based on a group of CGUs the impairment testing of the goodwill should reflect this.
Goodwill is tested for impairment annually and when there are impairment indicators. Those indicators might be specific to
an individual CGU or group of CGUs.
IAS 36 requires a bottom up then top down approach for impairment testing and the order in which the testing is performed
is crucial. The correct approach is particularly important if there is goodwill, indefinite lived assets, shared assets or
corporate assets. First, any individual CGUs with indicators of impairment must be tested and the impairment loss recorded
in the individual CGU. Then CGUs can be grouped for the purposes of testing shared assets, indefinite lived intangibles,
goodwill and corporate assets. The amended carrying values of any individual CGUs that have been adjusted for an
impairment charge are used as part of the second stage of the impairment test.
CGUs (including goodwill), there is no impairment to recognise. However, if the recoverable amount is less than the
combined carrying value, the group of CGUs and the goodwill allocated to it is impaired. The impairment charge is allocated
first to the goodwill balance to reduce it to zero, and then pro rata to the carrying amount of the other assets within the group
of CGUs. However, if the assessment of impairment indicators and the impairment tests have been performed accurately at
the individual CGUs, it is unlikely that a further impairment of fixed assets will be required as a result of the top down test.
Goodwill is also tested for impairment when there is an indicator that it is impaired, or when there is an indicator that the
CGU(s) to which it is allocated is impaired. When the impairment indicator relates to specific CGUs, those CGUs are tested
for impairment separately before testing the group of CGUs and the goodwill together.
Impairment testing of goodwill
At what level is goodwill tested for impairment?
The diagram below illustrates the levels at which impairment testing may be required. The entity has two operating
segments, A and B. Segment A comprises four CGUs; segment B comprises two CGUs. The goodwill within segment A
is monitored in two parts. The goodwill allocated to CGUs 1, 2 and 3 is monitored on a collective basis; the goodwill
allocated to CGU 4 is monitored separately. The goodwill within segment B is monitored at the segment B level—that is,
goodwill allocated to CGUs 5 and 6 is monitored on a combined basis.
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If there is an impairment indicator for CGU 2, the CGU is tested for impairment separately, excluding the goodwill
allocated to it. Any impairment loss calculated in this impairment test is allocated against the assets within the CGU. This
allocation of the impairment charge is made on a pro rata basis to the carrying value of the assets within the CGU. The
testing of CGU 2 at this level excludes goodwill, so no impairment is allocated against goodwill in this part of the
impairment test.
After recording any impairment arising from testing CGU 2 for impairment, CGUs 1, 2 and 3 and the goodwill allocated to
them is then tested for impairment on a combined basis. Any impairment loss calculated in this impairment test is
allocated first to the goodwill. If the impairment charge in this test exceeds the value of goodwill allocated to CGUs 1, 2
and 3, the remaining impairment charge is allocated against the fixed and intangible assets of CGUs 1, 2 and 3 pro rata
to the carrying value of the assets within those CGUs. However, if the assessment of impairment indicators and the
impairment tests at CGUs 1, 2 and 3 have been performed accurately, it is unlikely that a further impairment of fixed
assets will be required as a result of the top down test.
A similar approach is taken for Segment B (comprising CGUs 5 and 6) and CGU 4. However, because no other CGU is
combined with CGU 4 for goodwill impairment testing, there is no need to test CGU 4 for impairment separately from the
goodwill allocated to it.
9.9 Impairment reversals
The actual results in subsequent periods should be compared with the cash flow projections (used in impairment testing)
made in the previous year. Where performance has been significantly better than previously estimated, this is an indicator of
potential impairment reversal. Impairment charges are reversed (other than against goodwill) where the increase in
recoverable amount arises from a change in the estimates used to measure the impairment. Estimates of variables, such as
commodity prices, reflect the expectations of those variables over the period of the forecast cash flows, rather than changes
in current spot prices. The use of medium to long term prices for commodities means that impairment charges and reversals
tend not to reflect the same volatility as current spot prices.
9.10 Disclosure
A number of disclosures are required where an entity has recognised an impairment loss during the period or reversed a
previous impairment loss, including:
the amount of the impairment loss (or reversal), analysed per reportable segment;
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for each material impairment loss (or reversal):

the events and circumstances leading to the recognition of the loss (or
reversal);
an explanation of the nature of the asset or a description of the CGU;
whether the recoverable amount is based on FVLCTS or VIU;
the basis used to determine FVLCTS (where this is the recoverable
amount); and
the discount rate used to calculate the recoverable amount, if the
recoverable amount is based on a discounted cash flow analysis.
the main classes of assets affected and the main events and circumstances giving
rise to the impairment losses (or reversals) for the aggregate impairment losses (or
reversals) not covered by the detailed disclosures summarised above.
Additional disclosures are required in cases where a mining entity has significant amounts of goodwill. These are:
the carrying amount of the goodwill allocated to a CGU (or group of CGUs);
the basis on which the CGU’s (or group of CGUs’) recoverable amount has been
determined;
where the recoverable amount is based on FVLCTS, the methodology used to
determine FVLCTS; where it is not based on an observable market price (which will
usually be the case), a description of the key assumptions and management’s
approach to determining key assumptions;
where the recoverable amount has been calculated by means of a discounted cash
flow analysis, the key assumptions (including management’s approach to
determining key assumptions), the period for which cash flow projections have
been prepared (and an explanation as to why this exceeds five years, where
relevant), and the discount rate; and
where a reasonably possible change in a key assumption would cause an
impairment loss, the amount of headroom between the recoverable amount and
the carrying amount, the value assigned to the assumption and the amount by
which the value assigned to the assumption would have to change in order to
eliminate the headroom.
These disclosures are required for:
any individual CGUs (or groups of CGUs) that account for a significant proportion
of the entity’s total goodwill; and
any CGUs (or groups of CGUs) that do not account for a significant proportion of
the entity’s goodwill individually but are affected by the same key assumptions and
account for a significant proportion of the entity’s goodwill in aggregate.
An entity may need to disclose its commodity price and foreign exchange rate assumption(s) in order to meet the above
disclosure requirements, given that the value of each key assumption must be disclosed where a reasonably possible
change to the assumption would cause an impairment loss.
Where goodwill or an indefinite lived intangible asset is not allocated to a CGU, entities are encouraged to disclose the
assumptions used to determine the recoverable amount of each asset (or CGU). If a change in these assumptions have a
significant risk of resulting in an impairment being recognised, disclosure of these assumptions is required in terms of IAS 1.
Similar disclosures to those required for goodwill also need to be made for intangible assets with indefinite lives, although
this rarely applies to mining entities.
10. Royalties and income taxes

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Mining taxes can arise due to specific legislation or separate negotiation with the authoritied and generally fall into two main
categories—those that are calculated on profits earned (income taxes) and those calculated on sales (royalty or production
taxes). The categorisation is crucial: royalty and production taxes are deducted from revenue or included in operating
expenses, while income taxes usually require deferred tax accounting. In some countries the authorities may also charge
“production taxes”: charges which are based on a specified tax rate per quantity of mineral ore extracted regardless of
whether that mineral ore is subsequently sold. Such taxes may be recognised as operating expenses.
10.1 Mining taxes — royalty and excise
Mining taxes that are calculated by applying a tax rate to volume or a measure of revenue which has not been adjusted for
expenditure do not fall within the scope of IAS 12 and are not income taxes. Determining whether a mining tax represents an
income tax can require judgement.
Mining taxes outside the scope of IAS 12 do not give rise to deferred tax liabilities. These taxes are most often described as
royalty or production taxes. They are measured in accordance with the relevant tax legislation and a liability is recorded for
amounts due that have not yet been paid to the government. No deferred tax is calculated. The smoothing of the estimated
total tax charge over the life of a mine is not appropriate [IAS 37 para 15, 36].
Royalty and production taxes are in effect the government’s share of the natural resources exploited and are a share of
production free of cost. They may be paid in cash or in kind. If in cash, the entity sells the mineral ore and remits to the
government its share of the proceeds.
10.2 Mining taxes based on profits
Mining taxes that are calculated by applying a tax rate to a measure of profit fall within the scope of IAS 12 [IAS 12 para 5]
and are accounted for as income taxes. The profit measure used to calculate the tax is that required by the tax legislation
and will, accordingly, differ from the IFRS profit measure. Profit in this context is revenue less costs as defined by the
relevant tax legislation, and thus might include costs that are capitalised for financial reporting purposes.
Mineral taxes on income are often ‘super’ taxes applied in addition to ordinary corporate income taxes. The tax may apply
only to profits arising from specific geological areas or sometimes on a mine-by-mine basis within larger areas. The mineral
tax may or may not be deductible when determining corporate income tax; this does not change its character as a tax on
income. The computation of the tax is often complicated. There may be a certain volume of production which is free of tax,
accelerated depreciation and additional tax credits for investment. Often there is a minimum tax computation as well. Each
complicating factor in the computation must be separately evaluated and accounted for in accordance with IAS 12.
Deferred tax must be calculated in respect of all taxes that fall within the scope of IAS 12 [IAS 12 para 15, 24]. The deferred
tax is calculated separately for each tax by identifying the temporary differences between the IFRS carrying amount and the
corresponding tax base for each tax. Mineral income taxes may be assessed on a mine-specific basis or a regional basis. An
IFRS balance sheet and a tax balance sheet will be required for each area or mine subject to separate taxation for the
calculation of deferred tax. See section 10.6 for a more detailed discussion of the relevant deferred tax issues.
The tax rate applied to the temporary differences will be the statutory rate for the relevant tax. The statutory rate may be
adjusted for certain allowances and reliefs in certain limited circumstances where the tax is calculated on a mine-specific
basis without the opportunity to transfer profits or losses between mines [IAS 23 para 47, 51].
10.3 Resource rent taxes
Resource rent taxes are becoming more common in the mining and resources industry. The determination of whether
resource rent tax is an income tax or royalty is important to the amount and presentation of both the balance sheet and the
income statement. It is a key judgement.
A number of factors should be considered to determine if a particular tax is in the scope of IAS 12.
Some of the factors that indicate that a particular tax may be in the scope of IAS 12 are:
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Charged on the overall result of the company from activities (e.g. mining,
processing and marketing);
Reference to specific mining areas instead of the whole company’s operation in the
respective country;
Reference to profits for the year; and
Charged to all entities operating in the country/area.
Some of the factors that indicate that a particular tax may not be in the scope of IAS 12 are:
Reference to physical quantities as opposed to profits;

Caps and collars established in relation to the amounts payable;
Charged on areas of interest only; and

Reference to gross proceeds rather than profit.
Do Resource Rent Taxes (RRT) fall within the scope of IAS 12?
Background
Entity A has an interest in a mine. The mine is subject to RRT.
The determination of the amount of RRT payable by an entity is set out in the tax legislation. The RRT payable by an
entity is calculated based on the profits earned from the production of mineral ore.
The profits against which RRT is calculated are determined by legislation. The RRT taxable profit is calculated as the
revenue earned from the sale of mineral ore, on an accruals basis, less the costs incurred to produce and deliver the
mineral ore to its point of sale.
The deductible costs permitted by the legislation include all direct costs of production and delivery. Capital type costs
are allowable as incurred—there is no spreading/amortisation of capital costs as occurs in financial reporting or
corporation tax calculations.
The non-deductible costs are financing costs, freehold property costs and certain other types of costs. However, an
additional allowance (“uplift”) against income is permitted in place of interest costs. The uplift deduction is calculated as
35% of qualifying capital expenditure.
Solution
RRT falls within the scope of IAS 12. It is calculated by applying the stated tax rate to a measure of profit that is
calculated in accordance with the tax legislation.
How should management account for RRT tax losses?
Background
Entity A has an interest in a mine. The mine is subject to Resource Rent Tax (RRT). Entity A has incurred RRT losses in
prior years of C30,000. These losses arose because a deduction for capital expenditure can be made in the year in which
agreement is reached with the tax authorities rather than spread over future periods. The RRT rules allow the losses to
be carried forward indefinitely, and used against future RRT. The losses include the 100% basic deduction and the 35%
super deduction (uplift) permitted by the tax authorities for qualifying capital expenditure.
The statutory RRT tax rate is 45%.The effective RRT rate that reflects reliefs is 41%. Entity A’s management expect that
the mine will be sufficiently profitable over its life to absorb all of the C30,000 RRT losses carried forward.
At what value should A’s management recognise deferred RRT in respect of the RRT losses carried forward?
Solution
Entity A’s management should recognise a deferred tax asset of C13,500 (C30,000 x 45%). The temporary difference
arising in respect of the RRT losses is a deductible temporary difference of C30,000. The appropriate RRT rate to apply
to the temporary difference is the statutory rate.
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10.4 Discounting of mineral taxes
Under IAS 12, tax liabilities shall be measured at the amount expected to be paid to the taxation authorities and accordingly
would not be discounted. Accordingly, mineral taxes which fall within the scope of IAS 12 would not be discounted. Mineral
taxes outside the scope of IAS 12 must be measured after considering the effects of discounting.
10.5 Royalties to non-governmental bodies and

retained interests
Mineral “taxes” do not always relate to dealings with government authorities. Sometimes arrangements with third parties are
such that they result in the payment of a royalty. For example, one party may own the licence to a mine which is used by an
operating party on the terms that once the operator starts producing, it must pay the licence holder a percentage of its
profits or a percentage of production.
In cases where the licence holder receives a fixed payment per unit extracted or sold, it would generally be in the nature of
royalty. However, if the licence holder is entitled to a portion of the mineral ore extracted, it could potentially mean that the
licence holder retains an interest in the mine.
It would be important to consider whether the licence holder has a claim on the profits of the entity or on its net assets. If the
licence holder retains an interest in the net assets of the entity, it would have to be accounted for under the relevant IFRS.
10.6 Deferred taxation
Most transactions and events recorded in the financial statements have a tax consequence. The amount of tax payable on
the taxable profits for a particular period often bears little relationship to the amount of income and expenditure appearing in
the financial statements, as tax laws and financial accounting standards differ in their recognition of income, expenditure,
assets and liabilities.
The tax charge in profit or loss reflects not only the charge based on taxable profit (or loss) for the year, but also an amount
that recognises the tax effects of transactions appearing in the financial statements in one period, which will fall to be taxed
in a different period. The recognition of this additional amount gives rise to deferred taxation.
Examples where such differences arise include the following:
capitalised stripping costs which may be deducted in the current year for tax
purposes;
there may be accelerated deductions allowed for calculating taxable income that
create temporary differences between the tax written-down value of an asset and
its carrying value for accounting purposes (refer to example 1 below); and
a fair value adjustment to the accounting value of an asset acquired as part of a

business combination may have nil impact on the tax value of the asset.
10.6.1 Balance sheet liability method
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IAS 12 requires the use of the ‘balance sheet liability method’ and requires a deferred tax liability or asset to be recognised in
respect of temporary differences that exist at the balance sheet date. Temporary differences are defined as ‘differences
between the carrying amount of an asset or liability in the balance sheet and its tax base’. The deferred tax expense for the
period represents the amount required to adjust the net deferred tax liability or asset to the new balance at each reporting
date.
The balance sheet liability method requires an asset recorded in the financial statements to be realised for at least its
carrying amount in the form of future economic benefits, even where timing differences do not give rise to tax obligations in
their own right. These may give rise to amounts that enter into the determination of taxable profits and result in the
recognition of a deferred tax liability.
This is commonly seen on the fair value uplifts on mining licences in business combinations. IAS 12 requires the recognition
of a deferred tax liability; this is released to taxation expense at the same time as the fair value adjustment is charged to
depreciation.
10.6.2 Tax base
Deferred tax is calculated on the difference between the carrying amount of an asset or liability in the balance sheet and its
tax base. The tax base of an asset or liability is defined as ‘the amount attributed to that asset or liability for tax purposes’.
10.6.2.1 Tax base of an asset
The tax base of an asset is the amount that will be deductible from any taxable income derived when the carrying amount of
the asset is recovered.
Examples include:
mining equipment—the tax base is usually the written-down value for tax purposes
(the amount that can still be claimed as a deduction in future periods); and
receivables from the sale of concentrate—the tax base will be equal to the carrying
value in the accounts if the revenue is taxed on an accruals basis and therefore has
already been included in taxable income.
10.6.2.2 Tax base of a liability
The tax base of a liability is its carrying amount minus any amount that will be deductible for tax purposes in respect of that
liability in future periods. For revenue received in advance, the carrying amount will be reduced by revenue that will not be
taxable in future periods.
Examples include:
provisions for future restoration costs—the tax base will be nil if the costs are
deductible at the time when the restoration work is undertaken (but not when the
costs are accrued); and
trade creditors:
if the related expenditure has already been deducted for tax purposes, the
tax base is equal to the carrying amount of the liability;
if the related expenses will be deducted on a cash basis, the tax base is nil;
and
if the creditors relate to the acquisition of fixed assets, the payment has no
tax consequences, and the tax base equals the carrying amount.
10.6.3 Recognition
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A deferred tax asset or liability is recognised for a temporary difference between the accounting carrying value and the tax
base of an asset or liability. For an asset to be recognised, it must be probable that when it is realised it will create future
economic benefits. In other words, it must be probable that there will be a taxable profit against which the deductible
temporary differences can be used. A deferred tax liability should always be recognised in full.
There are exceptions to these rules for deferred tax assets or liabilities that arise from:
the initial recognition of goodwill; and

the initial recognition of an asset or a liability (as long as the recognition does not
affect the accounting profit or the taxable income at that time and the transaction is
not a business combination).
10.6.4 Measurement
The deferred tax assets and liabilities are measured at tax rates expected to apply when the associated asset is realised or
liability settled.
The measurement must reflect the manner in which the asset or liability is expected to be recovered or settled. For example,
if the tax rate on gains on disposal is different from the tax rate on other income and the entity expects to sell the asset
without further use, the tax rate applicable for disposals is used.
Where there is an intention for the asset to be used to generate income for a period of time and then sold, a blended rate
should be utilised which reflects management’s intention of both the timing of the disposal and the carrying value which will
be recovered through both use and sale. In such a circumstance, it is not appropriate to only use the tax rate applicable for
disposals nor that applicable to income, rather a rate that does reflect the actual plans of the entity.
Discounting of deferred tax assets and liabilities is not permitted under IAS 12.
10.6.5 Tax losses
A deferred tax asset is recognised for the estimated future tax benefit relating to unused tax losses and unused tax credits if
it is probable that taxable profits will be available against which the deferred tax asset can be used.
Mining operations often generate significant tax losses in the exploration, evaluation and development phases, which are
subsequently recouped through sale of product over many years. When is it appropriate to recognise a deferred tax asset in
relation to tax losses available?
In assessing the probability that the losses will be recouped and therefore whether the deferred tax asset is recognised,
management must first consider if any expiry period under relevant tax legislation exists. Any assessment of future taxable
profits against which these losses are recouped must not be over a longer period than the tax loss expiry period.
Cash flows used to determine future taxable profits are generally based on the same assumptions as those used for
forecasting cash flows in impairment assessments.
10.6.6 Tax holidays
Governments may offer tax concessions to encourage development of mine sites in the form of temporary tax holidays or
concessional tax rates. Where entities receive such benefits, an entity should record a deferred tax based on the expected
future tax consequences.
Deferred tax on temporary differences reversing within the tax holiday period is measured at the tax rates that are expected
to apply during the tax holiday period, which is generally the nil tax rate. Deferred tax on temporary differences reversing
after the tax holiday period is measured at the tax rates that will apply after the tax holiday period.
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10.6.7 Deferred tax and acquisitions of

participating interests in joint operation which
is not a legal entity
The deferred tax consequences of the acquisition of a participating interest in a joint operation which is not a legal entity are
discussed in section 6.9. The initial recognition exemption applies and deferred tax is not recognised if the transaction is not
deemed to be a business combination.
10.6.7.1 Why does deferred tax not arise on acquisition of an interest in a joint venture?
The initial recognition exemption (‘IRE’) is applicable on the acquisition of an asset and no deferred tax is recognised. The
IRE applies to temporary timing differences which arise from transactions which are not business combinations and affect
neither accounting profit nor taxable profit. These criteria would be considered to apply to:
Acquisitions of participating interests in joint operations which are not legal entities;
and
Acquisitions of interests in jointly controlled entities
Application of the IRE is mandatory and must be used when the tax base of the acquisition costs differs from the accounting
base. The IRE is not applied where there is no such difference, but this has the same result of no deferred tax being
recognised.
From a tax perspective, acquisitions of an additional interest in an asset or entity are treated the same as if the asset or entity
were being acquired for the first time. The application of the IRE is required for each acquisition of an additional interest that
does not provide control over the asset or entity.
10.6.7.2 Timing differences arising subsequent to acquisition
Timing differences between the carrying value of the investment and the tax base will often arise subsequent to the initial
acquisition for investment in jointly controlled entities. Investors should consider whether the exemption in IAS12.39 for
interests in joint arrangements where the venturer is able to control the timing of reversal of the temporary difference can be
applied to avoid recognition of a deferred tax liability.
The exemption allows a joint venturer or joint operator not to recognise a deferred tax liability where they are able to control
the timing of the reversal of the related temporary difference and be able to conclude that it is probable it will not reverse in
the future. In joint ventures, the determining factor will be whether the contractual arrangement provides for the retention of
profit in the joint venture, and whether the venturer can control the sharing of profits. From a tax perspective, the ability to
control the sharing of profits is viewed as the ability to prevent their distribution rather than enforce their distribution.
10.7 Disclosure
The disclosure requirements set out in IAS 12 are addressed below.
10.7.1 Accounting policy
Disclose an accounting policy explaining
how taxes and royalties are accounted for;

how royalties are assessed as within the scope of IAS 12 or otherwise
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presentation of royalty and production taxes
10.7.2 Tax expense
Disclose the major components of tax expense separately with:
a reconciliation between the tax expense and the profit multiplied by the statutory
tax rate; or
a reconciliation between the average effective tax rate and the applicable tax rate.
Also disclose:
an explanation of any change in tax rates.
10.7.3 Temporary differences
For each type of temporary difference, disclose:
the amount of any temporary differences not recognised as a deferred tax asset;
the amount of the deferred tax assets and liabilities recognised in the balance
sheet; and
the amount of deferred tax income or expense recognised in the income statement.
10.7.4 Recognition of deferred tax asset
Disclose the amount of deferred tax asset and evidence supporting the asset when:
the use of the asset depends on future taxable profits;

the entity has suffered a loss in the current or preceding year; and
tax losses are carried forward.
10.7.5 Netting deferred tax assets and

liabilities
Deferred tax assets and liabilities can only be disclosed net where there is a right of offset; i.e. the following conditions are
met:
the tax liabilities and assets are in relation to the same tax authority/country;
taxes relate to the same tax grouping; and
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taxes are expected to be settled or recovered net.
10.7.6 Other disclosures
The tax consequences of dividends proposed or declared before the issue of the
financial statements but not recognised as a liability in the financial statements
The existence and financial effect of any tax holiday.
11. Functional currency
11.1 Overview
Mining entities commonly undertake transactions in more than one currency, as commodity prices are often denominated in
US dollars and costs are typically denominated in the local currency. Determination of the functional currency can require
significant analysis and judgement.
An entity’s functional currency is the currency of the primary economic environment in which it operates. This is the currency
in which the entity measures its results and financial position. A group comprised of multiple entities must identify the
functional currency of each entity, including joint ventures and associates. Different entities within a multinational group often
have different functional currencies. The group as a whole does not have a functional currency.
An entity’s presentation currency is the currency in which it presents its financial statements. Reporting entities may select
any presentation currency (subject to the restrictions imposed by local regulations or shareholder agreements). However, the
functional currency must reflect the substance of the entity’s underlying transactions, events and conditions; it is unaffected
by the choice of presentation currency. Exchange differences can arise for two reasons: when a transaction is undertaken in
a currency other than the entity’s functional currency; or when the presentation currency differs from the functional currency.
11.2 Determining the functional currency
Identifying the functional currency for an mining entity can be complex because there are often significant cash flows in both
the US dollar and local currency. Management should focus on the primary economic environment in which the entity
operates when determining the functional currency. The denomination of selling prices is important but not determinative.
Many sales within the mining industry are conducted either in, or with reference to, the US dollar. However, the US dollar
may not always be the main influence on these transactions. Although entities may buy and sell in dollar denomination, they
are not exposed to the US economy.
Dollar denomination is a pricing convention rather than an economic driver. Instead, the main influence on the entity is
demand for the products and ability to produce the products at a competitive margin, which will be dependent on the local
economic and regulatory environment. Accordingly, it is relatively common for mining entities to have a functional currency
which is their local currency rather than the US dollar, even where their sales prices are in dollars.
Functional currency is determined on an entity by entity basis for a multi-national group. It is not unusual for a multi-national
mining company to have many different functional currencies within the group. There are three primary indicators of
functional currency:
the currency that mainly influences sales prices for goods and services;
the currency of the country whose competitive forces and regulations mainly
determine the sales prices of its goods and services; and
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the currency that mainly influences labour, material and other costs of providing
goods and services.
It is difficult to identify a single country whose competitive forces and regulations mainly determine selling prices of
commodities in mining. If the primary indicators do not provide an obvious answer to the functional currency question , the
currency in which an entity’s finances are denominated should be considered i.e., the currency in which funds from financing
activities are generated and the currency in which receipts from operating activities are retained.
If the primary and secondary indicators are mixed and inconclusive, management judgement should be considered to
determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events
and conditions.
What is the functional currency of an entity which is based in the Dominican Republic but prices all products sold in US
dollars?
Background
Entity A operates a gold mine in the Dominican Republic. All of the entity’s income is denominated and settled in US
dollars. Refined gold ore is primarily sold to US banks. The gold price is subject to the global supply and demand, and
gold is routinely traded in US dollars around the world. Around 55% of entity A’s cash costs are imports or expatriate
salaries denominated in US dollars. The remaining 45% of cash expenses are incurred in the Dominican Republic and
denominated and settled in Dominican pesos. The non-cash costs (depreciation) are US dollar denominated, as the
initial investment was in US dollars.
Solution
The factors point toward the functional currency of entity A being the US dollar. The product is primarily exported to the
US. The revenue analysis points to the US dollar. The cost analysis is mixed. Depreciation (or any other non- cash
expenses) is not considered, as the primary economic environment is where the entity generates and expends cash.
Operating cash expenses are influenced by the pesos (45%) and the US dollar (55%). Management is able to determine
the functional currency as the US dollar, as the revenue is clearly influenced by the US dollar and expenses are mixed.
What is the functional currency of an entity which is based in South Africa but prices all products sold in US dollars?
Background
Entity A operates a producing coal mine in South Africa and sells their product domestically. All of the entity’s income is
denominated in US dollars but is settled in a mixture of US dollars and South African Rand. Around 35% of entity A’s
cash costs are expatriate salaries denominated in US dollars. The remaining 65% of cash expenses are incurred and
settled in South African Rand.
Solution
The factors point toward the functional currency of entity A being the South African Rand. Although selling prices are
determined in US dollars, the demand for the product is dependent on the local economic environment in South Africa.
Although the cost analysis is mixed based, on the level of reliance on the South African marketplace for revenue and
margin management is able to determine the functional currency as the South African Rand.
Determining the functional currency of holding companies and treasury companies may present some unique challenges;
these have largely internal sources of cash although they may pay dividends, make investments, raise debt and provide risk
management services. The underlying source of the cash flows to such companies is often used as the basis for determining
11.3 Change in functional currency
Once the functional currency of an entity is determined, it should be used consistently, unless significant changes in
economic facts, events and conditions indicate that the functional currency has changed.
Mining entities at different stages of operation may reach a different view about their functional currency. A company which
is in the exploration phase may have all of its funding in US dollars and be reliant on their parent company. They may also
incur the majority of its exploration costs in US dollars (the availability of mining equipment may require this to be sourced
from the US). At this stage they may conclude US dollars as being the functional currency.
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However, when it reaches the development phase, its transactions may be predominantly denominated in local currency as
they are more reliant on the local workforce and suppliers to perform the development activity. The functional currency may
then change to being the local currency.
The functional currency may then change again when the project reaches the production phase and revenue is generated in
US dollars. As explained above, a selling price in dollars would not automatically mean that the functional currency is US
dollars and factors such as the territory the company sells to and marketplace in which they operate would have to be
considered. This does, however, illustrate that determination of the functional currency can be an ongoing process and
conclusions may change depending on the current facts and circumstances.
A change in functional currency should be accounted for prospectively from the date of change. In other words,
management should translate all items (including balance sheet, income statement and statement of comprehensive income
items) into the new functional currency using the exchange rate at the date of change. Because the change was brought
about by changed circumstances, it does not represent a change in accounting policy and a retrospective adjustment under
IAS 8 is not required.
The resulting translated amounts for non-monetary items are treated as their historical cost. It would be consistent that the
equity items are also translated using the exchange rate at the date of the change of functional currency. This means that no
additional exchange differences arise on the date of the change.
Entities should also consider presentation currency when there is a change in functional currency. A change in functional
currency may be accompanied by a change in presentation currency, as many entities prefer to present financial statements
in their functional currency. A change in presentation currency is accounted for as a change in accounting policy and is
applied retrospectively, as if the new presentation currency had always been the presentation currency. It may be that the
presentation currency does not change when there is a change in functional currency.
For example, an entity previously presented its financial statements in its functional currency being Euros. Subsequently on
account of certain change in economic facts its functional currency changes to US dollar. Since it is based in a country
where Euros is the local currency, it does not wish to change its presentation currency and so continues to present its
financial statements in Euros. In such a case the numbers in the entity’s financial statements for the period up to the change
in functional currency do not change in presentational currency terms. From the point that the functional currency changes
new foreign exchange differences will arise in the entity’s own financial statements when items expressed in the new
functional currency are translated into the presentation currency.
11.4 Hyperinflationary economies
Mining operations may be located in a country that is experiencing hyperinflation. IAS 29 “Financial Reporting in
Hyperinflationary Economies” describes a number of characteristics that indicate hyperinflation, including a cumulative
inflation rate over three years which approaches, or exceeds, 100 percent.
If the functional currency is determined to be the US Dollar the normal translation requirements described above apply.
If the functional currency is determined to be the local currency, IAS 29 requires the entity’s local currency financial
statements (including the corresponding figures for earlier periods) to be restated to reflect current price levels in accordance
with the specific rules in IAS 29. These restated financial statements can then be translated into a different, non-
hyperinflationary presentation currency (as would often be the case for a reporting entity with a subsidiary operating in a
hyperinflationary environment). All amounts (i.e., income, expenditure and equity items, not just assets and liabilities) are
translated at the exchange rate on the most recent balance sheet date, including comparative figures.
A mining entity does not have the option to use another currency (such as the US Dollar) as its functional currency to avoid
the need to restate its local currency financial statements at current price levels. The functional currency must be determined
on the basis of the indicators described above.
11.5 Disclosure
There is no explicit requirement to disclose an entity’s accounting policies in respect of foreign currency transactions.
However, IAS 1 requires disclosure of significant accounting policies that are relevant to providing a true understanding of
the financial statements, which is likely to include the policies relating to foreign currency transactions for most mining
entities. Where significant judgement is involved in determining the functional currency, some disclosure of this will also be
needed to meet the IAS 1 requirements for the disclosure of significant judgements.
Some of the disclosure requirements that can impact mining entities include:
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the aggregate net exchange difference recognised through the income statement
(excluding amounts arising on financial instruments measured at fair value through
the income statement);
the aggregate net exchange difference classified in a separate component of equity
(and a reconciliation of the movements during the year);
when the presentation currency is different from the functional currency, that fact
shall be stated, together with disclosure of the functional currency and the reason
for using a different presentation currency; and
currency risks and how these risks are managed, as required by IAS 32 “Financial
Instruments: Disclosure and Presentation” and IFRS 7 “Financial Instruments:
Disclosures”.
Exchange differences can be classified in the income statement according to the nature of the item to which they relate.
Exchange differences arising from trading transactions may therefore be included in the results of operating activities and
exchange differences relating to financing (such as US Dollar debt in a mining entity with its local currency as the functional
currency) may be included as a component of the finance cost/income.
13. Operating segments
13.1 Overview
Mining companies often operate in a range of geographic locations and, in many cases, produce a diverse range of mineral
commodities from numerous mines. The core principle of segment reporting is to provide information to the users of financial
statements to enable them to evaluate the nature, economic environments and financial effects of the business activities in
which a company operates. For mining companies, a key element of transparent financial reporting is the ability of a user to
understand financial information and operating results from each of a company’s mines. Although the user may want
detailed information at a mine level, companies often manage on a geographic or even product group basis. Financial
reporting requirements for segment reporting are covered in IFRS 8.
13.2 Guidance on what constitutes an

operating segment
An operating segment is defined as a component of an entity:
that engages in business activities from which it may earn revenues and incur
expenses;
for which discreet financial information is available; and
whose operating results are regularly reviewed by the chief operating decision
maker (CODM) of the entity to make decisions about resources to be allocated to
the segment and assess a segments performance.
A development project or exploration project will not necessarily earn revenues but they might still constitute an operating
segment.
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13.2.1 Identifying operating segments: “The

management approach”
The concept of defining segments at the level of review of the CODM is commonly referred to as the ‘management
approach’. The key benefits of this approach are that detailed segment information can be reported more frequently at a low
incremental cost to prepare that allows a user to better understand an entity as they are able to see an entity through the
eyes of management.
Identification of operating segments typically involves a four step process:
1. Identify the CODM;

2. Identify the business activities (these could be different mines or mining regions as well as development/exploration or Corporate
head office);
3. Determine whether discrete information is available for the business activities; and
4. Determine whether that information is reviewed by the CODM.
The CODM defines a function and not necessarily a position or title - examples of the CODM include the Chief Executive
Officer, the Chief Operating Officer and a group of executives or Directors functioning in the CODM capacity.
13.3 Aggregation of operating segments
Two or more operating segments may be aggregated into a single operating segment for reporting purposes if the segments
have similar economic characteristics and the segments are similar in each of the following respects:
a. the nature of the products and services;

b. the nature of the production processes;
c. the type or class of customer for their products and services;
d. the methods used to distribute their products or provide their services; and
e. if applicable, the nature of the regulatory environment.
The ability of an entity to aggregate its segments based on the ‘similar economic characteristics’ criteria requires judgement
to be applied to each set of facts and circumstances.
Aggregation of operating segments (1)
Background
An entity has three copper mines in one region using a central concentrator. Production processes and cash costs are
similar and marketing of the product is performed centrally (and sold based on the LME price). The CODM reviews
information for the individual mines.
Each of the three copper mines is an operating segment. Can they be aggregated into a single reportable segment?
Solution
Yes, the aggregation criteria are met due to the similarity of economic characteristics (products, processes and financial
and operating risks).
Aggregation of operating segments (2)
Background
An entity has two gold mines; one is underground and the other is open-cut. Their cash costs are quite different and with
one of the mines having a copper by-product. One mine produces gold ore and the other produces a combination of
gold ore and concentrate. The CODM reviews information for each of the mines and investors are provided with reserves
and operational information for each mine.
Each of the mines is an operating segment. Can the two gold mines be aggregated into a single reportable segment?
Solution
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In this case, it is unlikely that the mines would be aggregated due to the differences in products and processes. They do
not have similar economic characteristics and would be two reportable segments.
13.4 Minimum reportable segments
After identifying operating segments and aggregating those that met the aggregation criteria an entity should determine
which operating segments or aggregations of operating segments meet the quantitative thresholds for separate disclosure
as reportable segments. An entity must report information separately if any of the following quantitative thresholds are met:
a. Reported revenues, including sales to external customers and intersegment sales/transfers are 10% or more of the combined
internal and external revenue of all operating segments.
b. The absolute amount of the reported profit or loss is 10% or more of the greater, in absolute amounts, of the combined reported
profit of all operating segments that did not report a loss and the combined reported loss of all reporting segments that reported a
loss.
c. Assets are 10% or more of the combined assets of all operating segments.
Identifying reportable segments
Background
A company has the following operating segments. The revenues (internal and external), profits and assets are set out
below.
Segment Total Profit/(loss) Total

revenue assets
A 11,000,000 36% 2,000,000 50% 25,000,000 37%
B 7,500,000 25% 1,000,000 25% 15,500,000 23%
C 3,000,000 10% (1,000,000) 25% 10,500,000 15%
D 3,500,000 11% (500,000) 13% 7,000,000 10%
E 4,000,000 13% 600,000 15% 7,000,000 10%
F 1,500,000 5% 400,000 10% 3,500,000 5%
30,500,000 2,500,000 68,500,000
How many reportable segments does entity A have?

Solution
Segments A, B, D and E clearly satisfy the revenue and assets test (so there is no need to consider the profits test in
these cases) and are reportable segments.
Segment C does not satisfy the revenue test but does satisfy the asset test and the profits test and is also a reportable
segment.
Segment F does not satisfy the revenue or the assets test but does satisfy the profits test.
Therefore all six segments represent reportable segments and should not be aggregated.
If the total external revenue reported by reportable segments is less than 75% of the entity’s revenue, additional operating
segments will need to be identified as reportable segments until at least 75% of the entity’s revenue is included in reportable
segments.
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13.5 Disclosure
Entities are required to disclose information consistent with the core principles of segment reporting. The disclosure
requirements are summarised in the table below.
Reference to disclosure Required disclosures

requirements
General information
Factors used to identify the reportable
segments
Types of product/service from which each

reportable segment derives its revenue.
Information about the reportable

segment; profit or loss, revenue, For each reportable segment an entity
expenses, assets, liabilities and should disclose:
the basis of measurement
A measure of profit or loss.
A measure of total assets or liabilities if this
is regularly provided to the CODM.
A number of specific disclosures, such as
revenues from external customers if they are
included in segment profit or loss and
presented regularly to the CODM.
Explanation of the measurement of the
segment disclosures.
The basis of accounting for transactions
between reportable segments.
The nature of differences between the
measurements of segment disclosures and
comparable items in the entity’s financial
report.
Reconciliations
Totals of segment revenue, segment profit or
loss, segment assets and segment liabilities
and any other material segment items to
corresponding totals within the financial
statements.
Entity-wide disclosures
Revenues from external customers for each
product and service, or each group of similar
products and services.
Revenues from external customers
attributed to the entity’s country of domicile
and attributed to all foreign countries from
which the entity derives revenues.
Revenues from external customers
attributed to an individual foreign country, if
material.
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Non-current assets (other than financial

instruments, deferred tax assets, post-
employment benefit assets, and rights
arising under insurance contracts) located in
the entity’s country of domicile and in all
foreign countries in which the entity holds
assets.
Non-current assets in an individual foreign
country, if material
Extent of reliance on major customers,
including details if any customer’s revenue is
greater than 10% of the entity’s revenue.
15. Shares and national interest arrangements
There are a number of arrangements where mining entities make share grants where no identifiable goods or services are
received in return. These share grants may be made as part of corporate social responsibility programs, or as required by
local legislation designed to empower local communities. The economic benefits derived from an enhanced corporate image
can take
a variety of forms, such as attracting or retaining employees, or improving or maintaining the ability to do business with local
suppliers.
Consideration of all types of arrangement are outwith the scope of this publication, however, an example of one type of
arrangement is the black economic empowerment (BEE) provisions in South Africa; legislation requires locally disadvantaged
communities to have a minimum share ownership percentage in mining entities.
IFRS 2 addresses the accounting for such grants where no identifiable benefit is received in return for a grant of shares or
options.
15.1 When does this apply?
A mining entity would normally expect to receive goods or services in return for shares and options granted. IFRS 2 requires
either an expense or an asset to be recognised, based on the fair value of shares and options granted (employees) or the fair
value of goods and services received (suppliers). However, in all such instances an identifiable good or service is received.
Grants made under a corporate responsibility program or the BEE provisions do not have an identifiable good or service.
This is described in IFRS 2 as receipt of an unidentifiable benefit. A further example of this is where a principal shareholder
transfers a tranche of shares for no consideration to a related entity for tax planning purposes.
15.2 How is the unidentifiable benefit

measured and recorded?
The value of the unidentifiable benefit received is measured as the difference between the fair value of the shares or options
granted and any identifiable benefits received. For example, if disadvantaged community members can purchase shares at a
bargain price, the unidentifiable benefit is the difference between the fair value of the shares and the price paid. If there is no
consideration or identifiable benefits received, the value of the unidentifiable benefit is the fair value of the shares.
The benefit is accounted for in accordance with IFRS 2. Any identifiable good, such as a mining licence, is recorded at its fair
value and the remainder is recognised as an expense in the income statement. Shares of options that vest immediately result
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in immediate recognition of expense. The expense is allocated over the relevant periods where there is a vesting period
associated with the shares. Few BEE deals have vesting periods.
Recording an unidentifiable benefit
Background
Entity A awards C1,500 of shares to a local government in return for a five-year exploration licence. The fair value of the
licence is C1,000, resulting in an unidentifiable benefit of C500.
How should the unidentifiable benefit of C500 be accounted for?
Solution
A should immediately expense the unidentifiable benefit of C500 as it does not meet the criteria for recognition as an
asset.
16. First time adoption
IFRS 1 provides transition relief and guidance for entities adopting IFRS. However, it is regularly updated and amended by
the IASB. The amendments either update IFRS 1 for new standards and interpretations or address newly identified issues.
However, keeping abreast of these changes can be challenging.
Entities in the mining industry face many of the same transition issues as entities in other industries. This section focuses on
the specific transition issues and reliefs provided by IFRS 1 that are of particular importance in the industry.
16.1 Deemed cost
Depreciation under IFRS is calculated on a component basis (see also section 4.2.6). Similarly, section 9.3 describes the
requirement for impairment tests to be performed at the cash generating unit level which is the smallest group of assets
generating cash flows independent of other assets. These approaches may require more detailed information than entities
recorded under local GAAP, and it may not be possible to allow reconstruction of historical cost carrying amounts.
IFRS 1 allows entities to elect to revalue an item of property, plant and equipment to:
the fair value of the asset; or

a previous GAAP revaluation as deemed cost if the revaluation was broadly
comparable to fair value, or to the IFRS cost or depreciated cost adjusted to reflect
changes in a price index.
The assets are then tested for impairment at the date of transition.
This election provides mining companies with a method of setting an appropriate book value for assets which can be used
for the calculation of depreciation on a component basis or test for impairment on a CGU basis going forward.
Few first-time adopters have chosen to use the fair value approach. Those that have used it have done so selectively as
permitted under the standard. Fair value as deemed cost often results in a significant increase in carrying value with the
corresponding credit adjusting retained earnings. There is also a higher depreciation charge in subsequent years.
There is also an exemption that allows the use of fair value for intangible assets at transition to IFRS. However, it requires
there to be an active market in the intangible assets as defined in IAS 38; this criterion is not met for common intangibles in
the mining industry such as licences and patents.
16.2 Restoration and rehabilitation provisions

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Restoration and rehabilitation provisions are recognised at the present value of expected future cash flows, discounted using
a pre-tax discount rate. The discount rate should be updated at each balance sheet date if necessary and should reflect the
risks inherent in the asset.
The requirements for a pre-tax rate and periodic updating can also result in differences on adoption of IFRS. An entity’s
previous GAAP may not have required an obligation to be recognised, allowed a choice of rate or not required the rate to be
updated.
Changes in a decommissioning liability are added to or deducted from the cost of the related asset under IFRIC 1. There is
an optional short cut method for recognition of restoration and rehabilitation obligations and the related asset at the date of
first time adoption. The entity calculates the liability in accordance with IAS 37 as of the date of transition (the opening
balance sheet date). The related asset is derived by discounting the liability back to the date of installation of the asset from
the opening balance sheet date. This estimated asset amount at initial recognition is then depreciated to the date of
transition using the appropriate method.
IFRS distinguishes between the functional currency and the presentation currency. An entity can choose to present its
financial statements in any currency; the functional currency is that of the primary economic environment in which an entity
operates. Functional currency must be determined for each entity in the group and is the currency that of the primary
economic environment in which the specific entity operates. Functional currency is determined by the denomination of
revenue and costs and the regulatory and economic environment that has the most significant impact on the entity.
A first-time adopter must determine the functional currency for each entity in the group. Changes of functional currency on
adoption of IFRS are not unusual as previous GAAP may have required the use of the domestic currency or allowed a free
choice of functional currency. This can result in a significant amount of work to determine the opening balance sheet
amounts for all non-monetary assets. An entity needs to determine the historical purchase price in functional currency for all
non-monetary assets. These amounts may have been recorded in US dollars, for example. There is no exemption in IFRS 1
for this situation although use of the fair value as deemed cost exemption may prove less complex and time consuming than
reconstruction of historical cost.
Other common foreign currency challenges for mining entities on adoption of IFRS include the impact of hyperinflation,
revaluations of fixed assets in a currency other than the functional currency and the impact on hedging strategies. These can
involve considerable time and effort to address and need to be considered early during the planning process for transition to
IFRS.
IFRS 1 does provide an exemption that allows all cumulative translation differences in equity for all foreign operations to be
reset to nil at the date of transition. This exemption is used by virtually all entities on transition to IFRS as the alternative is to
recast the results for all foreign operations under IFRS for the history of the entity.
16.4 Assets and liabilities of subsidiaries,

associates and joint ventures
A parent or group may well adopt IFRS at a different date from its subsidiaries, associates and joint ventures (“subsidiaries”).
Adopting IFRS for the group consolidated financial statements means that the results of the group are presented under IFRS
even if the underlying accounting records are maintained under national GAAP, perhaps for statutory or tax reporting
purposes.
IFRS 1 provides guidance on a parent adopting IFRS after one or more of its subsidiaries and for subsidiaries adopting after
the group. When a parent adopts after one or more subsidiaries the assets and liabilities of the subsidiary are measured at
the same carrying value as in the IFRS financial statements of the subsidiaries after appropriate consolidation and equity
accounting adjustments.
A subsidiary that adopts after the group can choose to measure its assets and liabilities at the carrying amounts in the group
consolidated financial statements as if no consolidation adjustments (excludes purchase accounting adjustments) were
made, or as if the subsidiary was adopting IFRS independently.
16.5 Deferred tax

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There are no exemptions from recording deferred tax assets and liabilities on all differences the accounting base and tax
base where the initial recognition exemption does not apply. The corresponding adjustment is taken to retained earnings.
16.6 Financial instruments
Embedded derivatives are discussed in section 14.4. Upon adoption of IFRS, an entity must assess whether an embedded
derivative is required to be separated from a host contract and accounted for as a derivative on the basis of the conditions
that existed at the later of the date it first became a party to the contract and the date any reassessment is required.
Therefore if an entity became a party to a contract containing an embedded derivative prior to transition date, and the entity
is still a party to the contract, the embedded derivative must be recognised as of IFRS transition date. This would include
contracts where the definition of a derivative was not met under previous GAAP (for example, where a quantity to be
purchased was not specified or otherwise determinable).
The embedded derivative would then be measured at fair value using facts and circumstances in existence as of transition
date and an appropriate adjustment made to equity in the opening balance sheet.
16.7 Impairment
A first time adopter should apply IAS 36 regardless of whether there are any indicators of impairment, to test goodwill for
impairment at the date of transition to IFRS, based on conditions at the transition date. Any impairment loss should be
recorded in retained earnings.
In addition, IFRS requires that impairment losses be reversed if the circumstances leading to the impairment charge have
changed and cause the impairment to be reduced. Some local GAAPs would not have allowed this approach.
16.8 Stripping costs in the production phase of

a surface mine
Section 4.3 noted that there was diversity in practice on accounting for production stripping costs. Previous GAAPs may
have required that such costs be treated as current production costs.
As IFRS requires the capitalisation of production stripping costs, entities may choose on transition to IFRS to capitalise costs
which had been expensed under previous GAAP. The impact of this could be significant, and would also affect depreciation
charges related to the production assets.
IAS 8.53 states that “hindsight should not be used when applying a new accounting policy to...a prior period”. Entities should
therefore exercise caution where they choose to retrospectively capitalise costs previously expensed as there must be
sufficient information available from the relevant time period to confirm that those costs were of future benefit to the entity.
16.9 Borrowing costs
Sections 2.3.5 and 3.2 explained that the cost of borrowing should be capitalised for qualifying assets. Previous GAAP may
also have allowed an entity to expense borrowing costs. IAS 23 “Borrowing costs” is mandatory from the date of transition,
however, an entity can choose to adopt it with effect from an earlier date.
Transitioning entities must determine the date from which they will apply the standard, identify all qualifying projects
commencing after that date and capitalise costs accordingly. The deemed cost exemption described in section 16.1 above
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may provide some relief where an entity does not have the detailed records to perform this for all qualifying assets. IFRS 1
also provides a separate exemption from restating any borrowing cost component capitalised under a previous GAAP—
instead, for qualifying assets under construction at the date of transition, IAS 23 requirements are only applied to borrowing
costs incurred after that date.
An entity’s previous GAAP may also have allowed the capitalisation of borrowing costs for investments accounted for using
the equity method of accounting. An investment in an associate or joint venture would not meet the IAS 23 definition of a
qualifying asset. The associate or joint venture may only capitalise borrowing costs if they have their own borrowings and a
qualifying asset.
Therefore, an entity should consider whether it needs to make any adjustments to reverse previously capitalised interest on
transition.
16.10 Disclosure requirements
A first-time adopter is required to present disclosures that explain how the entity’s financial statements were affected by the
transition from previous GAAP to IFRS.
These include:
an opening balance sheet, prepared as at the transition date, with related footnote
disclosure;
reconciliation of equity reported in accordance with previous GAAP to equity in
accordance with IFRS;
reconciliation of total comprehensive income in accordance with IFRSs to the latest
period in the entity’s most recent annual financial statements;
sufficient disclosure to explain the nature of the main adjustments that would make
it comply with IFRS;
if the entity used the deemed cost exemption, the aggregate of the fair values used
and aggregate adjustment to the carrying amounts reported under previous GAAP;
and
IAS 36 disclosures if impairment losses are recognised in the opening balance
sheet.
Illustrative text
IND FAQ 3.4.1 – How does the amendment to

IAS 16 impact accounting for stockpiles?
Reference to standard: IAS 16

Reference to standing text: Manual 22.20
Industry: Mining industry
Question
How does the amendment to IAS 16 impact accounting for stockpiles?
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Answer
The scope of the IAS 16 amendment deals with materials produced which are expected to generate ‘proceeds’ while the
item of PP&E is still in the process of being brought to “the location and condition necessary for it to be capable of operating
in the manner intended by management”. The level of mineral content within the stockpile will determine whether it is
economically viable to develop or sell the stockpile, which in turn will drive whether management expects to generate
proceeds.
Where proceeds are expected to be earned based on the level of mineral content within the stockpile, the stockpiles are put
through the company's processing plant and developed further before being sold, or they are sold as unprocessed ore to
third parties, or they are stored for development or sale at a later date. The amendment will apply, and the stockpile ore will
need to be valued; this is because output, which is expected to be sold, has been generated while the item of PP&E is in the
development phase.
Where proceeds are not expected to be earned based on the mineral content being below what is considered economically
viable, the stockpile ore is considered to be a waste material generated. No costs will be allocated to this waste material; this
is because proceeds are not expected to be earned from the sale of output and, as a result, the stockpile ore does not fall
within the scope of the amendment.
In some cases, judgement will need to be applied to determine whether the stockpile is considered economically viable at
the time when it is extracted.
IND FAQ 3.4.2 – Should depreciation of the

mine, or components of a mine, that are still
being developed be included in the costs
allocated to the pre-production output?

There might be a long commissioning period for a mine, during which the mine or relevant component of the mine is not yet
in the condition necessary for it to be capable of operating in the manner intended by management. An entity might generate
proceeds from saleable material produced during this phase. The IAS 16 amendment requires the proceeds from sales of
any items, together with the cost of producing the output sold, to be recognised in profit or loss.
Question
Should an entity depreciate the mine, or components of the mine, that are still being developed (that is, not in the location
and condition necessary to be capable of operating in the manner intended by management) when output is generated
during the development phase?
Answer
In accordance with paragraph 55 of IAS 16, depreciation only commences at the date when the asset is in the location and
condition necessary for it to be capable of operating in the manner intended by management. The amendment to IAS 16 has
not changed this requirement. As a result, depreciation of the mine (or components of the mine) would not commence prior
to the asset being considered ready for its intended use, even if the related mine has a finite amount of reserves and where
the pre-production decreases the reserves.
However, it is important to take note of the clarification of the meaning of ‘testing’ in paragraph 17 of IAS 16, and to consider
the impact that this might have on the assessment of when an asset is available for use. Furthermore, once output begins to
be generated during th5e development phase, the prospective costs in developing the mine further might need to be
allocated between the mine and the output generated.
IND FAQ 3.4.3 – How is a loss on the write-

down of inventory during the development
phase accounted for?
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IAS 16 requires the cost of output generated before the item of PP&E is ready for its intended use (that is, when the mine is
in the development phase) to be measured in accordance with the principles of IAS 2.
In addition to the scenarios where output is sold at a profit during the year – or where output is generated but remains unsold
at year end, where the net realisable value (‘NRV’) exceeds the allocated costs – other scenarios might arise:
Output is produced which was initially expected to be sold, it remains unsold at

year end, and management subsequently decides to discard the output and
recognises an impairment to write off the inventory.
Output is produced and is then subsequently sold at a loss.
Output is produced but remains unsold at year end, the output is measured in
accordance with IAS 2, and an NRV write-down (that is, an impairment) must be
recognised.
In the above scenarios, the output generated contains enough mineral content to be economically viable. It is important to
take note of the guidance on output produced which is considered to be a waste removal cost, on the basis that the ore
material is low grade where the mineral content is below what is currently economically viable (refer to IND FAQ 3.4.1).
Question
During the development phase of the mine where output is produced before the item of PP&E is ready for intended use, can
the loss incurred as a result of NRV write-downs, loss on sale of output and write-offs due to the output being obsolete or of
lower than typical quality be capitalised to PP&E?
Answer
No.Paragraph 20A of IAS 16 states that the cost of items produced while bringing an item of PP&E to the location and
condition necessary for it to be capable of operating in the manner intended by management is measured in accordance
with IAS 2. Paragraph 34 of IAS 2 requires that, when inventories are sold, written off or written down to NRV, the resulting
expense is recognised in profit or loss.
Paragraph 20A of IAS 16 requires profits (that is, proceeds less cost) made on the disposal of output produced before an
item of PP&E is ready for its intended use to be recognised in profit or loss. Similarly, we believe that any loss incurred as a
result of NRV write-downs, loss on sale of output and write-offs should be treated in the same way. Additionally, paragraphs
20(b) and 22 of IAS 16 provide guidance that initial operating losses, as well as abnormal waste, should not be capitalised to
an item of PP&E, but rather recognised as an expense in profit or loss.
Paragraph 16(b) of IAS 16 allows “any costs directly attributable to bringing the asset to the location and condition necessary
for it to be capable of operating in the manner intended by management” to be capitalised. Once the output generated
during the development phase of the mine is sold – or the output remains unsold but incurs an NRV write-down or is
subsequently written off – the expense is a consequence of the proceeds (or expected proceeds), and the costs attributed to
the output are recognised in accordance with the principles of IAS 2. The losses incurred are not relevant to the development
of the item of PP&E, because the losses relate to an inventory rather than the item of PP&E being constructed.
IND FAQ 3.4.4 – Does the amendment impact

the value of and accounting for exploration
and evaluation activities?

Question
Does the amendment impact the value of and accounting for exploration and evaluation activities?
Answer
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The amendment to IAS 16 has not resulted in any consequential amendments to IFRS 6, ‘Exploration for and Evaluation of
Mineral Resources’. Therefore, the amendment will not have any impact on the current accounting for exploration and
evaluation activities. Entities should continue to apply their existing accounting policies with respect to exploration and
evaluation assets.
IND FAQ 3.4.5 – What is the accounting

treatment for the capitalisation of borrowing
costs during the testing phase of an item of
PP&E?

In the mining industry, mine assets often take a considerable amount of time to complete (that is, the asset might remain
under development for a period that spans more than one financial period). It might be the case that the company has
borrowed capital to fund the project and is incurring interest on the outstanding capital used to build the mine asset.
Question
Where an item of PP&E is in its development phase, does the amendment to IAS 16 impact the requirement for borrowing
costs to be capitalised to that item of PP&E?
Answer
If the item of PP&E meets the definition of a qualifying asset, the borrowing costs incurred during the development phase
should be capitalised to the cost of the PP&E [IAS 23 para 8], irrespective of whether pre-production proceeds are being
generated and recognised in profit or loss.
Although pre-production proceeds are being generated, the item is not yet in the location and condition necessary for it to be
capable of operating in the manner intended by management. Directly attributable costs should therefore continue to be
capitalised to that item of PP&E during this testing phase. This capitalisation of costs will include the capitalisation of
borrowing costs in accordance with the criteria of IAS 23.
IND FAQ 3.4.6 – Does the amendment impact

how entities should perform their unit of
account assessment to determine when an
asset is ready for its intended use?

Assets in the energy and resources industry are often large, complex and expensive to construct, and they tend to be
exposed to harsh environmental or operating conditions. The asset might also form part of a larger asset, which includes
other assets still under construction. An example of this would be a processing plant at the mine, where both the mine and
processing plant are still under construction, although one of them might be able to produce output before the other.
Question
Does the amendment impact how entities should perform their unit of account assessment to determine when an asset is
ready for its intended use?
Answer
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The amendment to IAS 16 does not provide any additional guidance on making the unit of account determination where two
assets (such as a processing plant and a mine) might be ready for intended use only when both have reached a specified
threshold. As a result, entities should continue following the guidance on componentisation in IAS 16, which requires each
significant part of an asset to be depreciated separately [IAS 16 para 43], and therefore the start date of depreciation (that is,
the date at which the asset is ready for its intended use) might differ.
Some examples of this principle could be where ‘yellow-metal equipment’ (such as front-end loaders and excavators) are
ready for their intended use before the mine asset, and depreciation on these front-end loaders and excavators would likely
start before the mine itself is ready for its intended use.
Entities in the mining industry should also consider whether the depreciation method is based on units of production. For
example, consider a processing plant that is considered a significant component of a mine asset – where this is the case,
even if the processing plant is ready for use, depreciation might not be recognised on that plant if no units are produced.
Determining whether a component is ‘significant’, and therefore whether it might have a separate date of when it is ready for
its intended use, might require judgement, and entities should consider whether this should be disclosed in accordance with
paragraph 122 of IAS 1.
IND FAQ 4.1.7.1 – Is a refiner acting as agent or

principal for the sale of goods to a customer?
Reference to standard: IFRS 15 paras B34 - B38

Reference to standing text: Manual Chapter 11 paras 264 - 272
A gold refiner has entered into a contract with a mining company to refine doré bars and to sell refined gold to a nearby
bullion bank. The mine will deliver doré bars to the refinery, which might conduct a head assay to make sure that they meet a
minimum quality for processing. The refiner will then refine the gold to the agreed purity level and produce gold bullion.
The refiner charges the mining company a refining fee based on the quantity processed, and a sliding-scale unit charge
determined by the gold spot price during the refining period. In addition, the refiner also receives metal gain. Metal gain is the
excess quantity of gold that the refiner is able to produce from the doré bars after an agreed quantity of gold has been
refined. The refiner will sell the gold bullion to the bullion bank, except for the metal gain (that is, the excess quantity of gold
above the agreed quantity), which they will keep. The refiner collects the sales proceeds from the bullion bank, deducts the
refining fee and the value of the metal gain, and then transfers the remaining proceeds to the mining company.
Ownership transfers to the refiner when the doré bars enter its premises, and the refiner bears the risks of damage to, and
theft of, the gold. The refinery takes out insurance for all of the gold on its premises, and it is obliged to transfer the
insurance proceeds to the mining company. The refiner never receives legal title of the gold, since legal title is transferred
from the mining company to the bullion bank. The gold is sold to the bullion bank once assaying has been completed and
the quantity and quality of gold has been determined.
Question
Is the refiner acting as an agent on behalf of the mining company for the sale of gold to the bank, or is the refiner the
principal in this sale transaction?
Answer
This determination often requires judgement, and different conclusions can significantly impact the amount and timing of
revenue recognition. The determination of whether the refiner is acting as the agent or principal is important, because it
determines whether the mining company or the respective bank is the refiner’s customer, and thus would impact on both the
amount and timing of revenue recognition. Disclosure might be required of the significant judgements applied in the agent
versus principal assessment.
An entity is the principal in a transaction if it obtains control of the specified good or service before it is transferred to the
customer. An assessment therefore needs to be made as to whether the refiner obtains control of the gold before selling to
the bank.
Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from the
asset. Due to the nature of the product being sold (that is, refined gold), some of the indicators included in paragraph B37 of
IFRS 15 are not considered conclusive in the control assessment. Gold is a fungible commodity with a traded price and, as
such:
Price discretion – There is very little if any discretion in establishing the price of
gold.
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Primary responsibility – Since gold is a fungible commodity, the bullion bank would
be unlikely to have any interest in knowing the origin of the gold.
There are different components to inventory risk:
Quantity risk – The mining company bears the quantity risk with regard to the gold
content, because assays are completed before gold bullion is sold to the bullion
bank and the refiner charges a refining fee based on the quantity processed.
Risk of damage and theft – The refiner does bear the risk of inventory losses once
the product is on its premises. This is an expected risk that any business that
performs this type of service and has a custodian responsibility will take on.
Price risk – The mining company bears the price risk during the refining process up
to a certain quantity, and the refiner bears the price risk related to the excess
quantity used to calculate metal gain. However, the metal gain is considered to be
a performance bonus for the refiner’s refining services.
In determining whether the refiner controls the gold before selling it, the example benefits of control in paragraph 33 of IFRS
15 and the control indicators in paragraph 38 also need to be considered in order to assess whether the refiner obtains
control of the gold when the doré bars are delivered to the refinery. In our example, the refiner never receives title to the gold,
and is contractually unable to sell the gold for its own benefit, to use the gold to produce or enhance the value of other
assets, or to use the gold as security to raise any form of financing.
Paragraph 38 of IFRS 15 includes the control indicators below:
Present right to payment – The mining company does not have a present right to
payment from the refiner when doré bars are delivered to the refinery.
Legal title – The refiner does not have legal title.
Physical possession – The refiner has physical possession, but that is necessary
for the refining service.
Significant risks and rewards of ownership – As discussed above for inventory
risks, the most significant risks and rewards of ownership of gold (quantity of gold
produced below a certain level and the price related to them) are retained by the
mining company.
Acceptance – Although the refiner might conduct a head assay to ensure that the
doré bars meet a minimum quality for processing, this acceptance is for the
purpose of providing the refining services. The refiner charges the refining fee
based on quantity processed, regardless of the quantity of gold produced,
indicating that it does not accept the quality of the doré bars when they are
delivered.
Combined with the inventory risk assessment above, it is considered that the refiner does not, even momentarily, gain
control of the gold, and would therefore not be considered to be the principal in the sale of gold to the bullion bank.
IND FAQ 4.1.7.2 – How many performance

obligations exist in the refining arrangement?
Reference to standard: IFRS 15 paras 26 - 30

Following on from the facts in IND FAQ 4.1.7.1 where it is concluded that the refiner is acting as an agent in the sale of gold
to the bullion bank, the refiner's customer is therefore the mining company, and the mining company's customer is the
bullion bank.
Question
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How many performance obligations do the mining company and the refiner each have?
Answer
There is a single performance obligation for the mining company, being the sale of the gold to the bullion bank. Any amount
paid to the refiner for the refining service and arranging the sale will be fulfilment costs.
There are two performance obligations for the refiner: (1) the refining of the gold; and (2) arranging for the sale of the gold on
behalf of the mining company, because these are distinct services.
IND FAQ 4.1.7.3 – How should the refiner

account for metal gains?
Reference to standard: IFRS 15 paras 66 - 69

This FAQ follows on from the facts included in IND FAQ 4.1.7.1 where it is concluded that the mining company is the
refiner’s customer and the refining service is a separate performance obligation.
Question
The refiner charges the mining company a refining fee and, in addition, the refiner generates income through metal gains.
How should the metal gains be accounted for?
Answer
IFRS 15 defines the transaction price as “the amount of consideration to which an entity expects to be entitled in exchange
for transferring promised goods or services to a customer”. Paragraph 66 of IFRS 15 indicates that consideration promised
in the contract can include non-cash consideration. The refiner receives the metal gain as consideration for the refining
service performed. This excess gold can be seen as a non-cash consideration and would need to be measured at fair value.
The amount of metal gain can only be known at a future date and would thus be considered to be variable consideration. If
the consideration promised in a contract includes variable consideration, an entity should estimate the amount of
consideration to which it will be entitled [IFRS 15 para 50]. When determining the transaction price, however, the guidance
on constraining the estimate of variable consideration will need to be considered. Guidance can be found in paragraphs 56
to 57 of IFRS 15.
PwC Observation
The gold gained will belong to the refinery and so it will be recognised as inventory. If sold, this inventory will result in an
additional sale of gold revenue being recognised – that is, resulting in ‘double revenue’.
IND FAQ 4.1.7.4 – Should the refiner account

for the revenue generated from the refining
services at a point in time or over time?

This FAQ follows on from the facts included in IND FAQ 4.1.7.1 and IND FAQ 4.1.7.2 where it is concluded that the mining
company is the refiner’s customer and the refining service is a separate performance obligation.
Question
Should the refiner account for the revenue generated from the refining services at a point in time or over time?
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Answer
If any of the criteria in paragraph 35 of IFRS 15 are met, revenue should be recognised over time. One of these criteria is that
the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced.
In this example control of the gold never transfers to the refiner. The refining service will meet the criteria to recognise
revenue over time, because the refining service is enhancing an asset that is not controlled by the refiner.
PwC Observation
An assessment will need to be made regarding the appropriate method of measuring progress towards complete
satisfaction of that performance obligation. Since the gold refining process is generally short, this is often not as
judgemental an area as, for example, refining of platinum group metals (PGMs), which could take up to six months.
The output method can be applied in considering the measure of progress. When applying this method, revenue is
recognised on the basis of direct measurements of the value to the customer transferred to date relative to the
remaining value promised under the contract. Different metals come out of the refining process at different times when
refining PGMs. A possible way of determining how value is transferring would be to look at the value of the metals that
are coming out of the process as a percentage of the total expected value. Under this method, because the high-value
metals might come out of the process near the end, it means that a significant percentage of revenue would be
recognised near the end of the refining process.
IND FAQ 4.1.7.5 – How is revenue recognised

in a take-or-pay arrangement?

A coal company, C, entered into an agreement with a power utility P for the supply of coal over a 10-year period. P is
allowed to use the coal for consumption at its power stations, but it cannot sell the coal to a third party. The agreement
requires C to supply and deliver a minimum of 10,000 tonnes of coal per month to P, which is invoiced by C on a monthly
basis at a fixed monthly amount. P is required to settle the invoice on or before the last day of the calendar month following
the month of invoice. The fixed monthly amount is payable on a take-or-pay basis. If P does not take the minimum of 10,000
tonnes of coal in a particular month, P still needs to pay C for the minimum tonnage, which is non-refundable. If the minimum
tonnage is not taken in a particular month, P can require any shortfall to be delivered by C as a catch-up in the future.
Question
How should C recognise revenue if P only takes 8,000 tonnes of coal in a particular month?
Answer
C will invoice P for the contractual minimum of 10,000 tonnes of coal, even though the minimum quantity is not delivered to
P. C will recognise the fixed amount allocated to the 8,000 tonnes of coal as revenue on delivery of the coal to P. C would
also recognise a contract liability for the amount allocated to the 2,000 tonnes of coal invoiced but not delivered to P. The
contract liability will be derecognised once the 2,000 tonnes of coal has been delivered to P and C has satisfied its
performance obligation.
P’s non-refundable prepayment to C gives P the right to receive 2,000 tonnes in future, and it obliges C to stand ready to
transfer the 2,000 tonnes. P might not exercise all of its contractual rights, meaning that P might not require C to deliver all or
a portion of the coal still due to P. The unexercised rights are referred to as breakage.
C should recognise the estimated breakage as revenue in proportion to the pattern of rights exercised by P. If C does not
expect P to take the tonnes owed, C should recognise the expected breakage amount as revenue when the likelihood of P
exercising its right to the remaining 2,000 tonnes of coal becomes remote.
12. Leasing
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12.1 Overview
IFRS 16 requires entities to determine whether contracts that they have entered into contain a lease. If a contract is
determined to contain a lease within the scope of IFRS 16, an entity that is the lessee is required, subject to certain scope
exceptions, to recognise on its balance sheet a ‘right of use’ asset and a corresponding lease liability. This is based on the
principle that a lease contract provides the lessee with a right to use an underlying asset for a period of time, with the
consideration for that right paid in instalments.
IFRS 16 defines a lease as: contract, or a part of a contract, that conveys the right to use an asset (the underlying asset) for a
period of time in exchange for consideration”.
IFRS 16 applies to all lease contracts except for:
leases to explore for or use minerals, oil, natural gas and similar non-regenerative
resources;
leases of biological assets within the scope of IAS 41, ‘Agriculture’, held by
lessees;
service concession arrangements within the scope of IFRIC 12, ‘Service
Concession Arrangements’;
licences of intellectual property granted by a lessor within the scope of IFRS 15,
‘Revenue from Contracts with Customers’; and
rights held by a lessee under licensing agreements within the scope of IAS 38,
‘Intangible Assets’, for items such as motion picture films, video recordings, plays,
manuscripts, patents and copyrights.
A lessee can choose to apply IFRS 16 to leases of intangible assets other than those mentioned above within the scope of
IAS 38. If a lessee does not apply IFRS 16 to leases of intangible assets, it generally applies IAS 38. A lessor, however, is
required to apply IFRS 16 to leases of intangible assets, other than those mentioned above that are within the scope of IFRS
15.
Further guidance on IFRS 16’s scope can be found in the PwC Manual of Accounting chapter 15 paras 1 to 4.
IND EX 12.1.1.1 – Application of IFRS 16 scope exclusion: surface rights (same counterparty)
IND EX 12.1.1.2 – Application of IFRS 16 scope exclusion: access right (different counterparty)
FAQ 15.5.1 – How is the term ‘consideration’ interpreted?
FAQ 15.5.2 – How is the term ‘period of time’ interpreted?
FAQ 15.3.2 – Is an underground space within the scope of IFRS 16?
In depth – Accounting for green/renewable power purchase agreements from the buyer’s perspective
12.2 Determining whether a contract contains

a lease
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The following diagram illustrates how entities are to determine whether a contract contains a lease within the scope of
IFRS 16:
PwC Observation
Where there is an identified asset and the customer has the right to obtain substantially all of the economic benefits
from the use of the asset throughout the period of use, leases are different from service contracts: a lease provides a
customer with the right to control the use of an identified asset; in a service contract, the supplier retains control over
the use of the asset.
12.2.1 Identifiable asset
Further guidance on identifying an asset can be found in the PwC Manual of Accounting chapter 15 paras 9 to 16.
An asset can be identified either explicitly (for example, the contract specifies the serial number or a similar identification
marking) or implicitly. If implicit, the asset is not mentioned in the contract (consequently, the entity cannot identify the
particular asset) but the supplier can fulfil the contract only by the use of a particular asset (for example, an oxygen plant
constructed next to a mine located in a remote location, where practically there is no other asset owned by the lessor to
supply the mine with output).
If the supplier has a substantive right to substitute the asset, it is considered not to be an identified asset. Substitution rights
are substantive where:
the supplier has the practical ability to substitute the asset throughout the period of
use; and
the supplier would benefit economically from substituting the asset.
If the customer cannot readily determine whether the supplier has a substantive substitution right, it is presumed that the
substitution right is not substantive.
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PwC Observation
In determining whether substitution rights are substantive, consideration should be given to the costs incurred to
substitute. For example, where a supplier has the right to substitute but the asset is located in a remote location and the
supplier would incur significant costs to move the asset to a location where it could be used by another customer (such
as a tunnel-boring machine used at a mine located in a country with no other mining companies nearby), the substitution
rights would not be considered to be substantive.
IND EX 12.2.1.1 – Contract mining arrangement: not containing a lease

IND EX 12.2.3.1 – Contract mining arrangement: containing a lease
IND EX 12.4.2 – Integral equipment in remote locations
FAQ 15.10.1 – What should be considered when assessing whether a lessor benefits economically from substituting the
asset?
EX 15.10.2 – Substantive substitution rights do not exist if a supplier would not benefit economically from the substitution of
an asset throughout the period of use
FAQ 15.14.1 – Are substitution rights considered at a particular point in time or on the occurrence of a particular event?
12.2.2 The right to obtain substantially all of

the economic benefit from the use of the
identified asset
Further guidance on the right to obtain substantially all of the economic benefit from the use of the identified asset can be
found in the PwC Manual of Accounting chapter 15 para 18.
An entity can obtain economic benefits directly or indirectly (by using, holding or subleasing the asset). These benefits
include the primary output and any by-products (including potential cash flows derived from these assets), as well as
payments from third parties that relate to the use of the identified asset, within the defined scope of the entity’s right to use
the asset. Economic benefits related to the ownership of the asset are ignored (for example, tax benefits or capital
appreciation).
FAQ 15.18.1 – Which economic benefits are to be taken into account for the identification of a lease?
12.2.3 The right to direct how and for what

purpose the identified asset is used
Further guidance on the right to direct how and for what purpose the identified asset is used can be found in the PwC
Manual of Accounting chapter 15 paras 19 to 27.
The entity should assess whether the right to direct how and for what purpose the identified asset is used is determined by
the customer, the supplier or predetermined. This could include who has the right to change the following:
what type of output is produced;

when the output is produced;
where the output is produced; and
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whether the output is produced or how much of the output is produced.

The entity should conclude that the contract contains a lease only where the above assessment has led it to conclude that all
relevant decisions that affect how and for what purpose the identified asset is used are predetermined, and one of the
following applies:
the customer operates the asset (or has the right to direct others to operate the
asset in a manner that it determines); or
the customer has designed the identified asset (or specific aspects of the asset) in
a way that predetermines how and for what purpose the asset will be used
throughout the period of use.
PwC Observation
The IASB has noted that it would expect decisions about how and for what purpose an asset is used to be
predetermined in relatively few cases.
IND EX 12.2.3.1 – Contract mining arrangement: containing a lease
FAQ 15.20.1 – Which decisions should be considered when assessing which party has the right to direct the use of an
asset?
FAQ 15.24.1 – What should be considered when analysing decisions that are made before the inception of the lease?
FAQ 15.24.2 – How do you interpret predetermined where many, but not all, of the decisions about how and for what
purpose the asset is used are predetermined?
EX 15.26.2 – Applying the lease definition to a rail car
EX 15.26.4 – Applying the lease definition to a ship
EX 15.26.5 – Applying the lease definition to a solar farm/power plant
12.3 Separating components of a contract
Further guidance on separating components of a contract can be found in the PwC Manual of Accounting chapter 15 paras
28 to 34.
For a contract that is, or contains, a lease, an entity accounts for each lease component within the contract as a lease,
separately from the non-lease components of the contract, unless the entity applies the practical expedient (described
below).
If the analysis concludes that there are separate lease and non-lease components, the consideration must be allocated
between the components as follows:
The lessee allocates the consideration on the basis of relative stand-alone prices.
If observable stand-alone prices are not readily available, the lessee estimates the
prices and should maximise the use of observable information.
The lessor allocates the consideration in accordance with IFRS 15 (that is, on the
basis of relative stand-alone selling prices).
As a practical expedient, lessees can elect not to separate non-lease components from lease components, and instead to
account for each lease component and any associated non-lease components as a single lease component. This accounting
policy choice must be made by class of underlying asset.
For example, a lease of diggers, with a clause for the supplier to provide maintenance services, contains the lease of
equipment and a non-lease component for providing maintenance services. The lessee can account for each lease and non-
lease component separately; or it can decide to combine the lease of a machine and the maintenance service related to that
lease and account for it as a single lease component.
FAQ 15.29.1 – How does a lessor separate components of a contract under IFRS 16 and IFRS 15?
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12.4 Lease term
Further guidance on the lease term can be found in the PwC Manual of Accounting chapter 15 paras 36 to 44.
The lease term is defined as the non-cancellable period of the lease plus periods covered by an option to extend or an option
to terminate if the lessee is reasonably certain to exercise the extension option or not exercise the termination option.
The assessment of whether the exercise of an option is reasonably certain is made at the commencement date (that is, the
date on which the lessor makes the underlying asset available for use).
A lessee re-assesses extension options and termination options only when a significant event or change in circumstances
occurs that is within the control of the lessee and affects whether it is reasonably certain to exercise an option. A lessor does
not re-assess whether or not an option is reasonably certain to be exercised.
A change in the non-cancellable lease period results in a change in the lease term for both lessee and lessor. Examples of a
change in the non-cancellable lease period include:
the lessee exercises an option in a different way than the entity had previously
determined was reasonably certain; or
an event occurs that contractually obliges the lessee to exercise an option
(/prohibits the lessee from exercising an option) not previously included in the
determination of the lease term (/previously included in the determination of the
lease term).
IND EX 12.4.1 – Lease term: option to extend

FAQ 15.37.1 – How do termination options affect the length of the lease term?
FAQ 15.37.2 – How is the lease term determined if one party has a termination option with a more than insignificant penalty?
FAQ 15.37.3 – How are perpetual lease contracts with bilateral termination options accounted for?
FAQ 15.37.4 – How is ‘penalty’ interpreted in the context of paragraph B34 of IFRS 16?
EX 15.37.5 – What is the enforceable period?
FAQ 15.39.1 – How is the lease term impacted by break clauses?
FAQ 15.39.2 – How is the lease term impacted by extension options?
FAQ 15.39.4 – Does the assessment of whether a lessee is ‘reasonably certain’ to exercise an option include non-monetary
economic incentives?
FAQ 15.39.5 – How should you consider enforceability beyond the written contract?
EX 15.43.1 – What are significant events or changes in circumstances within the control of the lessee that could result in a
reassessment of the lease term?
FAQ 15.47.2 – What is the lease term if there are non-consecutive periods of use?
12.5 Lessee Accounting
12.5.2 Initial recognition and measurement
Further guidance on recognition and measurement can be found in the PwC Manual of Accounting chapter 15 paras 56 to
75.
In economic terms, a lease contract is the acquisition of a right to use an underlying asset, with the
consideration generally paid in instalments. Lessees recognise a ‘right of use’ asset and a corresponding lease liability for
most lease contracts.
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The lease liability is initially recognised at the commencement date and measured at an amount equal to the present value of
the lease payments during the lease term that are not yet paid.
The ‘right of use’ asset is initially recognised at the commencement date and measured at cost, consisting of the amount of
the initial measurement of the lease liability, plus any lease payments made to the lessor at or before the commencement
date less any lease incentives received, plus the initial estimate of restoration costs of the leased asset and any initial direct
costs incurred by the lessee. The provision for the restoration costs is recognised as a separate liability.
12.5.2.1 Restoration costs

The lessee might be obliged to return the underlying asset to the lessor in a specific condition or to restore the site on
which the underlying asset has been located. The lessee recognises a provision in accordance with IAS 37, ‘Provisions,
contingent liabilities and contingent assets’, to reflect this obligation.
The initial carrying amount of any provision is included in the measurement of the ‘right of use’ asset when it incurs an
obligation for those costs (either at the commencement date or during the term of the lease). This corresponds to the
accounting for restoration costs under IAS 16, ‘Property, plant and equipment’.
EX 15.71.1 – Accounting for restoration costs relating to a leased asset

FAQ 15.74.1 – Which costs typically qualify as initial direct costs?
FAQ 15.74.2 – Can a lessee capitalise costs which do not qualify as initial direct costs?
FAQ 4.39.3 – Can the depreciation of assets (including ‘right of use’ assets) used for remediation activities be presented as
a reduction of the decommissioning provision?

exemptions
Further guidance on recognition exemptions can be found in the PwC Manual of Accounting chapter 15 paras 45 to 55.
IFRS 16 contains two optional recognition and measurement exemptions that only apply to the lessee. If one of these
exemptions is applied, the leases are accounted for by recognising the payments on a straight-line basis or another
systematic basis, whichever is more representative of the pattern of the lessee’s benefit, with no ‘right of use’ asset being
recognised:
Short-term leases
Short-term leases are defined as leases with a lease term of 12 months or less (including periods covered by an option to
extend or terminate if the lessee is reasonably certain to exercise that extension option or not to exercise the termination
option).
Any lease that contains a purchase option is not a short-term lease.
Leases for which the underlying asset is of low value

The standard does not define the term ‘low value’, but the Basis for Conclusions explains that the IASB had in mind assets of
a value of US$5,000 or less when new. The amount of US$5,000 is, however, not a quantitative threshold but an example
that the IASB has used to illustrate a general principle.
EX 15.47.1 – Can perpetual lease contracts that contain termination options qualify as short-term leases?
FAQ 15.50.1 – How does IFRS 16 define the term ‘low value’?
EX 15.53.1 – How does a lessee assess whether a leased asset meets the low-value asset criteria?
12.5.3 Subsequent measurement

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Further guidance on recognition and measurement can be found in the PwC Manual of Accounting chapter 15 paras 76 to
87.
The lessee subsequently measures the lease liability using the effective interest rate method.
The ‘right of use’ asset is subsequently measured using the cost model, unless the lessee applies the revaluation model in
IAS 16 or the fair value model in IAS 40, ‘Investment Property’. Under the cost model, the lessee must also apply the
impairment requirements in IAS 36, ‘Impairment of Assets’, to the ‘right of use’ asset.
Any subsequent change in the measurement of the provision for the restoration costs, due to a revised estimation of
expected costs, is accounted for as required by IFRIC 1, ‘Changes in Existing Decommissioning, Restoration and Similar
Liabilities’, which typically results in an adjustment to the ‘right of use’ asset.
FAQ 15.77.1 – Which events trigger a re-assessment and how does the lessee calculate the new carrying amount of the
lease liability?
FAQ 24.44.2 – How does IFRS 16 impact impairment testing?
EX 24.65.1 – Impact of IFRS 16 on value in use
12.5.4 Lease payments
IFRS 16 distinguishes between three kinds of variable payments, depending on the underlying conditions that trigger the
payment and the probability that they actually result in payments:
1. Variable lease payments based on an index or a rate

Variable lease payments based on an index or a rate (such as payments linked to a consumer price index, a benchmark
interest rate or a market rental rate) are part of the lease liability.
2. Variable lease payments based on any other variable

Variable lease payments not based on an index or a rate are not part of the lease liability. These include payments linked to a
lessee’s performance derived from the underlying asset, such as payments of a specified percentage of the ore mined.
These payments are excluded from the lease liability, and they are recognised in profit or loss in the period in which the
event or condition that triggers those payments occurs.
3. In-substance fixed payments

Lease payments that, in form, contain variability but, in substance, are fixed are included in the lease liability. The standard
states that a lease payment is in-substance fixed if there is no genuine variability (for example, where payments must be
made if the asset is proved to be capable of operating, or where payments must be made only if an event occurs that has no
genuine possibility of not occurring). Furthermore, the existence of a choice for the lessee within a lease agreement can also
result in an in-substance fixed payment. If, for example, the lessee has the choice either to extend the lease term or to
purchase the underlying asset, the lowest cash outflow (that is, either the discounted lease payments throughout the
extension period or the discounted purchase price) represents an in-substance fixed payment. In other words, the entity
cannot argue that neither the extension option nor the purchase option will be exercised. Care should be taken when
evaluating contracts to ensure that any clauses which create in-substance payments (for example, clauses that protect the
contractor from the risk of loss) are considered.
FAQ 15.63.1 – How is the term ‘index or rate’ interpreted?

EX 15.65.1 – How are variable lease payments that depend on an index or a rate initially measured?
FAQ 15.65.2 – How are lease payments denominated in a foreign currency accounted for?
FAQ 15.65.3 – How are lease payments that entirely depend on an index or a rate accounted for?
EX 15.65.4 – How are lease payments determined if there are extension options at market rates?
FAQ 15.66.2 – How are variable lease payments that depend on more than one variable accounted for?
FAQ 15.67.1 – When do variable lease payments meet the definition of in-substance fixed payments?
FAQ 15.77.2 – How are variable lease payments that depend on an index or a rate subsequently measured?
EX 15.77.3 – How are lease payments measured if they depend on more than one index or rate?
FAQ 15.78.1 – How are variable lease payments that become fixed for part of the remaining lease term accounted for?
12.5.5 Discount rate
The discount rate that the lessee uses is the interest rate implicit in the lease, if that rate can be readily determined. The
lessee uses its incremental borrowing rate if the interest rate implicit in the lease cannot be readily determined.
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FAQ 15.60.1 – What factors should a lessee consider when determining an incremental borrowing rate?
FAQ 15.60.2 – Is a lessee required to reflect the lease payment profile when determining an incremental borrowing rate?
FAQ 24.106.1 – How might IFRS 16 impact discount rates?
12.6. Joint arrangements
Depending on whether the joint arrangement has its own legal identity, the contract might be signed either by the joint
arrangement itself or by one or more of the parties to the joint arrangement on behalf of the joint arrangement.
If the definition of a lease is met collectively by the parties to the joint arrangement, the contract contains a lease (that is, the
assessment is not done separately for each party to the joint arrangement).
There is a substantive difference between a transaction in which all parties collectively enter into a lease agreement for which
they are jointly and severally liable (in which case, the joint operators recognise their share of the ‘right of use’ asset and the
lease liability), and a transaction in which one joint operator enters into both a lease agreement as the sole signatory with a
third party and a separate agreement to be reimbursed by the other parties to the joint operation.
FAQ 15.27.1 – How should you assess whether a joint arrangement has the right to control the use of an identified asset?
EX 32.62.7 – Accounting by the operator in a joint operation
IND EX 12.1.1.1 – Application of IFRS 16 scope

exclusion: surface rights (same counterparty)
Reference to standard: IFRS 16 para 3 and B32

Company C has been granted a 10-year right to extract minerals from a property by company Y. The right also includes
surface access, but only for the purpose of extraction.
Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources are excluded from the scope of
IFRS 16.
Question
Can surface rights be considered to be outside the scope of IFRS 16 because they are providing access to the land in order
to conduct mining activities?
Answer
The surface access and the mining right have been provided by the same counterparty, company Y, within the same
contract. Paragraph B32 of IFRS 16 provides guidance on identifying separate lease components within a contract. The right
to use an underlying asset is considered to be a separate lease component if the lessee can benefit from use of the
underlying asset on its own, and the underlying asset is neither highly dependent on, nor highly interrelated with, the other
underlying assets in the contract. Company C has been granted surface access only for the purposes of extraction. It would
not be able to conduct mining activities without having been given access to the land and, due to the access restrictions, it
has no alternative use for the land. As such, the surface rights and mining rights are not separate lease components, and so
the entire contract is excluded from the scope of IFRS 16.
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IND EX 12.1.1.2 – Application of IFRS 16 scope

exclusion: access right (different counterparty)

The South African government has granted company C a 10-year mining right to extract platinum group metals (‘PGMs’)
from a prescribed area of land. The land is owned by Mr X. Company C entered into a 10-year lease agreement with Mr X
solely to gain access to the land in order to start mining.
Question
Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources are excluded from the scope of
IFRS 16. Can this scope exclusion be applied to the lease of the land, where access to the land is required in order to
conduct mining activities?
Answer
Although the lease of the land has been entered into with a different counterparty from that of the mining right, it is possible
for the lease agreement entered into with Mr X to be excluded from the scope of IFRS 16. If the lease of land was entered
into exclusively for the purpose of accessing the prescribed area of land used for extraction activities, the lease would be
considered a lease that was entered into in order to explore for and/or use minerals, and it would therefore be excluded from
the scope of IFRS 16. This would differ from equipment used in extracting the mineral which is not unique to the current
mine site and could be used elsewhere.
IND EX 12.2.1.1 – Contract mining

arrangement: not containing a lease

Company B owns an open pit mine. Company B engaged with supplier Y to mine ore on its behalf on a small portion of the
mine site. Supplier Y’s only obligation is to mine a specified tonnage of ore from the designated area, and supplier Y has
discretion as to how to extract the specified tonnage of ore.
The contract does list the assets (that is, vehicles and other movable mining equipment) to be initially used at the mine, but
the purpose of this is to comply with health and safety regulations, and supplier Y will continuously supply company B with a
list of all assets coming on and off the mine premises. Supplier Y has the practical ability to substitute any of these assets,
since the mine is not in a remote location and the assets are considered to be movable. Supplier Y could utilise these assets
at nearby mining operations, and it regularly does so, based on logistical needs or delays at company B’s location.
Question
Does the contract with supplier Y contain a lease of the assets (that is, vehicles and other movable mining equipment)?
Answer
Although the assets are specifically identified in the contract, this is merely for health and safety reasons. A mining company
is required to know the identity of all assets located on site. Supplier Y has the right to bring any asset on site in order to fulfil
the contract, provided that it informs company B of this and the asset passes a basic safety test. Supplier Y can also remove
any of its assets from site at any time, provided that company B is informed (as these assets are not of a specialised nature),
and supplier Y regularly does so, based on logistical needs or delays at company B’s location.
Based on the above, company B does not have the right to use an identified asset, because supplier Y has a substantive
substitution right in terms of IFRS 16 over the assets to be used under this contract (and supplier Y also retains control of the
assets). As such, the contract mining arrangement does not contain a lease.
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IND EX 12.2.3.1 – Contract mining

arrangement: containing a lease

Company A operates a narrow seam coal mining operation in a remote part of the country, and it contracts with supplier X to
mine ore on its behalf. Supplier X has two continuous miners which it uses to provide these services. Based on the contract
terms, the continuous miners are expected to operate continuously, except for a limited amount of downtime permitted for
repair and maintenance by supplier X. The contract also stipulates that, in operating the continuous miners, supplier X should
follow a three-month rolling mine plan that is set by company A. The mine plan sets out where the continuous miners will be
utilised within the mine site, which in turn determines how much ore is to be produced based on the three-month rolling mine
plan. For this asset, there is therefore limited flexibility in how supplier X can operate the asset and limited economic benefit
that it can derive from the operating decisions that it can make. The contract explicitly identifies the serial numbers of these
continuous miners, but it does provide supplier X with the right to replace the miners.
There are currently no other narrow seam coal continuous miners in close proximity to company A’s mine, and so supplier X
could replace the assets with other miners but it would have to incur significant cost to do so. Supplier X would have to incur
further costs to transport this miner to other customers, due to the remote location of company A’s mine. Accordingly,
company A is expected to be the only user of the continuous miners during the contract period.The contract term is four
years.
Question
Does the contract with supplier X contain a lease?
Answer
The continuous miners are specifically identified through their serial numbers. Even though supplier X does have the
contractual ability to substitute the asset, it does not have a substantive right to substitute the continuous miners, because it
would not benefit economically from substituting the assets, due to company A operating in a remote part of the country and
the significant costs that it would have to incur to obtain another continuous miner to substitute the one utilised at company
A’s mine. As such, the contract is considered to contain an identified asset.
Company A will obtain substantially all of the economic benefits from the use of the continuous miners during the term of the
arrangement, because it is expected to be the sole user.
The contract only predetermines when and whether output is produced, by requiring supplier X to operate the miners
continuously, with only a specified amount of time for repair and maintenance activities. The most relevant decisions about
the right to direct the use of the continuous miners are made by company A in setting the mine plan, which determines
where the asset is to be utilised and therefore how much ore is produced. As such, company A has the ability to direct how
and for what purpose the continuous miners should be utilised at the mine.
The contract mining arrangement is therefore considered to contain a lease.

Company B operates an open cast mine and has contracted to use two of supplier V’s mobile manufacturing units (‘MMUs’)
which carry, blend and pump bulk explosive emulsions. These MMUs are considered specialised in nature and an important
part of company B’s ability to extract ore. Supplier V is one of only two suppliers with the exact MMU that company B would
require in its operation to extract ore.
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The agreement is considered to contain a lease in terms of IFRS 16.
The contract term is for a six-month period, after which company B will have the option to extend the agreement for a further
12 months. The payments required during the extended term will be below supplier V’s competitor pricing.
Question
Should the extension option be taken into account in the determination of the lease term? Can company B apply the short-
term lease exemption?
Answer
In evaluating whether the extension is reasonably assured of being exercised, company B considers all relevant facts and
circumstances individually and collectively, and it determines that the MMUs are an important part of its ability to extract ore,
which is expected to continue for many years; the lease payments payable for the extended period are considered to be
below market rates; and there is a scarcity of suppliers with the exact MMUs required by company B. Accordingly, it is
deemed reasonably certain that company B would exercise the option to extend the lease. The lease term would therefore
include the period of the extension option and would be considered to be 18 months.
The short-term lease exemption can only be applied to a lease that has a lease term of 12 months or less. Company B would
therefore not be able to apply the short-term lease exemption to this lease.
IND EX 12.4.2 – Integral equipment in remote

locations

Gold miner A operates in a very remote desert area and, due to this location, the conventional supply of oxygen (which is
required as part of the gold leaching process), by means of truck-transported liquid oxygen and local cryogenic storage
tanks, would not be possible. Gold miner A has therefore contracted with supplier E to build and operate an oxygen plant at
gold miner A’s facility for a period of three years, with an option to extend the contract for a further two years. Supplier E
expects gold miner A to expand its operations in this area, and it has therefore built the oxygen plant’s operating capacity in
excess of what is required by gold miner A. Currently, gold miner A only utilises 75% of the oxygen plant’s capacity.The
probability of any other customer taking up the remaining 25% capacity of the plant is considered highly unlikely. Gold miner
A is deemed to have the right to direct the use of the oxygen plant.
Question
Would this contract with supplier E meet the definition of a lease in terms of IFRS 16? If so, how would this impact the lease
term assessment of the contract with supplier E?
Answer
Since gold miner A’s operation is located in a remote location, along with the constructed oxygen plant, and there is no
alternative to transport to this location and store the oxygen required for its gold leaching operations, the contract is
considered to contain an implied identified asset.
IFRS 16 does not define ‘substantially all’, and therefore determining whether gold miner A obtains substantially all of the
economic benefits of the oxygen plant might involve judgement; however, because the probability of any other customer
utilising output of the plant is considered insignificant, gold miner A is considered to obtain substantially all of the economic
benefits from the use of the oxygen plant during the term of the arrangement, even though it only currently utilises 75% of its
nameplate capacity.
Gold miner A is deemed to have the right to direct the use of the oxygen plant.
Therefore, based on the above, the agreement with supplier E contains a lease and should be accounted for under IFRS 16.
Lease term consideration
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The non-cancellable period of the lease is considered to be three years (that is, the contractually agreed period); however,
paragraph 18 of IFRS 16 requires gold miner A to include the extension option if it is reasonably certain to exercise that
option. Since gold miner A operates in a remote location, with no alternative but to source the oxygen from the plant
constructed by supplier E, it is reasonably certain to exercise the extension option. Gold miner A should therefore apply
lease accounting principles based on a lease term of five years.
Pharmaceutical and life sciences
IFRS Issues and solutions for the

pharmaceuticals and life sciences industry -
2024 edition
IFRS Pharma Solutions 2024
Foreword
The IFRS Issues and solutions for the pharmaceuticals and life sciences industries is our collected insight on the application
of International Financial Reporting Standards (IFRS) in this industry – reflecting the views of many practitioners in the
pharmaceuticals and life sciences industries.
This edition has been updated in 2023 to reflect changes in IFRS and interpretations as at that date. Each solution is based
on a specified set of circumstances. Companies evaluating their own facts and circumstances may well find they differ from
those in these solutions. Creativity in licensing, manufacturing and research and development arrangements, for example,
lead to variations in underlying substance and corporate structures. This requires an individual case-by-case assessment of
the accounting implications that can be complex.
We hope you continue to find this publication useful in understanding the accounting for common transactions that you
encounter in your business. By stimulating debate of these topics through this publication, we hope we will encourage
consistent practices by the pharmaceuticals and life sciences industries in financial reporting under IFRS. This consistency
will be critical to the continued usefulness and transparency of pharmaceuticals and life sciences companies’ financial
reporting.
Peter Kartscher
Global Health Industries Assurance Leader
Acknowledgements
This publication would not have been possible without the input and cooperation of many people, both in the
pharmaceuticals and life sciences industries and PwC specialists. Special thanks go to Ruth Preedy, Andrea Allocco, Gary
Berchowitz, Marie-Claude Kling, Paul Shepherd, Lucy Durocher, Janet Milligan, Rajani Chandar Mylavarapu and Michael
Woodthorpe for their contribution in driving the 2023 update forward.
1. R&D and intangible assets
1.1 Capitalisation of internal development costs

Background
A pharmaceutical entity is developing a vaccine for HIV that has successfully completed Phases I and II of clinical testing.
The drug is now in Phase III of clinical testing. Management still has significant concerns about securing regulatory
approval and it has not started manufacturing or marketing the vaccine.
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Relevant guidance
Development costs are capitalised as an intangible asset if all of the following criteria are met [IAS 38 para 57]:
a. The technical feasibility of completing the asset so that it will be available for use or sale.
b. The intention to complete the asset and use or sell it.
c. The ability to use or sell the asset.
d. The asset will generate probable future economic benefits and demonstrate the existence of a market or the usefulness of the
asset if it is to be used internally,
e. The availability of adequate technical, financial and other resources to complete the development and to use or sell it.
f. The ability to measure reliably the expenditure attributable to the intangible asset.
Should management start capitalising development costs at this point?
Solution
No, management should not capitalise the subsequent development costs, because the project has not met all of the
capitalisation criteria. There is no definitive starting point for the capitalisation of internal development costs.
Management must use its judgement, based on the facts and circumstances of each project. However, a strong
indication that an entity has met all of the above criteria arises when it obtains regulatory approval. It is the clearest
point that the technical feasibility of completing the asset is proven [IAS 38 para 57(a)] and this is the most difficult
criterion to demonstrate. Filing for obtaining regulatory approval is also sometimes considered the point that all
relevant criteria, including technical feasibility, are considered to be met. The technical feasibility of the project is not
yet proven in the above scenario.
1.2 Capitalisation of internal development costs when regulatory

approval has been obtained in a similar market – scenario 1
Background
A pharmaceutical entity has obtained regulatory approval for a new respiratory drug in country A. It is now progressing
through the additional development procedures and clinical trials necessary to gain approval in another country B.
Management believes that achieving regulatory approval in this secondary market is a formality. Mutual recognition
treaties and past experience show that country B’s authorities rarely refuse approval for a new drug that has been
approved in country A.
Relevant guidance
asset if it is to be used internally.
Can the development costs be capitalised?
Solution
The company can capitalise any additional development costs if it judges that the development criteria have been
met. The company has judged that registration is highly probable and there are likely to be low barriers to obtaining
regulatory approval, so it is likely to be technically feasible.
1.3 Capitalisation of internal development costs when regulatory

approval has been obtained in a similar market scenario 2
Background
A pharmaceutical entity has obtained regulatory approval for a new AIDS drug in country A and is progressing through the
additional development procedures necessary to gain approval in country B.
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Experience shows that significant additional clinical trials will be necessary to meet country B’s regulatory approval
requirements. Some drugs accepted in country A have not been accepted for sale in country B, even after additional
clinical trials.
Relevant guidance
Can the development costs be capitalised?
Solution
The company should not capitalise additional development expenditure. It cannot demonstrate that it has met the
criterion of technical feasibility, because registration in another market requires significant further clinical trials.
Approval in one market does not necessarily predict approval in the other.
1.4 Examples of development costs that can be capitalised

Reference to standard: IAS 38 para 57, IAS 38 para 8
Background
A laboratory is developing a drug to cure SARS. Management has determined that it meets the criteria in paragraph 57 of
IAS 38, and that certain development costs must therefore be capitalised, because regulatory approval has been obtained.
Management is unsure about what costs to include.
Relevant guidance
Development is the application of research findings or other knowledge to a plan or design for the production of new or
substantially improved materials, devices, products, processes, systems or services before the start of commercial
production or use. [IAS 38 para 8].
What kinds of expenditure can be considered development costs in the pharmaceutical industry?
Solution
Management should consider the following development costs, assuming that the criteria for capitalising development
costs have been met [IAS 38 para 57]:
employee benefits for personnel involved in the investigation and trials,

including employee benefits for dedicated internal employees;
directly attributable costs, such as fees to transfer a legal right and the
amortisation of patents and licences that are used to generate the asset;
overheads that are directly attributable to developing the asset and that
can be allocated on a reasonable and consistent basis;
allocation of depreciation of property, plant and equipment (ppe) or rent;
legal costs incurred in presentations to authorities;
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Solution
design, construction and testing of pre-production prototypes and
models; and
design, construction and operation of a pilot plant that is not of an
economically feasible scale for commercial production, including directly
attributable wages and salaries.
1.5 Capitalisation of development costs for generics

Background
A pharmaceutical entity is developing a generic version of a painkiller that has been sold in the market by another
company for many years. The technical feasibility of the asset has already been established, because it is a generic version
of a product that has already been approved, and its chemical equivalence has been demonstrated. The lawyers advising
the entity do not anticipate that any significant difficulties will delay the process of obtaining commercial regulatory
approval. (The scenario assumes that the other conditions in paragraph 57 of IAS 38 can be satisfied).
Relevant guidance
Can management capitalise the development costs at this point?
Solution
There is no definitive starting point for capitalisation. Management should use its judgement, based on the facts and
circumstances of each development project. Regulatory approval is deemed probable in this scenario, so
management can start capitalising internal development costs. [IAS 38 para 57]. It might still be appropriate to
expense the costs if there are uncertainties about whether the product will be commercially successful.
1.6 Capitalisation of development costs for biosimilars

Background
A pharmaceutical manufacturer is developing a biosimilar product and has submitted its application to the FDA. The
application included robust analytical studies and data comparing the proposed product to the existing FDA-approved
reference product to demonstrate biosimilarity. The FDA has reviewed the product’s structural and functional
characterisations and requested the manufacturer to move forward with comparative Phase I clinical studies. Management
does not anticipate any significant difficulties with clinical trials.
Relevant guidance
Should management start capitalising development costs at this point?
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Solution
No, management should not capitalise additional development expenditure, because the product has not met all of
the capitalisation criteria. It cannot demonstrate that it has met the criterion of technical feasibility. The abbreviated
pathway for biological products does not mean that a lower approval standard is applied to biosimilar or
interchangeable products. The manufacturer must still demonstrate that the product is biosimilar to the reference
product and complete the requested Phase I, and later Phase III, clinical trials to support approval.
There is no definitive starting point for the capitalisation of internal development costs. Management must use its
judgement, based on the facts and circumstances of each product. However, a strong indication that an entity has
met all of the above criteria arises when it obtains regulatory approval of the biosimilar product. It is the clearest point
that the technical feasibility of completing the asset is proven [IAS 38 para 57(a)]. This is the most difficult criterion to
demonstrate.
1.7 Accounting for marketing expenditure once development criteria

are met
Background
Pharmaceutical entity MagicCure has obtained regulatory approval for a new respiratory drug. MagicCure determined that
the development criteria were met when it received regulatory approval. MagicCure is now incurring expenditure to
educate its sales force and perform market research.
Relevant guidance
Development costs are capitalised as an intangible asset if the criteria specified in IAS 38 are met.
Capitalisable costs are all directly attributable costs necessary to create, produce and prepare the asset to be capable of
operating in the manner intended by management. [IAS 38 para 66].
Selling, administration, general overheads, inefficiencies and training cannot be capitalised as part of an intangible
asset. [IAS 38 para 67].
Should the management of MagicCure capitalise these costs?
Solution
MagicCure should expense sales and marketing expenditure, such as training a sales force or performing market
research. This type of expenditure does not create, produce or prepare the asset for its intended use. Expenditure on
training staff, selling and administration should not be capitalised. [IAS 38 para 67].
1.8 Accounting for development expenditure once capitalisation criteria

are met
Background
Pharmaceutical entity Delta has determined that it has met the six criteria for capitalisation for a vaccine delivery device. It
is continuing expenditure on the device to add new functionality. The development of this device will require new
regulatory approval.
Relevant guidance
Capitalised costs are all directly attributable costs necessary to create, produce and prepare the asset to be capable of
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operating in the manner intended by management. [IAS 38 para 66].
Should the management of Delta capitalise these costs?
Solution
Delta should not capitalise the expenditure that it incurs to add new functionality, because new functionality will
require filing for new regulatory approval. This requirement implies that technical feasibility of the modified device has
not been achieved.
1.9 Development of alternative indications

Background
Pharmaceutical entity Arts Pharma markets a drug approved for use as a painkiller. Recent information shows that the
drug might also be effective in the treatment of cancer. Arts has commenced additional development procedures
necessary to gain approval for this indication.
Relevant guidance
When should management start capitalising the development costs relating to alternative indications?
Solution
Arts should begin capitalisation of development costs as soon as the criteria in paragraph 57 of IAS 38 are met.
Entities involved in developing new drugs or vaccines usually expense development expenditure before regulatory
approval. There is no definitive starting point for capitalising development costs of alternative indications.
Management must use its judgement, based on the facts and circumstances of each project.
Arts must determine whether the existing approval indicates that technical feasibility has been achieved, to assess if
capitalisation is required earlier than achieving regulatory approval for the alternative indication.
Management should consider, amongst other factors:
the risks associated with demonstrating effectiveness of the new

indication;
whether a significantly different dosage might be needed for the other
indication (potentially requiring new side effect studies); and
whether the new indication will target a different group of patients (for
example, children versus adults).
If these considerations indicate that the uncertainties are comparable to a new drug, and that commercialisation is
substantially dependent on regulatory approval, the entity should not begin to capitalise development costs prior to
achieving regulatory approval.
1.10 Costs incurred for performance comparisons

Background
Pharmaceutical entity Van Gogh Ltd has obtained regulatory approval for its new antidepressant drug and has started
commercialisation. Van Gogh is now undertaking studies to verify the advantages of its drug over competing drugs already
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on the market. These studies will support Van Gogh’s sales efforts. These studies are not required as a condition for
Relevant guidance
Development is the application of research findings or other knowledge to a plan or design for the production of new or
substantially improved materials, devices, products, processes, systems or services before the start of commercial
production or use. [IAS 38 para 8].
The cost of an internally generated intangible asset comprises all directly attributable costs incurred to create, produce
and prepare the asset for its intended use. [IAS 38 para 66]. Expenditure might be incurred to provide future economic
benefits to an entity, but no intangible asset or other asset is created that can be recognised. This includes, for example,
expenditure on advertising and promotional activities. [IAS 38 para 69].
Should costs incurred to compare various drugs, with the intention of determining relative performance for certain
indications, be capitalised as development costs?
Solution
The expenditure incurred for studies to identify performance features, after the start of commercial production or use,
should not be capitalised as part of the development cost. This is because it does not qualify for capitalisation under
IAS 38. Development costs after an asset has been brought into use are not directly attributable costs necessary to
create, produce and prepare the asset to be capable of operating in the manner intended by management. The
studies are directed at providing marketing support and the nature of the amounts spent is that of marketing and sales
expense. This expense should be included in the appropriate income statement classification.
1.11 Development costs for a drug which will treat a small patient group
Reference to standard: IAS 38 para 57, IAS 38 para 21, IAS 36 para 9, IAS 36 para
10
Reference to standing text: 21.32, 21.16, 24.9, 24.10
Background
Pharmaceutical entity Da Vinci Pharma is currently developing a drug that will be used in the treatment of a very specific
ailment affecting a small group of patients. Management has decided to pursue this drug for reputational reasons. Da Vinci
has introduced an innovative pricing mechanism for this drug, whereby a patient will only pay if the drug is proven to be
effective. Da Vinci has received regulatory approval and believes that all other capitalisation criteria in paragraph 57 of IAS
38 have been met, except for concerns about its market potential.
Relevant guidance
To qualify for capitalisation as development cost the asset should generate probable future economic benefits;
demonstrated by the existence of a market for the asset’s output and the usefulness of the asset if it is to be used
internally. [IAS 38 para 57(d)].
An intangible asset should only be recognised if it is probable that the expected future economic benefits that are
attributable to the asset will flow to the entity and the cost of the asset can be measured reliably. [IAS 38 para 21].
Should the development costs for a limited market be capitalised?
Solution
All development criteria must be met to start capitalising development costs. A strong indication that an entity has met
all of the above criteria is when it obtains regulatory authority for final approval. Da Vinci should capitalise
development costs for this drug when the criteria in IAS 38 are met, this is likely to be on regulatory approval.
Da Vinci will need to assess the capitalised costs for any indication of impairment at each reporting date [IAS 36 para
9], and to test for impairment annually before it is available for use. [IAS 36 para 10]. The concern over the potential
market might be a trigger for impairment.
1.12 Patent protection costs

Background
Pharmaceutical entity Velazquez Pharma has a registered patent on a currently marketed drug. Pharmaceutical entity
Uccello Medicines Ltd copies the drug’s active ingredient and sells the drug during the patent protection period.
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Velazquez goes to trial and is likely to win the case, but it has to pay costs for its attorneys and other legal charges.
Relevant guidance
Subsequent expenditure on an intangible can only be capitalised if it enhances the expected future economic benefits of
the intangible.
[IAS 38 para 20].
Should legal costs relating to the defence of pharmaceutical patents be capitalised?
Solution
Velazquez should not capitalise patent defence costs, because they maintain rather than increase the expected future
economic benefits from an intangible asset. Such costs should not be recognised in the carrying amount of an asset
under paragraph 20 of IAS 38. Patent defence costs should be expensed as incurred.
1.13 Priority review vouchers

Background
Pharmaceutical entity Egram developed a vaccine for a rare paediatric disease. It was awarded a paediatric priority review
voucher (PRV) by the FDA when it received marking approval. The PRV entitles the holder to request priority review by the
FDA of any future drug application that would otherwise get a standard review. The holder can use the PRV on one of its
own applications, or it can sell it to another company. The PRV does not guarantee that the FDA will approve the drug
application. Egram sold the PRV to pharmaceutical entity Fiorel for C65 million.
Relevant guidance
An intangible asset should be recognised if [IAS 38 para 21]:
a. it is probable that the future economic benefits from the asset will flow to the entity; and
b. the cost of the asset can be measured reliably.
The price that an entity pays to acquire a separate intangible asset reflects expectations about the probability that the
expected future economic benefits embodied in the asset will flow to the entity. The effect of probability is reflected in the
cost of the asset and the probability recognition criterion in paragraph 21(a) of IAS 38 is always considered to be satisfied
for separately acquired intangible assets.
[IAS 38 para 25].
How should Fiorel account for the acquired PRV?
Solution
The PRV is identifiable, because it can be sold or transferred to another company and it arises from a legal right. The
PRV will allow Fiorel to fast track a review with the FDA, saving costs and potentially accelerating the time to market.
Fiorel therefore has the power to obtain future economic benefits.
The recognition criteria in paragraph 25 of IAS 38 are met when an intangible is separately acquired. The C65 million
reflects the expectation of future economic benefits and the cost can be reliably measured. Fiorel should therefore
recognise the PRV on its balance sheet at cost.
Fiorel will subsequently need to assess whether the useful life of the PRV is finite or indefinite under paragraph 88 of
IAS 38. The PRV has a finite life that ends when the priority review has been committed and used with the FDA, or
when the PRV is sold to another company. The asset is consumed on a unit of production basis (when used) and,
therefore, this would be the most appropriate amortisation method. As such, the PRV will be amortised in full when
Fiorel uses the voucher for a priority review.
1.14 Exchange of intangible assets

Reference to standard: IAS 38 para 45, IAS 38 para 46, IAS 38 para 47
Reference to standing text: 21.54, 21.55, 21.58
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Background
Pharmaceutical entity Egram is developing a hepatitis vaccine. Pharmaceutical entity Fiorel is developing a measles
vaccine. Egram and Fiorel enter into an agreement to swap the two products. Egram and Fiorel will not have any
continuing involvement in the products that they have disposed of. The fair value of Egram’s compound has been
assessed as C3 million and the carrying value of the compound is C0.5 million.
Relevant guidance
An intangible asset might be acquired in exchange for a non-monetary asset or assets, or a combination of monetary and
non-monetary assets. The cost of the acquired intangible asset is measured at fair value, unless (a) the exchange
transaction has no commercial substance, or (b) the fair value of neither the asset received nor the asset given up is
reliably measurable. [IAS 38 para 45].
Whether an exchange transaction has commercial substance is determined by considering the degree to which future
cash flows are expected to change. An exchange transaction has commercial substance if [IAS 38 para 46]:
a. the risk, timing and amount of the cash flows of the asset received differ from the risk, timing and amount of the cash flows of
the asset transferred; or
b. the entity-specific value of the portion of the entity’s operations affected by the transaction changes as a result of the
exchange; and
c. the difference in (a) or (b) is significant, relative to the fair value of the assets exchanged.
The fair value of the asset given up is used to measure cost, unless the fair value of the asset received is more clearly
evident. [IAS 38 para 47].
How should Egram’s management account for the swap of vaccine products?
Solution
The exchange of vaccine products for different diseases has commercial substance. Egram is switching from a
hepatitis vaccine product to a measles vaccine product. The timing and value of cash flows expected to arise from the
development and commercialisation of the products differ. Egram’s management should recognise the compound
received at the fair value of the compound given up, that is C3 million. Management should also recognise a gain on
the exchange of C2.5 million (C3 million – C0.5 million), because there is no continuing involvement.
1.15 Partial disposal of an intangible asset

Background
Pharmaceutical entity Giant is developing a hepatitis vaccine. Pharmaceutical entity Hercules is developing a measles
vaccine. Giant and Hercules enter into an agreement to swap these two products. Under the terms of the agreement,
Giant will retain the marketing rights to its drug for all Asian countries. The fair value of Giant’s compound has been
assessed as C3 million, including C0.2 million relating to the Asian marketing rights and the carrying value of the
compound is C0.5 million.
Relevant guidance
An intangible asset might be acquired in exchange for a non-monetary asset or assets, or a combination of monetary and
non-monetary assets. The cost of the acquired intangible asset is measured at fair value, unless (a) the exchange
transaction has no commercial substance, or (b) the fair value of neither the asset received nor the asset given up is
reliably measurable. [IAS 38 para 45].
Whether an exchange transaction has commercial substance is determined by considering the degree to which future
cash flows are expected to change. An exchange transaction has commercial substance if [IAS 38 para 46]:
a. the risk, timing and amount of the cash flows of the asset received differ from the risk, timing and amount of the cash flows of
the asset transferred; or
b. the entity-specific value of the portion of the entity’s operations affected by the transaction changes as a result of the
exchange; and
c. the difference in (a) or (b) is significant, relative to the fair value of the assets exchanged.
The fair value of the asset given up is used to measure cost, unless the fair value of the asset received is more clearly
evident. [IAS 38 para 47].
How should Giant’s management account for the swap of vaccine products, assuming that the transaction has
commercial substance?
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Solution
Giant’s management should recognise the compound received at the fair value of the compound given up, that is
C2.8 million (C3.0 million – C0.2 million). The fair value of C0.2 million relating to the Asian marketing rights is
excluded from the calculation. This is because the rights have not been sold. Management should also recognise a
gain on the exchange of C2.3 million [C2.8 – (0.5 – ((0.2/3) × 0.5))].
1.16 Intangible asset derecognition on out-licence of rights

Reference to standard: IAS 38 para 112, IAS 38 para 113, IAS 38 para 116, IFRS 15
para B63
Reference to standing text:21.134, 21.135, 21.136, 11.94
Background
Pharma Co A enters into a contract with Pharma Co B with the following terms:
Pharma Co A grants Pharma Co B an exclusive perpetual licence to sell and

market an arthritis drug in the US.
Pharma Co A retains the rights to sell and market the drug in the rest of the world.
Pharma Co A will continue to manufacture the arthritis drug.
Pharma Co B will purchase the drug from Pharma Co A at cost plus a fair value
mark-up.
The consideration payable by Pharma Co B under this agreement comprises:
An up-front payment of C10 million.

A milestone payment of C5 million payable when sales exceed C 30 million.
Royalties of 5% payable on sales.

Pharma Co A has a capitalised intangible asset of C15 million in relation to the intellectual property for the arthritis drug.
The relative value of the US market to the rest of the world is 40%.
Relevant guidance
An intangible asset should be derecognised [IAS 38 para 112]:
a. on disposal; or
b. when no future economic benefits are expected from its use or disposal.
The gain or loss arising from the derecognition of an intangible asset should be determined as the difference between the
net proceeds, if any, and the carrying amount of the asset. Gains should not be classified as revenue. [IAS 38 para 113].
The amount of gain or loss arising from the derecognition of an intangible asset is determined in accordance with the
requirements for determining the transaction price in paragraphs 47–72 of IFRS 15. [IAS 38 para 116].
An entity should recognise revenue for a sales-based royalty in exchange for a licence of intellectual property only when
(or as) the later of the following events occurs [IFRS 15 para B63]:
a. the subsequent sale or usage occurs; and

b. the performance obligation to which some or all of the sales-based royalty has been allocated has been satisfied (or partially
satisfied). [IFRS 15 para B63].
How should Pharma Co A account for the disposal of the US rights to the arthritis drug?
Solution
Pharma Co A has granted Pharma B a right-of-use licence for the US rights to the arthritis drug. The gain or loss
arising from the disposal is the difference between the proceeds and the carrying amount of the asset.
Judgement is required to determine the portion of the carrying amount of the intangible asset to derecognise, relative
to the amount retained.
Pharma Co A has determined that 40% of the carrying amount of the intangible asset should be derecognised, since
this is the relative value of the US rights out-licenced compared to the rights retained in the rest of the world.
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Solution
The proceeds to include in the gain or loss arising from the derecognition of the intangible asset are determined in
accordance with IFRS 15. The consideration for the contract comprises a fixed element (the up-front payment) and
two variable elements (the milestone payment and the royalties). Initially, only the fixed consideration is recognised as
proceeds. The sales milestone and royalties are recognised when the subsequent sale occurs, using the royalty
exception applicable to licences. Therefore, the variable consideration is excluded from the calculation of the gain or
loss arising on the derecognition of the intangible asset. The variable consideration is recognised in the income
statement when the underlying sales are made.
A gain is recognised on disposal of the US rights of C4 million (that is, up-front payment of C10 million minus carrying
amount of intangible asset disposed of amounting to C6 million (calculated as C15 million × 40%)).
Note: Cash flows from future milestones and royalties in relation to the derecognised rights should not be used, in
ongoing impairment calculations, to support the carrying value of the remaining intangible that has not been
derecognised.
1.17 Patent acquired in exchange for own shares

Background
Pharmaceutical entity Buonarroti entered into a competitive bidding arrangement to acquire a patent. Buonarroti won the
bidding and agrees to settle in exchange for 5% of its publicly listed shares.
Relevant guidance
For equity-settled, share-based payment transactions, the entity measures the goods received at the fair value of the
goods received, unless that fair value cannot be estimated reliably. If the entity cannot estimate reliably the fair value of the
goods received, it measures their value by reference to the fair value of the equity instruments granted.
[IFRS 2 para 10].
How should an asset acquired in exchange for listed shares be recognised?
Solution
The acquisition of the patent in exchange for shares is a share-based payment. Buonarroti should recognise the
patent at its fair value. If the fair value cannot be measured, the patent would be measured at the fair value of the
publicly traded price of the shares on the acquisition date.
The accounting for the seller of the patent under IFRS 9 and IFRS 15 is explained in Solution 5.14.
1.18 In-licence of technology

Background
Pharmaceutical entities Regal and Simba enter into an agreement in which Regal will in-licence Simba’s know-how and
technology (which has a fair value of C3 million) to manufacture a compound for AIDS. It cannot use the know-how and
technology for any other project. Regal will use Simba’s technology in its facilities for a period of ten years. The agreement
stipulates that Regal will make a non-refundable payment of C3 million to Simba for access to the technology. Regal’s
management has not yet concluded that economic benefits are likely to flow from this compound or that relevant
regulatory approval will be achieved.
Relevant guidance
An intangible asset should be recognised if [IAS 38 para 21]:
a. it is probable that the future economic benefits from the asset will flow to the entity; and
b. the cost of the asset can be measured reliably.
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for separately acquired intangible assets. [IAS 38 para 25].
How should Regal account for the three-year licence?
Solution
The three-year licence is a separately acquired intangible capitalised under paragraph 25 of IAS 38. The probability of
economic benefit is assumed to be factored into the price that the buyer is prepared to pay.
The right should be measured at its cost of C3 million. The intangible asset should be amortised from the date when it
is available for use (see Solution 1.28). The technology, in this example, is available for use when the manufacturing of
the compound begins. The amortisation should be presented as cost of sales in the income statement (if expenses
are presented by function) or as amortisation (if expenses are presented by nature), because it is an expense directly
related to the production of the compound.
Regal continues to expense its own internal development expenditure until the criteria for capitalisation are met and
economic benefits are expected to flow to the entity from the capitalised asset. See Solution 5.15 for Simba’s
accounting under IFRS 15.
1.19 In-licence of marketing rights for a drug in development

Background
Pharmaceutical entities Sargent and Chagall enter into a collaboration deal in which Sargent in-licences a new antibiotic
from Chagall. Chagall will continue to develop the drug. Sargent will have exclusive marketing rights to the antibiotic if it is
approved. The contract terms require the following payments:
up-front payment of C20 million on signing of the contract;

milestone payment of C50 million on Phase III clinical trial approval; and
milestone payment of C80 million on securing final regulatory approval.
Development services are paid at cost plus a reasonable mark-up.
Relevant guidance
The cost of a separately acquired intangible asset can usually be measured reliably. This is particularly so where the
purchase consideration is in the form of cash or other monetary assets. [IAS 38 para 26].
How should Sargent account for the in-licence?
Solution
Sargent has assessed that the C20 million up-front payment is for the acquisition of an asset rather than prepaid R&D.
A separately acquired intangible is capitalised under paragraph 25 of IAS 38. The probability of economic benefit is
assumed to be factored into the price that the seller is prepared to accept.The intangible is recognised at cost of C20
million.
The future milestones must be assessed to determine if they meet the capitalisation criteria. A milestone payment can
be outsourced development work or an acquisition of an identifiable asset.
The substance of the payment will determine its classification; the label given to a payment is not relevant. This is a
judgemental area under the accounting standards and Sargent should develop an accounting policy that is clearly
articulated and understood by the organisation.
A robust method of making this judgement is to assess whether the payment is due only on a verifiable outcome, or
whether it is due for the execution of activities. A verifiable outcome would be the successful completion of Phase III
trials. The payment for a verifiable outcome is more likely to indicate the additional value of the intangible asset. The
execution of activities might be enrolling 3,000 patients for a clinical trial. The payment for enrolling patients is for
normal activities undertaken during the development stage.
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Solution
The milestones paid by Sargent are for the successful outcome of trials and regulatory approval. They are likely to
meet the capitalisation criteria and would be accumulated into the cost of the intangible. Development services are
being paid separately at fair value and, therefore, it is less likely that any milestone is for prepaid development
services.
There is a policy choice on how to treat variable payments for intangible assets: either a cost accumulation approach
or a financial liability approach.
Industry practice is generally to follow a cost accumulation approach to variable payments for the acquisition of
intangible assets. Contingent consideration is not considered on initial recognition of the asset, but it is added to the
cost of the asset initially recorded, when incurred.
1.20 In-licence of development-phase compound where the licensee

continues to do the development work
Background
Biotech Co has successfully developed a drug for Syndrome Q through Phase II trials. Biotech and a large pharmaceutical
entity, Pharma Co, have agreed the following terms:
Biotech grants a licence to Pharma to manufacture, sell and market the product
in the US for the treatment of Syndrome Q. Biotech retains the patents and
underlying intellectual property associated with the product.
Pharma is to fund and perform all Phase III clinical development work on the drug
developed by Biotech.
There is a development committee that oversees the development of the product.
The development committee makes all strategic decisions regarding the product.
Biotech is not required to attend the committee, but it has the right to and
expects to, attend.
Biotech gives Pharma a guarantee to defend the patent from unauthorised use.
Biotech retains the right to sell the product in the rest of the world.
The consideration payable by Pharma includes:
up-front payment of C10 million on signing the contract;
milestone payment of C20 million on regulatory approval;

royalties of 15% payable on sales; and
sales milestone of C20 million in the first year that annual sales exceed C500
million.
The up-front payments and milestones are non-refundable in the event that the contract is cancelled after the payments
have been made.
Relevant guidance
the intangible. [IAS 38 para 20].
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How should Pharma account for the in-licence?
Solution
The up-front purchase of the compound is a separately acquired intangible, which is capitalised under paragraph 25
of IAS 38. Biotech has no further performance obligations for development services. The intangible is recognised at
cost of C10 million.
The variable payments must be assessed to determine whether they meet the capitalisation criteria.
judgemental area under the accounting standards and Pharma should develop an accounting policy that is clearly
The milestones paid by Pharma are for regulatory approval and a sales target. They are likely to meet the
capitalisation criteria and would be accumulated into the cost of the intangible.
There is a policy choice on how to treat variable payments for intangible assets: either a cost accumulation approach
or a financial liability approach.
Industry practice is generally to follow a cost accumulation approach to variable payments for the acquisition of
intangible assets. Contingent consideration is not considered on initial recognition of the asset, but it is added to the
cost of the asset initially recorded, when incurred.
Royalties should be accrued for in line with the underlying sales and recognised as a cost of sales.
See Solution 5.18 for IFRS 15 guidance.
1.21 In-licence of development-phase compound where the licensor

20
Background
Biotech Co is a well-established company that has the expertise to perform clinical trials. Biotech enters into a contract
with Pharma Co with the terms:
Biotech grants Pharma a licence to manufacture, sell and market product.

Biotech is responsible for performing clinical trials and obtaining regulatory
approval.
The consideration payable by Pharma under this agreement comprises:
up-front payment of C10 million;

milestone of C20 million payable for enrolling 1,000 patients for Phase III trials;
milestone of C10 million on regulatory approval; and
royalties of 25% payable on sales.
Relevant guidance
cost of the asset, and the probability recognition criterion in paragraph 21(a) of IAS 38 is always considered to be satisfied
the intangible. [IAS 38 para 20].
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How should Pharma account for the in-licence?
Solution
Pharma needs to assess whether the up-front payment is for the acquisition of an intangible or for prepaid R&D. There
is no separate payment for R&D services and so it is likely that the up-front payment is, at least in part, a prepayment
for R&D. Any prepayment recognised is released to the income statement over the development period.
The future milestones must be assessed to determine whether they meet the capitalisation criteria. A milestone
payment can be outsourced development work or an acquisition of an identifiable asset.
judgemental area under the accounting standards and Pharma should develop an accounting policy that is clearly
A robust method of making this judgement is to assess whether the payment is due only on a verifiable outcome, or
whether it is due for the execution of activities. A verifiable outcome would be regulatory approval. The payment for a
verifiable outcome is more likely to indicate the additional value of the intangible asset that is controlled by the entity.
The C10 million milestone on regulatory approval is likely to meet the capitalised criteria and can be accumulated into
the cost of the intangible. The execution of activities is a normal R&D activity and should be expensed.
See Solution 5.19 for IFRS 15 guidance.
1.22 Up-front payments to conduct research

Background
Pharmaceutical entity Astro engages a contract research organisation (CRO) to perform research activities for a period of
two years in order to obtain know-how and try to discover a cure for AIDS. The CRO is well known in the industry for
having modern facilities and good practitioners dedicated to investigation. The CRO receives a nonrefundable, up-front
payment of C3 million in order to carry out the research under the agreement. It will have to present a quarterly report to
Astro with the results of its research. Astro has full rights of access to all of the research performed, including control of
the research undertaken on the potential cure for AIDS. The CRO has no rights to use the results of the research for its
own purposes.
Relevant guidance
Expenditure on research should be expensed when incurred. [IAS 38 para 54].
How should Astro account for up-front payments made to third parties to conduct research?
Solution
The payment is made for research activity to an external CRO, it does not meet the definition of an intangible asset
and it cannot be capitalised. The up-front payment is recognised as a prepayment in the income statement over the
period of the research activity.
1.23 Accounting for research which results in a development candidate

Background
Pharmaceutical entity Sisley Pharma contracts with pharmaceutical entity Wright Pharma to research possible candidates
for further development in its antihypertension programme. Sisley pays Wright on a cost-plus basis for the research, plus
C100,000 per development candidate that Sisley elects to pursue further.. Sisley will own the rights to any such
development candidates. After two years, Wright succeeds in confirming ten candidates that will be used by Sisley.
Relevant guidance
No intangible asset arising from research (or from the research phase of an internal project) should be recognised.
Expenditure on research (or on the research phase of an internal project) is recognised as an expense when it is
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incurred. [IAS 38 para 54].
An intangible asset arising from development (or from the development phase of an internal project) shall be recognised if,
and only if, an entity can demonstrate meeting all relevant criteria. [IAS 38 para 57].
Expenditure on an intangible item that was initially recognised as an expense shall not be recognised as part of the cost of
an intangible asset at a later date. [IAS 38 para 71].
How should Sisley account for the payments to Wright?
Solution
Costs incurred for research should not be capitalised. Sisley’s payments relating to the cost-plus portion of the
contract should be expensed. No separate intangible has been acquired and the technological feasibility criterion is
not met. At the point of regulatory approval, the research costs previously expensed cannot be reversed and
capitalised.
1.24 Third-party development of own intellectual property

Background
Pharmaceutical entity Tiepolo Pharma has appointed Tintoretto Laboratories, a third party, to develop an existing
compound owned by Tiepolo on its behalf. Tintoretto will act purely as a service provider, without taking any risks during
the development phase, and it will have no further involvement after regulatory approval. Tiepolo will retain full ownership
of the compound. Tintoretto will not participate in any marketing and production arrangements. A milestone plan is
included in the contract. Tiepolo agrees to make the following non refundable payments to Tintoretto:
C2 million on signing the agreement; and

C3 million on successful completion of Phase II.
Relevant guidance
Internally generated intangible assets should only be recognised if, amongst other criteria, the technical feasibility of a
development project can be demonstrated. [IAS 38 para 57].
How should Tiepolo account for up-front payments and subsequent milestone payments in a research and development
(R&D) arrangement in which a third party develops its intellectual property?
Solution
Tiepolo owns the compound. Tintoretto performs development on Tiepolo’s behalf. No risks and rewards of
ownership are to be transferred between the parties. By making the initial up-front payment and the subsequent
milestone payment to Tintoretto, Tiepolo does not acquire a separate intangible asset that could be capitalised. The
payments represent outsourced R&D services to be expensed over the development period, provided that the
recognition criteria in paragraph 57 of IAS 38 for internally generated intangible assets are not met.
1.25 Joint development of own intellectual property

57
Background
Pharmaceutical entity Tiepolo Pharma has appointed Tintoretto Laboratories, a third party, to develop an existing
compound owned by Tiepolo on its behalf. The agreement out-licences Tiepolo’s compound to Tintoretto. Tiepolo and
Tintoretto will set up a development steering committee to jointly perform the development and they will participate in the
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funding of the development costs according to specific terms. Tiepolo agrees to make the following payments to
Tintoretto:
C5 million on signing the agreement as an advance payment. Tintoretto is

required to refund the entire payment if it fails to successfully complete Phase III
50% of total development costs on successful completion of Phase II (after

deducting the advance payment).
Tiepolo will commercialise the drug. In the case of successful completion of development and commercialisation,
Tintoretto will receive milestone payments and royalty streams.
Relevant guidance
The cost of a separately acquired intangible asset comprises [IAS 38 para 27]:
1. its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates;
and
2. any directly attributable cost of preparing the asset for its intended use.
Internally generated intangible assets shall only be recognised if, amongst other criteria, the technical feasibility of a
development project can be demonstrated. [IAS 38 para 57].
How should Tiepolo account for the advance payment in an R&D arrangement in which a third party develops its
intellectual property?
Solution
Tintoretto becomes party to substantial risks in the development of Tiepolo’s compound and Tiepolo effectively
reduces its exposure to ongoing development costs. However, Tiepolo does not acquire a separate intangible asset
that could be capitalised. The payments represent funding for development of its own intellectual property by a third
party.. Tiepolo should record the C5 million as prepaid expense initially and it should recognise the prepaid amount to
R&D expense over the term of the agreement on successful completion of Phase II.
1.26 Cost-plus contract research arrangements
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Background
Pharmaceutical entity Whistler Corp enters into a contract research arrangement with pharmaceutical entity Ruskin Inc to
perform research on the geometry of a library of molecules. Ruskin will catalogue the research results in a database.
Whistler will refund all of Ruskin’s direct costs incurred under the contract and it will pay a 25% premium on a quarterly
basis as the work is completed.
Relevant guidance
Research expenses are recognised as incurred. [IAS 38 para 54]. Examples of research activities include the search for
alternatives for materials, devices, products, processes, systems or services. [IAS 38 para 56(c)].
Examples of development activities include the design, construction and testing of a chosen alternative for new or
improved materials, devices, products, processes, systems or services. [IAS 38 para 59(d)].
How should Whistler account for contracted research arrangements?
Solution
Whistler should expense costs for the contract research as incurred by Ruskin. The activity is within the definition of
research. It will not result in the design or testing of a chosen alternative for new or improved materials, devices,
products, processes, systems or services that could be capitalised as a development intangible asset. If the payment
from Whistler was fixed rather than cost-plus, the accounting treatment would be the same but the research costs
would be accrued and expensed over the service period.
1.27 Useful economic lives of intangibles

88, IAS 38 para 104
Reference to standing text: 21.32, 21.123, 21.25, 21.102, 21.126
Background
A laboratory has capitalised certain costs incurred in the development of a new drug. These costs have met the
capitalisation criteria in paragraph 57 of IAS 38, because regulatory approval has been obtained.
Relevant guidance
The depreciable amount of an intangible asset should be amortised on a systematic basis over the best estimate of its
useful life. [IAS 38 para 97].
Useful life is defined as the period of time over which an asset is expected to be used by the entity. [IAS 38 para 8].
Management should assess the useful life of an intangible asset, both initially and on an annual basis. [IAS 38 paras 88,
104].
What factors should management consider in its assessment of the useful life of capitalised development costs (including
ongoing reassessment of useful lives)?
Solution
Management must consider a number of factors that are relevant to all industries when determining the useful life of
an intangible asset. It should also consider industry-specific factors, such as the following:
duration of the patent right or licence of the product;

anticipated duration of sales of product after patent expiration; and
competitors in the marketplace.
1.28 Commencement of amortisation
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Background
A pharmaceutical entity acquired a compound in Phase III for C5 million on 1 January 20X3. The entity receives regulatory
and marketing approval on 1 March 20X4 and it starts using the compound in its production process on 1 June 20X4. The
entity amortises its intangible assets on a straight-line basis over the estimated useful life of the asset.
Relevant guidance
Amortisation of an asset starts when it becomes available for use. The asset should be in the location and condition that is
required for it to be operating in the manner intended by management. [IAS 38 para 97].
When should the entity begin amortising its intangible assets?
Solution
Amortisation should begin from 1 March 20X4, because this is the date that the asset is available for use. The
intangible asset should be tested for impairment at least annually, prior to 1 March 20X4, irrespective of whether any
indication of impairment exists. [IAS 36 para 10(a)].
1.29 Amortisation method of development – intangible assets

Background
Pharmaceutical entity Raphael & Co has begun commercial production and marketing of an approved product.
Development costs for this product were capitalised in accordance with the criteria specified in IAS 38. The patent
underlying the new product will expire in ten years and management does not forecast any significant sales once the
patent expires.
Relevant guidance
The depreciable amount of an intangible asset with a finite useful life should be allocated on a systematic basis over its
useful life. The amortisation method used should reflect the pattern in which the asset’s future economic benefits are
expected to be consumed. [IAS 38 para 97].
Acceptable methods include the straight-line method, the diminishing balance method and the unit of production method.
The method used is selected on the basis of the expected pattern of consumption, and it is applied consistently from
period to period, unless there is a change in the expected pattern of consumption of benefits. There is rarely, if ever,
persuasive evidence to support an amortisation method for intangible assets that results in a lower amount of accumulated
amortisation than under the straight-line method. [IAS 38 para 98].
The useful life of an intangible asset that arises from legal rights should not exceed the period of the legal rights, but it
might be shorter, depending on the period over which the entity expects to use the asset. [IAS 38 para 94].
What is the appropriate method of amortising the capitalised development costs, once a drug is being used as intended?
Solution
The patent provides exclusivity and premium cash flows over a ten-year period. The economic benefits are consumed
rateably over time. The limiting factor of the patent is time. Whether the drug is a blockbuster and exceeds
expectations, or it just breaks even, the patent’s economic benefit will still be consumed equally over time. Straight
line amortisation appropriately reflects the consumption of economic benefits.
Raphael should therefore amortise the capitalised development costs on a straight-line basis over the patent’s ten-
year life, unless the business plan indicates use of the patent over a shorter period. A systematic and rational
amortisation method should be utilised over this shortened remaining useful life. In addition, Raphael should perform
impairment testing whenever it identifies an impairment indicator.
1.30 Amortisation life of intangibles

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Background
Pharmaceutical entity Raphael & Co has begun commercial production and marketing of an approved product. The
production is done using a licensed technology that will be used in the production of other products for 20 years. The
patent underlying the new product will expire in ten years. An up-front payment for the 20-year licence of the technology
and development costs for the new product were capitalised in accordance with the criteria specified in IAS 38.
Relevant guidance
The depreciable amount of an intangible asset with a finite useful life should be allocated on a systematic basis over its
useful life. The amortisation method used should reflect the pattern in which the asset’s future economic benefits are
expected to be consumed. [IAS 38 para 97].
Acceptable methods include the straight-line method, the diminishing balance method and the unit of production method.
The method used is selected on the basis of the expected pattern of consumption and it is applied consistently from
period to period, unless there is a change in the expected pattern of consumption of benefits. There is rarely, if ever,
persuasive evidence to support an amortisation method for intangible assets that results in a lower amount of accumulated
amortisation than under the straight-line method. [IAS 38 para 98].
The useful life of an intangible asset that arises from legal rights should not exceed the period of the legal rights, but it
might be shorter, depending on the period over which the entity expects to use the asset. [IAS 38 para 94].
What is the useful life of the intangibles?
Solution
Each of these intangibles should be amortised on a straight-line basis. The intangible asset attributable to the patent
should be amortised over its ten-year expected useful life. The intangible asset attributable to the technology should
be amortised over the full 20-year life. Use of the straight-line method reflects consumption of benefits available from
the patent based on the passage of time. If the time that the technology or patent will generate economic benefits
decreases, Raphael should perform impairment testing, and a systematic and rational amortisation method should be
utilised over this shortened remaining useful life.
1.31 Indefinite-lived intangible assets

Background
Management of a pharmaceutical entity has acquired a branded generic drug as part of a business combination. The
brand is a well-established leader in the market and has a strong customer loyalty. Management believes that the brand
has an indefinite useful life and it has decided not to amortise it.
Relevant guidance
An intangible asset can be regarded as having an indefinite useful life when there is no foreseeable limit to the period over
which the asset is expected to generate positive cash flows for the entity. [IAS 38 para 88].
Can management regard the brand as having an indefinite life and how should management account for it?
Solution
Yes, management can regard the brand as having an indefinite life in accordance with IAS 38. Management would
need to test the indefinite-lived asset annually for impairment, comparing its recoverable amount with its carrying
value. [IAS 36 para 10(a)].
Technological and medical advances will reduce the number of situations where an indefinite life would apply. Only in
exceptional cases would the active ingredient of pharmaceutical products have unrestricted economic lives as a result
of limited patent lives.
1.32 Indicators of impairment intangible assets

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Background
A pharmaceutical entity has capitalised a number of products as intangible assets that it is amortising.
Relevant guidance
An entity should assess whether there is any indication that an asset is impaired at each reporting date. [IAS 36 para 9].
Indicators can be external or internal. Examples are included in the standard. [IAS 36 para 12].
What indicators of impairment should management consider?
Solution
Specific indicators relevant to the pharmaceutical entity include:
development of a competing drug;

changes in the legal framework covering patents, rights or licences;
failure of the drug’s efficacy after a mutation in the disease that it is supposed
to treat;
advances in medicine and/or technology that affect the medical treatments;
lower than predicted sales;

impact of adverse publicity over brand names;
changes in the economic lives of similar assets;
litigation;
relationship with other intangible or tangible assets; and
changes or anticipated changes in participation rates or reimbursement
policies of insurance companies, Medicare and governments for drugs and
other medical products.
1.33 Indicators of impairment – property, plant and equipment

Background
Pharmaceutical entity GloPharma Ltd announced a withdrawal of a marketed product from the market, due to
unfavourable study results. Management informed healthcare authorities that patients should no longer be treated with
that product. The property, plant and equipment (PPE) is either dedicated specifically to the production of the terminated
product, or it has no foreseeable future alternative use.
Relevant guidance
An entity should assess, at the end of each reporting period, whether an asset might be impaired. [IAS 36 para 9].
An entity should consider internal and external sources of information that indicate that there might be an adverse effect
on an asset. [IAS 36 para 12].
The carrying amount of an asset shall be reduced to its recoverable amount if, and only if, the recoverable amount is less
than its carrying amount. That reduction is an impairment loss. [IAS 36 para 59].
Should an impairment test be carried out for GloPharma?
Solution
Management should carry out an impairment test, because there is a trigger for impairment. The withdrawal of the
product from the market will adversely affect how the property, plant and equipment are used, since there is no
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Solution
alternative use. Management should consider whether this event is an impairment trigger for any other assets held.
Any intangible recognised in connection with the marketed product is also likely to be impaired.
1.34 Acquired compound where development is terminated

Background
Pharmaceutical entity Seurat Pharmaceutical has acquired a new drug compound that is currently in Phase I clinical
development. Seurat has capitalised the costs for acquiring the drug as an intangible asset. Soon after acquisition of the
drug, the results of the Phase I clinical trials show that the drug is not likely to be effective for the intended therapy.
Management terminates development of the drug for the intended therapy.
Relevant guidance
An intangible asset with a finite useful life should be amortised on a systematic basis over its useful life. Amortisation
begins when the asset is available for use in the manner intended by management. [IAS 38 para 97].
The carrying amount of an asset shall be reduced to its recoverable amount if, and only if, the recoverable amount is less
than its carrying amount. That reduction is an impairment loss. [IAS 36 para 59].
The recoverable amount of an asset is the higher of its fair value less costs of disposal and its value in use. [IAS 36 para
18].
How should Seurat account for the drug compound?
Solution
Seurat should not start to amortise the intangible asset when it is acquired, because it is not ready for use. The poor
results of the clinical trials indicate that the intangible asset might be impaired. Management must perform an
impairment test on the asset or relevant cash-generating unit and it might have to write it down to the higher of the fair
value less costs of disposal and the value in use.
1.35 Acquired compound used in combination therapy

Background
Pharmaceutical entity Picasso Pharma has acquired a new drug compound that is currently in Phase I clinical
development. Picasso has capitalised the costs of acquiring the new drug compound as an intangible asset.
Subsequently, Picasso’s scientists detect that the new drug substance is much more effective when used in a
combination therapy with another drug. Management stops the current development activities for the new drug.
New Phase I clinical trials are started for the combination therapy.
Relevant guidance
An intangible asset with a finite useful life should be amortised on a systematic basis over its useful life. Amortisation
begins when the asset is available for use in the manner intended by management. [IAS 38 para 97].
How should Picasso account for the new drug compound?
Solution
Picasso should not amortise the intangible asset subsequent to its acquisition, because it is not yet available for use.
Picasso should start amortising the intangible asset when the combination therapy obtains regulatory approval and is
available for use.
The intangible asset is not impaired by cessation of development of the initial drug compound as a stand-alone
product. The intangible asset continues to be developed by Picasso, who expect to create more value with it by using
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Solution
the new drug compound as part of a combination.
1.36 Impairment of IPR&D prior to approval

Background
Pharmaceutical entity Dali Pharmaceuticals has capitalised separately acquired IPR&D as an intangible asset. Dali
identified side-effects associated with the compound during development that indicate that its value is severely diminished
and an impairment charge must be recognised.
Relevant guidance
Impairment is shown as a separate line item in an income statement for expenses that are classified by nature. Impairment
is included in the function(s) that it relates to if expenses are classified by function. [IAS 1 para 99].
Where should Dali classify impairment charges on development intangible assets before such assets are available for use?
Solution
Dali should classify the impairment charge relating to the unapproved drug as a component of R&D expense if
presenting the income statement by function. Dali should classify the charge as an impairment charge if presenting
the income statement by nature of expense.
1.37 Impairment of development costs after regulatory approval

Background
Pharmaceutical entity Dali Pharmaceuticals has capitalised development costs as an intangible asset relating to a drug
that has been approved and is being marketed. Competitive pricing pressure from the early introduction of generic drugs
causes Dali to recognise an impairment of the intangible asset.
Relevant guidance
Impairment is shown as a separate line item in an income statement for expenses that are classified by nature. Impairment
is included in the function(s) that it relates to if expenses are classified by function. [IAS 1 para 99].
Where should Dali classify impairment charges on development intangible assets that are currently marketed?
Solution
Dali should classify the impairment consistently with the amortisation expense, usually in cost of goods sold, if
presenting the income statement by function. Dali should classify the charge as an impairment charge if presenting
the income statement by nature of expense.
1.38 Single market impairment accounting

Background
Pharmaceutical entity Veronese SpA acquired the rights to market a topical fungicide cream in Europe. The acquired rights
apply broadly to the entire territory. Patients in Greece prove far more likely to develop blisters from use of the cream,
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causing Veronese to withdraw the product from that country. Fungicide sales in Greece were not expected to be
significant.
Relevant guidance
An entity should assess, at each reporting date, whether there is any indication that an asset might be impaired. If any
such indication exists, the entity should estimate the recoverable amount of the asset. [IAS 36 para 9].
In assessing whether there is any indication that an asset might be impaired, an entity should consider significant changes
with an adverse effect on the entity that have taken place during the period, or are expected to take place in the near
future, in the extent to which, or manner in which, an asset is used or is expected to be used. [IAS 36 para 12(f)].
How should Veronese account for the withdrawal of a drug’s marketing approval in a specific territory?
Solution
The cash-generating unit for the marketing right, in this example, is viewed as sales from Europe. There is an
impairment trigger if there is a significant change with an adverse effect on the entity. Veronese should decide whether
the withdrawal from Greece is considered significant. Veronese’s management should carefully consider whether the
blistering in one jurisdiction is indicative of potential problems in other territories. An impairment test should be
performed if the issue cannot be isolated.
Any development costs that Veronese has capitalised specifically for achieving regulatory approval in Greece must be
written off, following the withdrawal of the product from the territory.
1.39 Reversals of impairment losses (cost model)

Background
Pharmaceutical entity Rubens Corp markets a weight-loss drug, for which development costs have been capitalised. A
competing drug was launched on the market with much lower pricing. Rubens recognised an impairment of the capitalised
development intangible asset, due to a reduction in the amounts that it estimated that it could recover as a result of this
rival drug. The competing drug was subsequently removed from the market because of safety concerns. The market share
and forecast cash flows generated by Rubens’ drug significantly increased.
Relevant guidance
An impairment loss recognised in prior periods for an asset accounted for under the cost model is reversed if there has
been a change in the estimates used to determine the asset’s recoverable amount since the last impairment loss was
recognised. The carrying amount of the asset is increased to its recoverable amount, but it should not exceed its carrying
amount adjusted for amortisation or depreciation if no impairment loss had been recognised for the asset in prior years.
That increase is a reversal of an impairment loss. [IAS 36 para 114].
A reversal of an impairment loss reflects an increase in the estimated service potential of an asset, either from use or from
sale, since the date when an entity last recognised an impairment loss for that asset. An entity must identify the change in
estimate that causes the increase in estimated service potential. [IAS 36 para 115].
How should Rubens account for reversals of impairment losses for intangible assets accounted for under the cost model?
Solution
The competing drug withdrawal is a reverse indicator. An impairment test should be performed, comparing the
carrying amount to the recoverable amount. The revised carrying value of the intangible asset cannot exceed the
amount, net of amortisation, that would have been recognised if no impairment charge had been recognised.
1.40 Impairment testing and useful life

17
Background
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Pharmaceutical entity Fra Angelico Inc has a major production line that produces its blockbuster antidepressant. The
production line has no alternative use. A competitor launches a new antidepressant with better efficacy. Angelico expects
sales of its drug to drop quickly and significantly. Management identifies this as an indicator of impairment, although
positive margins are forecast to continue. Management might exit the market for this drug earlier than previously
contemplated.
Relevant guidance
An entity should assess, at each reporting date, whether there is any indication that an asset might be impaired. If so, the
entity estimates the recoverable amount of the asset. [IAS 36 para 9].
The recoverable amount is defined as the higher of an asset’s fair value less costs to sell and its value in use [IAS 36 para
18]. If either of these amounts exceeds the asset’s carrying amount, no impairment is indicated and the other amount does
not have to be calculated. [IAS 36 para 19].
If there is an indication that an asset might be impaired, this could indicate that the remaining useful life or residual value
needs to be reviewed and potentially adjusted, even if no impairment loss is recognised for the asset. [IAS 36 para 17].
How should Angelico assess the impairment and useful lives of long-lived assets where impairment indicators have been
identified?
Solution
Angelico must evaluate the carrying value of the antidepressant’s cash-generating unit (including the production line)
for impairment relative to its recoverable amount. The recoverable amount is likely to exceed the asset’s carrying
value, given the margin achieved on the remaining sales. Angelico could determine that no impairment is required.
Angelico should also reduce the remaining useful life to the revised period that sales are expected over.
2. Manufacturing & supply chain
2.1 Treatment of trial batches in development

Background
A laboratory has just completed the development of a machine to mix components at a specified temperature to create a
new formulation of aspirin. The laboratory produces several batches of the new aspirin formulation, using the new
machinery to obtain validation (that is, approval for the use of the machine) from the relevant regulatory authorities. The
validation of the machinery is a separate process from the regulatory approval of the new formulation of aspirin. As the
new aspirin formulation has not received regulatory approval (the drug is in phase II), the trial batches cannot be sold.
Relevant guidance
Inventories are assets that are [IAS 2 para 6]:
a. held for sale in the ordinary course of business;

b. in the process of production for a sale in the ordinary course of business; or
c. materials or supplies that will be used in the production process or rendering of services.
How should management account for the trial batches?
Solution
The trial batches do not have any alternative future use and the technical feasibility of the drug is not proven. The trial
batches should be charged to research and development expenses in the income statement when they are produced.
2.2 Treatment of validation batches

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Background
A laboratory has just completed the development of a machine to mix components at a specified temperature to create a
new formulation of aspirin. The laboratory produces several batches of the aspirin, using the new machinery, to obtain
validation (that is, approval for the use of the machine) from the relevant regulatory authorities. The validation of the
machinery is a separate process from the regulatory approval of the new formulation of aspirin.
Relevant guidance
The cost of an item of property, plant or equipment (PPE) includes the asset’s purchase price and any directly attributable
costs of bringing the asset to its working condition, as well as any demolition or restoration costs. [IAS 16 para 16].
Examples of costs that can not be capitalised as PPE are the costs of opening a new facility, the costs of introducing a
new product or service, the costs of conducting business with a new class of customer, administration and other general
overhead costs. [IAS 16 para 19].
Should expenditure to validate machinery be capitalised?
Solution
The laboratory should capitalise the cost of the materials used to obtain the necessary validation for the use of the
machinery, together with the cost of the machinery. Validation is required to bring the machinery to its working
condition. The cost of the labour involved in the production process should also be capitalised, if it can be directly
attributed to the validation process. However, management should exclude abnormal validation costs caused by
errors or miscalculations during the validation process (such as wasted material, labour or other resources).
2.3 Development supplies and consumables

Background
Pharma Co has purchased supplies and consumables for use in research activities. Pharma Co is also able to resell them
for at least cost if they are not used, but this is not Pharma Co’s intention.
Relevant guidance
1. held for sale in the ordinary course of business;

2. in the process of production for a sale in the ordinary course of business; or
3. materials or supplies that will be used in the production process or rendering of services.
Intangible assets are identifiable non-monetary assets without physical substance [IAS 38 para 8].
No intangible asset arising from research (or from the research phase of an internal project) shall be recognised.
Expenditure on research (or on the research phase of an internal project) shall be recognised as an expense when it is
incurred. [IAS 38 para 54].
The cost of an internally generated intangible asset comprises all directly attributable costs necessary to create, produce,
and prepare the asset to be capable of operating in the manner intended by management. Examples of directly
attributable costs include:
a. costs of materials and services used or consumed in generating the intangible asset;
.....
[IAS para 66].
Expenditure on an intangible item is recognised as an expense when it is incurred unless it forms part of the cost of an
intangible asset that meets the recognition criteria in paragraphs 18-67. [IAS 38 para 68].
In some cases, expenditure is incurred to provide future economic benefits to an entity, but no intangible asset or other
asset is acquired or created that can be recognised. In the case of the supply of goods, the entity recognises such
expenditure as an expense when it has a right to access those goods. [IAS 38 para 69].
The conceptual framework notes “An economic resource is a right that has the potential to produce economic
benefits….” [CF para 4.14]. “There is a close association between incurring expenditure and generating assets but the two
do not necessarily coincide. Hence, when an entity incurs expenditure, this may provide evidence that future economic
benefits were sought but is not conclusive proof that an item satisfying the definition of an asset has been obtained.
Similarly, the absence of a related expenditure does not preclude an item from satisfying the definition of an asset and
thus becoming a candidate for recognition in the balance sheet; for example, items that have been donated to the entity
may satisfy the definition of an asset.” [CF para 4.18].
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When should the supplies and consumables purchased for use in research activities be expensed?
Solution
The supplies and consumables do not meet the definition of inventory because they are not held for sale or
consumption in the production of goods to be sold.
The supplies and consumables do not meet the definition of an intangible asset as they have physical substance.
However, the supplies and consumables do meet the definition of an ‘other asset’ since Pharma Co is able to resell
them for at least cost if they are not used, even though they were not purchased with that intention. They should
therefore be recognised as an asset (supplies and consumables) at the lower of cost and recoverable amount.
Until such time as the supplies and consumables are used in research activities (which might be when they are
specifically labelled for that purpose), they have the potential to generate economic benefits given they have an
alternative use, and therefore they are recognised as an ‘other asset’ even if the intention is to ultimately use them in
research activities. This is because the supplies and consumables are not in the scope of IAS 38 if an ‘other asset’ can
be recognised which is the case if the entity has an alternative use for the goods.
The supplies and consumables are in the scope of IAS 38 when they are used in research activities and the
associated cost forms part of research and development expenses recognised in the income statement unless the
criteria for capitalisation in IAS 38 para 57 are met. In this scenario, IAS 38 para 69 does not apply given the potential
for the goods to be used in other activities gives rise to an ‘other asset’ (that is, have an alternative use) prior to the
research activity taking place; for example, goods that could be resold for at least cost if not used
In September 2017 the IFRIC considered an issue in relation to goods acquired by a pharmaceutical entity for
promotional activities (the goods in question were refrigerators, air conditioners and watches). In the fact pattern, the
goods acquired were to be used solely in undertaking promotional activities. The conclusion reached was to expense
the goods when the entity acquired them. The fact pattern considered by the IFRIC differs from this scenario as there
was no mention of the entity having the substantive ability to use the goods in an alternative way. The agenda
decision concluded that the entity in question had no other purpose for the acquired goods other than to use them for
promotional activities and so the only benefit of the goods was to develop or create intangible assets that would fail
the IAS 38 criteria for capitalisation. Therefore, unlike this scenario, there was no ‘other asset’ on acquisition of the
goods.
2.4 Recognition of raw materials as inventory

Background
Pharma Corp buys bulk raw materials for use in manufacturing a variety of commercialised drugs for sale. The
manufactured drugs are also sometimes used as marketing samples and in R&D activities. The manufactured drugs are
warehoused in a common facility and are released based on orders from the sales, marketing and R&D departments.
Relevant guidance

b. in the process of production for such sale; or
c. in the form of materials or supplies to be consumed in the production process or in the rendering of services.
How should the purchased materials be accounted for when their ultimate end use is not known?
Solution
Pharma Corp should account for the raw materials as inventory, because they are used to manufacture
commercialised drugs. The manufactured drugs are accounted for as inventory as they are primarily held for sale. The
manufactured drugs should be accounted for as a marketing expense when they are used for marketing samples. The
manufactured drugs should be accounted for as R&D when they are used for R&D. The R&D should be accounted for
consistently with the treatment of other R&D expenses related to the product under development.
2.5 Pre-launch inventory produced before regulatory approval

Reference to standard: IAS 38 para 57, IAS 2 para 6, IAS 2 para 28, IAS 2 para 33
Background
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Pharmaceutical entity Van Eyck Ltd has an asthma drug in development. Management has determined that the drug has
not yet met the criteria in paragraph 57 of IAS 38 to allow capitalisation of development costs. Management believes that
there is a 40% likelihood that development will succeed and that final regulatory approval will occur in the short term. Van
Eyck takes the risk of building inventories of the finished product in order to facilitate immediate launch after regulatory
approval. The inventory has no alternative use.
The inventory building begins with small production runs prior to final regulatory approval and it continues after the
approval.
Relevant guidance

The practice of writing inventories down below cost to net realisable value is consistent with the view that assets should
not be carried in excess of amounts expected to be realised from their sale or use. [IAS 2 para 28].
A new assessment is made of net realisable value in each subsequent period. When the circumstances that previously
caused inventories to be written down below cost no longer exist, or when there is clear evidence of an increase in net
realisable value because of changed economic circumstances, the amount of the write-down is reversed. [IAS 2 para 33].
What is the carrying amount of pre-launch inventory?
Solution
Van Eyck’s management does not believe that the asthma drug has achieved technological feasibility prior to final
Inventory manufactured prior to this approval is immediately provided for and written down to zero (that is, the
probable amount expected to be realised from its sale at the time of production). The write-down should be
recognised in cost of goods sold or as R&D expense, according to its policy.
When Van Eyck has demonstrated the probability of the technological feasibility of the drug, by obtaining final
regulatory approval, it begins to capitalise the inventory costs. The provision recognised prior to approval should also
be reversed, up to no more than the original cost. The reversal should also be recognised through cost of goods sold
or as R&D expense, as applicable.
2.6 Treatment of inventory of ‘in-development’ drugs after filing

Background
Laboratory A has produced 15,000 doses of a new drug, following submission of the final filing for regulatory approval, so
that it can go to market with the drug as soon as it obtains regulatory approval. The doses cannot be used for any other
purpose. Management is considering whether the doses should be recognised as inventory.
Relevant guidance

b. in the process of production for a sale in the ordinary course of business; or
c. materials or supplies to be used in the production process.
Inventories shall be measured at the lower of cost and net realisable value. [IAS 2 para 9]
How should the costs associated with the production of inventory for ‘in development’ drugs be accounted for?
Solution
Laboratory A should recognise the doses that it has produced as inventory at the lower of cost and net realisable
value. Final filing for regulatory approval indicates that marketing approval is probable. Therefore, the cost of these
items of inventory can be treated as fully recoverable; that is, the net realisable value is not zero.
2.7 Treatment of inventory of ‘in-development’ generic drugs
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Background
Pharmaceuticals entity Tina Pharmaceuticals developed a generic version of an original drug whose patent is due to expire
at the end of 20X3. Management believed that the generic version was the chemical equivalent of the original drug and
that economic benefits were probable. Deeming that it had met the recognition criteria in paragraph 57 of IAS 38, it
therefore began to capitalise development costs in May 20X3.
Tina produced 15,000 doses of pre-launch inventory of the generic drug in June 20X3. The doses cannot be used for any
other purpose. The patent on the original drug expired and marketing approval for the generic version was received in
November 20X3. Management is considering whether the cost of the pre-launch inventory should be capitalised in its
financial statements as at 31 October 20X3.
Relevant guidance

How should the costs associated with the production of inventory for generic drugs ‘in development’ be accounted for?
Solution
Pre-launch inventory should be recognised as inventory at the lower of its cost and net realisable value.
Management’s conclusion to capitalise development costs is an indication that the generic drug is economically viable
and so it appears reasonable to assume that the pre-launch inventory costs will be realised through future sales.
The marketing approval received after year end is a subsequent event that confirms management’s year end
assessment.
2.8 Accounting for vaccine cultures in manufacturing of pharmaceutical

products
Background
Pharmaceuticals entity Caravaggio Corp’s leading product is a vaccine. The vaccine’s antibody is produced using virus
cultures. These cultures and the resulting antibody are an important part of Caravaggio’s total inventory costs.
Relevant guidance
IAS 2 applies to all inventories, except biological assets related to agricultural activity and agricultural produce at the point
of harvest. [IAS 2 para 2].
A ‘biological asset’ is a living animal or plant. [IAS 41 para 5].
A biological asset should be measured on initial recognition, and at each balance sheet date, at its fair value less
estimated point of sale costs. [IAS 41 para 12].
Should vaccine cultures used in the production of pharmaceutical products be measured at cost or at fair value less cost
to sell?
Solution
A virus is not a living plant or animal and is outside the scope of IAS 41. Caravaggio should account for its production
of vaccine cultures at cost as a component of inventories, following the guidance of IAS 2.
2.9 Indicators of impairment – inventory

Background
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Pharmaceutical entity Cerise has decided to temporarily suspend all operations at a certain production site, due to
identified quality issues. Cerise initiated a recall of products manufactured on the site. Cerise carries a significant amount
of inventory used in the manufacture of the product.
Relevant guidance
Inventories should be measured at the lower of cost and net realisable value. [IAS 2 para 9]. An entity should not carry its
inventory at values in excess of amounts expected to be realised from its sale or use. [IAS 2 para 28]. Management should
make a new assessment of the net realisable value in each subsequent period. [IAS 2 para 33].
Is the inventory used to manufacture the product impaired?
Solution
Cerise would need to consider all available evidence to determine if there is an impairment. Suspending production
and a product recall are indicators that the carrying value of raw material inventory used to manufacture the drug
might not be recoverable. Cerise would need to evaluate the reason for the recall, its history with past recalls, the
likelihood that the quality issue could be fixed and whether the raw materials have an alternative manufacturing use. In
addition to product recalls, the following events are impairment indicators within the pharmaceuticals and life sciences
industries:
patent expiration;
failure to meet regulatory or internal quality requirements;
product or material obsolescence;

market entrance of competitor products; and
changes or anticipated changes in third-party reimbursement policies that will
impact the selling price of the inventory.
3. Funding for R&D
3.1 Capitalisation of interest on loans received to fund R&D

Background
Pharmaceutical entity Pilax has obtained a loan from Qula, another pharmaceutical entity, to finance the late-stage
development of a drug to treat cancer. Pilax management has determined that the criteria for capitalisation are met after
filing for regulatory approval, because it is confident that approval will be received. Pilax capitalises borrowing costs on
qualifying assets, as required by IAS 23.
Relevant guidance
An entity should capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a
qualifying asset as part of the cost of that asset. An entity should recognise other borrowing costs as an expense in the
period in which it incurs them. [IAS 23 para 8]. A qualifying asset is an asset that necessarily takes a substantial period of
time to prepare for its intended use or sale. [IAS 23 para 5].
The cost of an internally generated intangible asset includes all directly attributable costs necessary to create, produce
and prepare the asset to be capable of operating in the manner intended by management. [IAS 38 para 66]. Allocations of
overheads are made on bases similar to those used in allocating overheads to inventories. IAS 23 specifies criteria for the
recognition of interest as an element of the cost of an internally generated intangible asset. [IAS 38 para 66].
Can Pilax capitalise the interest incurred for borrowings obtained to finance R&D activities?
Solution
Borrowing costs incurred before capitalisation of development costs are expensed. Borrowing costs should be
capitalised for qualifying assets once development costs are being capitalised. Capitalisation of borrowing costs
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Solution
should cease once the drug has been fully developed and is available for sale.
3.2 Funding for Phase III trials

Reference to standard: IAS 32 para 11, IAS 32 para 20(a), IAS 32 para 25, IFRS 9
para B5.4.6
Background
Pharmaceutical entity Tiepolo Pharma is developing a pharmaceutical compound, compound X, that has successfully
passed through Phase II clinical trials. A venture capital entity, Randolph Ventures, offers to fund, for Tiepolo, the Phase III
clinical trial studies and all registration costs. The study results and documentation will be the property of Randolph. The
terms of the agreement are:
Randolph will keep any trial results, if compound X fails in Phase III, and Tiepolo
will transfer the underlying intellectual property (IP).
Tiepolo has an obligation to acquire the studies and documentation if compound
X achieves regulatory approval. Tiepolo will pay a milestone on regulatory
approval equal to 150% of the estimated total development costs. Tiepolo will
also pay a 5% royalty on sales for five years.
Randolph subcontracts Tiepolo as a contract research provider to perform the necessary development activities for Phase
III clinical trials on its behalf.
Tiepolo will plan and carry out the necessary clinical development project. Tiepolo has a best efforts clause to continue to
develop compound X.
Relevant guidance
A financial liability is any liability that is a contractual obligation to deliver cash or another financial asset to another
entity. [IAS 32 para 11].
A financial instrument may contain a non-financial obligation that must be settled if, and only if, the entity fails to make a
distribution or to redeem the instrument. If the entity can avoid the transfer of cash or another financial asset only by
settling the non- financial obligation, the financial instrument is a financial liability. [IAS 32 para 20(a)].
A financial instrument might require the entity to deliver cash or another financial asset, or otherwise to settle it in such a
way that it would be a financial liability, in the event of the occurrence or nonoccurrence of uncertain future events or on
the outcome of uncertain circumstances. The issuer of such an instrument does not have the unconditional right to avoid
delivering cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability). [IAS 32
para 25].
1. Has Tiepolo lost control of compound X?
2. How should Tiepolo account for the funding received?
Solution
1. Has Tiepolo lost control of compound X?
Tiepolo has a contract to conduct development services and the obligation to acquire the outcome of the Phase III
studies if the study result is successful. At inception of the contract, the potential future economic benefits for the
owner of the Phase III study are limited. There is no alternative use for the study outcome without the patented IP for
the underlying compound. Tiepolo directs the Phase III trials. Tiepolo has not lost control of compound X.
2. How should Tiepolo account for the funding received?
Randolph has provided funding for Phase III trials. The contract stipulates that Tiepolo pays back 150% of the cash
and a sales-based royalty if the Phase III trials are successful. Tiepolo must transfer the IP of compound X if the trial is
unsuccessful. Tiepolo must pay cash contingent on a condition outside its control (that is, successful completion of
Phase III). It can avoid paying cash only by the settlement of a non-financial obligation (the IP). This meets the
definition of a financial liability. [IAS 32 para 20(a)].
A financial liability should be measured initially at fair value. Subsequently the liability would be measured at amortised
cost. If Tiepolo revises its estimates of payments, it should adjust the carrying amount of the liability. This adjustment
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Solution
would be charged to the income statement. Passage of time is dealt with through the unwind of the discount and also
charged to the income statement. [IFRS 9 para B5.4.6].
Results:
In case of failure – Tiepolo should derecognise the financial liability. Any intangible asset on the balance sheet for
compound X should be derecognised and the balance should go to the income statement.
In case of success – An adjustment to the liability in accordance with paragraph B5.4.6 is required if successful. [IFRS
9 para B5.4.6]. Tiepolo would need to estimate the future royalty payable and recognise a further financial liability.
R&D funding arrangements are a complex and judgemental area. Each structure should be evaluated on its specific
facts and circumstances.
3.3 Loans and grants from government/charitable organisations to fund

R&D
Reference to standard: IAS 32 para 11, IAS 32 para 25, IAS 32 para 20(a), IAS 20
para 10A
Background
Pharmaceutical start-up Warhol Inc is a small start-up entity and has obtained financing from the government in country A.
The financing, in cash, will be used for a research project for the development of a drug.
The cash is repayable to the government only if Warhol decides to exploit and commercialise the results of the research
project. The repayment terms require Warhol to repay an amount equal to 10% of sales per year if it starts selling the drug.
Warhol should transfer all of the intellectual property to the government, if the project is unsuccessful or if Warhol decides
to abandon the project.
Relevant guidance
A financial liability is any liability that is a contractual obligation to deliver cash or another financial asset to another
entity. [IAS 32 para 11].
A financial instrument might contain a non-financial obligation that must be settled if the entity fails to make distributions or
to redeem the instrument. If the entity can avoid a transfer of cash or another financial asset only by settling the non-
financial obligation, the financial instrument is a financial liability. [IAS 32 para 20(a)].
A financial instrument might require the entity to deliver cash or another financial asset, or otherwise to settle it in such a
way that it would be a financial liability, in the event of the occurrence or non-occurrence of uncertain future events or on
the outcome of uncertain circumstances. The issuer of such an instrument does not have the unconditional right to avoid
delivering cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability). [IAS 32
para 25].
A benefit of a government loan at below market rate of interest is treated as a government grant. The loan should be
recognised and measured in accordance with IFRS 9. The benefit should be measured as the difference between the initial
carrying value of the loan and the proceeds received. The benefit is accounted for in accordance with IAS 20. [IAS 20 para
10A].
How should the entity account for the loan obtained from the government?
Solution
The loan meets the definition of a financial liability under IAS 32 and it should be accounted for in accordance with
IFRS 9. The entity can avoid delivering cash only by settling the obligation with the intellectual property and research
results. The liability is initially recognised at fair value and any difference between the cash received and the day one
fair value of the liability is a government grant. This is accounted for under IAS 20.
3.4 Venture capital company funds Phase III through a new company
Reference to standard: IFRS 10 para 7, IFRS 10 para 12, IFRS 10 para 15, IFRS 10
para B53
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Background
Pharma, a large pharmaceutical entity, has a number of internally developed compounds that have successfully reached
Phase II. Pharma can only continue to develop a selection of these compounds, based on resource constraints. A venture
capital entity , VC, offers to fund Phase III trials in return for a success payment. VC sets up a new entity, DevCo, and
Pharma grants DevCo a licence to carry out the Phase III development and to seek regulatory approval. The licence
agreement stipulates that DevCo will make best efforts to continue development. DevCo will outsource the Phase III trials
to a contract research organisation, CRO. VC cannot sell DevCo and DevCo cannot sell any compounds to third parties.
Pharma holds a call option to purchase 100% of DevCo. The option can be exercised on successful completion of Phase
III at a price based on three times the R&D expenditure. VC holds a put option whereby, on successful completion of
Phase III, it can exercise the option to sell DevCo at three times the R&D expenditure back to Pharma (that is, a success
payment).
Relevant guidance
An investor controls an investee if, and only if, the investor has all of the following [IFRS 10 para 7]:
a. power over the investee;

b. exposure, or rights, to variable returns from its involvement with the investee; and
c. the ability to use its power over the investee to affect the amount of the investor’s returns.
An investor with the current ability to direct the relevant activities has power, even if its rights to direct have yet to be
exercised. Evidence that the investor has been directing relevant activities can help to determine whether the investor has
power, but such evidence is not, in itself, conclusive in determining whether the investor has power over an investee. [IFRS
10 para 12].
An investor is exposed, or has rights, to variable returns from its involvement with the investee when the investor’s returns
from its involvement have the potential to vary as a result of the investee’s performance. The investor’s returns can be only
positive, only negative, or both positive and negative. [IFRS 10 para 15].
Which party has control of DevCo?
Solution
Pharma controls DevCo and so it will consolidate. Control requires power over relevant activities, exposure to variable
returns, and a link between power and returns under IFRS 10. Control assessments are straightforward for an entity
controlled by voting rights. A structured entity exists where control is exercised by other means. The other means can
include participating in the determination of purpose and design of the structured entity and asset selection,
contractual arrangements, potential voting rights, contingent rights, as well as power over activity that happens
outside the structured entity, but is relevant to it.
Power over relevant activities
A relevant activity is an activity that significantly affects returns. The ultimate return from each product comes from the
original compound. The development that DevCo carries out will be successful or unsuccessful, based on the
underlying science. Asset selection is, therefore, the most relevant activity. Although Pharma and VC agree the
selection together, Pharma chooses the original set of compounds on offer. Pharma also retains the IP for the
compound. When assessing control, the purpose and design of the investee should be considered and, again, this
would suggest that asset selection is key. This is because, without it, there would be no purpose to DevCo.
Exposure to variable returns
Pharma has a nil or variable positive return on the compound. If the compound is unsuccessful, it has a nil return. If
the compound is successful, its return will be based on future sales. Paragraph 15 of IFRS 10 states that returns can
be wholly positive or negative. Pharma also has the ability to affect the returns through the initial asset selection and
its marketing efforts.
Rights over those returns
Paragraph B53 of IFRS 10 notes that the rights do not have to be currently exercisable, provided that the investor can
exercise its rights when the key decisions over relevant activities need to be made. This is likely to be when the
successful drug is returned to Pharma, gains regulatory approval and is brought to market.
4. Business combinations & asset acquisitions
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4.1 Accounting for acquired IPR&D

Reference to standard: IFRS 3 Appendix B para B31, IFRS 3 para 18, IAS 38 para
88, IAS 38 para 108, IAS 38 para 110, IAS 38 para 111, IAS 38 para 97
Reference to standing text: 29.110, 29.100, 21.102, 21.131, 21.115, 21.129, 21.123
Background
Pharmaceutical entity Alpha owns the rights to several product (drug compound) candidates. Alpha’s activities only consist
of research and development performed on the product candidates. Delta, also in the pharmaceutical industry, acquires
Alpha, including the rights to all of Alpha’s product candidates, testing and development equipment, and it hires all of the
scientists formerly employed by Alpha, who are integral to developing the acquired product candidates. Delta accounts for
this transaction as an acquisition of a business.
Relevant guidance
An entity should recognise the identifiable intangible assets acquired [IFRS 3 para B31] at the acquisition date fair
value. [IFRS 3 para 18].
An entity should assess whether the useful life of an intangible asset is finite or indefinite. An intangible asset should be
regarded by the entity as having an indefinite useful life when there is no foreseeable limit to the period over which the
asset is expected to generate net cash inflows. [IAS 38 para 88].
Assets with indefinite useful life should be tested annually for impairment, or when indications for impairment exist. [IAS 38
para 108]. If there is a change of useful economic life, from indefinite to finite, this is also considered to be an indicator for
impairment. [IAS 38 para 110]. Assets with a finite useful life should be tested for impairment when indications for
impairment exist. [IAS 38 para 111].
Amortisation of an intangible asset should begin when the asset is available for use. [IAS 38 para 97].
How should Delta account for the acquired IPR&D?
Solution
Research and development projects acquired as part of a business combination are recognised as an intangible
asset, if they can be reliably measured. Delta should measure the acquired IPR&D at its acquisition date fair value.
Acquired IPR&D would normally not be amortised, since it is not available for use until an approved product is
commercialised.
The acquired IPR&D would be tested for impairment annually or more frequently, whenever an impairment indicator is
identified. The impairment test would compare the recoverable amount of the IPR&D asset to its carrying value.
Subsequent expenditure incurred should be accounted for in accordance with IAS 38:
Research expenditure should be expensed.

Development expenditure should be expensed, provided that the relevant
criteria in IAS 38 are not met (usually until regulatory approval has been
achieved).
When the IPR&D becomes available for use, it should be amortised over its useful economic life.
4.2 Acquisition of a Biotech entity – one IPR&D project

Reference to standard: IFRS 3 Appendix B para B7A, IFRS 3 Appendix B B7B
Reference to standing text: FAQ 29.6.1, 29.7-29.19
Background
Pharma Co purchases from Biotech a legal entity that contains the rights to a Phase III compound developed to treat
diabetes. Included in the IPR&D is the historical know-how, formula protocols, designs and procedures expected to be
needed to complete the related phase of testing. The legal entity also holds an at-market contract research organisation
(CRO) contract and an at-market contract manufacturing organisation (CMO) contract. No employees, other assets or
other activities are transferred.
Pharma Co has decided to apply the optional concentration test.
Relevant guidance
IFRS 3 sets out an optional concentration test to permit a simplified assessment of whether an acquired set of activities
and assets is not a business. If the concentration test is met the acquisition is an asset acquisition and no further
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assessment is needed. [IFRS 3 para B7A]. The concentration test is met if substantially all of the fair value of the gross
assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets. [IFRS 3 para B7B].
Is the arrangement the acquisition of a business under IFRS 3?
Solution
No. Pharma Co elects to apply the optional concentration test and would conclude that this is an asset acquisition.
Although CRO and CMO contracts were acquired, the terms of these contracts are at market rates and therefore have
little fair value. When the fair value of the acquired IPR&D is compared to the consideration paid, it is clear that
substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset; that is the
IPR&D.
4.3 Acquisition of a Biotech entity – two IPR&D projects

Reference to standard:IFRS 3 Appendix B para B7A, IFRS 3 Appendix B B7B, IFRS
3 Appendix B B12B, IFRS 3 Appendix B B12D
Reference to standing text:FAQ 29.6.1, 29.7-29.19
Background
Pharma Co purchases from Biotech a legal entity that contains rights to two Phase 3 compounds developed to treat
diabetes and Alzheimer’s. Included in the IPR&D is the historical know-how, formula protocols, designs and procedures
expected to be needed to complete the related phase of testing. The legal entity also holds an at market value CRO
contract. The research could be performed by a number of CROs. No employees, other assets or other activities are
transferred.
Relevant guidance
The optional concentration test includes the concept of aggregating ‘similar’ assets. [IFRS 3 para B7B]. However, a group
of intangibles are not similar if they have significantly different risk characteristics. [IFRS 3 Appendix B para B7B(f)(vi)].
A business consists of inputs and processes applied to those inputs that have the ability to create outputs. [IFRS 3
Appendix B paras B7].
Processes are defined as any system, standard, protocol, convention or rule that creates, or contributes to the creation of,
output. [IFRS 3 Appendix B para B7(b)].
If a set of activities and assets does not have outputs at the acquisition date, an acquired process (or group of processes)
shall be considered substantive only if: a) it is critical to the ability to develop or convert an acquired input or inputs into
outputs; and b) the inputs acquired include both an organised workforce that has the necessary skills, knowledge, or
experience to perform that process (or group of processes) and other inputs that the organised workforce could develop or
convert into outputs. [IFRS 3 Appendix B para B12B].
An acquired contract is an input and not a substantive process. Nevertheless, an acquired contract may give access to an
organised workforce. An entity shall assess whether an organised workforce accessed through a contract performs a
substantive process that the entity controls and, thus, has acquired. Factors to be considered in making that assessment
include the duration of the contract and its renewal terms. [IFRS 3 Appendix B para B12D].
Solution
No. Pharma Co would conclude this is an asset acquisition.
The concentration test is not passed. This is because all of the fair value is not concentrated in a single identifiable
asset as two dissimilar IPR&D compounds have been acquired.
However, Pharma Co would then analyse the transaction referring to the guidance applicable to a set of activities and
assets that do not have outputs. . The acquisition includes an input of IPR&D and a CRO contract. The contract gives
access to an organised workforce that has the necessary skills, knowledge or experience to perform processes
needed to carry out clinical trials. However, the organised workforce cannot develop or convert the IPR&D into
outputs and so would not be considered to be substantive. Successful trials are a pre-condition for producing output
but carrying out those trials will not develop or convert the acquired inputs into outputs.
4.4 Acquisition of a Biotech entity – several IPR&D projects and
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scientists
Reference to standard: IFRS 3 Appendix B para B7B, IFRS 3 Appendix B para B7A,
IFRS 3 Appendix B para B8, IFRS 3 Appendix B B12B
Reference to standing text: FAQ 29.6.1, 29.7-29.19
Background
Pharma Co purchases from Biotech a legal entity that contains rights to several dissimilar IPR&D projects (each having
significant fair value); senior management and scientists who have the necessary skills, knowledge, or experience to
perform R&D activities; and tangible assets (including a corporate headquarters, a research lab and lab equipment).
Biotech does not yet have a marketable product and has not yet generated revenues.
Relevant guidance
The optional concentration test includes the concept of aggregating ‘similar’ assets. [IFRS 3 para B7B]. However, a group
of intangibles are not similar if they have significantly different risk characteristics.[IFRS 3 Appendix B para B7B(f)(vi)].
A transaction is not automatically a business combination if the optional concentration test does not result in the asset
classification. An entity would then need to assess the transaction under the framework in IFRS 3. [IFRS 3 Appendix B
para B7A b)].
IFRS 3 requires a business to include, at a minimum, an input and a substantive process that together significantly
contribute to the ability to create outputs. [IFRS 3 Appendix B para B8].
If a set of activities does not have outputs, an acquired process is considered substantive where [IFRS 3 para B12B]:
a. the process is critical in converting an acquired input to an output;

b. the inputs include an organised workforce that has the necessary skills, knowledge and experience to perform the process; and
c. the inputs include IP, other economic resources that could be developed to create output or rights to obtain or create
materials/future output; examples include IPR&D.
Solution
Yes. Pharma Co would conclude that this is a business combination.
The concentration test failed because the fair value of the assets acquired are not concentrated in a single identifiable
asset or a group of similar identifiable assets. Further analysis is required, following the guidance applicable to a set of
activities and assets that do not have outputs, to assess whether a process is acquired and whether the process is
substantive. A business is acquired, because the organised workforce (senior management and scientists) is a
substantive process. The organised workforce has proprietary knowledge of Biotech’s ongoing projects and
experience with them and has the intellectual capacity that is critical to the ability to develop and convert the inputs
(that is, workforce, IPR&D and tangible assets) into outputs.
4.5 Acquisition - Buyer’s accounting for contingent consideration

Reference to standard: IFRS 9 para 4.2.1(e), IFRS 3 para 58(b)(i)
Background
Alpha is a large pharmaceutical entity that sells and develops drugs. One of its drugs in development, Compound X,
recently received regulatory approval.
Pharmaceutical entity Beta enters into an agreement to acquire Alpha. The acquisition of Alpha by Beta meets the
definition of a business combination as Beta has acquired a business.
Beta makes an up-front cash payment to Alpha of C200m. Company Beta also agrees to pay Alpha the following:
fixed contingent payment of C40m once regulatory approval of Compound X in a

second market is obtained; and
future royalties of 5% of the net revenues of Compound X for the next ten years
payable quarterly.
Relevant guidance
Financial liabilities from contingent consideration in business combinations to which IFRS 3 applies are initially recognised
at fair value and subsequently measured at fair value with changes recognised in profit or loss. [IFRS 9 4.2.1(e)].
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Contingent consideration in the scope of IFRS 9 is measured at fair value through profit or loss. [IFRS 3 para 58(b)(i)].
How should Beta account for the contingent consideration payments due to Alpha?
Solution
Both the fixed contingent payment on regulatory approval and the future royalty payments meet the definition of
contingent consideration under IFRS 3. Beta has a contractual obligation to deliver cash to Alpha and, therefore,
recognises a financial liability at fair value on the date of acquisition as part of the purchase consideration.
Company Beta would need to consider the key inputs of the arrangement and market participant assumptions when
determining the fair value of the contingent consideration, including estimates of the amount, timing and likelihood of
obtaining market approval / expected royalties. The contingent consideration, based on estimated fair values of the
future payments, is measured at fair value through profit or loss until the contingency is resolved.
4.6 Disposals – seller accounting for contingent consideration

Reference to standard: IFRS 10 para B98, IAS 32 para 11, IFRS 9 para 5.1.1, IFRS 9
para 4.1.4
Background
Pharmaceutical entity Alpha sold its entire controlling stake in wholly owned subsidiary Beta, a pharmaceutical business
specialising in oncology treatments, on 1 January 20X1. One of the compounds Subsidiary Beta’s scientists had been
researching (compound X) is close to obtaining market approval. The proceeds from the sale of the subsidiary included:
C180m in cash paid upfront;

a one-off contingent payment of C40 million if subsidiary Beta’s compound X
obtains market approval; and
future royalties of 5% of the net revenues of subsidiary Beta’s compound X for the
next three years from market approval payable quarterly.
The one-off contingent payment of C40 million would be due and payable one market approval is obtained. As of the
transaction date, the fair value of the once-off contingent payment was estimated to be C30m and the fair value of the
future royalty payments was estimated to be C50m. The carrying amount of net assets of subsidiary Beta on the
transaction date was C100m.
Relevant guidance
If a parent loses control of a wholly owned subsidiary, it derecognises the assets (including goodwill) and liabilities of the
subsidiary and recognises the fair value of the consideration received. [IFRS 10 para B98].
A contract to receive contingent consideration meets the definition of a financial asset, because it gives the seller a
contractual right to receive cash when the contingency is resolved. [IAS 32 para 11].
At initial recognition an entity shall measure a financial asset at fair value. [IFRS 9 para 5.1.1].
A financial asset is subsequently measured at fair value through profit and loss if the contractual terms do not give rise on
specified dates to cash flows that are solely payments of principal and interest. [IFRS 9 para 4.1.4].
How should pharmaceutical company Alpha account for the contingent consideration?
Solution
The fair value of the contingent consideration should be included as part of the consideration received in determining
the gain or loss on disposal and it should be classified and measured in accordance with IFRS 9.
The financial asset is required to be classified and measured at FVTPL as the contractual terms of the contingent
consideration do not give rise to cash flows on specified dates that are solely payments of principal and interest.
As a result, Alpha would record a gain of C160 million on the transaction date (initial cash payment of C180m + fair
value of the one-off contingent consideration payment of C30m + fair value of future royalty payments of C50m –
carrying value of net assets of C100m).
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5. Revenue – IFRS 15
5.1 Contract term

Background
Biotech enters into a ten year term licence arrangement with Pharma under which Biotech transfers to Pharma the
exclusive rights to sell products using its intellectual property in a particular territory. The intellectual property is
considered a right of use licence and there are no other performance obligations in the arrangement. Pharma makes a
non-refundable up-front payment of C25 million and is obligated to pay an additional C1 million at the end of each year
throughout the stated term.
Pharma can cancel the contract for convenience at any time, but on cancellation, it must return its rights to the licensed
intellectual property to Biotech. On cancellation, Pharma does not receive any refund of amounts previously paid.
Relevant guidance
Some contracts with customers might have no fixed duration and can be terminated or modified by either party at any
time. Other contracts might automatically renew on a periodic basis that is specified in the contract. An entity should apply
the guidance in the revenue standard to the duration of the contract (that is, the contractual period) in which the parties to
the contract have present enforceable rights and obligations.
[IFRS 15 para 11].
What is the contract term for the purposes of IFRS 15?
Solution
In the scenario above, Biotech would likely conclude that the contract term is ten years, due to the substantive
termination penalty that Pharma would incur if the contract were cancelled prematurely. The substantive termination
penalty in this arrangement is Pharma’s obligation to transfer an asset to Biotech through the return of its exclusive
rights to the licensed intellectual property without refund of amounts paid. Furthermore, since the additional annual
payments are due over a ten year period, it is likely that Biotech will conclude that the arrangement contains a
significant financing component. Therefore, Biotech would recognise C25 million, plus the present value of the C1
million payments due at the end of each year throughout the stated term, on transferring control of the right of use
licence.
The assessment of whether a substantive termination penalty is incurred on cancellation could require significant
judgement for arrangements that include a licence of intellectual property. Factors to consider include the nature of
the licence, the payment terms (for example, how much of the consideration is paid up-front), the business purpose of
contract terms that include termination rights and the impact of contract cancellation on other performance
obligations, if any, in the contract. If management concludes that a termination right creates a contract term shorter
than the stated term, management should assess whether the arrangement contains a renewal option that provides
the customer with a material right.
5.2 Contract modifications

Reference to standard: IFRS 15 para 18, IFRS 15 para 20, IFRS para 21
Background
Pharma A has an arrangement with Pharma B, whereby Pharma A has provided a licence to its oncology drug and is
performing R&D services. Pharma A received a large upfront payment of C50 million. It receives reimbursement at cost for
R&D services throughout the contract term up to a specified budget of C30 million. Pharma A is recognising revenue over
time in a cost-to-cost model as a single performance obligation, because the parties concluded that the licence and the
R&D services were not distinct.
Pharma A and Pharma B enter into an amendment, to increase the budget for R&D on the oncology drug to C40 million.
As a result, Pharma A now expects to incur C10 million of additional R&D costs and to be reimbursed an additional C10
million by Pharma B. No other changes were made as part of this amendment.
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Relevant guidance
A contract modification is a change in the scope or price (or both) of a contract that is approved by the parties to the
contract. In some industries and jurisdictions, a contract modification might be described as a change order, a variation or
an amendment. A contract modification exists where the parties to a contract approve a modification that either creates
new or changes existing enforceable rights and obligations of the parties to the contract. A contract modification could be
approved in writing, by oral agreement or implied by customary business practices.
[IFRS 15 para 18].
An entity should account for a contract modification as a separate contract if both of the following conditions are present
[IFRS 15 para 20]:
a. the scope of the contract increases because of the addition of promised goods or services that are distinct, and
b. the price of the contract increases by an amount of consideration that reflects the entity’s stand-alone selling prices of the
additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the
particular contract.
How should Pharma A account for the modification?
Solution
Pharma A should account for the contract modification (to expand efforts and increase the transaction price) as if it
were a part of the existing oncology contract and it should adjust revenue on a cumulative catch-up basis to reflect
the related impact in accordance with paragraph 21 of IFRS 15.
The pricing on the extension (that is, zero margin) would not appear to represent the stand-alone selling price for the
additional R&D efforts. As a result, the contract modification would not meet the conditions to be accounted for as a
separate contract in accordance with paragraph 20 of IFRS 15. Pharma A is merely extending the existing oncology
program and, therefore, the modification would likely not constitute a separate performance obligation in the context
of the contract.
Pharma A would: (1) adjust the measure of progress by reflecting the additional costs that it expects to incur in the
denominator of the cost-to-cost model; (2) increase the transaction price by the additional consideration that it now
expects to receive, subject to the constraint; and (3) reflect the impact as a cumulative catch-up adjustment to
revenue.
5.3 Scope considerations when accounting for collaboration

arrangements
Reference to standard: IFRS 15 para 9, IFRS 15 App A
Background
A biotech entity, Biotech, enters into an arrangement with a pharmaceutical entity, Pharma. Biotech grants an IP licence to
a drug compound to Pharma and will perform manufacturing services on the compound. Biotech receives an up-front
payment of C40 million, per-unit payments for manufacturing services performed and a milestone payment of C150 million
on regulatory approval.
Relevant guidance
An entity should account for a contract with a customer only when all of the following criteria are met [IFRS 15 para 9]:
a. the parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business
practices) and are committed to perform their respective obligations;
b. the entity can identify each party’s rights regarding the goods or services to be transferred;
c. the entity can identify the payment terms for the goods or services to be transferred;
d. the contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to
change as a result of the contract); and
e. it is probable that the entity will collect the consideration that it will be entitled to in exchange for the goods or services that will
be transferred to the customer.
‘Customer’ is defined as: “A party that has contracted with an entity to obtain goods or services that are an output of the
entity’s ordinary activities in exchange for consideration”.
[IFRS 15 App A].
Is this arrangement within the scope of IFRS 15?
Solution
Determining whether an arrangement is within the scope of IFRS 15 can be a difficult judgement. In the scenario
above, the arrangement appears to be within the scope of the revenue standard, because Biotech and Pharma have a
vendor-customer relationship. Biotech is providing a licence and manufacturing services to Pharma and those goods
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Solution
and services are the outputs of Biotech’s ordinary activities. Also, the two companies do not share in the risks and
benefits that result from the activities under the arrangement.
Identifying the customer is straightforward in many instances, but in some instances a careful analysis needs to be
performed to confirm whether a customer relationship exists. For example, a contract with a counterparty to
participate in an activity where both parties share in the risks and benefits of the activity (such as developing an asset)
is unlikely to be within the scope of the revenue guidance. This is because the counterparty is unlikely to meet the
definition of a customer. An arrangement where, in substance, the entity is selling a good or service is likely to be
within the scope of the revenue standard, even if it is termed a ‘collaboration’ or something similar. The revenue
standard applies to all contracts, including transactions with collaborators or partners, if they are a transaction with a
customer.
5.4 Post-development phase obligations

Reference to standard: IFRS 15 para 24, IFRS 15 App A
Reference to standing text: 11.58 , 11.60
Background
A medium-sized pharmaceutical entity, Med Co, received regulatory approval for its new drug against high blood pressure,
Benirol. Med Co decided to outsource certain work streams (such as provision of information, patent defence and
marketing support) and it entered into a collaboration agreement with a well-known post-development services group,
Service Co. Service Co is trying to identify what performance obligations have been promised.
Relevant guidance
Performance obligations identified in a contract with a customer might include promises that are implied by an entity’s
usual practices, policies or statements. Such promises might create a valid expectation of the customer that the entity will
transfer a good or service to the customer.
[IFRS 15 para 24].
Performance obligations do not include activities that are necessary for the entity to fulfil a contract. Only activities that
transfer a good or service to a customer are considered.
[IFRS 15 para 25].
What are some examples of performance obligations that could be provided by Service Co?
Solution
The assessment of the different types of obligations that might arise under a contract requires judgement. There are a
number of factors that should be considered as a minimum, when forming that judgement:
Is the obligation substantive or perfunctory? This requires an assessment as to

whether the obligation is significant, whether it results in the transfer of a
significant good or service to the customer or whether it is incidental and of
little consequence from a revenue recognition perspective. For example, an
agreement to answer another party’s questions about a compound that they
had purchased could be viewed as part of normal relationship management
(that is, perfunctory); whereas an agreement to supply 500 million free sample
tablets would appear to be a substantive obligation.
Is the obligation a separate performance obligation? If the obligation is a

separate performance obligation, revenue can only be recognised when
control of that performance obligation has been transferred.
Contractual obligation Likelihood of being a separate PO
Likely
Marketing contributions
Likely
Delivery of investigational
products and clinical trial
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Solution
supplies
Potentially
Participation in a steering
committee
Unlikely
Provision of information
Unlikely
Patent defence
If a contractual obligation is not considered to be a separate performance obligation

under the terms of the contract, there might still be accounting implications. The
obligation might represent a cost that needs to be provided for or the obligation
might need to be combined with another promise in the contract as part of a larger
performance obligation.
5.5 Assessing distinct promises – (licence and manufacturing)

Reference to standard: IFRS 15 para 27, IFRS 15 para 29
Background
Alpha, a pharmaceutical entity, enters into an agreement with Delta to provide it with a licence related to a mature product
for a period of ten years. For the first three years, Alpha will continue to manufacture the drug, while Delta is developing its
manufacturing facilities in order to continue to manufacture the product. Since the licence is related to a mature product, it
is not expected that the underlying product will change over the licence period. The manufacturing could be performed by
another contract manufacturing organisation (CMO).
Relevant guidance
Licences transferred together with other services, such as manufacturing, must first be assessed to determine whether the
licence is distinct and therefore a separate performance obligation. Goods and services that are distinct are accounted for
separately. A good or service is distinct if both of the following criteria are met [IFRS 15 para 27]:
a. the customer can benefit from the good or service, either on its own or together with other resources that are readily available
to the customer; and
b. the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the
contract.
The following are indicators that an entity’s promise is not separately identifiable from other promises [IFRS 15 para 29]:
a. the entity provides a significant service of integrating the goods or services with other goods or services promised in the
contract into a bundle;
b. one or more of the goods or services significantly modifies or customises, or is significantly modified or customised by, one or
more of the other goods or services promised in the contract
c. the goods or services are highly interdependent or highly interrelated.
Should Alpha consider the licence a distinct performance obligation in this arrangement?
Solution
Determining whether a licence and manufacturing services are distinct will depend on the facts and circumstances
surrounding the licence and the related manufacturing services. Alpha will need to determine whether the customer
can benefit from the licence on its own, as well as whether the licence is separately identifiable from the
manufacturing services. In this scenario, Alpha is likely to judge that there are two performance obligations. The
manufacturing services can be performed by a CMO, so Delta could benefit from the licence on its own. This would
be the case even if Delta was contractually obligated to manufacture the product with Alpha for the defined period.
In a scenario where the licence that Delta obtained was solely limited to a right to distribute Alpha’s product, and
Delta could not use the underlying IP to manufacture products on its own, the licence would be merely a mechanism
for Delta to sell what it had purchased, and it would not be distinct.
5.6 Accounting for reimbursement of costs

Reference to standard: IFRS 15 para 56, IFRS 15 para 44, IFRS 15 para 45
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Background
Biotech enters into a licence arrangement with Pharma to develop a potential drug that is currently in the preclinical stage.
Biotech agrees to provide Pharma with a perpetual licence to Biotech’s proprietary IP and perform R&D services for
Pharma relating to the completion of clinical trials to develop the potential drug. Biotech determines that the licence to the
proprietary IP and the R&D services are not distinct and they are accounted for as a single performance obligation that is
satisfied over time.
Revenue is recognised using a cost-to-cost model. Biotech receives an up-front payment of C100 million at the inception
of the arrangement and it receives 100% reimbursement for all R&D costs incurred.
Relevant guidance
The transaction price includes some or all of an amount of variable consideration only to the extent that it is highly
probable that a significant reversal in the amount of cumulative revenue recognised will not occur.
[IFRS 15 para 56].
Revenue should be recognised, for a performance obligation satisfied over time, only if the entity can reasonably measure
its progress towards complete satisfaction of the performance obligation (this requires reliable information).
[IFRS 15 para 44].
An entity might not be able to reasonably measure the outcome of a performance obligation. An entity should recognise
revenue to the extent of the costs incurred until it can reasonably measure the outcome of the performance obligation.
[IFRS 15 para 45].
At the inception of the arrangement, should Biotech include an estimate of cost reimbursement for the R&D in the
transaction price?
Solution
Biotech should generally include a best estimate of R&D reimbursements in the transaction price, at the inception of
the arrangement. In most circumstances, the R&D reimbursements included in the estimated transaction price would
be aligned with the measure of progress used in the denominator of the cost-to-cost model (assuming that is the most
relevant measure). In this scenario, if Biotech expects to incur R&D costs of C60 million to fulfil the performance
obligation, it should include that same amount in the transaction price, assuming it is contractually entitled to an equal
reimbursement.
Actual reimbursements might vary from initial estimates, however, the contract requires Pharma to reimburse Biotech
for 100% of costs incurred. The related R&D services revenue would be recognised only as the costs are incurred and,
therefore, Biotech would not be exposed to a significant reversal of cumulative revenue at any point in time in the
arrangement. In this example, the transaction price is C160 million. Biotech should revise its estimates of the R&D
reimbursements included in the transaction price to reflect its best estimate at each reporting period.
5.7 Estimating variable consideration where there are contingent

payments
Background
Research Co, a contract research organisation, enters into an arrangement with Company Pharma, a pharmaceutical
entity, to perform a clinical trial on a Phase III drug candidate. Research Co will receive fixed consideration of C20 million
plus an additional milestone or bonus payment of C2 million if it screens 100 patients to enrol in the clinical trial in the first
two months of the contract term. Research Co has extensive experience in enrolling patients and completing similar types
of trials in the same field that Company Pharma’s drug candidate is targeting. Research Co believes that: (1) there is a
large population of patients to potentially screen for the clinical trial; and (2) its past experience of screening patients has
significant predictive value.
Relevant guidance
If the consideration promised in a contract includes a variable amount, an entity should estimate the amount of
consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a
customer.
[IFRS 15 para 50].
An entity should estimate an amount of variable consideration by using either the expected value or most likely amount
method, depending on which method the entity expects to better predict the amount of consideration to which it will be
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entitled.
[IFRS 15 para 53].
probable that a significant reversal in the amount of cumulative revenue recognised will not occur. [IFRS 15 para 56].
At the inception of the arrangement, should Research Co include the C2 million contingent payment in the transaction
price?
Solution
Since there is a binary outcome of the contingent payment (that is, Research Co either will or will not screen 100
patients in the first two months), the most likely amount method would generally be used to estimate the variable
consideration.
In the scenario above, Research Co has extensive experience which it believes has predictive value.
Based on this experience, Research Co believes that the most likely outcome is that it will be successful in
screening the 100 patients to enrol in the clinical trial in the first two months and therefore be entitled to the C2
million bonus payment.
Research Co would then consider the variable consideration constraint and it is likely to conclude that it is highly
probable that there will not be a significant reversal of cumulative revenue. This is due to the large up-front payment
(C20 million), their past experience with contracts of a similar type with predictive value, the fact that screening
patients is largely within their control and the fact that the contingency is likely to be resolved in two months.
Assuming the performance obligation is satisfied over time, the entire C22 million would be included in the transaction
price and not ‘held back’ due to the constraint.
5.8 Revenue recognition for sales to customers with a history of long

delays in payment
para 53
Background
Pharmaceutical entity Tiepolo Pharma sells prescription drugs to a governmental entity in a country in Southern Europe.
Tiepolo has historically experienced long delays in payment for sales to this entity, due to slow economic growth and high
debt levels in the country. Tiepolo currently has outstanding receivables from sales to this entity over the last three years
and it continues to sell products at its normal market price.
Tiepolo and the country’s government have not renegotiated the payment terms. Tiepolo has an unconditional right to
receive payment.
Tiepolo has not entered into any factoring arrangements for the settlement of these receivables.
Relevant guidance
An entity should account for a contract with a customer when the criteria set out in paragraph 9 of IFRS 15 are met. The
most relevant criterion in this situation is that the entity should account for the contract when it is probable that the entity
will be able to collect the consideration it is entitled to. In evaluating collectability, the entity should only consider the
client’s ability and intention to pay.
[IFRS 15 para 56].
The promised consideration is variable if other facts and circumstances indicate that the entity’s intention, when entering
into the contract, is to offer a price concession.
[IFRS 15 para 52(b)].
How should Tiepolo’s management account for the sales to the governmental entity in this country in Southern Europe
under IFRS 15?
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Solution
Tiepolo’s management must first determine whether it is appropriate to recognise new sales to this country. Revenue
should be recognised only when it is probable that the entity will collect the consideration it is entitled to.
Slow payment does not, on its own, preclude revenue recognition. However, it might affect the amount of revenue that
can be recognised. This is because the receivable will be discounted at initial recognition if there is a significant
financing component.
When assessing whether the entity will collect the consideration, the entity needs to determine whether it expects to
provide a price concession and accept a lower amount of consideration. If so, the consideration is variable [IFRS 15
para 52(b)] and the entity will need to estimate the variable consideration in accordance with paragraph 53 of IFRS 15
and determine the amount that it expects to receive, subject to the constraint set out in paragraph 56 of IFRS 15.
If the entity concludes that it will receive an amount less than the invoiced amount, it has to evaluate whether it
granted an implicit price concession or whether the receivable is impaired.
5.9 Rebates on volume purchases

Background
Pharmaceutical entity Alpha has a multi-year contract with Delta to sell pharmaceutical drugs and it agrees to pay Delta an
annual rebate if Delta completes a specified cumulative level of purchases during any year of the contract period. The
contract specifies that the amount of rebate will vary based on a tiered structure agreed to in the contract as follows (note
that the rebate earned is not retroactive to prior purchases):
Purchases Rebate Probability

1-1,000 units 0% 15%
1,001-2,000 units 2% 60%
Greater than 2,000 units 5% 25%
The unit price for each product is C100. Based on historical experience of rebates due to Delta, Alpha has assigned
probabilities to each possible outcome.
Relevant guidance
If the consideration promised in a contract includes a variable amount, an entity should estimate the amount of
consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a
customer.
[IFRS 15 para 50].
An entity should estimate an amount of variable consideration by using either the expected value or the most likely amount
method, depending on which method the entity expects to better predict the amount of consideration to which it will be
entitled.
[IFRS 15 para 53].
probable that a significant reversal in the amount of cumulative revenue recognised will not occur. [IFRS 15 para 56].
Consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to the customer (or to
other parties that purchase the entity’s goods or services from the customer).
Consideration payable to a customer also includes credit or other items (for example, a coupon or voucher) that can be
applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the
customer). An entity should account for consideration payable to a customer as a reduction of the transaction price and,
therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service (as described in
paras 26–30 of IFRS 15) that the customer transfers to the entity. If the consideration payable to a customer includes a
variable amount, an entity should estimate the transaction price (including assessing whether the estimate of variable
consideration is constrained) in accordance with paragraphs 50–58 of IFRS 15.
[IFRS 15 para 70].
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How should Alpha account for the rebate expected to be paid to the customer at the end of the year?
Solution
Alpha determines that the ‘expected value’ method best predicts the amount of consideration it will be entitled to.
Alpha concludes that it is probable that a significant reversal in the amount of cumulative revenue recognised will not
occur when the uncertainty is resolved.
Under the expected value approach, Alpha estimates the rebate to be 2.45% ((0% rebate x 15% likelihood) + (2%
rebate x 60% likelihood) + (5% rebate x 25% likelihood)), based on a probability-weighted assessment of each
possible scenario. Therefore, as each unit is shipped during the year, Alpha will recognise a rebate accrual of C2.45
and revenue of C97.55. At the end of each reporting period, Alpha should revise the estimate of sales and true up the
calculation and rebate that will be due at the end of the arrangement. This true-up would include a cumulative
adjustment on shipments throughout that reporting period.
Companies might have rebate programs that require payments to government health systems. In cases where the
government health system is considered the customer, the guidance above would generally apply.
5.10 Outcome-based pay-for-performance arrangements

Background
Umbrella Insurance Company and Rembrandt Pharmaceuticals put in place a reimbursement scheme in territory X for the
treatment of Alzheimer’s with Rembrandt’s newly developed and approved product. Umbrella will only pay, under the
scheme, for the drug in territory X for those patients in whom Rembrandt’s product is shown to effectively slow down the
progression of Alzheimer’s. The contract stipulates specific indicators that show progression has slowed. Umbrella will
only pay if all indicators have been evidenced.
The outcome, at the inception of this arrangement, is unknown. Rembrandt’s product has already been subject to clinical
trials during the approval process, but the patient population used in the clinical trials is different from the population in
territory X.
Relevant guidance
Revenue is recognised over time if any of the following criteria is met:
1. the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;
2. the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or
3. the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to
payment for performance completed to date.
[IFRS 15 para 35].
If a performance obligation is not satisfied over time, it is satisfied when the customer obtains control of the promised
asset. [IFRS 15 para 38]. The transaction price includes some or all of an amount of variable consideration only to the
extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur.
[IFRS 15 para 56].
How should Rembrandt recognise revenue under a pay-for-performance arrangement?
Solution
Rembrandt has promised to provide Alzheimer’s drugs to patients. Rembrandt assesses that each drug is a separate
performance obligation satisfied at a point in time. The consideration for the contract is variable. Rembrandt estimates
the total transaction price at the start of the contract using the expected value method that it judges to be most
appropriate. However, it might be that, given the differences in population between the original trial and territory X,
Rembrandt cannot assert that it is highly probable that any consideration will be received and so it would constrain
the transaction price to nil initially.
If Rembrandt is able to build a sufficient record of outcomes over time, such that it improves its ability to predict how
many patients in the population of territory X will benefit from the drug, it should re-evaluate the application of the
constraint and this could result in the expected value of consideration being allocated to each each drug.
5.11 Contract manufacturing
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para B8
Background
Vendor is hired by Customer to manufacture a batch of 100,000 units of a drug with specific package labelling. The initial
contract term is six months. Once bottled and labelled, there are significant practical limitations that preclude Vendor from
redirecting the product to another customer. Vendor also has an enforceable right to payment for performance completed
to date if the contract is cancelled for any reason other than a breach or non performance.
Relevant guidance
[IFRS 15 para 35].
[IFRS 15 para 44].
[IFRS 15 para 45].
A practical limitation on an entity’s ability to direct an asset for another use exists if an entity would incur significant
economic losses to direct the asset for another use. A significant economic loss could arise, because either the entity
would incur significant costs to rework the asset or it would only be able to sell the asset at a significant loss. For example,
an entity might be practically limited from redirecting assets that have design specifications that are unique to a customer
or are located in remote areas.
[IFRS 15 para B8].
When and how should Vendor recognise revenue?
Solution
Vendor should recognise revenue on transfer of control of the product to the distributor. In this scenario that would be
over time as the units are being manufactured. Management has concluded that the drug to be manufactured by
Vendor has no alternative use to Vendor (that is, the bottled and labelled product imposes a practical limitation that
precludes Vendor from redirecting it to another customer). A practical limitation on an entity’s ability to direct an asset
for another use exists if the entity would incur significant economic losses to direct the asset for another use. Vendor
has an enforceable right to demand payment if Customer cancels the contract. Therefore, Vendor should record
revenue over time as the units are being manufactured.
5.12 Contract for development services

Background
Alpha, a small pharmaceutical entity, contracts with a much larger pharmaceutical entity, BetaX, to develop a new medical
treatment for migraine over a five-year period. Alpha is engaged only to provide development services and it will
periodically have to update BetaX with the results of its work. BetaX owns the underlying product IP and it has exclusive
rights over the development results. Beta X owns Alpha’s work-in-progress at all points in the contract.
BetaX will make 20 equal quarterly non-refundable payments of C250,000 (totalling C5 million). Payments do not depend
on the achievement of a particular outcome, but Alpha is required to demonstrate compliance with the development
programme. Alpha’s management estimates that the total cost will be C4 million.
Alpha has completed many similar contracts and it has a track record of reliably estimating costs to complete. Alpha
incurs costs of C400,000 in the first quarter of year 1, in line with its original estimate. Alpha is in compliance with the
research agreement, including the provision of updates from the results of its work.
Relevant guidance
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[IFRS 15 para 35].
[IFRS 15 para 44].
[IFRS 15 para 45].
How should Alpha recognise the payments that it receives from BetaX to conduct development?
Solution
Alpha identifies that it has promised to supply development services to BetaX. Alpha concludes that the control of
development services is transferred over time. This is because BetaX controls an asset (that is, the work-in-progress)
at any stage during the contract. Alpha is enhancing that asset through its development services.
Alpha determines that an appropriate measure of progress is an input method, based on an estimate of total costs.
Alpha can reasonably measure its progress towards completion. Alpha recognises revenue of C500,000, costs of
C400,000 and profit of C100,000 for the first quarter. The unbilled C250,000 of revenue should be recognised as a
contract asset on Alpha’s balance sheet.
5.13 Development services with up-front and contingent payments

Reference to standing text: 11.87,11.156
Background
Pharmaceutical entity CareB has appointed research entity Devox to develop an existing compound on its behalf. Devox
will have no further involvement in the compound after regulatory approval. CareB will retain full ownership of the
compound (including intellectual rights) at all stages during the development contract and after regulatory approval is
obtained. Devox will not participate in any further marketing or production arrangements. A milestone plan is included in
the contract. CareB agrees to make the following non-refundable payments to Devox:
a. C3 million on signing of the agreement;

b. C1 million upon successful completion of Phase III clinical trial approval; and
c. C2 million on securing regulatory approval.
Devox expects to incur costs totalling C3 million up to the point of securing regulatory approval. At the inception of the
agreement, Devox management has concluded that it is not probable that the compound will obtain Phase III clinical trial
approval or regulatory approval.
Relevant guidance
[IFRS 15 para 56].
[IFRS 15 para 35].
How should Devox recognise revenue for this contract?
Solution
Management has reviewed the contract and concluded that it has contracted to supply development services, that is
a single performance obligation with the control transferred over time.
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Solution
The consideration that Devox receives includes a fixed amount (the up-front payment) and two contingent amounts
(dependent on clinical trial and regulatory approval). The contingent amounts are variable consideration. Devox uses
the most likely outcome to estimate variable consideration and concludes that the most likely amount is zero.
Therefore, it is unlikely that Devox can include these amounts in the transaction price until the contingencies are
resolved. The nature of the contingencies are such that the resolution is outside Devox’s control and thus, in most
cases, it would not be possible for Devox to conclude that no reversal is highly probable.
The up-front payment is initially deferred. This amount has been received, but Devox has not transferred any goods or
services to the customer.
Revenue for the services provided is recognised using an appropriate measure of progress. That is, the percentage of
completion at the reporting date is applied to the total transaction price at that date (including the fixed up-front fee
and any element of variable consideration that is no longer constrained). At the end of each reporting period, the
company would reassess its estimate of the variable consideration that is no longer constrained. For example, if it is
highly probable that the milestone payments will be received, these amounts are included in the transaction price.
This could result in a cumulative catch-up of revenue for the performance to date.
5.14 Sale of an intangible asset in exchange for listed shares

Reference to standard: IFRS 9 para 5.1.1, IFRS 9 para 5.7.1, IFRS 9 para 5.7.5, IFRS
15 para 66, IFRS 15 paras 50,IFRS 15 para 56, IFRS 15 para 59
Reference to standing text: 42.94, 42.62, 42.63, 11.114, 11.78, 11.87, 11.93
Background
Pharmaceutical entity Jerome agrees to acquire a patent from pharmaceutical group Kupla in order to develop a more
complex drug. Jerome will pay for the patent by:
issuing shares (that are listed) to Kupla representing 5% of the total issued share
capital; and
if Jerome is successful in developing a drug and bringing it to the market, Kupla
will also receive a 5% royalty on all sales.
The transaction represents an acquisition of an intangible asset by Jerome and a disposal of an intangible asset by Kupla.
The transfer of the intangible asset and the transfer of shares occur on the same date.
Kupla’s management intends to make an irrevocable election to classify the shares at fair value through other
comprehensive income, under IFRS 9.
Relevant guidance
IFRS 9 guidance
An entity should initially measure a financial asset classified at fair value through other comprehensive income at its fair
value plus transaction costs directly attributable to the acquisition. [IFRS 9 para 5.1.1]. The fair value of a financial asset is
determined using IFRS 13. As the financial asset is an equity investment, if it is not held for trading and an irrevocable
election is made, it is allowed to be classified at fair value through other comprehensive income. Consequently, the equity
investment should be subsequently measured at fair value at each reporting date, with any gains or losses recognised in
other comprehensive income. [IFRS 9 paras 5.7.1 and 5.7.5].
IFRS 15 guidance
Non-cash consideration is measured at fair value [IFRS 15 para 66]. Variable consideration should be estimated and
included in the transaction price to the extent that it is highly probable that a significant reversal in the amount of the
cumulative revenue recognised will not occur. [IFRS 15 paras 50, 56]. The transaction price, taking into account the
estimate and any constraint of variable consideration, should be reassessed at each reporting date.
[IFRS 15 para 59].
How should Kupla’s management account for the shares and royalties that it receives?
Solution
Kupla should derecognise the patent and recognise the shares, because control has transferred. A gain or loss on
disposal will also be recognised. IAS 38 requires the consideration to be measured in accordance with IFRS 15. This
should be calculated for the purpose of calculating the net gain on disposal of the patent. There are two elements to
the consideration:
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Solution
The shares received represent non-cash consideration and are measured at
fair value.
Royalties are variable consideration. Since this transaction is a sale of IP and

not a licence, the sales- and usage-based royalty exemption does not apply. If
Kupla can estimate a minimum amount of royalties that it expects to receive
and it is highly probable that the amount will not reverse in the future, this
estimated amount is included in the transaction price, and thus the gain or
loss on disposal. Kupla revises the estimate for variable consideration at each
reporting date.
Kupla should initially recognise the shares received at their fair value plus transaction costs that are directly
attributable to the acquisition. [IFRS 9 para 5.1.1]. The fair value would be based on the quoted share price multiplied
by the quantity of shares. IFRS 15 does not specify the measurement date for non-cash consideration. The shares
could be measured on the date of the contract inception, the date when the licence is transferred, or the date when
the shares are received. Therefore, management should apply judgement to determine the measurement date.
The shares should subsequently be measured at fair value at each reporting date, with any gains or losses recognised
in other comprehensive income.
[IFRS 9 paras 5.7.1, 5.7.5].
5.15 Receipts for out-licensing

Reference to standard: IFRS 15 para B58, IFRS 15 para B61, IFRS 15 para B63
Background
Pharmaceutical entities Regal and Simba enter into an agreement in which Regal will licence Simba’s know-how and
technology to manufacture a compound for AIDS. Regal will use Simba’s technology in its facilities for a period of 10
years. Simba receives a non-refundable up-front payment of C3 million for access to the technology. Simba will also
receive a royalty of 20% from sales of the AIDS drug.
Relevant guidance
A promise to grant the licence is a separate performance obligation, if it is distinct.
IFRS 15 identifies two types of licences: a right to access, that transfers over time; and a right to use, that transfers at a
point in time. The promise is to provide a right to access if all of the following criteria are met [IFRS 15 para B58]:
a. the contract requires, or the customer reasonably expects, that the entity will undertake activities that significantly affect the
intellectual property to which the customer has rights;
b. the rights granted by the licence directly expose the customer to any positive or negative effects of the entity’s activities
identified in paragraph B58(a); and
c. those activities do not result in the transfer of a good or a service to the customer as those activities occur.
If these are not met, it is a right to use a licence and it is recognised when the licence is granted to the customer. [IFRS 15
para B61].
Revenue in the form of a sales-based or usage-based royalty, in exchange for a licence of intellectual property, is
recognised only when (or as) the later of the following events occurs [IFRS 15 para B63]:

b. the performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been
satisfied (or partially satisfied).
How should Simba account for a non-refundable up-front fee received for out-licensing its know-how and technology and
the royalty to be received on sales?
Solution
Simba concludes that it has a single performance obligation under the contract to issue the licence.
Simba concludes that it has granted a ‘right to use’ licence and revenue is recognised at the point in time that the
licence is granted to Regal. In this case, the IP licensed to Regal has significant stand-alone functionality (being the
technology) and Simba does not perform any activities that affect that functionality.
The consideration for the licence comprises a fixed element (the up-front payment) and variable elements (the
royalties).
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Solution
The up-front fee is not variable and it is recognised when control of the licence transfers. This is when Regal obtains
the rights to use the underlying IP.
Simba applies the exception for variable consideration related to sales- or usage-based royalties received in exchange
for a licence of intellectual property. Royalties are not included in the transaction price until Regal makes sales,
regardless of whether or not Simba has predictive experience with similar arrangements.
See Solution 1.18 for Regal’s accounting.
5.16 Contingent payments based on first commercial sale

Reference to standard: IFRS 15 paragraphs 56–59, IFRS 15 para B63
Background
In June 20x7, pharmaceutical entity Alpha enters into an arrangement to licence IP to Delta. The IP relates to an
unapproved drug that will be further developed by Delta. The licence is a right to use licence and is transferred at contract
inception and there are no other performance obligations in the contract. In exchange for the licence, Alpha will receive:
an up-front payment of C50 million; and

a milestone payment of C30 million on first commercial sale of a product by Delta.
In December 20x8, the drug is approved by the FDA and the first commercial sale occurs in February 20x9. Assume that,
as of 31 December 20x8, it is probable that a commercial sale will occur.
Relevant guidance
Notwithstanding the guidance in paragraphs 56–59 of IFRS 15, an entity should recognise revenue for a sales-based or
usage-based royalty promised in exchange for a licence of intellectual property only when (or as) the later of the following
events occurs [IFRS 15 para B63]:

How should Alpha account for the C30 million milestone payment triggered on first commercial sale?
Solution
The C30 million milestone payment is contingent on Delta’s sale of the drug, thus, it is reasonable to conclude that the
exception for sales- and usage-based royalties received in exchange for licences of IP applies.
Under the royalty exception, the milestone is recognised at the later of: (1) when the subsequent sales or usage
occurs; and (2) full or partial satisfaction of the performance obligation that some or all of the sales-based royalty has
been allocated to.
The milestone payment should be recognised as revenue in the period that the first commercial sale occurs (that is, in
February 20X9). Alpha should consider providing disclosure about the milestone and the related accounting policies in
the December 20X8 financial statements, if material.
5.17 Licence of intellectual property is predominant

Reference to standard: IFRS 15 paragraphs 56–59, IFRS 15 para B63, IFRS 15 para
63A
Background
Pharma licences its patent rights to an approved, mature drug compound to Customer for a licence term of 10 years.
Pharma also promises to provide training and transition services relating to the manufacturing of the drug for a period not
to exceed three months. The manufacturing process is not unique or specialised and the services are intended to help
Customer to maximise the efficiency of its manufacturing process. Pharma concludes that the licence and the services are
distinct. The only compensation for Pharma in this arrangement is a percentage of Customer’s sales of the product.
Relevant guidance
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Notwithstanding the guidance in paragraphs 56–59 of IFRS 15, an entity should recognise revenue for a sales-based or
usage-based royalty promised in exchange for a licence of intellectual property only when (or as) the later of the following
events occurs [IFRS 15 para B63]:

The guidance for a sales-based or usage-based royalty applies where the royalty relates only to a licence of intellectual
property or where a licence of intellectual property is the predominant item to which the royalty relates (for example, the
licence of intellectual property might be the predominant item to which the royalty relates where the entity has a
reasonable expectation that the customer would ascribe significantly more value to the licence than to the other goods or
services to which the royalty relates).
[IFRS 15 para 63A].
Does the sales-and usage-based royalty exception apply to this arrangement?
Solution
Yes. The sales- and usage-based royalty exception applies, because the licence of IP is predominant in the
arrangement. In this scenario, the Customer would ascribe significantly more value to the licence than to the three
months of training and transition services. Pharma would recognise revenue as Customer’s sales occur, assuming this
approach does not accelerate revenue ahead of performance.
5.18 Out-licence of development-phase compound where the licensee

does the development work
Reference to standard: IFRS 15 para B58, IFRS 15 para B61, IFRS 15 para 56, IFRS
15 para B63
Background
Biotech Co has successfully developed a drug for Syndrome Q through Phase II trials. Biotech and a large pharmaceutical
entity, Pharma Co, have agreed the following terms:
Biotech grants a licence to Pharma to manufacture, sell and market the product
in the US for the treatment of Syndrome Q. Biotech retains the patents and
underlying intellectual property associated with the product.
Pharma is to fund and perform all Phase III clinical development work on the drug
developed by Biotech to obtain regulatory approval in the US.
There is a development committee that oversees the development of the product.

The development committee makes all strategic decisions regarding the product.
Biotech is not required to attend the committee, but it has the right to and
expects to, attend.
Biotech retains the rights to develop and sell the product in the rest of the world
and will seek to licence these rights to another pharmaceutical company.
The consideration payable by Pharma includes:
an Up-front payment of C10 million on signing the contract;

a milestone payment of C20 million on regulatory approval;
royalties of 15% payable on sales; and
a sales milestone of C20 million in the first year that annual sales exceed C500
million.
The up-front payments and milestones are non-refundable in the event that the contract is cancelled after the payments
have been made.
Relevant guidance
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IFRS 15 identifies two types of licence: a right to access, that transfers over time; and a right to use, that transfers at a
point in time. The promise is to provide a right to access if all of the following criteria are met [IFRS 15 para B58]:
a. the contract requires, or the customer reasonably expects, that the entity will undertake activities that significantly affect the
intellectual property to which the customer has rights;
b. the rights granted by the licence directly expose the customer to any positive or negative effects of the entity’s activities
identified in paragraph B58(a); and
c. those activities do not result in the transfer of a good or a service to the customer as those activities occur.
If these are not met, it is a right to use a licence and it is recognised when the licence is granted to the customer. [IFRS 15
para B61]. The transaction price includes some or all of an amount of variable consideration only to the extent that it is
highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur. [IFRS 15 para 56].
There is an exception to this rule. Revenue for a sales-based or usage-based royalty in exchange for a licence of
intellectual property is recognised only when (or as) the later of the following events occurs:

[IFRS 15 para B63].
How should Biotech recognise revenue under the out-licencing agreement?
Solution
The out-licence is within the scope of IFRS 15, because Biotech’s ordinary business activities are to develop new
drugs for out-licensing. The objective being that Pharma Co completes the clinical research, obtains regulatory
approval and takes the drug to market. The guarantee that Biotech has given to defend the patent from unauthorised
use is not considered to be a promised good or service under the contract. Biotech has a seat on a development
committee, but it is not required to attend. This is not a performance obligation to Pharma, because it does not
transfer a good or service.
Accounting for the out-licence
Biotech has granted a ‘right to use’ licence and revenue is recognised when the licence is granted to Pharma. The IP
licensed to Pharma has significant stand-alone functionality (being a patented drug formula) and Biotech does not
perform any activities that affect that functionality. The participation of Biotech in the development committee does
not affect the functionality of the patent.
The consideration for the licence comprises a fixed element (the up-front payment) and two variable elements (the
milestone payments and the royalties).
Variable consideration
When the contract is signed, Biotech estimates the consideration for the contingent regulatory approval-based
milestone and it determines that the most likely amount is zero. The ‘most likely amount’ method of estimation is
considered to be the most predictive of the outcome, since the outcome is binary (either regulatory approval is
granted or it is not). The transaction price is, therefore, initially the up-front payment, that is recognised at a point in
time.
The transaction price should be reassessed at each reporting date. Biotech will include the regulatory approval
milestone payment (a variable contingent part of the transaction price), in the total estimated transaction price when it
is highly probable that the resulting revenue recognised would not have to be reversed in a future period. This is
unlikely to be before regulatory approval is granted. This amount will be recognised as revenue when it is included in
the transaction price. This is because the transaction price relates to the licence that has already been granted to the
customer.
Biotech applies the exception for variable consideration related to sales- or usage-based royalties received in
exchange for licences of intellectual property. Royalties are not included in the transaction price until Pharma makes
the relevant sales in the US, regardless of whether or not Biotech has predictive experience with similar arrangements.
The additional consideration that might arise from the sales milestone is not received until an annual sales threshold is
met. Biotech concludes that this milestone is, in substance, a sales-based royalty, since it is receivable only when
underlying sales are made. As such, revenue for this milestone is recognised if and when the annual sales threshold is
met in accordance with the exception for royalties. If Biotech had recognised an intangible asset for Syndrome Q, the
portion of the carrying amount of the intangible asset relating to the US rights disposed of should be derecognised
(see Solution 1.16).
See Solution 1.20 for the accounting of Pharma.
5.19 Out-licence of pre-clinical phase compound where the licensor

Reference to standard: IFRS 15 para 27, IFRS 15 para B56, IFRS 15 para 56 , IFRS
15 para B63 , IFRS 15 para B63A , IFRS 15 para 35
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Reference to standing text: 11.65, 11.254, 11.87, 11.261, 11.262, 11.156
Background
A biotech entity, Biotech Co has patented pre-clinical intellectual property (IP) for compound X and has entered into an
agreement with a pharmaceutical entity, y Pharma Co. The agreement contains the following terms:
Biotech Co will perform development services over the IP through to the end of
phase I and will out-licence the patented IP and the arising IP to compound X to
Pharma Co.
Compound X is highly specialised and only Biotech Co has the specialist
knowledge to take this specific compound through the early phases of
development.
The consideration payable by Pharma Co to Biotech Co under this agreement comprises the following:
upfront payment of LC6 million;

milestone payment of LC10 million on successful completion of phase I clinical
studies;
milestone payment of LC5 million on regulatory approval; and
royalty payments of 5% on future sales of compound X.
All payments are non-refundable once they have been made. The upfront and milestone payments align with the
standalone selling price of the development services alone.
Relevant Guidance
Licences transferred together with other services, such as R&D, must first be assessed to determine if the licence is
distinct and, therefore, a separate performance obligation. Goods and services that are distinct are accounted for
separately. A good or service is distinct if both of the following criteria are met:
b. the entity's promise to transfer the good or service to the customer is separately identifiable from other promises in the
contract.
[IFRS 15 para 27].
IFRS 15 identifies two types of licence: a right to access, that transfers over time; and a right to use, that transfers at a
point in time.
[IFRS 15 para B56].
[IFRS 15 para 56].
There is an exception to this rule. Revenue for a sales-based or usage-based royalty in exchange for a licence of
intellectual property is recognised only when (or as) the later of the following events occurs:

[IFRS 15 para B63].
This exception only applies to a licence of intellectual property or when a licence of intellectual property is the predominant
item to which the royalty relates.
[IFRS 15 B63A].
IFRS 15 explains that if one of the following criteria is met, then revenue is recognised over time:
a. the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs
(see paragraphs B3–B4);
b. the entity’s performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset
is created or enhanced (see paragraph B5); or
c. the entity’s performance does not create an asset with an alternative use to the entity (see paragraph 36) and the entity has an
enforceable right to payment for performance completed to date (see paragraph 37).
[IFRS 15 para 35].
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How should Biotech Co recognise revenue under the agreement?
Solution
The out-licence is within the scope of IFRS 15, because Biotech Co licences its IP to Pharma Co and performs
development services, both of which are an output of its ordinary business activities. Pharma Co is considered a
customer of Biotech Co.
Identifying Performance Obligations
Biotech Co has promised to provide Pharma Co with a licence to compound X and it has also promised to provide
development services. No other deliverables are identified.
Significant judgement is required when identifying the number of performance obligations in an arrangement that
includes a licence to IP as well as R&D services performed by the licensor. In determining whether the licence is
distinct, Biotech should consider whether the licence is capable of being distinct and whether the promise to transfer
the licence is distinct in the context of the contract.
The licence is capable of being distinct if Pharma Co can benefit from the licence on its own or with other readily
available resources. The licence may not be capable of being distinct if the R&D services are so specialised that the
services could only be performed by Biotech Co as opposed to Pharma Co or another qualified third party.
The licence is distinct in the context of the contract if the promise to transfer the licence is separately identifiable from
the R&D services. The licence may be separately identifiable from the R&D services if the R&D services are not
expected to significantly modify or customise the IP. This is often the case with clinical trials when the purpose is to
validate efficacy. However, this may not be the case for very early-stage IP within the drug discovery cycle if the R&D
services are expected to involve significant further development of the drug formula or biological compound.
Biotech Co concludes that there is only one performance obligation, the combined sale of the licence and
development service, because this is very early-stage IP and the R&D services are expected to involve significant
further development of the drug formula that could only be performed by certain employees of Biotech Co.
Measuring the transaction price
The consideration for the contract comprises a fixed element (the upfront payment) and three variable elements; the
two milestone payments and the royalties.
Initially only the fixed consideration (LC6 million) is included in the transaction price.
The variable consideration for the milestone payments are not included in the transaction price at inception, because
based on the application of the variable consideration constraint it is not highly probable that the milestone conditions
will be met.
The variable consideration for the royalties are also not included in the transaction price at inception based on the
application of the royalty exception for licences. The sales-based royalty exception applies when a licence of IP is the
predominant item that the royalty relates to. Although there is one performance obligation, the development services
and the licence of in-process IP, the output of the performance obligation is a licence of developed IP and that licence
is the predominant item that the royalty relates to. This judgement considers in particular that the variable
consideration from the royalty does not materialise until the development services are completed and the licence of
developed IP is available for use. In addition, the upfront and milestone consideration is aligned with the standalone
selling price of the development services alone and therefore indicates that the royalty relates to the licence of
developed IP.
Recognising revenue
The performance obligation (the development services and the licence of in-process IP) transfers to Pharma Co over
time as Biotech Co undertakes the development services and creates and further enhances the IP controlled by
Pharma Co.
Biotech Co determines an appropriate measure of progress and it recognises revenue in relation to the amounts
included in the transaction price over time based on the measure of progress.
Biotech Co reconsiders, at each reporting date, whether or not the variable consideration for the milestone payments
should be included in the transaction price. The milestone consideration is estimated using the most likely amount
method and included in the transaction price once it is highly probable that it will not reverse.
When the milestone payments are added to the transaction price, a cumulative catch-up adjustment will be required
in the period that the transaction price is adjusted in. To the extent the services are complete when the milestone
consideration becomes highly probable, the milestone payments are recognised in revenue immediately.
The royalties would be recognised as revenue when subsequent sales are made in accordance with the sales-based
royalty exception explained above. This will be sometime after Biotech Co’s development services have been
completed and compound X has received regulatory approval.
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5.20 Out-licence of development-phase compound where the licensor

Reference to standard: IFRS 15 para 27, IFRS 15 para 29, IFRS 15 para B58, IFRS
15 para 56, IFRS 15 para B63, IFRS 15 para 85(a), IFRS 15 para 85(b)
Reference to standing text: 11.65, 11.68, 11.256, 11.87, 11.261, 11.147
Background
Biotech is a well-established company that has the expertise to perform clinical trials. Biotech enters into a contract with
Pharma Co with the following terms:
Biotech grants Pharma a licence to manufacture, sell and market product.

Biotech is responsible for performing Phase III clinical trials and obtaining
Biotech is not involved in the manufacture, selling or marketing of the product.
The consideration payable by Pharma under this agreement comprises:
up-front payment of C10 million;

milestone payment of C20 million payable on successful completion of a Phase III
trial;
milestone payment of C10 million on regulatory approval; and

royalties of 25% payable on sales.
Royalties on a similar licence, at the same stage of development, would typically be in the range of 23% to 26% of sales.
Relevant guidance
Licences transferred together with other services, such as R&D, must first be assessed to determine whether the licence is
distinct and, therefore, a separate performance obligation. Goods and services that are distinct are accounted for
separately. A good or service is distinct if both of the following criteria are met [IFRS 15 para 27]:
b. the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the
contract.
The following are indicators that an entity’s promise is not separately identifiable from other promises [IFRS 15 para 29]:
a. the entity provides a significant service of integrating the goods or services with other goods or services promised in the
contract into a bundle;
b. one or more of the goods or services significantly modifies or customises, or is significantly modified or customised by, one or
more of the other goods or services promised in the contract; or
c. the goods or services are highly interdependent or highly interrelated.
IFRS 15 identifies two types of licences: a right to access, that transfers over time; and a right to use, that transfers at a
point in time. [IFRS 15 para B58].
probable that a significant reversal in the amount of cumulative revenue recognised will not occur. [IFRS 15 para 56]. There
is an exception to this rule. Revenue for a sales-based or usage-based royalty in exchange for a licence of intellectual
property is recognised only when (or as) the later of the following events occurs [IFRS 15 para B63]:

This exception applies to a licence of intellectual property or a licence of intellectual property is the predominant item to
which the royalty relates.
How should Biotech recognise revenue under the out-licensing agreement?
Solution
The out-licence is within the scope of IFRS 15, because Biotech licences its IP to Pharma and this is an output of its
ordinary business activities. Pharma is considered a customer of Biotech.
Identifying performance obligations
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Solution
Biotech has granted a ‘right to use’ licence and it has also promised to provide development services. No other
deliverables are identified. The IP licensed to Pharma has significant stand-alone functionality (being a patented drug
formula) and Biotech does not perform any activities that affect that functionality.
The licence and the development services are both capable of being distinct, because Pharma can benefit from both
on their own. Biotech could have provided the licence without any development services. The next phase of
development is Phase III trials and there are several other entities that could have provided these services. Biotech
could have provided the licence without the development services and Pharma would have been able to benefit from
it by obtaining development services from another provider.
The licence and development services are separately identifiable. This is because the services are not integrated with
(and do not modify) the original licence and the licence and services are not highly interrelated or interdependent.
Biotech has therefore judged that there are two performance obligations.
Measuring and allocating the transaction price
The consideration for the contract comprises a fixed element (the up-front payment) and two variable elements (the
milestone payments and the royalties).
Initially, only the fixed consideration is included in the transaction price. The amount of the variable consideration for
both milestone payments (Phase III and regulatory approval) included in the transaction price is determined to be zero
at inception, based on the most likely amount and the application of the variable consideration constraint.
Biotech needs to determine how to allocate the variable consideration. Biotech concludes in this arrangement that the
sales-based royalties are linked to the commercial success of the IP and that they relate to the outcome of
transferring the licence. [IFRS 15 para 85(a)]. This is also consistent with the IFRS objective of allocating the
transaction price to each performance obligation based on the stand-alone selling price.
Biotech concludes that the milestone payments relate to both performance obligations and not specifically to the
licence. This is because of the nature of the service being delivered and the fact that Biotech assesses that an
allocation of the up-front payment alone would be unlikely to cover the costs of development.
The total transaction price is then allocated to the licence and the development services, based on their estimated
stand-alone selling prices.
Biotech reconsiders, at each reporting date, whether or not the variable consideration should be included in the
transaction price. Changes to the transaction price are allocated to the two performance obligations in the same ratio
as was determined initially, based on stand-alone selling prices.
Recognising revenue
Control of the licence transfers at a point in time, as described in Solution 5.18. This is when Pharma obtains the
rights to use the underlying IP. Control of the development services is transferred over time, for similar reasons to
those described in Solution 5.12. Biotech determines an appropriate measure of progress and it recognises revenue
accordingly.
The royalties are recognised as revenue when the subsequent sales are made.
See Solution 1.21 for the accounting of Pharma.
6. Presentation and disclosure
6.1 Presentation of capitalised development costs

Background
Pharmaceutical entity Dali Pharmaceuticals capitalised the development costs relating to a diabetes drug that has been
approved and is being marketed. Amortisation of the development costs is being recognised on a straight-line basis over
the remaining patent life.
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Relevant guidance
Cost of sales consists of those costs previously included in the measurement of inventory that has now been sold and
unallocated production overheads and abnormal amounts of production costs of inventories. The circumstances of the
entity might also warrant the inclusion of other amounts, such as distribution costs.
[IAS 2 para 38].
Under the ‘nature of expenses’ income statement format, the entity discloses the costs recognised as an expense for raw
materials and consumables, labour costs and other costs, together with the amount of the net change in inventories for the
period.
[IAS 2 para 39].
Under the ‘function of expenses’ income statement format, the costs are recognised as part of costs of goods sold.
The ‘function of expenses’ or ‘cost of sales’ method classifies expenses according to their function as part of cost of sales
or, for example, the costs of distribution or administrative activities. At a minimum, an entity discloses its cost of sales
under this method separately from other expenses.
[IAS 1 para 103].
Where should the amortisation of development costs be classified in Dali’s income statement?
Solution
Dali must use the intellectual property and begin to consume its value, in order to
bring the diabetes drug to market. Amortisation of the development intangible
should be classified as a cost of sale under the ‘function of expenses’ income
statement format. The amortisation expense should be presented as an amortisation
expense under the ‘nature of expenses’ income statement format. The cost of
intellectual property used in production (royalties and intangible asset amortisation)
should be classified consistently for products and all periods presented.
6.2 Accounting for promotional campaigns

Reference to standard: IAS 38 para 8, IAS 38 para 69(c)
Background
A pharmaceutical entity has developed a new drug that simplifies the long-term treatment of kidney disease. The
company’s commercial department has incurred significant costs with a promotional campaign, including TV commercials
and presentations in conferences and seminars for doctors.
Relevant guidance
An intangible asset is an identifiable non-monetary asset without physical substance. An asset is a resource controlled by
the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
[IAS 38 para 8].
How should these costs be accounted for and presented in the income statement?
Solution
The entity should not recognise its advertising and promotional costs as an intangible asset, even though the
expenditure incurred might provide future economic benefits; it should charge all promotional costs to the income
statement. Expenditure on advertising and promotional activities should be expensed when incurred.
[IAS 38 para 69(c)].
The presentation of promotional costs in the income statement will depend on the analysis of expenses (that is, by
nature or by function) preferred by management. If the analysis of expenses is presented by nature, promotional costs
should be classified as advertising and promotional costs. However, more detailed analysis might be needed. If the
analysis of expenses is presented by function, promotional costs should be included within sales and marketing
expenses and further disclosure might be warranted.
6.3 Advertising and promotion costs
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Background
Pharmaceutical entity Kandinsky Medical recently completed a major study, comparing its Alzheimer’s drug to competing
drugs. The results of the study were highly favourable and Kandinsky has invested in a significant new marketing
campaign. The campaign will be launched at the January 20X5 International Alzheimer’s Conference. Kandinsky has also
paid for direct-to-consumer (DTC) television advertising, to appear in February 20X5. Related DTC internet advertising will
likewise begin in February and will be paid for based on ‘click-through’ to its Alzheimer’s site.
Relevant guidance
Expenditure is incurred, in some cases, to provide future economic benefits, but no asset is acquired or created. The
expenditure is recognised as an expense when it is incurred. An expenditure that is recognised as an expense when it is
incurred includes expenditure on advertising and promotional activities.
[IAS 38 para 69].
How should expenditure on advertising and promotional campaigns be treated before the campaign is launched?
Solution
The company should not recognise its advertising and promotional costs as an intangible asset, even though the
expenditure incurred might provide future economic benefits. It should charge all promotional costs to the income
statement. Expenditure on advertising and promotional activities should be expensed when incurred.
[IAS 38 para 69(c)].
All costs to develop and produce the marketing campaign and related materials, including the television
advertisement, internet advertisement and website, should be expensed immediately. Amounts paid to television
broadcast providers should be accounted for as a prepayment and expensed immediately when the advertisement
airs in 20X5. Costs for hits to the company’s internet site should be expensed, based on the click-through rate in
20X5.
6.4 Accounting for the cost of free samples

Reference to standard: IAS 1 paras 102, IAS 1 para 103
Background
Goya Laboratories is eager to increase knowledge of its new generic pain medication within hospitals. Accordingly, Goya’s
sales force distributes free samples of the pain medication during sales calls and at certain hospital conventions.
Relevant guidance
An entity might classify expenses according to nature or function/cost of sales methods.
[IAS 1 paras 102, 103].
Functions are defined as cost of sales, distribution activities or administrative activities.
[IAS 1 para 103].
How should Goya classify, and account for, the costs of free samples distributed in order to promote a product?
Solution
The cost of product distributed for free, and not associated with any sales
transaction, should be classified as marketing expense. Goya should account for the
sample product given away at conventions and during sales calls as marketing
expense. The product costs should be recognised as marketing expense where the
product is packaged as sample product.
6.5 Classification of co-promotion royalties

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Background
Pharmaceutical entity Mondrian Pharma uses the sales force of Matisse Inc for co-promotion of its transplantation drug in
the US. The co-promotion agreement requires Mondrian to pay Matisse 25% of net sales in the US for its marketing
efforts. The agreement is material to both parties.
Relevant guidance
Where items of income and expense are material, their nature and amount should be disclosed separately.
[IAS 1 para 97].
An entity should present an analysis of expenses recognised in profit and loss, using a classification based on either the
nature or the function within the entity, whichever provides information that is reliable and more relevant.
[IAS 1 para 99].
How should Mondrian classify co-promotion payments?
Solution
If expenses are presented by function, Mondrian should classify the co-promotion
payments as marketing and sales expenses. If Mondrian presents expenses by
nature, the co-promotion payments should be classified as third-party marketing
expenses and presented separately as such on the face of the income statement.
6.6 Segmental reporting of internal research and development

Background
Pharmaceutical entity Alpha produces and sells a portfolio of drugs that comprises three separate divisions. It funds the
majority of its R&D activities internally, in order to develop new drugs for all three divisions. It does not provide any
significant R&D services to external parties. The operational results for its R&D activities, for all of these divisions, are
regularly reviewed by the entity’s chief operating decision-maker (CODM). In addition, the CODM regularly reviews a
divisional report, with three separate divisional operating profit and loss statements, to make operational decisions. There
are three divisional heads that are directly accountable to, and maintain regular contact with, the CODM to discuss
operating activities (including R&D activities), financial results, forecasts and plans for their division.
Relevant guidance
An operating segment is a component of an entity that engages in business activities from which it might earn revenues or
incur expenses whose operating results are regularly reviewed by the entity’s CODM, to make decisions about resources
to be allocated to the segment and assess its performance, and for which discrete financial information is available. [IFRS
8 para 5].
Operating segments normally have segment managers who report to the CODM. [IFRS 8 para 9].
If the CODM reviews two or more overlapping sets of components for which managers are held responsible, the entity
should determine the operating segments based on which set would help users to evaluate the nature and financial effects
of the business activities of the entity. [IFRS 8 para 10].
Should R&D activities be reported as a segment?
Solution
The CODM reviews different sets of overlapping information. Management should consider qualitative factors in
determining the appropriate operating segments. These should include an assessment of whether the resultant
operating segments are consistent with the core principle of IFRS 8, whether the identified operating segments could
realistically represent the level that the CODM is assessing performance and allocating resources at, and whether the
identified operating segments enable users of its financial statements to evaluate its activities and financial
performance, and the business environment it operates in.
Alpha’s R&D activities are not reported as a separate operating segment. The divisions have heads directly
accountable to, and maintaining regular contact with, the CODM to discuss operating activities, financial results,
forecasts and plans for their division. Division segments are consistent with the core principle of IFRS 8, because they
enable users of their financial statements to evaluate the activities and financial performance and the business
environment of the pharmaceutical entity.
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6.7 Segmental reporting of research and development services

Background
Entity B has R&D facilities that it uses to perform contract investigation activities for other laboratories and pharmaceutical
companies. Approximately 65% of the laboratory’s revenues are earned from external customers – and these external
revenues represent 15% of the organisation’s total revenues. The R&D facilities’ operating results are regularly reviewed by
entity B’s chief operating decision-maker (CODM), to make decisions about resources to be allocated to the segment and
to assess its performance.
Relevant guidance
incur expenses whose operating results are regularly reviewed by the entity’s CODM, to make decisions about resources
to be allocated to the segment and to assess its performance, and for which discrete financial information is available.
[IFRS 8 para 5].
An entity should report separately the information about an operating segment that meets any of the following quantitative
thresholds [IFRS 8 para 13]:
a. its reported revenue, including both sales to external customers and inter-segment sales or transfers, is 10% or more of the
combined revenue (internal and external) of all operating segments;
b. the absolute amount of its reported profit or loss is 10% or more of the greater, in absolute amount, of (i) the combined reported
profit of all operating segments that did not report a loss, and (ii) the combined reported loss of all operating segments that
reported a loss; or
c. its assets are 10% or more of the combined assets of all operating segments.
Should entity B report its R&D activities as a business segment?
Solution
Entity B’s management should report its R&D activities as a separate reportable
segment. The activities meet the quantitative threshold for percentage of total
revenues and they otherwise meet the criteria for an operating segment.
6.8 Disclosure of R&D when reported to CODM

Reference to standard: IFRS 8 para 5, IFRS 8 para 23(f), IFRS 8 para 24(b)
Background
Manet Corp is a pharmaceutical entity with several operating segments.
R&D capitalised (such as in-process R&D) and R&D expensed is reported to the CODM, by operating segment, to make
decisions about resources to be allocated.
Relevant guidance
incur expenses, whose operating results are regularly reviewed by the entity’s CODM, to make decisions about resources
to be allocated to the segment and to assess its performance, and for which discrete financial information is available.
[IFRS 8 para 5].
An entity should disclose material expenses about each reportable segment if the specified amounts are included in the
measure of segment profit or loss reviewed by the CODM.
[IFRS 8 para 23(f)].
An entity should also disclose non-current assets if these are included in the measure of segment assets reviewed by the
CODM or are otherwise regularly provided to the CODM.
Should Manet disclose R&D expenses and capital expenditure separately in its segment reporting?
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Solution
R&D capitalised and expensed during the year should be disclosed for all reportable
segments, because this information is reported to the CODM to make decisions
about resources to be allocated.
7. Leases – IFRS 16
7.1 Substitution Rights

Reference to standard: IFRS 16 para 9, IFRS 16 App B para B13, IFRS 16 App B
para B14, IFRS 16 App B para B9
Background
Apollo, a medical device entity, enters into an arrangement with Star hospital to provide a medical imaging scanner and
supply medical imaging consumables (cartridges) for five years. On executing the arrangement, Apollo instals a medical
imaging scanner at Star’s premises that requires the use of Apollo’s consumables. The scanner has been customised to
run Star’s proprietary software and staff at Star determine when and how to operate the scanner. Apollo provides the
scanner free of charge to Star. However, Apollo expects to recover the scanner cost through Star’s purchase of
consumables. Legal title to the scanner remains with Apollo. The contract permits Apollo to substitute the scanner.
However, due to the potential disruption substitution would have on Star’s activities, the contract includes a significant
penalty in the event of downtime above a specified threshold. Therefore, it is expected that Apollo will substitute the
equipment only in the case of malfunction. Apollo also provides maintenance services.
Relevant guidance
A contract is, or contains, a lease if there is an identified asset and the contract conveys the right to control the use of the
identified asset for a period of time in exchange for consideration.
[IFRS 16 para 9].
An asset can be identified either explicitly or implicitly. Both cases could result in an identified asset.
[IFRS 16 App B para B13].
There is no identified asset if the supplier has a substantive right to substitute the asset throughout the period of use.
A contract conveys the right to control the use of an identified asset if the customer has both the right to obtain
substantially all of the economic benefits from use of the identified asset and the right to direct the use of the identified
asset throughout the period of use.
Does the contract contain a lease?
Solution
Yes. The contract contains a lease. The contract does not explicitly specify the scanner. However, since the scanner
is on site and customised for Star, it is implicitly identified. While Apollo has the legal right of substitution, this right is
not substantive due to the significant disruption and potential downtime penalty if the equipment was to be
substituted. Substitution for maintenance or malfunction is not considered a substantive right to substitute. Therefore,
the arrangement contains an identified asset, that is the scanner. Star has the right to control the use of the equipment
throughout the period of use because:
a. Star has the right to obtain substantially all the economic benefits from the use
of the identified equipment, based on its exclusive access and use of the
equipment during the five-year term; and
b. Star makes the relevant decisions about how and when the equipment is
operated by the hospital staff in their practice of medicine, throughout the
period of use.
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7.2 Identifying components within an arrangement: lab facility

para B33
Background
Biotech leases a biotech lab facility that comprises land, buildings and laboratory equipment. Biotech’s right to use the
land is highly integrated with its right to use the building. Biotech’s objective is to lease a lab facility as part of its
operations and Biotech cannot achieve its intended use of the lease without both the land and building. The lessor does
not lease or sell the laboratory equipment separately, but other suppliers do with similar facilities. The laboratory
equipment can be used in other facilities. The monthly payment to the lessor includes: (a) fixed rent for the building, land
and laboratory equipment; (b) a fixed amount for property taxes and insurance; (c) a fixed amount for maintenance related
to the laboratory equipment; and (d) a fixed amount related to the maintenance of building and land. Biotech elects to not
apply the practical expedient to combine the non-lease components with the associated lease components, due to the
significance of the maintenance services.
Relevant guidance
Contracts often combine different kinds of obligations of the supplier. In a multi-element arrangement, an entity has to
identify each separate lease component (based on the guidance on the definition of a lease) and account for it separately.
[IFRS 16 para 12].
An arrangement contains more than one lease component if both of the following criteria are met:
a. the lessee can benefit from use of the asset, either on its own or together with other resources that are readily available to the
lessee; and
b. the underlying asset is neither highly dependent on, nor highly interrelated with, the other underlying assets in the contract.
When identifying non-lease components, an entity must consider whether a good or service is transferred to the lessee.
The consideration shall be allocated between the components if the analysis concludes that there are separate
components (unless the practical expedient in IFRS 16 para 15 is applied).
[IFRS 16 para 12].
What are the various components in this arrangement?
Solution
The lease components in the arrangement are the building (including the land that it
sits on) and the laboratory equipment. The laboratory equipment is considered a
separate lease component as it is neither dependent on, nor highly interrelated with,
the building or land since it could be sourced from other providers and be used in
other lab facilities. (Note for the purposes of illustration in this solution we have
assumed there is one lease component for all of the laboratory equipment, but this
may not be the case in practice). The non-lease components are the building and
equipment maintenance services. Property taxes and landlord’s insurance that are
recharged to the lessee are not separate non-lease components as they do not
transfer separate goods or services to the customer. The total consideration, that
includes the fixed payments for the property taxes and insurance is allocated to the
separately identified components of the contract. This being the two lease
components and the identified non-lease components (building and equipment
maintenance services).
7.3 Lease classification and initial and subsequent measurement

Background
Pharmaceutical entity MDC leases specialised medical imaging equipment to a hospital, designed and customised to work
with the hospital’s proprietary software. Given the age and customisation of the equipment for the hospital, MDC would
incur significant costs to modify the equipment for use with another lessee or to facilitate its sale. The costs exceed the
expected benefit resulting from any such sale. Assume that the arrangement is a lease of the equipment with the following
additional facts.
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Lease term 4.5 years with no renewal option
Purchase option None
Present value of lease payments C200,000
Fair value of leased asset C210,000
Remaining economic life of equipment 5 years
Title to the asset remains with Lessor upon lease expiration
Relevant guidance
A lease is classified as a finance lease if it transfers substantially all of the risks and rewards incidental to ownership of an
underlying asset.
[IFRS 16 para 62].
Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease
are:
a. the lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
b. the lessee has the option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair value,
at the date the option becomes exercisable, for it to be reasonably certain, at the inception date, that the option will be
exercised;
c. the lease term is for the major part of the economic life of the underlying asset even if title is not transferred;
d. at the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the
underlying asset; and
e. the underlying asset is of such a specialised nature that only the lessee can use it without major modifications.
[IFRS 16 para 63].
How should MDC (the Lessor) classify the lease?
Solution
MDC assesses the arrangement and classifies the lease as a finance lease. The
hospital would utilise the equipment for 90% of its remaining economic life (4.5-year
lease / 5-year remaining economic life). The present value of the sum of the lease
payments represents 95% of the fair value of the leased asset (C200,000/C210,000).
In addition, the underlying asset is of a specialised nature. It is expected to have no
alternative use to MDC at the end of the lease term because the equipment is
customised and MDC would incur significant costs to reprogram the asset for use
by another customer.
7.4 Exclusive supply agreement – no control

Reference to standard: IFRS 16 para 9, IFRS 16 App B para B9, IFRS 16 App B para
B24
Background
Pharma Corp enters into a two-year agreement with an experienced drug manufacturer, Supplier Corp, to exclusively
manufacture two well-established drug compounds for a specified geographic region. Pharma Corp has arrangements
with other manufacturers in other geographic regions to fulfil the demand in those regions. Supplier Corp receives a
licence to be the exclusive manufacturer of the drug compounds for that geographic region, in exchange for a fee. Pharma
Corp and Supplier Corp also form a joint steering committee where Pharma Corp, in an advisory capacity, can provide
feedback to Supplier Corp and address any queries raised by Supplier Corp. The contract explicitly specifies the
manufacturing facility and Supplier Corp does not have the right to substitute the specified facility. The contract specifies
the monthly volumes of the two drug compounds that need to be delivered by Supplier Corp. Supplier Corp only has one
production line to fulfil the contractual requirements, but the capacity of that production line exceeds Pharma Corp’s
monthly volumes. The specified volume cannot be changed by Pharma Corp during the term of the arrangement. Supplier
Corp operates the manufacturing facility and makes all manufacturing decisions including how and when the drug
compounds are to be produced to meet the specified volume requirements.
Relevant guidance
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[IFRS 16 para 9].
The decisions about how and for what purpose the underlying asset is used could be predetermined before the inception
of the lease. The customer in this case has the right to direct the use of an asset if either:
it has the right to operate the identified asset throughout the period of use,
without the supplier having the right to change the operating instructions; or
it has designed the identified asset (or specific aspects of the asset) in a way that
predetermines how and for what purpose the asset will be used throughout the
period of use.
Solution
No. Although the asset is identified, Pharma Corp lacks control of the asset during
the period of use and so the contract does not contain a lease. The asset is
identified, because the manufacturing facility is explicitly specified in the contract
and Supplier Corp has only one manufacturing production line available to fulfil the
contract and no substitution rights. Pharma Corp does not have the right to control
the use of the manufacturing facility throughout the two-year period of use despite
its right to substantially all of the economic benefits from the use of the
manufacturing facility. This is because the monthly volumes have been pre agreed
between the parties and Pharma Corp has no right to change these volumes during
the term of the arrangement. Supplier Corp is entitled to make all operating
decisions, such as determining how and when the facility is operated during the
period of use, the production schedule for the two drug compounds, the batch size
and so on. Therefore, Supplier Corp has the right to control the use of the identified
asset during the period of use.
7.5 Exclusive supply agreement – no identified asset

para B14
Background
Customer A enters into an arrangement with a contract manufacturing organisation (CMO) to produce medical equipment
and disposables (‘the Products’) that customer A then sells to outside customers. The CMO has multiple production lines
that it uses to fulfil orders for multiple customers. The arrangement allows the CMO to choose the production line used to
fulfil customer A’s orders. Even after the production of the Products commences on a product line, CMO can easily
change to a different production line, with minimal transfer costs, because other production lines are available. Therefore,
the CMO can economically benefit from the ability to manage multiple customer orders across all production lines.
Customer A submits binding purchase orders quarterly to the CMO and it is contractually required to provide an annual
non-binding production forecast. The Products are generic, easily stored and the CMO has full discretion over the
operating process, including the selection of materials to use in production.
Relevant guidance
[IFRS 16 para 9].
An asset can be identified either explicitly or implicitly. Both cases could result in an identified asset.
There is no identified asset if the supplier has a substantive right to substitute the asset throughout the period of use.
Substitution rights are substantive if the supplier has the practical ability to substitute an alternative asset and would
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benefit economically from substituting the asset.
Does this arrangement contain a lease?
Solution
This arrangement does not contain a lease under IFRS 16. While the use of an asset
(that is, the production line) is implicit in the contract, there is likely no identified
asset, because substantive substitution rights exist. This is because the CMO has
the practical ability to substitute production lines throughout the contract and can
benefit from such substitution. In addition, CMO has the right to change the
operating process and decide when the output is produced.
7.6 Exclusive supply agreement – contains a lease

Reference to standard: IFRS 16 para 9, IFRS 16 App B para B9, IFRS 16 App B para
B24
Background
Customer B enters into an arrangement with a CMO to produce medical equipment and disposables (‘the Products’) that
customer B then sells to outside customers. The CMO has multiple production lines that it uses to fulfil orders for multiple
customers. However, there is a dedicated production line for the Products, meaning the CMO is contractually unable to
use any other production line for the customer and cannot use this production line for other customers. Customer B
submits binding purchase orders very frequently and these effectively determine whether, when and how much output is
produced. Customer B is also contractually required to provide the CMO with an annual non-binding forecast of output
requirements. The Products are highly specialised, key operating decisions are standardised and any changes in operating
procedures are subject to approval by Customer B.
Relevant Guidance
[IFRS 16 para 9].
The customer has the right to direct the use of an asset if either:
it has the right to operate the identified asset throughout the period of use,
without the supplier having the right to change the operating instructions; or
it has designed the identified asset (or specific aspects of the asset) in a way that
predetermines how and for what purpose the asset will be used throughout the
period of use.
[IFRS 16 App B para B24(b)].
Does this arrangement contain a lease?
Solution
This arrangement contains a lease under IFRS 16. An identified asset is explicit in
the contract (that is, the production line) and there are no substitution rights. There
is a dedicated production line and Customer B appears to control the decision-
making rights over the use of the production line. This is because Customer B’s
purchase orders determine whether, when and how much output is produced by the
dedicated production line. The CMO does not have the right to change the
operating instructions, including types of materials/components, overall production
process and other decisions related to the output, without prior authorisation by
Customer B. Customer B also has substantially all of the economic benefits from
use of the production line as the CMO cannot use it for other customers.
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7.7 Embedded lease of production line in supply agreement – fixed

minimum consideration
Background
Pharmaceutical entity Paddington enters into a two-year contract manufacturing agreement with LondonCo, a CMO, to
manufacture and supply a drug product. Paddington has concluded that the supply arrangement contains an embedded
lease for the production line (see solution 7.6). Paddington pays LondonCo a fee for each batch of drug product produced.
The contract specifies the minimum monthly volume of the drug product that is contractually required to be purchased by
Paddington. The specified volume cannot be changed by Paddington during the term of the arrangement. Paddington
separates lease and non-lease components and does not apply the practical expedient.
Relevant guidance
The consideration must be allocated between the components if the analysis concludes that there are separate
[IFRS 16 para 12].
[IFRS 16 para 13].
How should Paddington determine the lease payments for the embedded lease under IFRS 16?
Solution
Paddington is required to purchase minimum volumes throughout the two-year period of use. As a result, although the
total consideration is variable, the minimum volumes establish a fixed minimum consideration. First Paddington
should allocate the fixed consideration between the leased production line (lease component) and drug product (non-
lease component), based on their relative stand-alone prices at lease commencement. Then, Paddington would
record a lease liability (and a corresponding right of use asset) on its balance sheet at the present value of the
amounts allocated as lease payments.
7.8 Embedded lease of production line in supply agreement – variable

consideration
Background
Pharmaceutical entity Paddington enters into a two-year contract manufacturing agreement with LondonCo, a CMO, to
manufacture drug product. Paddington has concluded that the supply arrangement contains an embedded lease for the
production line (see solution 7.6). Paddington pays LondonCo a fee for each batch of drug product produced. The
contract does not specify a minimum monthly volume of the drug product that is contractually required to be purchased
by Paddington. There are no ‘in substance’ fixed payments. Paddington separates lease and non-lease components and
does not apply the practical expedient.
Relevant guidance
The consideration must be allocated between the components if the analysis concludes that there are separate
[IFRS 16 para 12].
[IFRS 16 para 13].
How should Paddington determine the lease payments for the embedded lease under IFRS 16?
Solution
While this contract manufacturing agreement contains an embedded lease, the
consideration is 100% variable. Because variable consideration is excluded from the
determination of lease payments included in the lease liability, there would be no
lease liability recorded on commencement date for this agreement. Paddington is
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Solution
still required to allocate the consideration between the lease and non-lease
components and would allocate the fee for each batch based on the relative
standalone selling prices of the lease and non-lease components. Paddington would
record variable lease expenses for the embedded lease component over the two-
year period. Paddington would recognise inventory/cost of sales for the non-lease
component relating to the supply of the drug product.
Contacts
PLS assurance leader contacts
Territory Name E-mail

Australia Mark Dow mark.dow@au.pwc.com
Brazil Daniel Fumo daniel.fumo@pwc.com
China/HK Tony Ng tony.ng@cn.pwc.com
France Cedric Mazille cedric.mazille@pwc.com
Germany Bernd Roese bernd.roese@pwc.com
India Nitin Khatri nitin.khatri@pwc.com
Italy Stefano Pavesi stefano.pavesi@pwc.com
Japan Takeshi Shioya takeshi.shioya@pwc.com
Mexico Esmeralda Garcia esmeralda.garcia@pwc.com
Netherlands Helga Keijzer helga.keijzer@pwc.com
Singapore Daniel Khoo daniel.khoo@pwc.com
South Africa Saffiyah Bootha saffiyah.bootha@pwc.com
South Korea Yongbeom Seo yongbeom.seo@pwc.com
Spain Esteban Cobo Vallés esteban.cobo.valles@pwc.com
Sweden Jon Arwidson jon.arwidson@pwc.com
Switzerland Petra Schwick petra.schwick@pwc.ch
UK Sarah Quinn sarah.l.quinn@pwc.com
US Laura Robinette laura.robinette@pwc.com
PwC clients who have questions about this publication should contact their engagement partner.
Name E-mail
IFRS Peter Kartscher peter.kartscher@pwc.ch
IFRS Ruth Preedy ruth.e.preedy@pwc.com
Real estate
Need guidance on preparing Real estate financial statements? See our publication 'Applying IFRS for the real estate industry
2023'. This publication considers the main accounting issues encountered by real estate entities and the practices adopted
in the industry under IFRS.
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Applying IFRS for the real estate industry
What is the focus of this publication?
This publication considers the main accounting issues encountered by real estate entities and the practices adopted in the
industry under IFRS® Accounting Standards.
Who should use this publication?
This publication is intended for entities that construct and manage real estate property. Activities such as the construction of
properties on behalf of third parties, and holding or developing properties principally for sale or otherwise own use, are not
considered in this publication.
This publication is intended for:
audit committees, executives and financial managers in the real estate industry;
investors and other users of real estate industry financial statements, so that they
can identify some of the accounting practices adopted to reflect features unique to
the industry; and
accounting bodies, standard-setting agencies and governments throughout the
world that are interested in accounting and reporting practices and are responsible
for establishing financial reporting requirements.
What is included?
This publication covers issues that we believe are of financial reporting interest due to their particular relevance to real estate
entities and/or historical varying international practice.
This publication has a number of sections designed to cover the main issues raised.
This publication is based on the experience gained from the worldwide leadership position of PwC in the provision of
services to the real estate industry. This leadership enables PwC’s Real Estate Industry Accounting Group to make
recommendations and lead discussions on international standards and practice.
We hope you find this publication helpful.
1. Real estate value chain
1.1 Overview of the investment property

industry
The investment property or real estate industry comprises entities that hold real estate (land and buildings) to earn rentals
and/or for capital appreciation.
Real estate properties are usually held through a variety of structures that include listed and privately held corporations,
investment funds, partnerships and trusts.
1.2 Real estate life cycle
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The life cycle of real estate that is accounted for as investment property typically includes the following stages:
 View image
1.2.1. Step 1: Acquisition or construction of

real estate
Step 1: Acquisition or construction of real estate
Control of real estate can be obtained through:
direct acquisition of real estate;

construction of real estate;
leasing of real estate; or

a combination of the above.
Entities normally perform strategic planning before the acquisition, construction or leasing, to assess the feasibility of the
project.
Entities might incur costs attributable to the acquisition, construction or leasing of real estate during this first step of the
cycle. Entities might also enter into financing arrangements to secure the liquidity required for the acquisition or construction
of real estate.
1.2.2. Step 2: Leasing or subleasing of real

estate
Step 2: Leasing or subleasing of real estate
Most real estate entities primarily hold real estate for the purpose of earning rentals. They may also hold some real estate for
their own use.
For entities holding real estate for the purpose of earning rentals, lease agreements might contain a variety of terms. The
most common terms that will feature in all leases include matters such as the agreed lease term (and any options to extend
that term), as well as the agreed rental payments due. Additional items that might feature include payments for maintenance
services, utilities, insurance, property taxes and terms of lease incentives provided to the tenant.
1.2.3. Step 3: Management of real estate
Step 3: Management of real estate
Real estate entities often provide management services to tenants who occupy the real estate that they hold, to ensure that
the property is in good condition and to preserve the value of the real estate. These services might be performed by the real
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estate owners themselves, or they might be outsourced to other entities that are designed to provide these services.
Services might include maintenance of common areas, cleaning and security.
1.2.4 Step 4: Sale or demolition of real estate
Step 4: Sale or demolition of real estate
Real estate entities might sell the real estate that they hold at the end of the life cycle to benefit from capital appreciation.
Alternatively, entities might proceed with demolition of the property, potentially with a view to construction of a new property.
1.3. Relevant accounting standards
The acquisition and construction of real estate that is accounted for as investment property are governed by the
requirements of IAS 40, ‘Investment property’, IAS 16, ‘Property, plant and equipment’, and IAS 23, ‘Borrowing costs’.
The requirements of IFRS 16, ‘Leases’, apply to both arrangements where an entity leases out real estate property and real
estate properties held under leases as a lessee.
The requirements of IFRS 15, ‘Revenue from contracts with customers’, apply to revenue generated by a real estate entity for
the provision of services to tenants, which are separated from that portion of income that relates to the leased asset
accounted for under IFRS 16.
The requirements of IFRS 9, ‘Financial Instruments’, apply to financial assets and liabilities recognised by real estate entities.
This publication is based on accounting standards that are effective for annual periods beginning on or after 1 January 2023.
There area number of new accounting pronouncements, issued as of the date of this publication, that are not yet effective.
Their impact, where relevant, is presented in separate sections under each related area or otherwise referred to specifically in
the guide. These pronouncements are as follows:
Amendments to IAS 1, ‘Presentation of financial statements’, on classification of

liabilities as current or non-current and non-current liabilities with covenants
(effective 1 January 2024);
Amendments to IFRS 16 ‘Leases’, on lease liabilities in a sale and leaseback
(effective 1 January 2024);
Amendments to IAS 7 ‘Statement of Cash Flows’ and IFRS 7 ‘Financial

Instruments: Disclosures), on supplier finance arrangements (effective 1 January
2024); and
Amendments to IAS 21 ‘The Effects of Changes in Foreign Exchange Rates’, on
lack of exchangeability (effective 1 January 2025).
The following standards and interpretations, effective as at the date of this publication, are referred to in the guide:
IFRS 3, ‘Business combinations’ (‘IFRS 3’);

IFRS 5, ‘Non-current assets held for sale and discontinued operations’ (‘IFRS 5’);
IFRS 7, ‘Financial instruments: disclosures’ (‘IFRS 7’);

IFRS 8, ‘Operating segments’ (‘IFRS 8’);
IFRS 9, ‘Financial Instruments’ (‘IFRS 9’);
IFRS 10, ‘Consolidated financial statements’ (‘IFRS 10’);

IFRS 11, ‘Joint arrangements’ (‘IFRS 11’);
IFRS 13, ‘Fair value measurement’ (‘IFRS 13’);
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IFRS 15, ‘Revenue from contracts with customers’ (‘IFRS 15’);

IFRS 16, ‘Leases’ (‘IFRS 16’);
IFRS 17, ‘Insurance Contracts’ (‘IFRS 17’)

IAS 1, ‘Presentation of financial statements’ (‘IAS 1’);
IAS 2, ‘Inventories’ (‘IAS 2’);
IAS 7, ‘Statement of cash flows’ (‘IAS 7’);
IAS 8, ‘Accounting policies, changes in accounting estimates and errors’ (‘IAS 8’);
IAS 12, ‘Income taxes’ (‘IAS 12’);
IAS 16, ‘Property, plant and equipment’ (‘IAS 16’);

IAS 21, ‘The effects of changes in foreign exchange rates’ (‘IAS 21’);
IAS 23, ‘Borrowing costs’ (‘IAS 23’);
IAS 27, ‘Separate financial statements’ (‘IAS 27’);
IAS 28, ‘Investments in associates and joint ventures’ (‘IAS 28’);

IAS 36, ‘Impairment of assets’ (‘IAS 36’);
IAS 37, ‘Provisions, contingent liabilities and contingent assets’ (‘IAS 37’);
IAS 38, ‘Intangible assets’ (‘IAS 38’);

IAS 40, ‘Investment property’ (‘IAS 40’);
IFRIC 22, ‘Foreign currency transactions and advance consideration’ (‘IFRIC 22’);
and
IFRIC 23, ‘Uncertainty over income tax treatments’ (‘IFRIC 23’).
2. Acquisition or construction of real estate
2.1. Overview
Real estate entities obtain real estate either by acquiring, constructing or leasing property. Property used for the purpose of
earning rentals or held for capital appreciation is classified as investment property under IAS 40.
2.2 Definition and classification
2.2.1. Principles
IAS 40 defines investment property as property that is held to earn rentals or capital appreciation, or both. [IAS 40 para 5].
The property might be land or a building (or part of a building), or both. Further guidance on scope and classification can be
found in the PwC Manual of Accounting chapter 23 paragraphs 1–15.
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Investment property does not include the following:
Property intended for sale in the ordinary course of business or for development
and resale.
Owner-occupied property, including property held for such use or for

redevelopment prior to such use, and property occupied by employees.
Owner-occupied property awaiting disposal.
Property that is leased to another entity under a finance lease.
[IAS 40 para 9].
Owner-occupied property is property that is used in the production or supply of goods or services or for administrative
purposes. [IAS 40 para 5]. A factory or the corporate headquarters of an entity would qualify as owner-occupied property.
During the life cycle of a property, real estate entities might choose to redevelop property for the purposes of onward sale.
Property held for sale in the ordinary course of business is classified as inventory rather than investment property. [IAS 40
para 9(a)]. Transfers between investment property and both owner-occupied property and inventory are dealt with in section
3.7.
Classification as investment property is not always straightforward. Factors to consider, when determining the classification
of a property, include but are not limited to:
the extent of ancillary services provided (see section 2.2.2);

the extent of use of the property in running an underlying business;
whether the property has dual use (see section 2.2.6);

the strategic plans of the entity for the property; and
previous use of the property.
Where an entity decides to dispose of an investment property without development, it continues to treat the property as an
investment property [IAS 40 para 58]. The property will continue to be classified as investment property until it meets the
criteria to be classified as a non-current asset held for sale in accordance with IFRS 5 (see section 6).
IND FAQ 2.2.1.1 – Does a property leased out to a hotel management entity meet the definition of ‘investment property’?
IND FAQ 2.2.1.2 – Does a property subject to a hotel management contract meet the definition of ‘investment property’?
2.2.2. Ancillary services
Where an entity provides insignificant ancillary services, such as maintenance, to the third party occupants of the property,
this does not affect the classification of the property as an investment property [IAS 40 para 11].
Where ancillary services provided are more than insignificant, the property is regarded as owner-occupied, because it is
being used, to a significant extent, for the supply of goods and services. For example, in a hotel, significant ancillary services
(such as a restaurant, fitness facilities or spa) are often provided. IAS 40 provides no application guidance as to what
‘insignificant’ means. Accordingly, entities should consider both qualitative and quantitative factors in determining whether
services are insignificant. Further guidance on Ancillary services can be found in the PwC Manual of Accounting chapter 23
paragraphs 16–18.
IND FAQ 2.2.2.1 – Does a property meet the definition of ‘investment property’ when significant ancillary services are
provided?
2.2.3. Properties under construction or

development
Real estate that meets the definition of ‘investment property’ is accounted for in accordance with IAS 40, even during the
period when it is under construction. Further, an investment property under redevelopment for continued future use as
investment property also continues to be recognised as investment property.
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2.2.4. Properties held to be leased out as

investment property
Real estate entities might hold investment properties that are vacant for a period of time. Where these properties are held to
be leased out under an operating lease, they are classified as investment property.
2.2.5. Properties with undetermined use
Land with undetermined use is accounted for as investment property. This is due to the fact that an entity’s decision around
how it might use that land (be it as an investment property, inventory or as owner-occupied property) is, of itself, an
investment decision. In turn, the most appropriate classification for such property is as investment property. [IAS 40 para
8(b)].
2.2.6 Properties with dual use
A property might be partially owner-occupied, with the rest being held for rental income or capital appreciation.
If each of these portions can be sold separately (or separately leased out under a finance lease), the entity should account for
the portions separately. [IAS 40 para 10]. That is, the portion that is owner-occupied is accounted for under IAS 16, and the
portion that is held for rental income or capital appreciation, or both, is treated as investment property under IAS 40.
If the portions cannot be sold or leased out separately under a finance lease, the property is investment property only if an
insignificant portion is owner-occupied, in which case the entire property is accounted for as investment property. If more
than an insignificant portion is owner-occupied, the entire property is accounted for as property, plant and equipment. There
is no guidance under the standards as to what ‘insignificant’ means; accordingly, entities should consider both qualitative
and quantitative factors in determining whether the portion of the property is insignificant.
IND EX 2.2.6.1 – Accounting for multi-purpose properties
2.2.7. Group situations
Within a group of entities, one group entity might lease property to another group entity for its occupation and use.
In the consolidated financial statements, such property is not treated as investment property; this is because, from the
group’s point of view, the property is owner-occupied. In the separate financial statements of the entity that owns the
property or holds it under a lease, the property will be treated as investment property if it meets the definition in paragraph 5
of IAS 40. [IAS 40 para 15].
In contrast, property owned or held under a lease by a group entity and leased to an associate or a joint venture should be
accounted for as investment property in both the consolidated financial statements and any separate financial statements
prepared. Associates and joint ventures are not considered part of the group for consolidation purposes. Further guidance
on group considerations can be found in the PwC Manual of Accounting chapter 23 paragraphs 19–20.
2.2.8. Properties held under leases
Under IFRS 16, almost all leases must be brought on the balance sheet of the lessee. The lessee recognises a right-of-use
asset and a corresponding liability at the lease commencement date. [IFRS 16 para 22]. Further guidance on lease
recognition for leases of investment property can be found in the PwC Manual of Accounting chapter 23 paragraph 36.
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Real estate entities often hold investment properties that are located on leased land, and these ground leases are often for
long periods of time (for example, 99 years). These entities are lessees in respect of the ground lease and, under IFRS 16,
they must recognise a right-of-use asset and lease liability in relation to these leases. In turn, the right-of-use asset is
classified as an investment property, given that the leased land is held solely for the purposes of holding the related
investment property building. Further, where the real estate entity applies the fair value model for its investment property, it
will equally be required to apply this model to right-of-use assets that meet the definition of investment property. [IFRS 16
para 34].
The right-of-use asset is measured on initial recognition in accordance with IFRS 16. [IAS 40 para 29A]. IFRS 16 requires a
right-of-use asset to be measured at the amount of the initial measurement of the lease liability, adjusted for any lease
payments made at or before the commencement date and any lease incentives received. Any initial direct costs incurred by
the lessee and the estimated costs of decommissioning or restoration obligations required by the lease are also added to the
right-of-use asset. Where a ground lease is negotiated at market rates, the fair value of the right-of-use asset, net of the
market rents promised under the lease and the expected outflows for any decommissioning or restoration obligations,
should be zero. [IAS 40 para 41]. It follows that the fair value of a newly negotiated ground lease at market rents should differ
from the net of the initial recognition amounts only in respect of any initial direct costs incurred by the lessee, since
transaction costs are not included in a fair value calculation in accordance with IFRS 13. Similarly, a lease interest purchased
in an arm’s length transaction (other than in a business combination) would be expected to have a fair value equal to the
purchase consideration paid (that is, the cost of the right-of-use asset), before any initial direct costs are considered.
On subsequent measurement of the right-of-use asset at fair value, valuation models for investment property will include
ground lease payments as cash outflows and typically present the fair value on a net basis. However, IFRS 16 requires the
lease liability and the right-of-use investment property to be presented on a gross basis on the balance sheet. To achieve
this presentation, IAS 40 requires the amount of the recognised lease liability, calculated in accordance with IFRS 16, to be
added back to the amount determined under the net valuation model, to arrive at the carrying amount of the investment
property under the fair value model. Subsequent accounting considerations in relation to subleases entered into with
tenants, where the underlying investment property is held under a lease, are discussed in section 4.2.
IND EX 2.2.8.1 – Accounting for investment property held under a lease
2.3. Acquisition of investment properties: asset

acquisition or business combination
Entities might acquire investment properties that meet the definition of an asset, or investment properties (together with other
inputs and processes) that meet the definition of a business under IFRS 3.
It is also common in the real estate industry to structure property acquisitions and disposals in a tax-efficient manner. This
often involves the transfer of a company, frequently referred to as a ‘corporate wrapper’, which holds one or more properties.
The accounting treatment for an acquisition depends on whether it is a business combination or an asset acquisition.
A ‘business’ is defined as an ‘integrated set of activities and assets that is capable of being conducted and managed for the
purpose of providing goods or services to customers, generating investment income (such as dividends or interest) or
generating other income from ordinary activities’. [IFRS 3 App A].
The legal form of the acquisition is not a determining factor when assessing whether a transaction is a business combination
or an asset acquisition. For example, the acquisition of a single vacant investment property is not a business combination
simply because it is purchased through a corporate wrapper. Similarly, a transaction is not an asset acquisition simply
because the acquiring entity purchases a group of assets directly rather than purchasing shares of a company.
A transaction will qualify as a business combination only where the assets purchased constitute a business. Significant
judgement may be required in the determination of whether the definition of a business is met.
To be considered a business, an acquisition would have to include an input and a substantive process that together
significantly contribute to the ability to create outputs. Not all of the elements need to be present for the group of assets to
be considered a business:
Outputs are not required for an integrated set to qualify as a business. [IFRS 3 App
B para B7].
A business does not need to include all of the inputs or processes that the seller
used in operating that business. However, to be considered a business, an
integrated set of activities and assets must include, at a minimum, an input and a
substantive process that together significantly contribute to the ability to create
output. [IFRS 3 App B paras B7-B12D].
The guidance provides a framework to evaluate when an input and a substantive process are present, and it considers an
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optional concentration test that, if met, eliminates the need for further assessment.
 View image
The concentration test
Under the concentration test, companies consider whether substantially all of the fair value of the gross assets acquired is
concentrated in a single asset (or a group of similar assets). If so, the assets acquired would not represent a business and no
further analysis is required. Gross assets acquired exclude cash, deferred tax assets and any goodwill that results from the
effects of deferred tax liabilities. The fair value of the gross assets acquired can usually be determined based on the
consideration transferred (plus the fair value of any non-controlling interest and previously held interest, if any) plus the fair
value of any liabilities assumed, other than deferred tax liabilities. In order to compare like with like, any items excluded from
the ‘gross assets acquired’ would also be excluded from the ‘fair value of gross assets acquired’ calculation.
The optional concentration test includes the concept of aggregating ‘similar’ assets. In the real estate industry, it is common
for acquisitions to include several properties. Entities should carefully consider the specific facts and circumstances,
including class of property and location, when concluding whether assets purchased in a transaction are similar. A group of
properties are not similar if they have significantly different risk characteristics. [IFRS 3 App B para B7B(f)(vi)].
IND EX 2.3.0.1 – Acquisition of a residential real estate portfolio: determined to be an asset acquisition
Framework in IFRS 3
IFRS 3 requires a business to include, as a minimum, an input and a substantive process that together significantly
contribute to the ability to create output. The guidance provides a framework to evaluate when an input and a substantive
process are present, differentiating between transactions with outputs and those with no outputs. Outputs are defined as
‘the results of inputs and processes applied to those inputs that provide goods or services to customers, generate
investment income (such as dividends or interest) or generate other income from ordinary activities’. [IFRS 3 App B para B7].
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Without outputs
An acquired process is considered substantive where the process is critical to the ability to convert an acquired input to an
output. In addition:
the inputs acquired include an organised workforce that has the necessary skills,
knowledge and experience to perform that process; and
other inputs are acquired that can be developed or converted into outputs by the
organised workforce (for example, intellectual property, other economic resources
that could be developed to create outputs, or rights to obtain materials that enable
future output to be created).
With outputs
An acquired process is considered substantive where, either:
the process is critical in continuing to produce outputs and the input includes an
organised workforce with the necessary skills, knowledge or experience to perform
that process; or
the process significantly contributes to the ability to continue to produce outputs
and is unique or scarce or cannot be replaced without significant cost.
Contracted workforce
An acquired contract could give access to an organised workforce (for example, outsourced property management services).
The entity needs to assess whether the organised workforce provides a substantive process that it controls. Factors to
consider include: the service is not ancillary or minor; it would be difficult to replace the workforce; and the duration of the
contract and renewal terms.
IND EX 2.3.0.2 – Acquisition of a residential and office real estate portfolio: determined to be an asset acquisition
IND EX 2.3.0.3 – Acquisition of a residential and office real estate portfolio: determined to be a business combination
2.3.1. Accounting treatment for business

combinations and asset acquisitions
The accounting treatment for an acquisition that is a business combination differs from the accounting when acquiring a
group of assets that does not meet the definition of a business (that is, an asset acquisition).
The key considerations are explained below:
Asset acquisition Business

combination
Standard IFRS 3 – apply scope IFRS 3
exemption explained in
paragraph 2(b) and apply
the relevant standards for
the acquired
assets/liabilities 1
Assets and liabilities Allocate the purchase Recognise and measure the
price to the individual identifiable assets and
identifiable assets and liabilities at their acquisition-
liabilities on the basis of date fair values
their relative fair values
Deferred tax No deferred tax is Deferred tax is recognised in

recognised under IAS 12, accordance with IAS 12
given the initial
recognition exception [IAS
12 para 15(b)]
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Asset acquisition Business

combination
Goodwill Not recognised Recognise any related goodwill
or bargain purchase
Contingent liabilities Not recognised, although Contingent liabilities that are a

the presence of present obligation arising from
contingent liabilities might past events and can be reliably
impact transaction price measured should be
and asset valuation recognised at fair value. This is
the case even if it is not
probable that a future outflow
of economic benefits will occur
Transaction costs Form part of the Expensed in the period

cost of the asset incurred
Subsequent measurement implications Follow relevant standards Follow relevant standards for
for each asset each asset
For contingent liabilities, these

should be measured at the
higher of:
the amount
that would be
recognised
under IAS 37;
and
the amount
initially
recognised,
less (if
appropriate)
the cumulative
income
recognised
Annual impairment test for any
recognised goodwill is required
(see section 3.4.5)
1
Paragraph 2(b) of IFRS 3 removes from the scope of the standard the acquisition of an asset or a group of assets that does
not meet the definition of a business. In such cases, the acquirer recognises the acquired assets and assumed liabilities in
accordance with the relevant standards. The cost should be allocated to the individual identifiable assets and liabilities on
the basis of their relative fair values at the purchase date.
2.3.2. Accounting for deferred tax at initial

recognition
One of the more important features for the real estate industry, in respect of the accounting for deferred tax, is the initial
recognition exemption in paragraph 15(b) of IAS 12, which applies for property acquisitions outside a business combination.
Deferred tax is recognised for all taxable temporary differences, except to the:
a. the deferred tax liability arises from the initial recognition of goodwill, or
b. the initial recognition of an asset or liability in a transaction which
i. is not a business combination;

ii. at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss); and
iii. at the time of the transaction, does not give rise to equal taxable and deductible temporary differences.
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An example of equal taxable and deductible temporary differences would be the acquisition of investment property held by
way of a lease if initial recognition of the lease liability and corresponding right-of-use asset gives rise to equal amounts of
taxable and deductible temporary differences. The recognition guidance in IAS 12 for deferred tax assets and deferred tax
liabilities is applied to these deductible and taxable temporary differences, respectively. Further guidance on the recognition
of deferred tax can be found in the PwC Manual of Accounting chapter 14 paragraph 18.
It is important therefore to determine whether or not the transaction is a business combination or an asset acquisition (see
section 2.3).
IND EX 2.3.2 Deferred tax at initial recognition
Goodwill that arises on the acquisition of an investment property that is a business might result (partially) from the
recognition of deferred tax. Such goodwill must be tested for impairment annually (see section 3.4.5).
2.3.3. Accounting for portfolio

premiums/discounts
Entities acquire real estate properties either individually or in a portfolio. The price paid to acquire a portfolio of properties in
a single transaction could differ from the sum of the fair values of the individual properties.
Portfolio premiums (discounts) are the excess (shortfall) of the market value of a portfolio of properties compared to the
aggregate market value of the properties taken individually. Such premiums (discounts) affect the allocation of consideration.
Portfolio premiums could arise as a result of a purchaser’s ability to build a portfolio immediately rather than over a period of
time, short supply in the market, or because of saved transaction costs. In some instances, expected portfolio synergies
might also result in portfolio premiums. In such a case, it is important to consider whether the existence of a portfolio
premium is an indicator of a business combination as opposed to the acquisition of a group of assets.
Portfolio discounts could be granted by a seller in order to encourage a single buyer to purchase a large number of
properties, and thereby avoid future marketing and other administrative costs associated with selling properties one-by-one.
The accounting for such portfolio premiums (discounts) at initial recognition differs, depending on whether the transaction
qualifies as a business combination or not.
The following table summarises the principles of accounting for portfolio premiums and discounts paid when acquiring a
portfolio of real estate properties:
Portfolio Asset acquisition Business combination

premiums
Initial The consideration is allocated The assets and liabilities acquired are
measurement to the underlying assets recognised at fair value, so any premiums or
proportionately to their fair discounts affect the amount of goodwill
value. Premiums (discounts) arising from acquisition accounting.
might result in a higher (lower)
amount being allocated to the If the discount results in a bargain purchase,
investment property when the gain is recognised in profit or loss.
compared to its fair value.
2.4. Asset acquisitions: measurement at initial

recognition
The rules for recognition of real estate that meets the definition of investment property are similar to those for all other
assets. Investment properties (that are not a business) are initially recognised at cost, including transaction costs. [IAS 40
para 20].
Cost is generally the amount of cash or cash equivalents paid, or the fair value of other consideration given, to acquire an
asset at the time of its acquisition or construction. [IAS 40 para 5].
An entity might acquire investment property for an initial payment, plus agreed additional payments contingent on future
events, outcomes or the ultimate sale of the acquired asset at a threshold price. The entity will usually be contractually or
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statutorily obligated to make the additional payment if the future event or condition occurs. This is often described as
variable or contingent consideration for an asset.
These types of arrangements need to be analysed carefully to determine whether or not the future variable or contingent
payment is related to the cost of the asset. Payments which are not related to the cost of the asset should be expensed as
incurred. The accounting for contingent consideration of an asset has been discussed by the IFRS Interpretations Committee
although it has currently not provided further guidance in the form of an interpretation or an agenda decision that explains
how the existing guidance is applied. An entity should therefore develop an accounting policy for contingent consideration
related to the cost of acquiring an investment property that is consistently applied in accordance with IAS 8. There is
diversity in practice in accounting for contingent consideration of an asset, with three acceptable approaches.
1. Financial liability model

Investment property is initially recognised including the fair value of the future contingent payments, and a financial
liability is recognised at the same fair value of contingent payments. Subsequently, the financial liability is measured
at amortised cost, following the requirements of IFRS 9. The entity should adjust the carrying amount of the financial
liability to reflect actual and updated estimated cash flows whenever the cash flow estimates are revised. The entity
recalculates the carrying amount of the liability by computing the present value of estimated future cash flows at the
financial instrument’s original effective interest rate or, where applicable, the revised effective interest rate calculated
in accordance with IFRS 9 paragraph B5.4.6. Subsequent changes in the measurement of the liability are unrelated
to the cost of the asset. Those adjustments are therefore recognised in profit or loss as income or expense.
2. Cost accumulation model
Investment properties are initially recognised, at the date of acquisition, at the amount of consideration paid. Variable
payments contingent on future events are not included in the carrying amount of the asset on day 1, and no liability
is recognised for these payments. The entity does not recognise a liability because, following the agenda decision by
the IFRS Interpretations Committee to not include the accounting for contingent consideration to acquire an asset to
its agenda because it is too broad, it is not clear that there is an obligation before the uncertainty is resolved. The
IFRS Interpretations Committee also noted, in the 2016 agenda decision, that there are unanswered questions about
the accounting for subsequent payments. An entity could therefore choose to capitalise the variable payments as
part of the cost of the asset when paid, on the basis that these payments represent the direct cost of acquisition.
This treatment is typically only acceptable if a change in the variable payment is as a consequence of the utility of
the asset. If the variation is as a consequence of another factor not associated with the asset, the accounting for that
aspect of the variable payment would generally follow the applicable guidance in IFRS.
3. Analogy to IFRIC 1 approach
Investment properties are initially recognised at cost, at the date of acquisition, which includes an estimate for the
future anticipated variable costs. A liability will be recognised at the same time. The liability is subsequently
measured at amortised cost, in a similar way to approach 1 above. However, subsequent changes in the liability will
be recognised against the cost of the asset. This treatment is typically only acceptable if a change in the variable
payment is as a consequence of the utility of the asset. If the variation is as a consequence of another factor not
associated with the asset, the change in cost would generally follow the applicable IFRS guidance.
2.4.1. Accounting for transaction costs, start-

up costs and subsequent costs shortly after
acquisition
Cost is the purchase price, including directly attributable expenditures. Such expenditures include transaction costs (such as
legal fees and property transfer taxes) and, for qualifying properties under construction not subsequently measured under
the fair value model, borrowing costs in accordance with IAS 23.
Except for transaction costs relating to acquisitions that meet the definition of a business combination, external transaction
costs are included in the cost of acquisition of the investment property.
The cost of acquired investment property excludes internal transaction costs (for example, the cost of an entity’s in-house
lawyer who spends a substantial amount of time drafting the purchase agreement and negotiating legal terms with the
seller’s lawyers). The entity cannot apportion the in-house lawyer’s salary and include an estimated amount related to the
work on the acquisition of a property in the cost of that property. The in-house lawyer’s employment-related costs are
internal costs that relate to ‘general and administrative costs’, and they are not directly attributable to the acquisition of the
property.
Example – Market study research costs (1)

Background
Entity Y purchased an investment property in Lisbon. It performed a study of the real estate market in Portugal before it
purchased the property. Management proposes to capitalise the costs of this study.
Can management capitalise the real estate study costs?
Solution
No. The costs cannot be capitalised, since the costs of the market study are not directly related to the acquired
property. Such costs are pre-acquisition costs, and they are expensed as incurred.
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Background
Entity A has a 31 December year end, and it adopts the fair value model for its investment properties (see section 3.5).
Entity A acquired a property in December 20X1 at a cost of C100, and it incurred transaction costs amounting to C5.
There is no movement in the underlying market value of the property between the acquisition date and the year-end
date, so the fair value of the investment property at 31 December 20X1 is C100.
How should the entity account for the transaction costs incurred?
Solution
Investment property is initially measured at the cost of C105, including the transaction costs of C5. [IAS 40 para 20].
Transaction costs include legal fees, property transfer taxes etc that are directly attributable to the acquisition of the
property. [IAS 40 para 21]. However, investment property measured subsequently at fair value cannot be stated at an
amount that exceeds its fair value. At 31 December 20X1, entity A should report its investment property at the fair value
of C100, and it should recognise a loss of C5 in its income statement.
The cost of an investment property excludes items such as:
start-up costs, unless they are necessary to bring the property to its working
condition;
initial operating losses incurred before the investment property achieves the
planned level of occupancy; and
abnormal amounts of wasted material, labour or other resources incurred in
constructing or developing the property.
Such costs, incurred in the period after the acquisition or completion of an investment property, do not form part of the
investment property’s carrying amount, and they should be expensed as incurred. [IAS 40 paras 21–23].
An entity might incur costs subsequent to completion of a property but before it can be put to its intended use (for example,
where a regulatory approval must be obtained first). Costs incurred subsequent to the completion of the property are either:
expensed, where they relate to maintenance of the building and attracting new
tenants; or
capitalised, where they enhance the value of the asset or where they help to bring
the asset to an operational condition.
Example – Costs incurred subsequent to completion: prior to being fully let
Background
Entity M develops an office building for rental. Subsequent to completion of the building, it incurs expenses (such as
security, utilities and marketing) before the building has secured a reasonable level of occupancy. The time between the
building’s completion and securing a reasonable number of tenants is three months. Management considers capitalising
these operating costs that are incurred in this period.
Can entity M capitalise costs that are incurred after the date of completion of the property and prior to it being fully let?
Solution
No. The costs should be expensed as incurred. These costs relate to maintaining the building and attracting tenants.
They are not necessary in bringing the asset to an operational condition.
Example – Costs incurred subsequent to completion and prior to approval by

relevant government agency
Background
Entity N develops an office building for rental, and it incurs expenses (such as security and utilities) subsequent to
completion. The building was physically completed on 31 March, but the local health and safety regulator did not clear
the property for use until 30 June, when the security system met the required conditions. The delay of three months in
receiving health and safety approval is standard for the type and location of the building. Entity N incurred C100,000
security expenses in the period between 31 March and 30 June. These costs were necessary in order to ensure that the
required conditions for health and safety approval could be satisfied.
Can entity N capitalise those costs in the period between the date of completion and the date when the building
receives approval for use from the relevant government agency?
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Example – Costs incurred subsequent to completion and prior to approval by

relevant government agency
Solution
Yes. The security expenses incurred during the period from 31 March to 30 June should be capitalised. The legal
requirement to receive the regulatory clearance meant that the building could not be put to its intended use, although
construction was completed on 31 March.
2.4.2. Accounting for forward contracts and

options to acquire real estate
Entities might enter into forward contracts or options for purchasing investment property. Contracts to buy a non-financial
asset (such as property) that are entered into for the purposes of receipt of that non-financial asset, and that cannot be
settled net in cash or another financial instrument, are outside the scope of IFRS 9. [IAS 32 para 8]. Since the contract will be
settled by physical delivery of property (typically land) rather than by delivery of a financial asset or exchange of financial
instruments and cannot be settled net in cash, it is not accounted for as a derivative.
Entities usually make a small initial deposit payment to enter into these contracts. This initial deposit payment is recognised
in the balance sheet if it meets the definition of an asset. The cost can be measured reliably, since it is the amount paid. If it
is probable that the acquisition of the property will occur in the future, or economic benefits could be derived from this option
in some other way (for example, if it is possible to sell the option to a third party), the recognition criteria for an asset are met.
The contract does not meet the definition of investment property, since it has not yet represented a current interest in
property. In substance, it is the first payment to secure the future acquisition of the property. If the property is subsequently
acquired, the amount paid for the option (or forward) would form part of the cost of that property.
The amount paid to the owner of the property for the option or forward is recognised as a non-financial asset. If future
economic benefits are no longer expected to occur, for example, if acquisition of the property is no longer probable, and
economic benefits cannot be derived from the option in any other way, such as the absence of the ability to sell the option to
another party or obtain a refund, the asset is derecognised. The asset would also need to be assessed for indicators of
impairment in accordance with IAS 36.
Where the asset is denominated in a foreign currency, an entity will need to determine whether the asset is monetary or non-
monetary in the context of IAS 21. For example, if the asset is non-refundable, it will be treated as a non-monetary item;
whereas, if the amount is fully refundable, it will be treated as a monetary item. Judgement might be required in determining
whether or not the asset is a monetary or non-monetary item, considering the terms of the specific contract. On initial
recognition, the asset should be translated to the entity’s functional currency using the spot rate at the date of the
transaction. For a non-monetary asset, the date of the transaction, should be the date on which an entity initially recognises
the non-monetary asset arising from the advance deposit or prepayment. [IFRIC 22 para 8]. If there are multiple payments or
receipts in advance of recognising the related item, the entity should determine the date of the transaction for each payment
or receipt. [IFRIC 22 para 9]. Non-monetary items are not remeasured to reflect changes in foreign currency. If the asset is a
monetary item, it will need to be remeasured at each reporting date, using the closing rate. If it is a non-monetary item, no
remeasurement should be performed.
Example – Land options

Background
Entity A made a one-off payment to entity B for the option to buy entity B’s land within the next 10 years, subject to
planning permission for development being achieved. The price of the land will be based on market value at the time of
exercise, less the initial one-off payment already made. The initial one-off payment for the option is non-refundable.
Entity A plans to develop the land into investment property when it is acquired. Entity A has a high expectation of
purchasing the underlying land.
How should the initial payment for the land option be accounted for?
Solution
Provided that it is probable that entity A can derive future economic benefits from the land option, the one-off payment
is recognised as a non-financial asset in the statement of financial position. The subsequent measurement is at cost and
will be assessed for impairment under IAS 36.
Example – Purchase of an investment property: share deal

Background
Entity A enters into a forward contract to purchase 100% of the outstanding shares of entity X in six months’ time. Entity
X holds a single property that is currently rented out to a single lessee on a long-term lease contract.
The final purchase price is calculated as the pro rata share of the equity presented in the balance sheet of entity X at the
settlement date. The investment property held is accounted for under the fair value model in entity X’s financial
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Example – Purchase of an investment property: share deal

statements. The contract does not contain any net settlement provisions.
Entity A will be required to consolidate entity X when control is transferred (see section 5.1). Entity A intends to use the
property as investment property.
Should entity A account for the forward purchase contract as a derivative within the scope of IFRS 9?
Solution
There are two permissible accounting approaches in this case. Entity A should select an accounting policy approach
and apply that approach consistently.
Accounting policy 1 – Forward purchase contract is accounted for as the purchase of an investment property,
based on the economic substance of the contract
The forward purchase contract has the economic substance of a contract to purchase investment property, and it is
outside the scope of IFRS 9 as a result of the own use exemption. [IFRS 9 para 2.4]. The economic substance needs to
be considered; this is because the legal form of the purchase contract, being a contract to purchase shares rather than
an asset, should not impact the accounting.
Accounting policy 2 – Forward purchase contract is accounted for as a derivative, based on the legal structure of
the contract
Entity A intends to purchase the outstanding shares of an entity. Therefore, the forward purchase contract is within the
scope of IFRS 9. Entity A has the right to receive 100% of the shares of entity X, and it has the obligation to pay the
purchase price at the settlement date. Accordingly, the forward purchase contract is within the scope of IFRS 9.
Note that, if entity A had entered into a contract to purchase 50% of the outstanding shares of entity X resulting in entity
X being a joint venture, the above accounting policy choice would not apply. Where entity A has entered into a joint
venture arrangement, the substance of the transaction would be broader than just purchase of an investment property.
As a result, such a contract would be accounted for as a derivative within the scope of IFRS 9. [IFRS 9 para 2.1(a)].
Example – Purchase of an investment property: asset deal

Background
Entity A enters into a contract to purchase a property in six months’ time. Entity A is required to pay the fixed purchase
price for the property, and the counterparty is required to transfer all rights attached to the property at the future
settlement date. The contract does not contain any net settlement provision. Entity A pays a small signing fee to the
seller in order to enter into the purchase contract. The non-refundable deposit is deductible from the final amount that
entity A pays at the settlement date, and it is considered by the entity as a down payment.
Entity A intends to use the property, which is rented out to a single lessee on a long-term lease contract, as an
investment property in accordance with IAS 40.
Should entity A account for the forward purchase contract to buy an investment property as a derivative within the
scope of IFRS 9?
Solution
Entity A enters into a contract to purchase a non-financial instrument which cannot be settled net in cash and which has
been entered into and is held for the purpose of delivery of the investment property for its own use. Thus, the forward
purchase contract is not within the scope of IFRS 9. The non-refundable deposit should be recognised as a prepayment
on the balance sheet.
2.5. Special considerations: investment

properties under construction
An entity might enter into a binding forward purchase agreement to purchase a completed property after construction is
completed. Where the contract requires the entity to pay a fixed purchase price, the entity will need to consider whether the
contract is onerous. A provision for onerous contracts is recognised if the unavoidable costs of meeting the obligations
under the contract or exiting from it exceed the economic benefits expected to be received under it. [IAS 37 paras 66–69].
For example, if this fixed price has a net present value of CU100 million at the reporting date, and the estimated economic
benefits of the completed investment property at the reporting date is below that (say, CU80 million), a loss of CU20 million
is recognised immediately in the income statement. The resulting provision is recognised on the balance sheet, unless there
is an asset dedicated to the contract.
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If there is an onerous contract as defined above, an impairment test is performed on any asset dedicated to the contract (for
example, prepayments made in relation to the purchase). Such an asset relating to an onerous contract is written down to
the recoverable amount (see section 3.4 for further guidance on impairment), if this is less than the carrying amount. [IAS 37
para 69]. A provision is recognised only after such an asset is reduced to zero.
Regardless of the assessment as to whether or not there is an onerous contract, contractual obligations to purchase,
construct or develop investment property, or for repairs, maintenance or enhancements, should be disclosed.
[IAS 40 para 75(h)].
2.6. Accounting for rental guarantees
Sellers of real estate might provide guarantees to the potential buyers. A typical rental guarantee contract usually has the
following characteristics:
The seller guarantees a minimum tenancy level of the building.

The buyer does not need to meet certain requirements to be eligible to receive
payment.
The payments under the guarantee do not change based on market yields, but
rather they represent a percentage of the initial purchase price of the building.
From the sellers’ perspective, there is diversity in practice. If the guarantee transfers non-financial risk (and no scope
exception applies), the contract would be accounted for as an insurance contract applying IFRS 17. Determining whether the
non-financial risk transferred by a contract is significant requires judgement applying specific guidance in IFRS 17 (see In
depth ‘IFRS 17 affects more than just insurance companies’ for more information).
This guidance sets out considerations and illustrative examples for applying either IFRS 9 or IFRS 15 (that is, when IFRS 17
is determined not to apply) - which are both commonly observed as being applied to rental guarantees in practice.
IFRS 9
Contracts with the above characteristics might be viewed as a financial liability assumed in the transaction and classified in
accordance with IFRS 9 as an ‘other financial liability’ (or a derivative, if appropriate). This approach might be appropriate
where the rental guarantee is dependent on market factors, such as the fair value of the asset. The liability is initially
recognised at its fair value for the consideration to be paid under the rental guarantee, reducing revenue for the sale of the
real estate. Changes to the expected cash flows are subject to the provisions of paragraph B5.4.6 of IFRS 9 as follows:
The entity should revise its estimates of receipts by adjusting the carrying amount
of the financial liability.
The difference between the carrying value and the revised amount, using the
revised cash flows discounted at the original effective rate, is recognised in profit or
loss.
IFRS 15
The rental guarantee could be accounted for as variable consideration within the scope of IFRS 15. If the rental guarantee is
related to the performance and quality of the property being sold and is contingent on the occurrence or non-occurrence of a
future event, sellers apply the variable consideration guidance in IFRS 15 (see section 4.13.2). In this case:
The estimated rental guarantee payment (as determined following the variable
consideration guidance in IFRS 15 will reduce the transaction price).
A refund liability for this amount will be recognised, reducing the revenue or net
gain on sale as appropriate.
Any subsequent changes in the rental guarantee liability will be adjusted against
revenue or the net gain on sale as appropriate.
There is judgement involved in determining which approach is appropriate for each specific fact pattern and whether the
variability arises from market factors, the performance/quality of the property, or a mixture of the two. Factors to consider
include whether the rental guarantee payment is dependent on:
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future fair value of the building and property in the market (that is, market factors) –
this might suggest a financial liability approach;
current and/or future tenancy level of the building – this might suggest a variable
consideration approach; or
current and/or future total rent receivable amount of the building – this might
suggest a variable consideration approach.
This judgement should be applied consistently to all similar transactions and appropriately disclosed.
IND EX 2.6.2 - How to account for rental guarantee from seller’s perspective
See section 4.13.2 for further guidance on accounting for variable consideration, and section 6.2.1 for guidance on deferred
sales proceeds with significant financing components.
2.7. Development properties: accounting for

the costs of construction
2.7.1. Capitalisation of construction costs
Investment property under construction is initially measured at cost. Cost is usually the price paid to the developer to
construct the property, together with any directly attributable costs of bringing the asset to the condition necessary for it to
be capable of operating in the manner intended by management.
Costs that are eligible for capitalisation include, but are not limited to:
contract costs with the developer;

architect fees;
civil engineer fees; and

staff costs for employees employed specifically for the construction process.
Costs that are not eligible for capitalisation include, but are not limited to:
abnormal amounts of wasted materials and labour or other resources, such as for
errors (including design errors);
storage and leasing costs of equipment located at construction sites that continue
to be incurred during a pause in construction (other than pauses that are directly
attributable to bringing the asset to the condition necessary for it to be capable of
operating in the manner intended by management);
feasibility studies in identifying development opportunities; and
staff costs for project management if these would be incurred irrespective of any
development.
2.7.2. Demolition costs
An entity might acquire a property and demolish some of the existing buildings in order to construct new buildings.
Demolition costs are capitalised as part of the investment property if they are directly attributable to bringing the asset to the
location and condition for its intended use. [IAS 16 paras 16(b), 17(b)]. Depending on the condition of the acquired property,
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these costs might be recognised as part of the cost of the land or the cost of the building. Correct classification will impact
future depreciation where the cost model is applied and the land and buildings are subject to different depreciation rates.
IND EX 2.7.2 – Demolition of a building (1)

2.7.3. Borrowing costs for properties under

construction
The cost of investment property might include borrowing costs incurred during the period of construction.
Under IAS 23, borrowing costs are capitalised if an asset takes a substantial period of time to get ready for its intended use.
Capitalisation of borrowing costs is optional for qualifying assets that are measured at fair value (for example, investment
property under IAS 40). [IAS 23 para 4(a)].
Borrowing costs include, but are not limited to:
interest expense calculated using the effective interest method, as described in

IFRS 9;
finance charges in respect of leases in accordance with IFRS 16; and

exchange differences arising from foreign currency borrowings, to the extent that
they are regarded as an adjustment to interest costs.
Borrowing costs should be capitalised while construction is actively underway.
These costs include the costs of:
specific funds borrowed for the purpose of financing the construction of the asset;
and
general borrowings, being all borrowings that are not specific borrowings for the
purpose of obtaining a qualifying asset. The general borrowing costs attributable to
an asset’s construction should be calculated by reference to the entity’s weighted
average cost of general borrowings.
Capitalisation starts when all three of the following conditions are met:
expenditures for the asset are incurred;

borrowing costs are incurred, and
the activities necessary to prepare the asset for its intended use are in progress.
Capitalisation of borrowing costs in respect of real estate developments can commence before the physical construction of
the property (for example, when obtaining permits, completing architectural drawings, or performing other activities
necessary to prepare the property for its intended use).
IND FAQ 2.7.3 How should an entity account for borrowing costs incurred?
An entity should suspend capitalisation of borrowing costs during extended periods in which it suspends active development
of a qualifying asset. Where construction activities are interrupted, but the cessation is a necessary and foreseeable part of
the process, capitalisation of borrowing costs can continue. In addition, if substantial technical and administrative work
continues during a suspension in physical construction, borrowing costs would likely continue to be capitalised.
For other suspensions such as revised business plans or certain unanticipated government-imposed restrictions, the
assessment of whether or not the suspension results in an extended period in which active development on a qualifying
asset has ceased is a matter of judgement. IAS 23 does not provide guidance regarding what it envisages to be an
‘extended period’. Management may consider, among other things, the expected total period of suspension, including the
possibility of the suspension being extended, and the projected length of the delay relative to the time period ordinarily
expected for the construction of the specific asset. The shorter the projected length of delay relative to the project as a
whole, the more likely it is that borrowing costs should continue to be capitalised.
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2.7.4. Income arising on redevelopment of

property
Properties might need to be redeveloped following initial acquisition. Redevelopment might include structural changes to the
building, renovations or construction of new facilities. Property owners usually contract property developers to run the
redevelopment process.
Depending on the extent of redevelopment, property owners might be unable to lease out the property to tenants and
generate income during the redevelopment period. Developers might undertake to compensate the property owners for their
loss of income during the period by agreeing to refund the owners for a ‘licence’ or ‘interest’ fee. The fee is normally paid
throughout the period of redevelopment, and its payment usually reduces the total development cost payable to the
developer. Such payment is neither revenue nor rental income, provided that it does not relate to a promised separate
performance obligation of the owner. It represents a deduction from the total redevelopment cost to the property owner,
similar to a discount, and it should be deducted from the total property cost.
2.8. Loan investments in subsidiaries, joint

ventures and associates
Entities might make investments in subsidiaries, joint ventures and associates as a method of acquiring direct/indirect
interests in investment properties. These investments might be made using a mix of equity and debt finance. The accounting
treatment for any equity investment would follow IAS 27 in separate financial statements, and IFRS 10 (for subsidiaries) or
IAS 28 (for joint ventures and associates) in consolidated/economic interest financial statements. However, any debt finance
provided through repayable loans would fall within the scope of IFRS 9. The guidance within IAS 32 should be considered in
determining whether an instrument meets the definition of debt or equity.
2.8.1. Accounting at initial recognition
Intra-group loans made to subsidiaries within the scope of IFRS 9, and loans to joint ventures and associates (‘funding’), are
required to be measured at fair value on initial recognition. Funding might sometimes be either interest-free or provided at
below-market interest rates. In those cases, the amount lent is, therefore, not fair value.
Funding at below-market or nil-interest rate is not advanced at fair value. Practically, this means that the cash advanced will
not be the receivable recorded. Instead, the receivable will be recorded at a lower amount, to take into account the impact of
discounting at a market interest rate.
A day 1 difference arises between the cash advanced and the recorded receivable. If the funding is advanced from a parent
entity to its subsidiary, this difference is added to the cost of investment in the subsidiary, because it is the nature of the
relationship that gives rise to the off-market/interest-free loan. For loans to joint ventures and associates, this difference
would also generally be added to the cost of investment, since the relationship between the investor and the joint venture or
associate is often the reason for the loan being off-market/interest-free.
2.8.2. Impairment considerations
The impairment model in IFRS 9 is based on a forward-looking, expected credit loss (‘ECL’) impairment model outlined
further below:
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 View image
Stage 1 includes financial instruments that have not had a significant increase in
credit risk since initial recognition or that have low credit risk at the reporting date.
For these assets, 12-month ECLs are recognised and interest revenue is calculated
on the gross carrying amount of the asset.
Stage 2 includes financial instruments that have had a significant increase in credit
risk since initial recognition (unless they have low credit risk at the reporting date)
but are not credit-impaired. For these assets, lifetime ECLs are recognised, and
interest revenue is still calculated on the gross carrying amount of the asset.
Stage 3 consists of financial assets that are credit-impaired (that is, where one or
more events that have a detrimental impact on the estimated future cash flows of
the financial asset have occurred). For these assets, lifetime ECLs are also
recognised, but interest revenue is calculated on the net carrying amount (that is,
net of the ECL allowance).
Impairment: Intra-group loans and loans to joint ventures and associates
IFRS 9 contains simplifications to this model for certain types of receivable; however, intra-group loans and loans to joint
ventures and associates do not qualify for these simplifications. As such, the full impairment model needs to be applied and
a 12-month ECL will be recorded on the day when funding is advanced. The impact of IFRS 9 on intra-group funding might
often be dismissed, because it is eliminated on consolidation. However, the impact in separate financial statements could be
significant.
Subsequently, if there is a significant increase in credit risk (for example, if the trading performance of the subsidiary, joint
venture or associate declines), the impairment loss will be increased to a lifetime ECL.
In order to apply the above model, entities will need to ensure that they implement adequate processes for collection of the
information needed for impairment. For example:
Indicators for a significant increase in credit risk must be developed.

Forward-looking information, as well as past events, must be incorporated.
The contractual period over which to assess impairment might not be clear.
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IND FAQ 2.2.1.1 – Does a property leased out

to a hotel management entity meet the
definition of ‘investment property’?

Reference to standing text: 23.10 – 23.15
Industry: Real Estate
Background
Entity A owns property which it leases out under an operating lease to a hotel management entity. Entity A has no
involvement in the running of the hotel or any decisions made; these decisions are all undertaken by the hotel management
entity, which also bears the operating risk of the hotel business.
Question
Does the property meet the definition of ‘investment property’ for entity A?
Answer
Yes. Although the property is used as a hotel by the lessee, entity A uses the property to earn rentals, and so the property
meets the definition of ‘investment property’.
IND FAQ 2.2.2.1 – Does a property meet the

definition of ‘investment property’ when
significant ancillary services are provided?

Background
An entity owns a number of apartments which it leases out to tenants under short-term leases. The entity is also responsible
for providing in-house cleaning services, and it undertakes to provide internet, telephone and cable television to the tenants
for an additional monthly fee. The additional fee charged for the services is approximately 20% of the total monthly rental.
Question
Does the property meet the definition of ‘investment property’?
Answer
No. The entity provides ancillary services to the tenants other than the right to use the property. The value of these services
represents around 20% of the income earned from the tenants. Therefore, these services cannot be viewed as insignificant.
The property is classified as property, plant and equipment in the financial statements of the entity.
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IND EX 2.2.6.1 – Accounting for multi-purpose

properties

Reference to standing text: 23.15, FAQ 23.15.1
Entity A owns a hotel resort which includes a casino, housed in a separate building.
The entity operates the hotel and other facilities on the hotel resort, with the exception of the casino, which can be sold or
leased out under a finance lease. The casino is leased to an independent operator. Entity A has no further involvement in the
casino. The casino operator will only operate the casino with the existence of the hotel and other facilities.
Analysis
Management should classify the casino as investment property. The casino can be sold separately or leased out under a
finance lease. The hotel and other facilities would be classified as property, plant and equipment.
If the casino could not be sold or leased out separately on a finance lease, the whole property would be treated as property,
plant and equipment.
IND EX 2.2.8.1 – Accounting for investment

property held under a lease
Reference to standard: IAS 40 para 19A

Reference to standing text: 23.36 - 23.37
On 1 January 20X1, entity A pays C1,000 in an arm’s length transaction to obtain a leasehold investment property, consisting
of a building and land subject to a ground lease. The ground lease has a lease term of 70 years.
Entity A is required to pay an annual ground rent of C50 during the lease period. Entity A is unable to readily determine the
interest rate implicit in the lease and has calculated its incremental borrowing rate as 5%. Using this discount rate, it has
determined that the present value of the future ground lease payments is C967.
Entity A applies the fair value model in accordance with IAS 40 to subsequently measure its investment properties. The
amount of C1,000 paid by entity A represents the fair value of the leasehold investment property at the date of acquisition.
Entity A did not incur any initial direct costs.
Accounting at lease acquisition – 1 January 20X1
IAS 40 requires the initial recognition of investment properties to be at cost. The amount of C1,000 is the consideration paid
to acquire the leasehold investment property, including the assumption of the obligation to pay ground rent to the lessor
under the lease. However, under IFRS 16, a lease liability as well as a right-of-use investment property must be recognised in
respect of the ground lease. This results in the following entries on initial recognition:
Dr Investment property – C1,967
Cr Lease liability – C967
Cr Cash – C1,000
Accounting at 31 December 20X1
Entity A determines the fair value of the investment property (net of the future obligation to pay ground rent) to be C1,080 at
this date. The valuation approach used to determine this amount includes the future cash outflows associated with the
ground lease. Further, the valuation approach used assumes a market discount rate of 6%. As a result, the valuation amount
can be analysed as follows:
Present value of future lease net operating income discounted at 6% – C1,898
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Present value of future ground lease payments discounted at 6% – (C818)
Fair value of investment property – C1,080
Under IFRS 16, a lease liability in respect of the ground lease is reflected on the balance sheet. During the year, a ground
lease payment of C50 was made, resulting in the following entries:
Dr Interest expense – C48
Dr Lease liability – C2
Cr Cash – C50
As a result, the carrying value of the lease liability as at 31 December 20X1 is C965 (being the initial carrying value of C967
less the principal payment of C2). In line with paragraph 50(d) of IAS 40, since a separate liability is recorded on the balance
sheet in respect of the ground lease, the carrying value of the investment property must reflect this. At 31 December 20X1,
this would mean that the overall fair value of the investment property would be reflected on the balance sheet as follows:
Investment property – C2,045
Lease liability – (C965)
Net fair value – C1,080
In turn, the following entries would be recorded to recognise the revaluation of the investment property from C1,967 to
C2,045:
Dr Investment property – C78
Cr Fair value gain – C78
The overall impact on the income statement is net income of C30 (being the fair value gain of C78 less the interest expense
of C48).
From the perspective of the cash flow statement, payments relating to the ground lease are reflected as a financing cash
outflow of C2 in respect of repayment of principal and an interest cash outflow of C48 (classified in accordance with the
entity’s policy for interest cash outflows).
IND EX 2.3.0.1 – Acquisition of a residential

real estate portfolio: determined to be an asset
acquisition

Background
Property Co purchases a portfolio of 10 residential homes. Each home is considered to be a separate investment property
for accounting purposes. All homes are leased out to separate tenants and comprise land and buildings. Each home has a
different design and layout, but all homes are located in the same geographical area and the risk profile of the real estate
market across that area is similar. No employees, other assets or other activities are transferred.
Question
Is the arrangement the acquisition of a business or asset?
Answer
No. Property Co elects to apply the optional concentration test and would conclude that this is an asset acquisition, because
substantially all of the fair value is concentrated in a group of similar assets. Property Co would treat this as an asset
acquisition.
A transaction is not automatically a business combination if the optional concentration test does not result in an asset
classification. An entity would then need to assess the transaction under the full framework.
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and office real estate portfolio: determined to
be an asset acquisition

Reference to standing text: 29.19, EX 29.19.3
Property Co purchases a portfolio of 10 residential homes (the nature of these homes being as outlined in the example
above), as well as an office park containing five fully let office buildings. In addition, an outsourcing contract for maintenance
services for the office park is also acquired. The maintenance services are considered ancillary or minor in the context of
generating rental income at the office park. No employees, other assets or other activities are transferred.
Analysis
Analysis No, Property Co would conclude that this is an asset acquisition.
The concentration test is not passed, since all of the fair value is not concentrated in a single identifiable asset or a group of
similar identifiable assets. This is because two dissimilar classes of real estate with different risk profiles (that is, residential
and office) are acquired.
Since there are leases in place for both the residential homes and office park buildings, Property Co would then analyse the
transaction, referring to the framework with outputs and considering whether the acquired processes are substantive. No
organised workforce is acquired and the maintenance services are considered ancillary or minor in the context of generating
rental income. Further, the maintenance services do not significantly contribute to the ability to generate rental income and
also could be replaced without significant cost.
Would the answer be different if there were no in-place lease contracts and, therefore, no outputs?
Analysis
No, Property Co would still conclude that this is an asset acquisition.
In order for the definition of a business to be met where there are no outputs, an organised workforce with the necessary
skills critical to the ability to develop and convert the inputs into outputs would need to be present. Since no such organised
workforce is acquired, the definition of a business is not met.

and office real estate portfolio: determined to
be a business combination

Property Co acquires a portfolio of residential and office assets (the nature of these assets being as outlined in the example
above), and it also acquires employees that are responsible for operational management of the assets as well as all tenant
management and leasing activity.
Analysis
Yes. Property Co would conclude that this is a business combination.
The concentration test is not met, because the fair value of the assets acquired is not concentrated in a single asset or a
group of similar identifiable assets. Further analysis is required, following the framework with outputs, to assess whether a
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process is acquired and whether the process is substantive. A business is acquired, because the organised workforce is a
substantive process with the necessary skills that is critical to the ability to develop and convert the inputs (that is, the land,
buildings and in-place leases) into outputs.
IND EX 2.3.2 Deferred tax at initial recognition
Reference to standard: IAS 12 para 15(b)

Reference to standing text: 14.17 - 14.18, 14.27 - 14.28
An investment property with a fair value of C100 is acquired in a ‘corporate wrapper’ (see section 2.3). The purchase price
amounts to C90. The discount is the result of the seller and the buyer negotiating the price, based on the fact that the
property’s tax base in the ‘wrapper’ is C50. For simplicity, it is assumed that there are no transaction costs and that the
blended tax rate is 40%.
Analysis
In the group accounts, the investment property is recognised at its cost of C90. At the point of acquisition, there is a
temporary difference of C40 (being the carrying value of C90 less the tax base of C50). No deferred tax liability is recognised,
because this is prohibited by the initial recognition exemption in paragraph 15(b) of IAS 12.
Business combination: In the group accounts, the investment property is recognised at its fair value of C100. At the point of
acquisition, there is a temporary difference of C50 (being the carrying value of C100 less the tax base of C50). This results in
a deferred tax liability of C20 (C50 × 40%) that must be recognised as part of the business combination accounting.
The following entries are recorded at acquisition:
Asset acquisition Business combinatio

Dr (C) Cr (C) Dr (C) Cr (C
Investment 90 100
property
Goodwill 10
Cash 90 9
Deferred tax 2
liability
Subsequent to initial recognition, the investment property must be recorded at its fair value of C100, resulting in the following
entries in the case of an asset acquisition (assuming no change in the tax base):
Asset acquisition Business combinatio

Dr (C) Cr (C) Dr (C) Cr (C
Investment 10 - -
property
Deferred tax - 4 -
liability
Gains or losses - 10 -
from fair value
change
Deferred tax 4 - -
expense (CU10
× 40%)
IND EX 2.6.2 - How to account for rental

guarantee from seller’s perspective
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Reference to standard: IAS 32 para AG8, IFRS 9 para 5.1.1, IFRS 9 App B para
B5.4.6; IFRS 15 para 50-54
Reference to standing text: 11.80-11.83, 42.121, 42.123
Background
On 1 January 20X1, entity A acquired an investment property from entity B, a property developer, for C100. Entity B provided
a rental guarantee to entity A as follows:
Entity B guarantees to entity A that, if the property is not fully rented during the first
three years post acquisition, entity B will compensate entity A.
The maximum amount of compensation payable to entity A is 5% of the total
purchase price paid by entity A; if entity A is unable to rent the building to any
tenants and the building remains vacant for each of the first three years, entity B
will pay C5 (being 5% of the purchase price) to entity A.
Compensation for part occupancy of the building is calculated as the proportionate
amount of the maximum guarantee; for example, for 20% vacancy, the guarantee
amount to be paid would be C1 (that is, 20% of C5).
At the acquisition date, the property is partially rented out (80%).
The fair value of the rental guarantee has been determined to be C3 (for simplicity, the time value of money has been
ignored).
The fair value of the property, without the guarantee, at the acquisition date is C97. On 31 December 20X1, the fair value of
the property without the guarantee is C95. There are no transaction costs, no VAT and no transfer tax.
On 31 December 20X1, entity B made payment of C1 compensation for the first year. Due to a change in market conditions,
the estimated vacancy rate for the second year increased to 40%. The new cash flow projection estimates a payment of C2
per year for the next two years, resulting in a fair value of the rental guarantee at 31 December 20X1 of C4.
Entity B is a property developer, so the property is classified as inventory, because the property has been constructed with
the view to sell. The cost of construction is C95 and it is assumed that costs to sell are nil.
Question
How should entity B account for the rental guarantee provided to entity A?
Analysis
The rental guarantee is not in scope of IFRS 17 as it has been assessed that no significant insurance risk has been
transferred from Entity A to Entity B.
Approach one: accounting under IFRS 9
Entity B has assessed the fact pattern to determine whether the variability arises from market factors, the
performance/quality of the property, or a mixture of the two, to determine which standard to apply. Entity B concludes that
IFRS 9 is appropriate in this instance, and it accounts for the rental guarantee as an other financial liability.
Entity B derecognises the property and recognises a rental guarantee financial liability at fair value of C3 on initial recognition
[IFRS 9 para 5.1.1]. The entity subsequently measures the liability at FVTPL, in accordance with IFRS 9 para B5.4.6.
On initial recognition, the following is recorded:
Dr (C) Cr (C)
Cash 100 -
Revenue - 97
Rental guarantee (financial liability) - 3
Cost of sales 90 -
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Inventory - 90
As at 31 December 20X1, entity B makes a payment of C1 to entity A, since the vacancy rate for the first year was 20%.
Dr (C) Cr (C)
Rental guarantee (financial liability) 1 -
Cash - 1
As at 31 December 20X1, entity B revises the rental guarantee financial liability using the revised cash flows (C4)
discounted at the original effective interest rate. Assume that the revised carrying value is C4 (ignoring the effect of
discounting).
Dr (C) Cr (C)
Profit or loss 2 -
Rental guarantee (financial liability) - 2
Approach two: accounting under IFRS 15
Entity B has assessed the fact pattern to determine whether the variability arises from market factors, the
performance/quality of the property, or a mixture of the two, to determine which standard to apply. Entity B concludes
that IFRS 15 is appropriate in this instance.
Entity B derecognises the property and recognises a refund liability, following the variable consideration guidance in
IFRS 15. The revenue from the sale of the property must be constrained to ensure that it is highly probable that a
significant reversal in the amount of cumulative gain recognised will not occur when the uncertainty associated with the
rental guarantee is resolved. Assuming that the rental guarantee payment is initially measured at C6 based on the
variable consideration guidance, on initial recognition, the following is recorded:
Dr (C) Cr (C)
Cash 100 -
Revenue - 94
Refund liability (rental guarantee) - 6
Cost of sales 90 -
Inventory - 90
As at 31 December 20X1, entity B makes a payment of C1 to entity A, since the vacancy rate for the first year was 20%.
Dr (C) Cr (C)
Refund liability (rental guarantee) 1 -
Cash - 1
As at 30 December 20X1, entity B revises its estimated rental guarantee payment based on variable consideration
guidance under IFRS 15. Assume that the revised carrying value is C4.5 (ignoring the effect of discounting). This is
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adjusted through the same income statement line item as at contract inception.
Dr (C) Cr (C)
Revenue 0.5
Refund liability (rental guarantee) 0.5
See section 4.13.2 for further guidance on accounting for variable consideration, and section 6.2.1 for guidance on deferred
sales proceeds with significant financing components.
Reference to standard: IAS 16 para 16(b), para 17(b)

Entity A acquires a property for C100.
The fair value of the property (land and a building) is represented by the value of the land only, because the current building
on the land is derelict and unusable.
The building is demolished after purchase, in order to construct a new building in its place. Entity A incurs demolition costs
of C3.
How should entity A account for the acquisition cost of the property and the costs of demolition?
Analysis
Entity A should recognise C100 as the cost of the land, and it should not allocate any part of the purchase price to the
building. The purchased building is derelict and does not have stand-alone value, since no market participant would be
willing to pay consideration for an unusable building. [IAS 16 para 7]. The economic rationale behind the purchase was to
acquire land, rather than land and a building. The sole purpose of the demolition was to bring the land to its intended use
because it would not be available for use until the building was demolished. Therefore, all consideration paid (C100 million)
should be allocated to the land.
The demolition costs of C3 are capitalised as part of the cost of the land. In accordance with paragraphs 16(b) and 17(b) of
IAS 16, this represents costs directly attributable to bringing the land to the condition necessary for it to be capable of being
developed. Without demolishing the existing building, the intended use of the land cannot be realised.
Cost of Land (C) Building (C)

Initial acquisition costs 100 -
Demolition 3 -
Cost – post demolition 103 -
Reference to standard: IAS 16 para 16(b), para 17(b)

Entity B purchases land together with a building. The purchase price is C200. The fair value of the property is C190 for the
land and C10 for the building. The building has value because a market participant would normally use the building rather
than demolish it.
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Entity B plans to demolish the building immediately after purchase, in order to construct a new building in its place. The
costs of demolishing the old building will be C3.
How should entity B account for the acquisition cost of the property and the demolition costs?
Analysis
Entity B should recognise C190 as the cost of the land and C10 as the cost of the purchased building. This is because the
purchased building has value, based on the fact that a market participant would normally use the building rather than
demolish it. The intended use of the land has already been achieved – in contrast to the previous example, where the
intended use had not been achieved, because of the presence of the derelict building on the land. On demolition, the
carrying value of the building is derecognised and expensed to the income statement.
The demolition costs of C3 are capitalised as part of the cost of the new building. In line with paragraphs 16(b) and 17(b) of
IAS 16, this represents costs directly attributable to constructing the new building, and they are capitalised when incurred.
Cost of Land (C) Building (C)

Initial acquisition costs 190 10
Demolition of old building (Profit or loss) (10)
Demolition costs – part of new building 3
Cost – post demolition 190 3
IND FAQ 2.7.3 How should an entity account

for borrowing costs incurred?
Reference to standard: IAS 23 para 8-9, 17

Background
Entity A contracts a third party for the construction of a building. Entity A will make progress payments to the third party over
the construction period of the building.
Entity A obtains a loan from the bank to finance the progress payments made to the third party, and it incurs borrowing costs
on this loan.
Question
How should entity A account for the borrowing costs incurred?
Answer
The borrowing costs incurred by entity A, to finance prepayments made to a third party to construct the property, are
capitalised on the same basis as the borrowing costs incurred on an asset that is constructed by the entity itself.
Capitalisation should start when:
expenditures are incurred – that is, when the prepayments are made;
borrowing costs are incurred – that is, when borrowing is obtained; and
the activities necessary to prepare the asset for its intended use are in progress –
that is, when a third party has started the construction process; determining
whether construction is in progress will likely require information directly from the
contractor.
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IND FAQ 2.2.1.2 – Does a property subject to a

hotel management contract meet the definition
of ‘investment property’?

Background
Entity A owns property that is operated as a hotel. The entity signed a contract with a hotel management entity. Entity A has
no involvement in the running of the hotel or any day-to-day operating decisions made; these decisions have all been
delegated to the hotel management entity which receives a fixed management fee. However, the operating risk of the hotel
business remains with entity A, because the returns received by entity A include all of the variability of the performance of the
hotel.
Question
Does the property meet the definition of ‘investment property’ for entity A?
Answer
No. Although the management entity operates the property as a hotel, entity A bears the operational risk of the hotel
business and, thus, the contract with the hotel management entity is a management contract rather than a lease contract.
The property is classified as property, plant and equipment in the financial statements of entity A.
3. Subsequent measurement of investment

property
The standard permits an entity to adopt either the fair value model or the cost model as its accounting policy for subsequent
measurement of investment property. The policy selected must be applied to all of the entity’s investment property,
irrespective of whether the properties are owned or held under a lease.
[IAS 40 para 30].
3.1. Costs incurred after initial recognition
Subsequent expenditure should be recognised in the carrying amount of the investment property if it is expected to produce
future economic benefits to the entity and its costs can be reliably measured.
[IAS 40 para 16].
Such costs are usually capitalised within the carrying amount of an investment property where they increase the investment
property’s originally assessed standards of performance.
If an entity acquires a property that requires renovation, the price and initial carrying amount would reflect this and would be
lower than the cost of a fully renovated property. The cost of renovation work would be capitalised when incurred, because
the renovation costs give rise to additional future economic benefits.
Investment property often includes parts, such as lifts or an air-conditioning system, which have shorter useful lives than the
rest of the property and might require regular replacement. The replacements give rise to future economic benefits, because
the carrying amount takes into account the loss of economic benefits from the deterioration of the originally acquired assets,
and the new assets give rise to new economic benefits. Parts that require regular replacement are often called ‘components’,
and the accounting applied to them is referred to as the ‘component approach’ (see section 3.3.2).
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Subsequent costs of day-to-day servicing and maintaining a property are not recognised as an asset. Instead, they are
expensed as incurred. Such costs normally include costs of labour and consumables and the cost of replacing minor parts.
They are normal repairs and maintenance and, as such, they do not meet the criteria for recognition as an asset, because
they do not add future economic benefits.
[IAS 40 para 18].
A provision for such subsequent expenditure should be recognised only when an entity has a present obligation, an outflow
of resources is probable, and a reliable estimate can be made of the amount of the obligation.
[IAS 37 para 14].
IND FAQ 3.1 Can an entity establish a provision for planned major expenditure on an investment property?
3.2. Replacement of parts of investment

property and subsequent expenditure
Subsequent expenditure on an investment property is added to the investment property’s carrying amount when it is
probable that future economic benefits will flow to the entity. All other subsequent expenditure is expensed in the period in
which it is incurred. [IAS 40 paras 16 - 18]. The cost of a replacement part is recognised as an asset, and the carrying
amount of the replaced part is derecognised. This applies irrespective of whether the cost method or the fair value method is
used. [IAS 40 para 68]. However, where the fair value model is used, it needs to be carefully assessed whether the fair value
already reflects the loss in value of the part to be replaced, or whether it is too difficult to discern how much fair value should
be reduced for the parts being replaced. An alternative approach could be used which allows for the cost of the replacement
to be included in the carrying amount of the asset and for the fair value to be reassessed afterwards. [IAS 40 para 68].
Under the cost method, it is compulsory to recognise every replacement of a part, and derecognise the replaced part, if the
recognition criteria are met. It is not relevant whether a replacement was planned or not. For example, the unplanned
replacement of a significant portion of the windows of a building should not be treated as a repair expense. The carrying
amount of the replaced windows is derecognised, and the cost of the new windows is recognised.
The significance of the cost of the part, compared to the cost of the total item, is not a criterion for determining the parts of a
building for recognition and derecognition purposes. Significance is relevant for the identification of the parts that need to be
depreciated separately where the cost model is applied. [IAS 16 para 43]. (See section 3.3.2.1.)
Where the cost model is applied, management should document the historical cost of the parts of a building that are not
depreciated separately. An entity should derecognise the carrying amount of a replaced part, regardless of whether the
replaced part had been depreciated separately or not. [IAS 16 para 70]. In order to ensure the correct derecognition of
replaced parts, the entity might need to determine the carrying amount of the replaced parts. To do so, the entity depreciates
the historical cost of each part over its useful life.
If it is not possible to determine the carrying amount of the replaced part based on historical cost, the cost of a replacement
might be a good indication of the cost of the replaced part at the time when it was acquired or constructed. [IAS 16 para 70].
IND FAQ 3.2 Can subsequent expenditure be capitalised on a property carried at cost if it enhances a property’s future
income-earning potential?
IND FAQ 3.2 Can subsequent expenditure be capitalised on a property carried at fair value if it enhances a property’s future
3.3. Subsequent measurement: cost model
Entities that choose the cost model should apply the requirements in IAS 16 for property, plant and equipment measured at
cost. Investment properties that meet the criteria to be classified as held for sale, or that are included in a disposal group that
is classified as held for sale, should be measured in accordance with IFRS 5 (see section 6).
3.3.1. Depreciation
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Under the cost model, an entity will need to separately depreciate each component part of investment property which is
significant in relation to the total cost of the property.
Depreciation should be recognised over the useful life of each individual component. Further guidance on depreciation under
the cost model can be found in the PwC Manual of Accounting chapter 22 paragraphs 79–102.
3.3.2. Component approach and depreciation
Under the component approach, each part of an investment property with a cost that is significant in relation to the total cost
of the property is depreciated separately.
The objective of the component approach is to reflect more precisely the pattern in which the asset’s future economic
benefits are expected to be consumed by the entity.
To apply the component approach, it is necessary to identify the various parts of an asset. There are two reasons for
identifying the parts: depreciation; and the replacement of parts. IAS 16 requires separate depreciation only for significant
parts of an item of property, plant and equipment with different useful lives or consumption patterns. However, the principles
regarding replacement of parts (that is, subsequent cost of a replaced part) apply generally to all identified parts, regardless
of whether they are significant or not.
On replacement of a part, the remaining book value of the replaced part is derecognised, and the cost of the new part is
recognised, irrespective of whether the part was depreciated separately or not. Further guidance on the depreciation of
components can be found in the PwC Manual of Accounting chapter 22 paragraphs 85–87.
The diagram below illustrates the steps required by the ‘component approach’.
 View image
3.3.2.1. Identification of significant parts of an

asset
The significance of a part of a building for depreciation purposes is determined based on the cost of the part in relation to
the total cost of the building at initial recognition. [IAS 16 para 43].
The standard is silent on how to determine the parts of a building. The asset’s specific circumstances need to be taken into
account.
Separation between interior and exterior parts would normally not be sufficient for all types of building and across all regions,
depending on the type of building.
Management should carefully evaluate whether separation into interior and exterior truly reflects the significant parts of the
building, taking into account the need to make replacements during the useful life of the building. For example, solid walls,
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floors and ceilings can be used over a longer term, and they can be replaced later than plasterboard walls and the heating
system.
In practice, the first step in determining the parts of a building should be analysis of the construction contracts, the
inspection report or the invoice (being parts of the acquisition cost). If these documents do not provide sufficient information,
other sources such as construction catalogues should be taken into account. For construction catalogues to be a sufficient
source, they need to be a standard that is commonly used in the economic environment in which the entity operates. It
would be expected that such standards take into account the specifics of the geographical area as well as type of building.
It might be necessary to request an expert opinion (for example, construction experts) in order to determine the parts of a
building.
The following practices are commonly used to identify the parts of a building:
Example practice 1 Example practice 2
Exterior walls Structural design
Interior walls Membrane
Windows Exterior doors and windows
Ceiling Interior walls, doors and windows
Roof Heating and other technical

systems
Staircase Sanitary facilities
Lifts
Air-conditioning system
Heating system
Water system
Electrical system
Major inspections
3.3.2.2. Replacement of parts
When a part of an asset is replaced and the recognition criteria are met, the entity needs to derecognise the carrying value of
the replaced item and recognise the cost of the replacement (see section 3.2).
Note that, for insignificant parts that are replaced, the carrying amount of the replaced parts should be derecognised,
regardless of whether the replaced part had been depreciated separately. [IAS 16 para 70].
3.3.2.3. Depreciation principles
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Determining the useful life of the building
An entity is required to estimate the useful life of a building as a whole, in addition to estimating the useful lives of the parts
of the building. The entity might include, in its accounting manual, guidance on how the useful life of a building as a whole is
estimated.
An entity should estimate the useful economic life of the building, to ensure that the individual useful economic lives of the
individual components are reasonably determined within the context of the overall utility of the building to the entity.
Management should estimate the useful life of a building as a whole on a stand-alone basis, taking into account only the
expected utility to the entity. [IAS 16 para 57]. The average of the useful lives of the parts is not a sufficient basis to estimate
the useful life of the building as a whole.
However, to estimate the useful life of the building as a whole, it might be necessary to consider the useful life or the
economic life of significant parts, and whether these parts are so significant that they could affect the useful life of the
building as a whole. Management should carefully evaluate situations where the useful life of a building is considered to be
longer than the useful life of the structure of the building, such as the walls and roof. Further guidance on the determination
of useful life can be found in the PwC Manual of Accounting chapter 22 paragraphs 88–90.
Determining the useful life of significant parts
The cost of a part is depreciated on a systematic basis over its useful life. The asset management policy of the entity might
involve disposal of significant parts after a specified time, or after consumption of a specified proportion of the future
economic benefits embodied in the asset. Therefore, the useful life of the asset could be shorter than its economic life. The
estimation of useful life is a matter of judgement, based on the entity’s experience with similar assets.
An entity should review the useful life (and the residual value) of an asset at least at each financial year end. However, an
entity can choose to evaluate the estimated useful life of an asset additionally at each interim reporting date. [IAS 16 para
51].
In principle, the useful life of a part of a building should not be longer than the useful life of the building as a whole. For
example, it would be unlikely for a building with a useful life of 25 years to have interior walls with a useful life of 30 years.
However, an entity should carefully assess whether parts might be transferred to another building for further use. In those
cases, the useful life of the parts might reasonably be longer than the useful life of the building as a whole.
Significant parts can be grouped and depreciated together if their useful life and the depreciation method are the same. [IAS
16 para 45].
Determining the useful life of the remainder
An entity is obliged to depreciate significant parts of a building and the ‘rest of the building’ separately. The ‘rest of the
building’ consists of parts that are not individually significant. An entity groups these parts to one depreciation unit: the
‘remainder’ (see the diagram in section 3.3.2).
The remainder consists of those parts of the building that are not individually significant but could have a useful life
significantly different from the useful life of the building as a whole.
The applicable useful life of the remainder, as well as the depreciation method used, needs to be determined in a way that
faithfully represents the consumption pattern and/or useful life of its parts. [IAS 16 para 46]. One acceptable method to
determine the useful life of the remainder could be the average of the useful life of its parts, rather than the useful life of the
building as a whole.
The standard is silent on whether one remainder is sufficient where the useful lives of insignificant parts differ significantly
(for example, parts with five years and parts with 20 years of useful life). In such a case, it would be appropriate to have more
than one remainder. Further, applying a depreciation rate – calculated based on the average useful life of the parts in the
remainder – in that instance might not faithfully represent the consumption pattern and/or the useful life of the parts. [IAS 16
para 46].
3.4. Impairment
3.4.1. Overview
Under the cost model, investment properties should be tested for impairment whenever indicators of impairment exist.
Impairment is recognised if the carrying amount of an asset or a cash-generating unit (CGU) exceeds its recoverable amount,
which is the higher of fair value less costs of disposal and value in use.
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A CGU is defined as the smallest identifiable group of assets that generates cash inflows that are largely independent of the
cash inflows from other assets or groups of assets. [IAS 36 para 6]. Management needs to define the CGU at an appropriate
level. In the case of investment property, it is likely that an individual investment property, and its associated assets, would
meet the definition of a CGU, since it is usually able to generate independent cash inflows.
Impairment indicators relevant to the real estate sector include, but are not limited to:
decline in property prices;

decline in market rental prices;
decline in the share prices for property companies;

market oversupply of properties;
decline in building permits, in the event that this limits the options for use of the
property;
unfavourable changes in market interest rates;
increase in country risk;
cost overruns for property under construction;

newly constructed properties that might be more attractive to existing tenants of an
entity’s property; and
physical or other damage caused to the property.
Properties measured under the fair value model are not tested for impairment.
An impairment test is performed for investment property under construction, accounted for at cost in accordance with IAS
40, where there is an indication (triggering event) that the property is impaired. At each reporting date, management
assesses whether there is a triggering event, irrespective of whether cost accounting is a result of management’s decision to
apply the cost model or due to the fact that fair value cannot be determined reliably in accordance with paragraph 53 of IAS
40.
The impairment process in accordance with IAS 36 is illustrated in the diagram below:
 View image
3.4.2. Impairment of individual assets and

CGUs
IAS 36 requires a bottom-up, rather than a top-down, approach for impairment testing, and the order in which the testing is
performed is crucial.
First, any individual CGUs with indicators of impairment must be tested, and any impairment loss must be recorded in the
individual CGU.
The bottom-up approach is applied where there are indications of impairment for individual assets. If those assets do not
generate independent cash flows (that is, they are not individual CGUs), they need to be grouped with other assets to
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determine the CGU (that is, the lowest level at which independent cash inflows arise).
For the purposes of testing goodwill, indefinite-lived intangible assets and corporate asset CGUs might need to be grouped
together. The amended carrying values of any individual CGUs that have been adjusted for an impairment charge are used
as part of this impairment test. Impairment testing for goodwill is specifically considered in section 3.4.5. It is therefore
important to test the individual properties (or CGUs in which the properties are included) for impairment first of all, before
testing goodwill for impairment.
CGUs, there is no impairment to recognise. However, if the recoverable amount is less than the combined carrying value, the
group of CGUs is impaired.
Where goodwill is allocated to the group of CGUs, the impairment charge is allocated first to the goodwill balance to reduce
it to zero, and then pro rata to the carrying amount of the other assets within the group.
IND FAQ 3.4.2 Can an entity with individual assets test for impairment on a portfolio basis?
3.4.3. Calculating the recoverable amount
The recoverable amount is computed as the higher of value in use and fair value less costs of disposal. Fair value assumes
recovery of the asset through its sale. Fair value is an objective, market participant, value, which is independent from the
specific company, where market prices and market information are incorporated in its determination. Further guidance on fair
value measurement is contained in section 3.6.
Value in use assumes recovery of the asset through its use. Value in use is an entity-specific measure, determined in
accordance with the entity’s view of use of the investment property. It is a present value measure, in which cash flows
incorporate the estimates of the entity rather than the market. Nevertheless, an entity should place greater reliance on market
data and corroborate its estimates with external information.
3.4.4. Key considerations when estimating

value in use
3.4.4.4. Cash flows
Cash flow forecasts should be based on the latest management-approved budgets or forecasts for the investment property.
Assumptions made in the cash flows should be reasonable and supportable. [IAS 36 para 33]. For example, cash flows
should be derived by contractual agreements, and they should take property yields into consideration. They should represent
management’s best estimate of the economic circumstances that will prevail over the remaining life of the property.
Greater weight should be given to external evidence. For example, the cash flows/forecasts should be compared with
external information, such as analysts’ reports, the views of other third party experts and economic forecasters
3.4.4.5. Carrying amount: like with like
Cash flows being used in the recoverable amount should be consistent with the assets being tested in the carrying amount
of the CGU. The impairment test should compare like with like. Working capital and tax are two key areas to consider.
IAS 36 permits cash flows from the settlement of working capital balances to be unadjusted if they are included in the
budgets/forecast, provided that the carrying value of the CGU is increased/reduced by the amount of the working capital
assets/liabilities. Assets arising from incentives or prepayments should be carefully considered, to avoid double counting.
Cash flow forecasts should exclude cash flows relating to financing (including interest payments). Cash flows should exclude
cash flows relating to tax losses, because these do not affect the recoverable amount of the CGU being tested. Current and
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deferred taxes are excluded from value in use cash flows. [IAS 36 para 50(a)].
When assessing impairment for any leased investment properties, cash flows should exclude lease payments if they are
captured as part of the lease liability. The discount rate would be impacted as a result of the inclusion of the lease liability,
which will increase the debt to equity ratio.
3.4.4.6 Terminal value
Cash flows are projected over the life of the property. If the investment property is part of a CGU with an indefinite life, a
terminal value is required in the cash flow forecast. This represents what an investor might pay for the cash flows beyond the
specific forecast period.
This is usually calculated using a perpetuity formula which takes the last year of cash flows into consideration. Careful
consideration is needed as to whether the business is cyclical. It is important to ensure that the forecast period is long
enough to achieve normalised growth and margin levels.
The long-term growth rate should be reasonable in comparison to long-term inflation expectations. Nominal long-term
growth rates in excess of long-term nominal GDP growth imply that the business will eventually grow larger than the
economy itself. This is unlikely to be appropriate.
3.4.4.7 Discount rates
The discount rate used is the rate that reflects the specific risks of the investment property or the CGU to which it relates.
Different CGUs might warrant different discount rates (for example, properties held in different countries are likely to be
subject to different political and currency risks).
The discount rate should not be adjusted for risks that have already been considered in projecting future cash flows.
Management should also consider country risk, currency risk and cash flow risk.
Value in use is calculated on pre-tax cash flows using a pre-tax discount rate.
3.4.5. Special considerations: goodwill

impairment for real estate entities
3.4.5.8 Testing goodwill on a portfolio basis
Goodwill is tested for impairment at least annually, where there is an indicator that it is impaired or where there is an
indicator that the CGU(s) to which it is allocated is impaired. Where the impairment indicator relates to specific CGUs, those
CGUs are tested for impairment separately, before testing the group of CGUs and the goodwill together.
Goodwill is tested at the lowest level at which it is monitored by management. The lowest level cannot be higher than the
operating segment as defined in IFRS 8 (see section 8.2).
If management monitors goodwill on an individual CGU basis, testing goodwill for impairment should be performed on that
individual basis. However, where management monitors goodwill based on a group of CGUs, the impairment testing of the
goodwill should reflect this.
IND FAQ 3.4.5 At which level should an entity test goodwill arising on a business combination?
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3.4.5.9 Goodwill arising from deferred tax
Where a property acquisition meets the definition of a business, the entity should apply IAS 12, and it might need to
recognise a deferred tax liability on acquisition. The corresponding debit entry will increase goodwill.
Deferred tax liabilities on investment properties in a business combination might be significant, because there might be no
tax deduction for these assets. This leads to the recognition of a higher amount of goodwill.
A value in use calculation, which is a pre-tax value, might indicate an impairment charge soon after an acquisition is made,
due to the higher amount of goodwill that is recorded as a result of recognising a deferred tax liability.
In order to address this anomaly, a test should be performed using fair value less costs of disposal. The fair value less costs
of disposal is a post-tax measure of recoverable value. The carrying value of a CGU under the fair value less costs of
disposal method should include the deferred tax liabilities. The comparison of discounted post-tax cash flows and the CGU’s
carrying value, including deferred tax liabilities, might eliminate or reduce the amount of any impairment charge.
3.5. Subsequent measurement: fair value

model
An entity that chooses to apply the fair value model for its investment property measures its properties at fair value, with any
resulting gain or loss being recognised in the income statement. The measurement of fair value of investment properties is
within the scope of IFRS 13. Fair value measurement is a market-based measurement. It is the price that would be received
to sell an asset in an orderly transaction between market participants. Market participants are independent, knowledgeable
buyers that would be willing to transact with the entity in an orderly transaction.
Management measures the property at fair value until disposal or change in use (for example, the property becomes owner-
occupied, see section 3.7.1), even if comparable market transactions become less frequent or market prices become less
readily available. [IAS 40 para 55]. In this case, management uses alternative valuation methods, such as discounted cash
flow projections. [IAS 40 para 46(c)]. It is prohibited to change from the fair value model to the cost model. [IAS 40 para 31;
IAS 8 para 14(b)].
3.5.1. Application where fair value cannot be

determined on a continuous basis
Fair value measurement is applied if the fair value is considered to be reliably measurable. [IAS 40 para 53]. The general
presumption for investment properties, including properties under construction, is that fair value can be reliably determined.
[IAS 40 para 53]. This presumption can only be rebutted on initial recognition. [IAS 40 para 53B]. We would expect rebuttal of
this presumption to be rare.
The fair value of the investment property is not reliably determinable on a continuing basis only where comparable market
transactions are infrequent and alternative reliable estimates of fair value (that is, based on discounted cash flow projections)
are not available. [IAS 40 para 53]. Where there is a clear expectation or other evidence that the market transactions are not
orderly, little if any weight should be placed on the expected disorderly transaction prices. [IFRS 13 App B para B44]. Where
an entity does not have sufficient information to know if the market transactions are orderly, the anticipated transaction
prices should be taken into account, but it will be given less weight than those market transactions known to be orderly.
Once an investment property has been measured at fair value, it continues to be measured at fair value, even if comparable
market transactions become less frequent or unavailable.
Excluded from the fair value measurement requirement are investment properties for which:
the fair value cannot be reliably determined whilst the property is under
construction, but for which the entity expects the fair value to be reliably
determinable when construction is completed; or
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in exceptional cases, there is clear evidence, when an entity first acquires or initially
recognises the investment property, that the fair value cannot be determined
reliably on a continuing basis.
In order to evaluate whether the fair value of an investment property under construction can be determined reliably,
management considers the following factors, among others:
The provisions of the construction contract.

The stage of completion.
Whether the project/property is standard (that is, typical for the market) or non-
standard.
The level of reliable information as to cash inflows after completion.
The development risk specific to the property.

Past experience with similar developments.
The status of construction permits.
In the event that the presumption that fair value can be reliably determined is rebutted for investment property under
construction, management applies the cost model in accordance with IAS 16 for that property (or IFRS 16 where the
investment property is held by a lessee as a right-of-use asset and IFRS 16 has been adopted). However, the property is
required to be measured at fair value at the earlier of the date when a reliable fair value can be determined for the property
and the date when construction is completed. [IAS 40 para 53A]. Once a property has been measured at fair value, the entity
cannot later conclude that the fair value of the property cannot be determined reliably. [IAS 40 para 53B].
In the rare event that the fair value of a property that is not a property under construction cannot be reliably determined on a
continuing basis, management:
a. applies the cost model in accordance with IAS 16 for that property [IAS 40 para 53] (or IFRS 16 where the investment property is
held by a lessee as a right-of-use asset and IFRS 16 has been adopted); and
b. accounts for its remaining investment properties at fair value, if their fair value can be determined reliably.
An entity continues to apply IAS 16 (or IFRS 16) until the investment property is disposed of. The property cannot
subsequently be measured at fair value.
3.5.2. Fair value measurement of assets held in

corporate wrappers in consolidated financial
statements
Entities might carry an investment property in a separate legal entity (that is, a corporate wrapper). Usually, this structure is
used for tax purposes, as quite often it is more tax beneficial for the entity to sell the corporate wrapper rather than the
underlying property itself. The implications of such structures for the recognition of deferred tax are discussed in section
5.3.6.
Similar to the accounting for deferred tax, for the purposes of consolidated financial statements, there is no guidance on how
to determine fair value of investment properties where they are held in corporate wrappers. In our view, management should
determine fair value based on the underlying investment property itself, which is the unit of account for consolidated financial
statement purposes, and not by reference to the expected sale of the property in a corporate wrapper. The fair value should
exclude any benefits from the legal structure. For further guidance on the unit of account, see section 3.6.2.
3.6. Fair value measurement of investment

property: IFRS 13
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3.6.1. Overview
As mentioned in section 3.5, entities look to the guidance in IFRS 13 in determining fair value. Fair value is the price that
would be received to sell an asset in an orderly transaction between market participants. A fair value measurement takes into
account the characteristics of the asset. Applying this to real estate, those characteristics could be the condition and
location of the asset, and restrictions on its use. The overall fair value approach in IFRS 13 is summarised in the following
diagram:
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3.6.2. Principal market and unit of account for

investment property
IFRS 13 requires management to identify the relevant market in which a typical transaction of the asset would take place. A
fair value measurement assumes that the transaction to sell an asset takes place in the principal market for the asset or, in
the absence of a principal market, in the most advantageous market for the asset. The principal market is the market with the
greatest volume and level of activity for the asset or liability that can be accessed by the entity.
In the absence of evidence to the contrary, the market in which the entity would normally enter into a transaction to sell the
asset or to transfer the liability is presumed to be the principal market or, in the absence of a principal market, the most
advantageous market. However, management does not need to continuously monitor different markets to identify the most
advantageous market at the measurement date.
The identification of the principal market requires, first, the identification of the unit of account which is subject to
transactions in this market. IFRS 13 refers to the unit of account as it is defined by the respective IFRS that requires or
permits fair value measurement:
Fair value measurement: unit of account
Unit of account for investment ‘Whether the asset or liability is a stand-alone asset or liability, a group of assets, a
properties is defined group of liabilities or a group of assets and liabilities for recognition or disclosure
according to IAS 40 purpose depends on its unit of account. The unit of account for the asset or liability
shall be determined in accordance with the IFRS that requires or permits the fair
value measurement, except as provided in this IFRS’. [IFRS 13 para 14].
According to paragraph 5 of IAS 40, ‘investment property is property (land or building, or part of a building, or both) held (by
the owner or by a lessee under a finance lease) to earn rentals or for capital appreciation or both’. As a result, the unit of
account – the single property (for example, land and building) – is the relevant level at which to measure an investment
property.
IFRS 13 allows fair value to be determined in combination with other assets, where this would result in the highest and best
use of the asset. The fair value might be the same, whether the asset is used on a stand-alone basis or in combination with
other assets. This conclusion is based on the assumption that the use of the assets as a group in an ongoing business would
generate synergies that would be available to market participants.
As a result, market participants would judge the synergies on a stand-alone basis, as well as in an asset group on the same
basis. However, for real estate assets, the valuation of the investment property is almost always on a stand-alone basis. Only
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in extremely rare circumstances ‘the entity might measure the asset at an amount that approximates its fair value when
allocating the fair value of the asset group to the individual assets of the group’. [IFRS 13 App B para B3(e)].
Sometimes, an entity expects to sell a number of properties together as a portfolio, resulting in a portfolio premium being
negotiated for the transaction. However, each investment property should continue to be valued on a stand-alone basis. It
would not be appropriate to allocate an expected portfolio premium to the fair value of individual investment properties.
3.6.2.10 Comparing like with like
When determining the fair value of investment property, entities need to avoid double counting of assets or liabilities that are
separately recognised in the balance sheet. [IAS 40 para 50].
For example, the impact of prepayments should be considered. If the cash flow projections include the impact of
prepayments, the carrying value should include the related prepayment together with the investment property. Conversely, if
the cash flows do not include the effect of prepayments, the carrying value should also exclude such impact. Whereas the
above principles, if applied correctly, should produce the same answer, the decision to include or exclude certain assets
from the valuation might also be driven by regulatory requirements.
IND FAQ 3.6.2 Should an entity adjust the carrying value of a property to avoid double counting of accrued lease payments?
3.6.3. Valuation premise: highest and best use
The valuation premise for non-current assets is the concept of ‘highest and best use’. This is particularly relevant for real
estate valuations, because land values depend significantly on the assumptions about the land’s potential use.
Fair value measurement of a non-financial asset takes into account a market participant’s ability to generate economic
benefits by using the asset in its highest and best use, or by selling it to another market participant that would use the asset
in its highest and best use. The highest and best use takes into account the use of the asset that is physically possible,
legally permissible and financially feasible. [IFRS 13 para 27].
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An entity’s current use of a non-financial asset is presumed to be its highest and best use, unless market or other factors
suggest that a different use by market participants would maximise the value of the asset.
In cases where the current use differs from the highest and best use, management should estimate a fair value based on the
hypothetical exit price, assuming the asset’s highest and best use by market participants. This issue will arise from time to
time in the real estate industry, because the way in which an entity uses land sometimes differs from the use of surrounding
land.
When determining the highest and best use of a non-financial asset, management should take into account two possibilities:
the highest and best use of an asset when used in combination with other assets as a group (as installed or otherwise
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configured for use); and in combination with other assets and liabilities (for example, a business).
If the highest and best use of the asset is to use the asset in combination with other assets, or with other assets and
liabilities, the asset’s fair value is the price that would be received, assuming that the asset would be used with other assets,
or with other assets and liabilities, and that those complementary assets and liabilities would be available to market
participants.
However, the fair value measurement of a non-financial asset assumes that the asset is sold consistently with the unit of
account specified in the standard requiring fair value measurement, being IAS 40 in the case of investment property (see
section 3.6.2). This is the case, even where the fair value measurement assumes that the highest and best use of the asset is
to use it in combination with other assets, or with other assets and liabilities.
The estimation of an exit price is not based on a transaction including the complementary assets and liabilities; it assumes
that the market participant already holds the complementary assets and the associated liabilities.
IND EX 3.6.3.1 Highest and best use - future change in legislation

IND EX 3.6.3.2 Highest and best use - Market participants
3.6.4. Valuation techniques
IFRS 13 sets out three approaches that can be used to derive fair value:
The income approach: under this approach, future amounts are converted into a single current amount using
discounted cash flows.
The market approach: under this approach, prices and other information generated by market transactions of
similar assets are used to determine fair value.
The cost approach: this approach reflects the amount that would be required to replace the asset.
Management should use valuation techniques consistent with one or more of these approaches. The valuation techniques
used should be those that are appropriate in the circumstances and those for which sufficient data is available. Management
should use techniques that maximise the use of relevant observable inputs and minimise the use of unobservable inputs (see
further section 3.6.5). Valuation techniques should be applied consistently. However, a change in the valuation technique or
its application can be appropriate if the result is equally or more representative of fair value.
Paragraph 40 of IAS 40 requires fair value to reflect rental income from current leases in addition to assumptions that market
participants would use when determining the price of investment property. Market participants would usually estimate the
price of an investment property based on their expectations about future income. On that basis, a market or income
approach will, therefore, almost always be more appropriate. For specific considerations for property under development,
see section 3.6.6.
IFRS 13 encourages an entity to apply multiple valuation techniques if appropriate. In this case, the results (that is, the
respective indications of fair value) should be evaluated, considering the reasonableness of the range of values indicated by
those results.
The fair value measurement is the amount that is most representative of fair value in the circumstances. This approach
obviously requires significant judgement, and the results of the multiple valuation techniques should be evaluated carefully.
3.6.4.11 The income approach
The fair value of an investment property can be measured using discounted cash flow projections based on reliable
estimates of future rental income and expenditure, supported by the terms of the existing lease and other contracts. External
evidence should also be used, such as current market rents for properties of a similar nature, condition and location.
Discount rates that reflect current market participant assessments of uncertainty regarding the amount and timing of cash
flows should be used to discount the projected future cash flows.
Using the income approach to measure the fair value of investment property is likely to result in a Level 3 measurement,
because the most significant input will be the projected cash flows (see section 3.6.5).
3.6.4.12 The market approach
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The best evidence of fair value is usually provided by current prices in an active market for similar property in a similar
location and condition and subject to similar lease terms and other conditions. Clearly, such conditions are not always
present, and so an entity should take account of, and make allowances for, differences from the comparable properties in
location, nature and condition of the property, or in contractual terms of leases and other contracts relating to the property.
For example, if the property is leased by the entity under a lease that contains restrictions on the uses to which a property
can be put by present and future lessees, that could significantly affect its fair value, because it might restrict the entity’s
ability to obtain the optimum market rentals.
Where current prices in an active market are not available, entities should consider evidence from alternative sources, such
as:
Current prices in an active market for properties of a different nature, condition or

location or that are subject to different lease or other contractual terms, adjusted to
reflect the differences.
Recent prices from transactions on less active markets, adjusted to reflect changes
in economic conditions since the date of those transactions.
Using the market approach to measure the fair value of investment property might, in some cases, be a Level 2
measurement. If significant adjustments are made to the observable data inputs to the valuation, the measurement will be
classified as Level 3 (see section 3.6.5).
3.6.4.13 Expenditures included in fair value

measurement
Fair value measurement of a property requires the use of estimates and judgements.
Estimates and judgements should be made on the basis of a market participant’s expectations. A key issue arising, in
measuring fair value of investment properties, is whether future capital expenditures for the development of a property
should be considered.
As a general rule, such expenditure should be considered only when a market participant would be reasonably expected to
consider these in valuing the property.
This expectation becomes more prominent for properties under development, in which case a market participant would
indeed be reasonably expected to complete the development of the property. In this case, it can be considered that the
related expenditure is part of the strategic construction plan for the property.
3.6.5. Fair value hierarchy and valuation

inputs
Fair value measurements are categorised into a three-level hierarchy based on the type of inputs. The hierarchy is defined as
follows:
Level 1 inputs are unadjusted quoted prices in active markets for items identical to
the asset being measured.
Level 2 inputs are inputs other than quoted prices in active markets included within
Level 1 that are directly or indirectly observable.
Level 3 inputs are unobservable inputs that are usually determined based on
management’s assumptions. However, Level 3 inputs have to reflect the
assumptions that market participants would use when determining an appropriate
price for the asset.
Entities are not free to choose which level of inputs to use; they must select the most appropriate valuation techniques that
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maximise the use of observable inputs and minimise the use of unobservable inputs. [IFRS 13 para 61].
 View image
In some cases, the inputs used to measure fair value might be categorised within different levels of the fair value hierarchy. In
such instances, the fair value measurement is categorised in its entirety based on the lowest level input that is significant to
the measurement.
Due to the nature of real estate assets – which are often unique and not traded on a regular basis – and the subsequent lack
of observable input data for identical assets, fair value measurements of real estate will be categorised as Level 2 or Level 3
valuations. All observable market data is given higher priority and should be preferred over unobservable inputs.
The table below gives examples of inputs to real estate valuations and their typical categorisation in the fair value hierarchy:
Level 2 – Valuation inputs Level 3 – Valuation inputs
Sale prices per square metre for Yields based on management

similar properties in similar estimation
locations
Significant yield adjustments based
Observable market rent per square on management’s assumptions
metre for similar properties about uncertainty/risk
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Level 2 – Valuation inputs Level 3 – Valuation inputs

Property yields derived from latest Assumptions about future
transactions development or parameters (for
example, vacancy, rent) that are
not derived from the market
Cash flow forecast using the
entity’s own data
The use of unobservable inputs is a complex and judgmental area. An entity should develop unobservable inputs using the
best information available in the circumstances. An entity might begin with its own data, but it should adjust that data if
reasonably available information indicates that other market participants would use different data, or there is something
particular to the entity that is not available to other market participants, such as an entity-specific synergy.
An entity does not need to undertake exhaustive efforts to obtain information about market participant assumptions. It is,
however, expected to take into account all information about market participant assumptions that is reasonably available.
[IFRS 13 para 89].
So, unobservable inputs should still be adjusted for market participant assumptions, but the information gathered to
determine market participant assumptions should be limited to the extent that it is reasonably available. Information that
becomes known after the measurement date is only taken into account where reasonable and customary due diligence
would have identified the additional information at the measurement date. An entity should revise its fair value estimates if
reasonably available information at the measurement date indicates that other market participants would use different data.
[IFRS 13 para 89].
When valuing businesses and most non-financial assets, entities in practice use an expected cash flow model. Even if
management is not explicitly modelling scenarios, it is implicitly assigning a probability weighting to possible scenarios to
arrive at a single forecast. Another approach is to use a forecast that is not an expected cash flow forecast, for example,
management’s best estimate. IFRS 13 requires the use of a discount rate that is consistent with the risk inherent in the cash
flows. This means that the discount rate applied to the expected cash flows and ‘best estimate’ cash flows are not the same.
If the cash flow forecasts do not fully reflect multiple scenarios capturing the range of relevant outcomes, an entity may need
to add a company-specific risk premium, also known as an alpha, to the discount rate. This will result in a higher discount
rate that reflects the risks in the forecast. A multiple scenario approach may eliminate the need for the alpha adjustment
since discount rates should not be adjusted for risks that are already reflected in the cash flows.
If management moves from a single set of cash flows to a probability weighted set of cash flows, this represents a change in
accounting estimate in accordance with IAS 8, which should be accounted for as such. However, in accordance with IFRS
13 paragraph 66, the disclosures in IAS 8 for a change in accounting estimate are not required for revisions resulting from a
change in a valuation technique or its application. However, IFRS 13 requires that a change in valuation technique is
disclosed, along with the reasons for making that change. IFRS 13 paragraph 65 cites changing market conditions as an
example of a circumstance where a change in valuation technique or its application may be appropriate.
Additionally, IFRS 13 deals with uncertainty in relation to Level 3 fair value measurements through providing users with
appropriate disclosure. For example, including a description of the valuation techniques used, how decisions are made in
relation to valuation procedures and for recurring fair value measurements, the sensitivity of fair value measurements to
significant unobservable inputs.
3.6.6. Application to developments in progress
Developments in progress are the most challenging, from a valuation perspective, because there is normally very little, if any,
market evidence which would be representative of fair value. Forced sales are not viewed as representative of fair value.
The lack of transactions and the property-specific nature of development often rule out the use of a market approach for
valuation. Instead, the valuation of development properties is typically based on the expected future cash flows, and so it is
effectively an income approach.
The first and perhaps most important step when estimating future cash flows is to identify the optimal development scheme
to maximise the value of the site (that is, its highest and best use, as described in section 3.6.3). The estimation of the end
value and the development costs will then be based on this conceptual scheme.
It is important that the assumptions made regarding the proposed development scheme are realistic and achievable, having
regard to the site constraints, planning restrictions, project economics and market demand. Once the construction phase
has started, the future cash flows will normally be based on the actual scheme in progress, unless it clearly fails to deliver
optimal value.
In the very early stages of a development project (for example, at the conception/feasibility stage), a question arises as to
whether the fair value can be reliably measured (see section 3.5.1) or whether costs incurred to date are representative of fair
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value. This approach will only be robust in a stable market with constant values where the site was originally acquired at fair
value and the major value accretive steps in the development process have yet to begin.
Two common approaches are followed when determining the fair value of property under construction:
1. The static approach (traditional residual method).

2. The discounted cash flow approach (dynamic approach).
3.6.6.1. Static approach (traditional residual

method)
The methodology for valuing development properties is reasonably well established in many countries, although it is primarily
used for appraising development opportunities prior to acquisition.
Historically, the principal methodology used to value development properties was known as the ‘residual method’
(alternatively known as the ‘static approach’), which is summarised as follows:
 View image
This methodology has traditionally been applied using the mathematical formula above, which involves a number of
simplifications and needs to be applied with caution. The use of this approach is likely to be most appropriate in the
feasibility stages of a project, when the future cash flows have yet to be quantified in detail.
3.6.6.2. Discounted cash flow approach

(dynamic approach)
A dynamic discounted cash flow (DCF) method will often be a more robust approach to determine a development property’s
fair value, compared to the traditional (static) approach.
The inputs into a DCF methodology will typically be more explicit, both in terms of quantification and timing, than those
applied in the traditional approach. The net present value derived from the DCF calculation will represent the current value of
the development. The internal rate of return will also be visible. It provides a helpful sense check and indicates whether the
implied return is commensurate with the risks involved, having regard to other potential investment opportunities with a
similar risk profile.
The fair value measured by applying a dynamic valuation approach has to include the developer’s profit that has accrued
until the valuation date. The estimation of this profit portion should consider the level of risk that has been mitigated until the
valuation date, as well as the level of outstanding risk. For example, such an estimation can be based on a risk matrix
approach. Nevertheless, the identification and detailed assessment of individual risk factors will arguably be a complex and
difficult process.
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3.7. Change in use of assets: transfers into and

out of investment property
Transfers into, or out of, investment property are made where there is an evidenced change in use. To conclude that there is
a change of use, there should be an assessment of whether or not the definition of investment property is met. This change
must be supported by evidence. A change in management’s intention, in isolation, does not provide evidence of a change in
use. Paragraph 57 of IAS 40 provides a non-exhaustive list of examples of when a change in use might be evidenced.
Changes in use of an existing asset are not changes in accounting policies, and so they are accounted for prospectively. [IAS
8 para 16]. No changes in comparatives should be made.
3.7.1. Transfers out of investment property
Investment property to owner-occupied property
An investment property is transferred to property, plant and equipment (PP&E) when owner-occupation commences or if the
investment property is redeveloped with a view to owner-occupation. [IAS 40 para 57(a)]. However, if an entity begins to
redevelop an existing investment property for continued future use as investment property, the property is not reclassified as
owner-occupied property during the redevelopment.
Investment property to inventory
An investment property is transferred to inventory at the time of commencement of development with a view to sale. [IAS 40
para 57(b)].
If a property is to be disposed of without development, there has been no change in use, and the property is not transferred
to inventory. It is retained as investment property. The property might be reclassified as a non-current asset held for sale and
accounted for in accordance with IFRS 5 where the relevant criteria are met (see section 6).
IND FAQ 3.7.1 When should an entity transfer a property to be redeveloped into inventory?
3.7.2. Transfers into investment property
Property, plant and equipment to investment property
An item of owner-occupied property is transferred to investment property when owner-occupation ceases. [IAS 40 para
57(c)].
IND FAQ 3.7.2 When should an entity transfer a previously owner-occupied property into investment property?
Inventory to investment property
Property held as inventory is transferred to investment property on commencement of an operating lease with a third party.
A property under construction, that was previously classified as inventory, is not transferred to investment property solely
when the intention to sell changes. The inventory will be transferred to investment property when there is a change in use
evidenced, for example, by signing an operating lease to lease all or part of the property to a third party. [IAS 40 para 57(d)].
IND FAQ 3.7.3.1 When should an entity transfer inventory into investment property?
IND FAQ 3.7.3.2 Which factors should be considered in determining when inventory should be transferred to investment
property?

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IND FAQ 3.1 Can an entity establish a provision

for planned major expenditure on an
investment property?
Reference to standard: IAS 37 para 10, IAS 40 para 16-17

Background
Entity L has acquired an investment property for C100. The building’s sewage system was not operating, and entity L
decided to incur the minimum expenditure that would make the sewage system operational (which is C5), and to undertake
major upgrade of the system at the end of year 5.
Entity L uses the cost model and is proposing to initially recognise this investment property at C115 (being cost of C100,
expenditure of C5, and the present value of the planned expenditure at the end of year 5 of C10).
Question
Can an investment property entity establish a provision for planned major expenditure on an investment property?
Answer
No. A provision should be recognised when:
1. an entity has a present obligation;

2. an outflow of resources is probable; and
3. a reliable estimate can be made of the amount of the obligation.
The major maintenance expenses that will arise at the end of year 5 do not meet the definition of a present obligation, so a
provision in accordance with IAS 37 cannot be established.
Entity L should recognise the investment property at C100 and will capitalise the C5 expenditure to make the sewage system
operational when incurred, as this expenditure is expected to produce future economic benefits over five years as the
building can only be used with an operational sewage system. The sewage system component should be depreciated over
five years. At the end of year 5, when the sewage system will be replaced, C10 will be capitalised and depreciated over its
useful life.
IND FAQ 3.2 Can subsequent expenditure be

capitalised on a property carried at cost if it
enhances a property’s future income-earning
potential?

Background
Entity A acquired an investment property on 1 January 20X0. During 20X9, entity A spent a significant amount of money to
install a modern upgraded glass roof on this property. Management believes that it is important for the property to have a
modern roof system, to attract and retain tenants and resist downward pressure on rents. It also enables management to
reduce electricity costs.
Entity A’s management would like to capitalise the expenditure.
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Question
Can subsequent expenditure on investment properties carried at cost be capitalised if it enhances the property’s future
Answer
Yes. The roof is usually replaced during the life of a building. The new roof should be capitalised. It is considered likely that
the new roof will provide future economic benefits for entity A. The existing roof must be derecognised. The roof of a building
is a separate component of the building, and it should be depreciated separately. [IAS 16 para 43].
IND FAQ 3.2 Can subsequent expenditure be

capitalised on a property carried at fair value if
it enhances a property’s future income-earning
potential?
Reference to standard: IAS 40 paras 16 and 40

Background
The facts are as in the above example, except that entity A applies the fair value model to its investment properties. Entity A
did not establish the components of the investment property, and it concluded that it is not possible to determine the
amount by which the fair value should be reduced for the roof to be replaced.
Question
Can subsequent expenditure on an investment property carried at fair value be capitalised if it enhances the property’s future
Answer
Yes. Subsequent expenditure relating to an investment property is added to the investment property’s carrying amount
where it is probable that future economic benefits will flow to the entity. All other subsequent expenditure is expensed in the
period in which it is incurred. [IAS 40 paras 16 - 18]. The new roof should be capitalised, because it is considered likely to
provide future economic benefits for entity A. On the next reporting date, the building’s new fair value will be assessed, and
any gains/losses will be adjusted accordingly through the income statement. Under this approach, there is no need to
derecognise the existing roof or to establish the components of an investment property carried at fair value.
IND FAQ 3.4.2 Can an entity with individual

assets test for impairment on a portfolio basis?

Reference to standing text: 24.25-24.29
Background
Entity A is a real estate entity that holds real estate properties with only one operating segment. It purchases a portfolio of
investment properties at an amount higher than the aggregated amount of the individual assets’ fair value. The portfolio does
not constitute a business. However, entity A intends to manage the portfolio together, and it has a clear plan to dispose of
the portfolio as a whole in the future.
Management accounts for investment properties using the cost model.
Question
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Can entity A test the portfolio of assets, whose carrying value is higher than its fair value, for impairment on a portfolio basis?
Answer
No, each property is a CGU, and so it should be separately tested for impairment.
IND FAQ 3.4.5 At which level should an entity

test goodwill arising on a business
combination?

Background
Entity A is a real estate entity that holds investment properties with only one operating segment. It purchases a portfolio of
investment property at an amount higher than the aggregated amount of the individual assets’ fair value. The portfolio is an
individually managed portfolio and constitutes a business.
Entity A recognises each identifiable asset at its fair value at the date of acquisition. [IFRS 3 para 18]. The entity first
considers whether the premium has been paid to gain control over any other identifiable and reliably measurable intangible
assets, and then the remaining difference is accounted for as goodwill in accordance with paragraph 32 of IFRS 3. Goodwill
is monitored at the portfolio level. Entity A needs to test the recognised goodwill annually for any impairment.
Question
At which level should goodwill be tested?
Answer
The portfolio is the group of CGUs that represents the lowest level at which the entity monitors the goodwill, and it cannot be
higher than the operating segment level. Therefore, the goodwill is tested on a portfolio basis, and the recoverable amount of
the portfolio needs to be considered, to determine whether or not goodwill is impaired. This would apply equally to
companies applying the fair value model and the cost model.
IND FAQ 3.6.2 Should an entity adjust the

carrying value of a property to avoid double
counting of accrued lease payments?
Reference to standard: IAS 40 para 50(c)

Background
Entity Z rents a building to third parties under operating leases. It has accrued lease payments of C1 in its balance sheet as a
result of certain rent incentives that it gave to its tenants during the first year of the leases.
Entity Z uses the fair value model for measuring its investment properties. The valuation of its investment properties is based
on discounted cash flows. The fair value of the building at the balance sheet date is C10.
Question
Should management adjust the carrying value of a property to avoid double counting of the accrued lease payments?
Answer
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Yes. Management should make an adjustment to the fair value of investment property to the extent of any separately
recognised element of revenue not yet received in cash. Fair value calculations will not take into account the fact that an
asset has already been recognised for a portion of the future cash flows. The carrying amount of the building is therefore C9,
adjusted for the C1 already recognised in the balance sheet.
IND EX 3.6.3.1 Highest and best use - future

change in legislation
Reference to standard: IFRS 13 para 28, IFRS 13 BC para 69

A piece of land being developed for industrial use as a site for a factory could be developed as a site for high-rise apartment
buildings if there is a future change in legislation (for example, a new zoning).
How should management estimate the highest and best use?
Analysis
As a starting point, the current use of land is presumed to be its highest and best use, unless market or other factors suggest
a different use. Highest and best use is determined from the perspective of market participants. According to paragraph BC
69 of IFRS 13, ‘a fair value measurement can assume a different zoning if market participants would do so (incorporating the
cost to convert the asset and obtain that different zoning permission, including the risk that such permission would not be
granted)’. See Illustrative Example 2 of IFRS 13. In this case, there would need to be appropriate supporting evidence that
the potential re-zoning would be considered by market participants when determining the fair value. Furthermore, the use of
the asset must be physically possible and financially feasible.
IND EX 3.6.3.2 Highest and best use - Market

participants

Entity X holds an undeveloped plot of land (without street access) as investment property. In front of the plot, there are
industrial sites with street access. There are three companies located next to the undeveloped plot which are strongly in
need of additional storage space. For those three market participants, the undeveloped plot – although hinterland – is very
valuable, whereas for all others it is all but worthless.
How should management estimate the highest and best use for the purposes of determining its fair value?
Analysis
The market participants in the market for the plot are the three industrial companies located next to the plot. The value of the
plot would be the exit price that one of the industrial companies would be willing to pay.
IND FAQ 3.7.1 When should an entity transfer

a property to be redeveloped into inventory?

Background
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Entity D is engaged in two lines of business: developing property for sale; and holding real estate property for rental
purposes. Two of the properties currently classified as investment property are to be sold in the near future.
Property X is going to be redeveloped prior to sale. The redevelopment will significantly improve and enhance the property.
Property Y will also be sold, but significant redevelopment is not necessary, although some basic repairs will be undertaken.
Entity D wishes to transfer both properties from investment property to inventory at the date when the redevelopment and
basic repair works commence.
Question
How should entity D account for the properties?
Answer
Entity D should transfer property X to inventory at the commencement of the redevelopment. Property Y should continue to
be classified as investment property until the criteria in IFRS 5 are met, at which point the property should be classified as
held for sale.
Paragraph 57(b) of IAS 40 requires an investment property to be transferred to inventory only when it is being developed with
a view to sale. Developments, in this context, should substantially modify or otherwise enhance the property; basic repairs
would typically not qualify as a substantial modification.
IND FAQ 3.7.2 When should an entity transfer

a previously owner-occupied property into
investment property?

Background
Entity A owns an office building that it has previously used for its own administrative purposes. The building has been
classified as PP&E.
During the year, management moved the workforce to a new building and leased the old building to a third party.
Question
Should the building be reclassified to investment property?
Answer
Yes. The building should be reclassified to investment property when management moves to the new building and owner-
occupation ceases. The change represents a change in use of the property, and so no restatement of the comparative
amounts should be made. The fact that different accounting treatment is applied to the same property in the current year
and the prior year is appropriate, because the building was used for different purposes in the two years.
IND FAQ 3.7.3.1 When should an entity

transfer inventory into investment property?
Reference to standard: IAS 40 para 9(a)

Background
Entity A, a property developer with a history of developing properties for sale immediately after completion, constructs a
residential apartment block for sale. It decides to lease out individual apartments when construction is completed, to
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increase the possibility of selling the entire property after completion. The tenants move in before the property in its entirety
is completed and sold. For the purpose of this example, it is assumed that entity A still ‘controls’ the asset within the
meaning of paragraph 31 of IFRS 15.
Question
How should entity A account for the property?
Analysis
Entity A should continue to classify the property as inventory, because this is consistent with the entity’s principal activities
and its strategy for the property, even after the commencement of leases. The leases are intended to increase the possibility
of selling the property, rather than to earn rental income on a continuing basis, and the property is not held for capital
appreciation.
The entity’s intention to sell the property immediately after completion has not changed, because the property continues to
be held exclusively with a view to sale in the ordinary course of business; it does not therefore meet the definition of
investment property. [IAS 40 para 9(a)].
IND FAQ 3.7.3.2 Which factors should be

considered in determining when inventory
should be transferred to investment property?

Background
Entity B, a property developer with a history of developing properties for sale immediately after completion, constructs a
residential property for sale. However, as property prices are at a multi-year low and there are few buyers/transactions in the
market, entity B decides to rent out the property until market activity improves.
Question
How should entity B account for the property?
Answer
Entity B needs to carefully assess whether the property should continue to be classified as inventory or be transferred to
investment properties in accordance with paragraph 57 (d) of IAS 40. The property should continue to be classified as
inventory if this is consistent with entity B’s strategy for this property. However, it should be transferred to investment
property if there is a change in management’s intention to hold the property for future rentals or for capital appreciation (for
example, until market prices recover).
Determining the correct classification of such a property requires judgement. The inception of a lease with third parties, in
itself, does not automatically require reclassification as investment property, although it might be indicative of a change in
management’s intention.
The property can, therefore, continue to be classified as inventory to the extent that it is available for immediate sale in its
present condition, at a current market price, in the ordinary course of business.
Factors to consider include:
Is the property actively marketed for sale?

Is the property available for sale at a price that is reasonable relative to its current
market value?
Does a market exist for properties with sitting tenants, with longer lease terms,
such that the property is in a condition to be sold immediately?
Where there is no market for properties with sitting tenants, are the terms of any
leases less than the length of the period that other similar properties take to be sold
in the ordinary course of business under current market conditions?
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If the entity is unwilling to sell the property at the current depressed market price, it is likely that the property’s intended use
has changed to meet the definition of an investment property – that is, held to earn rental income and for capital
appreciation. Factors to consider are:
Has the board decided to postpone the sale of the property until the market price
recovers?
Is there a change in the business plan that takes into account the rental income
earned and the necessary future maintenance expenses?
Has this change in business plan been publicly announced?
Is the property no longer actively marketed for sale?

Is there currently no active market for similar properties?
Is the property available for sale only at a price that is not reasonable relative to its
current market value?
4. Rental income: accounting by lessors
4.1. Overview of guidance
Owners of investment property lease out property to tenants. Guidance on lessor accounting and lease incentives is
contained in IFRS 16.
4.2. Definition of a lease
Under IFRS 16, a contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for
a period of time in exchange for consideration. A contract contains a lease if fulfilment depends on an identified asset and it
conveys the right to control the use of that identified asset throughout the period of use.
IFRS 16 requires a lessor to account for the lease and non-lease components of a contract separately. [IFRS 16 para 12].
The lessor should also assess whether there are separate lease components in the lease (for example, lease of property,
furniture and electrical equipment). [IFRS 16 para 12 and App B paras B12, B32].
Non-lease components in a property lease contract might be the provision of building maintenance services, lift services or
concierge services.
The allocation of the consideration between lease and non-lease components is performed in accordance with IFRS 15.
[IFRS 16 para 17]. The lessor should allocate the transaction price to each component on the basis of relative stand-alone
selling prices. This is achieved as follows:
At contract inception, the lessor determines the stand-alone selling price of each
component.
The stand-alone selling price is the price at which an entity would sell the service
separately to a customer. Paragraphs 76 to 80 of IFRS 15 provide further guidance
on how to estimate the stand-alone selling price.
The lessor allocates the consideration in proportion to the stand-alone selling
prices.
The non-lease components would then need to be accounted for in accordance with the relevant standard. For example,
security or cleaning services would be accounted for in accordance with IFRS 15. The lease components would be
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accounted for in accordance with IFRS 16.
Special consideration is required where contracts include payments related to property taxes and insurance. Where property
taxes and insurance do not constitute a separate component, no consideration is allocated to them separately; consideration
(including any payment received as reimbursement of property taxes or insurance) is allocated only to the identified lease
and non-lease components.
As noted in section 2.2.8, investment property might be held under a lease. This raises the question of how to account for
the subsequent lease of the land and/or building to tenants. There are two potential situations that could arise: a building
situated on leased land might be sublet to multiple tenants, or to a single tenant.
Where different floors in a building are sublet to multiple tenants, it is necessary to determine whether there is a lease of land
as a separate component of the lease arrangement with each tenant. Whether the land on which the building is situated is a
separate lease component needs to be determined in light of the lease contract between the lessor and its tenants, to
determine if there are any specific provisions in relation to the underlying land lease.
If the land is used by multiple tenants located on different floors of a building, there is unlikely to be a lease in place for a
separate land component. This is analogous to common areas such as foyers and lifts in a building, which are not
considered separate lease components, because the tenant cannot direct the use of these elements. [IFRS 16 App B para
B9]. This is also similar to capacity portions of an asset where a portion of an asset that is not physically distinct is not an
identified asset and, therefore, does not meet the definition of a lease. [IFRS 16 App B para B20]. Given this, the land would
not be generally considered to be a lease component. The ground lease is effectively an input required by the lessor to
enable leasing of the building. The lessor would classify the building lease as operating or financing, considering the
indicators in paragraphs 62 to 66 and B53 and B54 of IFRS 16.
Where the land and building have been leased to one tenant only, or where there are multiple tenants in distinct sections of a
single-storey building, both the land and building are identified assets being leased by the tenant. Real estate entities will
need to assess the classification of the land and building elements as a finance lease or an operating lease separately. [IFRS
16 App B para B55]. Given that the land and building are held under a lease, any sublease is classified by reference to the
right-of-use asset arising from the head lease, rather than by reference to the underlying asset. [IFRS 16 App B para B58(b)].
In the context of the land element, the fact that land normally has an indefinite life would be disregarded, and classification
would be based on the term of the ground lease.
In order to classify each element of the lease, the lessor will need to allocate lease payments between the land and the
building elements on a relative fair value basis. If it is not possible to allocate lease payments between the two elements on a
reliable basis, the entire lease would be classified as a finance lease, unless it is clear that both the land and building
elements are operating. [IFRS 16 App B para B56]. Real estate entities typically conclude that the building element is an
operating lease which, in turn, confirms the classification of the land lease as operating.
4.2.1. Lease term
The lease term is the non-cancellable period for which the lessee has agreed to lease the asset from the lessor, together with
periods covered by options to extend the lease that the lessee is reasonably certain to exercise, and periods covered by
options to terminate the lease that the lessee is reasonably certain not to exercise. [IFRS 16 App A]. The non-cancellable
period of a lease is any period during which the lessee is unable to terminate the contract. However, lessees of property
often have the option either to extend the lease or to cancel the lease earlier than the contractual lease term. For example, a
lessor and a lessee enter into a lease agreement for five years. The lessee might have the option to cancel the lease after
three years at no significant penalty. The lessee might also have the option to extend the lease for an additional five years.
When determining which periods covered by options are included in the lease term in order to account for the lease income
in the case of an operating lease, the lessor needs to consider what the lessee might reasonably be expected to do. If the
lessee can reasonably be expected to cancel the lease, the lease term would be three years. If the lessee can reasonably be
expected to extend the lease, the lease term would be 10 years. If the lessee is reasonably expected to neither extend nor
cancel, the lease term would be five years. An entity should consider all facts and circumstances that create an economic
incentive for the lessee to exercise an extension option (or not to exercise a termination option) in order to assess whether
the exercise (or the non-exercise) is reasonably certain. These could include, among other factors, contractual terms, market
conditions, significant leasehold improvements undertaken or expected to be undertaken by the lessee, the importance of
the underlying asset to the lessee’s operations, the lessee’s costs relating to the termination of the lease and any
conditionality associated with the exercise of the options.
A lessor does not reassess, after the commencement date, whether or not an option is reasonably certain to be exercised by
the lessee. A lessor would reassess the lease term only upon a change in the non-cancellable period of the lease or a lease
modification.
4.3. Rental income: lessor accounting
The table below summarises the requirements for lessor accounting under IFRS 16. The key matter, in determining the
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accounting for lessors, is whether the leases entered into are classified as finance or operating leases.
4.3.1. General principles
Finance leases Operating leases

Classification A lease is classified as a finance lease if A lease is classified as an
substantially all the risks and rewards operating lease if substantially
incidental to ownership of an underlying all the risks and rewards
asset are transferred to the lessee. [IFRS 16 incidental to ownership of an
para 62]. underlying asset are retained by
the lessor. [IFRS 16 para 62].
Initial A receivable is recognised at an amount The underlying asset remains recognised in
recognition equal to the net investment in the the lessor’s balance sheet. [IFRS 16 para 88].
lease. [IFRS 16 para 67].
Initial direct Initial direct costs in negotiating and Initial direct costs in negotiating and
costs arranging the lease are included in the initial arranging the lease are added to the carrying
measurement of the finance lease amount of the leased asset, and they are
receivable, and they reduce the amount of subsequently recognised as an expense over
income recognised over the lease term. the lease term. [IFRS 16 para 83].
[IFRS 16 para 69].
Subsequent Finance income is recognised Lease income is recognised on a straight-line

measurement based on a pattern reflecting a basis over the lease term, unless another
and lease constant periodic rate of return. systematic basis is more representative of
income [IFRS 16 para 75]. the time pattern in which benefit derived from
the leased asset is diminished. [IFRS 16 para
81].
Appendix A to IFRS 16 defines lease payments in the same way for both lessees and lessors, comprising the following
components:
fixed payments (including in-substance fixed payments), less any lease incentives
receivable by the tenant;
variable lease payments that depend on an index or a rate;
amounts expected to be payable by the lessee under residual value guarantees;
the exercise price of a purchase option (if the lessee is reasonably certain to
exercise that option); and
payments of penalties for terminating the lease (if the lease term reflects the lessee
exercising the option to terminate the lease).
For the lessor, lease payments also include any residual value guarantees provided to the lessor. The definition in Appendix
A to IFRS 16 of lease payments also specifically excludes payments allocated to non-lease components, and lessors are
required to account for these components separately from lease components.
IFRS 16 paragraph 81 requires a lessor to recognise lease payments from operating leases as income on either a straight-
line basis or another systematic basis. If a lessor assesses some rents on an operating lease to be increasingly uncertain,
IFRS 16 does not specify a collectability criterion that must be met in order for a lessor to recognise operating lease income.
A lessor could therefore continue to recognise operating lease income. However, a lessor is required to apply IFRS 9’s
impairment requirements to lease receivables. Impairment losses on lease receivables should be recognised separately as an
expense. For guidance on modifications of operating leases, refer to section 4.12.
4.3.2. Rental income relating to an underlying

variable: contingent rentals
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Payments due under lease agreements entered into between real estate entities and tenants might be calculated based on
an underlying variable. For example, rental income might be calculated as a percentage of future sales, or it might vary
depending on a rate or index.
IFRS 16 distinguishes between three kinds of contingent payments, depending on the underlying variable and the probability
that they actually result in payments:
1. Variable lease payments based on an index or a rate. Variable lease payments based on an index or a rate (for example, linked to
a consumer price index, a benchmark interest rate or a market rental rate) are part of the lessor’s lease payments and accounted
for as part of the lease liability. These payments are initially measured using the index or the rate at the commencement date
(instead of forward rates/indices).
2. Variable lease payments based on any other variable. Variable lease payments not based on an index or a rate are not part of the
lessor’s lease payments, such as payments of a specified percentage of sales made from a retail store. Such payments are
recognised in profit or loss in the period in which the event or condition that triggers those payments occurs.
3. In-substance fixed payments. Lease payments that, in form, contain variability but, in substance, are fixed are included in the
lessor’s lease payments. The standard states that a lease payment is in-substance fixed if there is no genuine variability.
For lessees, in relation to payments initially excluded from the lease liability , if the variability is resolved at a later point in
time so that the payments become fixed for the remainder of the lease term (for example, insurance premiums or taxes that
become known and unavoidable for the upcoming year), they may become in-substance fixed payments at that point in time
in accordance with paragraph B42 of IFRS 16.
However, there is no similar explicit requirement in IFRS 16 for a lessor under an operating lease. Lessors could apply the
guidance as for lessees or, alternatively, they could recognise the variable lease payments in the periods in which they occur.
The method applied is an accounting policy choice, and it should be applied consistently in accordance with IAS 8.
IAS 8 requires that, in the absence of specific guidance, users should consider whether other IFRSs deal with similar issues.
Lessee accounting requires contingent rent to be recognised as the event or condition that triggers those payments occurs.
In our view, it would be appropriate for lessor accounting for contingent rent to mirror that of lessee accounting.
IND EX 4.3.2.1 – Variable lease payments based on an index or a rate

IND EX 4.3.2.2 – Rent reviews
4.4. Impairment of trade and lease receivables:

scope exception for applying the simplified
approach
4.4.1. Expected Credit Loss (‘ECL’) Impairment

Model
Lessors will need to determine whether lease balances are lease receivables (that is, net investments in finance leases and
operating lease receivables) that are within the scope of IFRS 9’s expected credit loss (ECL) model, or whether lease
balances are accrued lease payments, such as those that arise from accounting for lease incentives under IFRS 16, that are
within the scope of IAS 36’s impairment model. Accrued lease payments are not in scope of IFRS 9 impairment guidance
and are within the scope of IAS 36’s impairment model. Further guidance on the principles of impairment under IAS 36 can
be found in the PwC Manual of Accounting chapter 24 paragraph 6.
For those lease receivables that are within the scope of IFRS 9, the standard contains a forward looking ECL impairment
model. The general impairment model includes some operational simplifications for trade receivables, contract assets and
lease receivables, because they are often held by entities that do not have sophisticated credit risk management systems.
These simplifications eliminate the need to calculate 12-month ECL and to assess when a significant increase in credit risk
has occurred.
For trade receivables or contract assets that do not contain a significant financing component, the loss allowance should be
measured at initial recognition and throughout the life of the receivable, at an amount equal to lifetime ECL. As a practical
expedient, a provision matrix could be used to estimate ECL for these financial instruments. For trade receivables or contract
assets that contain a significant financing component (in accordance with IFRS 15) and lease receivables, an entity has an
accounting policy choice: either it can apply the simplified approach (that is, to measure the loss allowance at an amount
equal to lifetime ECL at initial recognition and throughout its life), or it can apply the general model. An entity can apply the
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policy election for trade receivables, contract assets and lease receivables independently of each other, but it must apply the
policy choice consistently.
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What does this mean for the real estate industry?
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IND FAQ 4.4.1.1 – What are the expected credit loss requirements for an operating lease receivable?
4.4.1.1. Provision matrix
IFRS 9 allows an operational simplification whereby entities can use a provision matrix to determine their ECL under the
impairment model. A provision matrix method uses past and forward information to estimate the probability of default of
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lease and trade receivables.
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Step 1
The first step, when using a provision matrix, is to define an appropriate period of time to analyse the proportion of lease and
trade receivables written off as bad debts. This period should be sufficient to provide useful information: too short might
result in information that is not meaningful, while too long might mean that changes in market conditions or the tenant base
make the analysis no longer valid. In the example below, a period of one year has been selected, with a focus on lease
receivables. The overall lease receivables were C10,000 and the receivables ultimately written off were C300 in that period.
Total lease income C10,000

Bad debts written off out of this lease income C300
Step 2
In step 2, the amount of receivables outstanding at the end of each time bucket is determined, up until the point at which the
bad debt is written off. The ageing profile calculated in this step is critical for the next step, when calculating default rate
percentages.
Total lease 10,000 Total paid Ageing profile of

income(C) lease income
(step 3)
Paid in 30 days (2,000) (2,000) 8,000
Paid between 30 (3,500) (5,500) 4,500
and 60 days
Paid between 60 (3,000) (8,500) 1,500
and 90 days
Paid after 90 days (1,200) (9,700) 300 (written off)
Step 3
In this step, the entity calculates the historical default rate percentage. The default rate for each bucket is the quotient of the
defaulted receivables at each bucket over the outstanding lease income for that period. For example, in the above
information, C300 out of the C10,000 lease income for the period was written off.
Current lease income: historical rate of default
Since all of the receivables relating to the lease income for the period and those written off were current at some stage, it can
be derived that, for all current amounts, the entity might incur an eventual loss of C300. The default rate would therefore be
3% (C300/C10,000) for all current amounts.
Lease income outstanding after 30 days
An amount of C8,000 was not paid within 30 days. An eventual loss of C300 was a result of these outstanding receivables.
Therefore, the default rate for amounts outstanding after 30 days would be 3.75%.
Remaining buckets
The same calculation is then performed for 60 days and after 90 days. Although the amount outstanding reduces for each
subsequent period, the eventual loss of C300 was, at some stage, part of the population within each of the time buckets,
and so it is applied consistently in the calculation of each of the time bucket default rates.
The historical default rates are determined as follows:
Current lease Lease Lease Lease

income payments payments payments
outstanding outstanding outstanding
after 30 days after 60 days after 90 days
Ageing profile 10,000 8,000 4,500 1,500
of lease
income (1)
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Loss (2) 300 300 300 300
Default rate: 3 3.75 6.67 20
(2)/(1) (%)
Step 4
IFRS 9 is an ECL model, so consideration should also be given to forward-looking information.
Such forward-looking information would include:
changes in economic, regulatory, technological and environmental factors (such as

industry outlook, GDP, employment and politics);
external market indicators; and

tenant base.
For example, the entity concludes that the defaulted receivables should be adjusted by C100 to C400 as a result of
increased retail entity failures, given that its tenant base is primarily retail focused. The entity also concludes that the
payment profile and amount of lease income are the same. Each entity should make its own assumption of forward-looking
information. The provision matrix should be updated accordingly.
The default rates are then recalculated for the various time buckets, based on the expected future losses.

Ageing profile 10,000 8,000 4,500 1,500
of lease
income (1)
Loss (2) 400 400 400 400
Default rate: 4 5 8.9 27
(2)/(1) (%)
Step 5
Finally, take the default rates from step 4 and apply them to the actual receivables, at the period end, for each of the time
buckets. There is a credit loss of C12 in the example illustrated.
Total Current lease Lease Lease

income payments payments
outstanding outstanding
after 30 days after 60 days
Lease 140 50 40 30
receivable
balances at
year end: (1)
Default rate: (2) - 4 5 8.9
(%)
Expected C12 C2 C2 C3
credit loss: (1)
x (2)
4.4.2. Lease prepayments and cash collateral
Lease accounting might give rise to prepayments as a result of the straight-line recognition of rental income (for example,
lease contracts that contain fixed escalation clauses).
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The entity should classify the prepayment as current if it expects to realise, sell or
consume the prepayment during its normal operating cycle or within 12 months
after the reporting period. Otherwise, the prepayment should be classified as non-
current. Refer to section 4.10 for further guidance on tenant deposits received.
4.4.2.1. Overview
Lessors often give incentives to tenants to occupy property. Examples of incentives include rent-free periods and discounts
during the initial periods of the lease. All incentives for the agreement of a new or renewed operating lease should be
recognised as an integral part of the net consideration agreed for the use of the leased asset.
The lessor should recognise the aggregate cost of incentives as a reduction of rental income over the lease term. This should
occur on a straight-line basis, unless another systematic basis is more representative of the time pattern over which the
benefit of the leased asset is diminished. [IFRS 16 para 81]. In practice, the use of an allocation basis other than straight-line
is rare.
All incentives for the agreement of a new or renewed operating lease should be recognised as an integral part of the net
consideration agreed for the use of the leased asset, irrespective of the incentive’s nature or form, or the timing of payments.
[IFRS 16 para 81].
Lease incentives could take the form of reimbursements of a tenant’s cost of leasehold improvements. As part of negotiating
a new or renewed lease, a lessor might agree to pay to the tenant an allowance for leasehold improvements, either through
an upfront payment or by requiring a tenant to submit invoices to support expenditures on leasehold improvements. The
lessor will need to determine when it has an obligation under the lease contract to pay the tenant for the allowance, because
this will determine the recognition point for both the inclusion of the lease incentive in the reduction of rental income under
IFRS 16 and accrual for the reimbursement of these costs to the tenant.
Except in circumstances where the lessor has substantive discretion to accept or reject future claims under the allowance,
the past transaction that obligates the lessor is the commencement of the lease arrangements, rather than the submission of
the claim for reimbursement by the tenant or payment of the allowance. The lessor has promised to reimburse the tenant for
certain items as part of the net consideration agreed for the use of the leased asset, and that use starts on the
commencement date of the lease. Whether or not the tenant submits claims for reimbursement is outside the control of the
lessor, and it would usually be considered probable that the tenant would claim all, or a substantial portion, of the
reimbursement rights. The expected amount of reimbursement should be accrued on the commencement date of the lease
and included as a reduction of rental revenue over the lease term.
IND EX 4.4.2.1.1 – How should lease incentives be accounted for?
4.4.2.2 Loans issued to tenants at off-market

terms as a rent incentive
IND EX 4.4.2.2.1 - Loans issued to tenants at off-market terms as a rent incentive
4.4.2.3. Accounting for assets arising from

operating lease incentives
Assets arising from operating lease incentives are not in scope of IFRS 9 as financial assets, except to the extent that the
recovery of any incentive is included in operating lease receivables recognized. However, where these assets are
denominated in a foreign currency, they are usually considered monetary assets for the purposes of applying IAS 21, as they
will be received in a fixed number of units of currency as specified in the lease contract.
IND EX 4.4.2.3 – Rent incentives in foreign currency
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4.5. Premiums for properties in a prime

location
Real estate entities might receive initial premiums from tenants over and above annual rents, in order for a tenant to gain
access to property in a prime location. In such cases, all incentives for the agreement of a new or renewed operating lease
should be recognised as an integral part of the net consideration agreed for the use of the leased asset, irrespective of the
incentive’s nature or the form or timing of payments. [IFRS 16 para 81]. Similar to other lease incentives, real estate entities
should recognise the aggregate amount of premiums received in rental income over the lease term.
IND FAQ 4.5.1 –Should an initial premium received be recognised over the lease term?
4.6. Surrender premiums
Payments between the lessor and the former lessee, also known as ‘surrender premiums’, are common in the real estate
industry where, for example, the lessor needs to provide an incentive to existing tenants to vacate the property in order to
redevelop it. Depending on the specific facts and circumstances, such costs might need to be expensed or capitalised by
the lessor. The following table addresses two scenarios that are common in the real estate industry:
Surrender premium paid to remove existing tenants to allow …

… redevelopment of Redevelopment costs are costs incurred subsequent to the acquisition of
a recently acquired the investment property, to add to or replace part of it.
or existing
investment property An entity should determine whether subsequent expenditure is capitalised,
using a test similar to the test used for owner-occupied property in IAS 16. [IAS
40 para BC B40].
Since no redevelopment is possible in the presence of the existing tenant, the

surrender premium paid to incentivise the tenant to move out is a cost of
bringing the investment property to the condition necessary for it to be capable
of operating in the manner intended by management. [IAS 40 para BC B41; IAS
16 para 16(b)].
The surrender premium is therefore capitalised as part of the investment

property. This applies to entities using both the cost model and the fair value
model for investment properties. See ‘Example – Surrender premiums paid to
remove existing tenants to allow redevelopment of a real estate property’
below.
… new tenants to occupy Capitalisation of costs on the carrying amount of an item of property ceases
recently acquired or when the item is in the condition necessary for it to be capable of operating in
existing investment the manner intended by management. The investment property is already in use
property as intended by management (no redevelopment is necessary), and so the
incurred costs cannot be capitalised.
In addition, IFRS 16 requires initial direct costs incurred by lessors in

negotiating an operating lease to be added to the carrying amount of the leased
asset and expensed over the lease term. Based on this principle, the surrender
premium should be expensed, because it is not a cost of entering into the (new)
operating lease.
If the surrender premium is payable as a result of a modification of the lease

contract, the payment should be accounted for from the effective date of the
modification (see further section 4.12). This applies to entities using both the
cost model and the fair value model for investment properties.
If the surrender premium is payable as a result of an existing break clause

term contained in the lease contract, this would result in a change in the lease
term. In addition, the lessor previously should not have included the surrender
premium payment within lease payments unless it was reasonably certain to be
exercised but, given exercise of the break clause, the premium would now
form part of lease payments to be recognised.
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Surrender premium paid to remove existing tenants to allow …

In accordance with paragraph 81 of IFRS 16, lease payments from operating
leases should be recognised as income on premium payable from an existing
break clause either a straight-line basis or another systematic basis, if that
basis is more representative of the pattern in which benefit from the use of the
underlying asset is diminished. There are therefore two possible approaches
for the recognition of the surrender premium payable from an existing break
clause based on the guidance in paragraph 81.
One approach would be to recognise the surrender premium prospectively on

a straight-line basis over the new lease term. Although not a modification,
since the surrender premium and break clause were already included in the
original lease contract, this straight-line approach is consistent with
modification guidance in paragraph 87 of IFRS 16 (see further section 4.12).
Another approach would be to calculate the overall lease payments (including

the surrender premium) that would have been recognised if the reduced lease
term had been determined at the commencement date. Any difference between
the lease payments recognised prior to notification of the exercise of the break
clause and the revised lease payments calculated assuming the new, shorter
lease term would be recognised as a cumulative catch-up adjustment. The
lessor would then recognise the remaining revised lease payments over the
remaining lease term. Because the lease term has now been reduced, the
overall benefit from the use of the leased asset has been accelerated, and so
applying a catch-up adjustment reflects the revised pattern of benefit from the
lessee’s use of the asset.
In our view, either approach could be followed, and an entity therefore has an
accounting policy choice. The policy chosen should be consistently applied and
disclosed where material. See ‘Example – Termination premiums paid to
remove existing tenants to allow new tenants to occupy the real estate
property’ and ‘Example – Termination premiums paid on exercise of an existing
break clause within the lease contract’ below.
IND FAQ 4.6.1 – Does a termination premium paid to existing tenants represent an integral part of the costs of redeveloping
a property?
IND FAQ 4.6.2 – Does a termination premium paid to existing tenants represent an integral part of the costs of a property?
IND FAQ 4.6.3 – How should a lessor account for surrender premium when a break clause is exercised?
4.7. Assumption of potential tenant’s existing

lease
Real estate entities might enter into agreements with prospective tenants, to assume the tenant’s existing lease with a third
party, in order to incentivise the tenant to enter into a new lease agreement for their own property.
For example, entities A and B own properties A and B respectively. Entity B has a lease agreement with tenant C over
property B. Entity A might undertake to pay any remaining lease payments of tenant C under that lease, in exchange for
tenant C entering into a new lease agreement for property A. In accordance with lessee accounting under IFRS 16, entity A
must recognise a right-of-use asset and a corresponding liability at the commencement date of assuming tenant C’s lease.
[IFRS 16 para 22].
4.8. Key money
An entity looking to move to a sought-after location might make payments to the lessor in order to take over the lease. Such
payments are often referred to as ‘key money’. From the lessor’s perspective, such payments are considered as part of the
lease income and would be recognised over the term of the lease.
IND FAQ 4.8.1 – How does a lessor account for a key money payment received?
4.9. Letting fees

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Initial direct costs are often incurred by lessors in negotiating and arranging a lease. They are defined as ‘Incremental costs
of obtaining a lease that would not have been incurred if the lease had not been obtained …’. [IFRS 16 App A].
Under this definition, only incremental costs can be treated as initial direct costs. Internal costs that are not incremental –
such as administration, selling expenses and general overheads – should be recognised as an expense as incurred.
Incremental external costs, in the form of agent commissions and legal, arrangement and professional fees, normally qualify
as initial direct costs.
Initial direct costs incurred by lessors in obtaining an operating lease are added to the carrying amount of the leased asset,
and they are recognised as an expense over the lease term on the same basis as the lease income. [IFRS 16 para 83]. It is
important to amortise initial direct costs separately from the asset, because they will be recognised as an expense over the
lease term rather than over the life of the asset. The lease term is likely to be a significantly shorter period than the life of the
asset. Recognition of initial direct costs as an immediate expense is not acceptable.
If an entity measures investment property at fair value, it should carefully assess all effects of letting fees incurred on the
calculated fair value, so that no double counting occurs. Valuers might consider the impact of letting fees when determining
the fair value of the property. If letting fees are included, the entity will not need to add the impact of letting fees. By contrast,
if the valuation excludes the impact of letting fees, the entity will need to add the letting fees when determining the fair value,
to ensure that it compares like with like. [IAS 40 para 50(d)]. This is illustrated in the example below.
IND EX 4.9.1 – Letting fees incurred, fair value model
4.10. Tenant deposits received
The terms of a property lease contract typically require the lessee to provide a security deposit to the lessor. The security
deposit is held by the lessor throughout the term of the lease and carries no, or a low rate of, interest. The deposit is
refunded to the lessee at the end of the lease term if the lessee has fully performed and observed all of the conditions set out
in the lease contract. If the lessee has not abided by the relevant conditions, the lease terms generally permit the lessor to
apply the security deposit to remedy the breach and to indemnify the lessor from any consequential costs and losses
incurred.
The amount of the deposit to be paid is usually determined during the negotiations between landlord and prospective tenant
regarding the terms of the lease and the rental payments. In some jurisdictions, for example, it is not unusual for a landlord to
accept a lower rental if the tenant is willing to provide a large security deposit.
Tenant deposits will generally meet the definition of cash for the lessor if they are held in a bank account belonging to, and
accessible on demand to, the lessor. Restrictions on the use of amounts held as a deposit arising from a contract with a third
party lessee do not result in the deposit no longer being cash, unless those restrictions change the nature of the deposit in a
way that it would no longer meet the definition of cash in IAS 7. This was clarified in an IFRS Interpretations Committee
Agenda Decision in April 2022.
Often tenant deposits qualify as financial instruments where the contract gives rise to a financial asset of one entity (the
lessee) and a financial liability of another entity (the lessor). [IAS 32 para 11].
However, an alternative view to the above is that security deposits paid by a lessee could be considered to be within the
scope of IFRS 16. IFRS 9 excludes rights and obligations under leases to which IFRS 16 applies. In light of the
interdependency of the amounts of deposit and monthly rental, the deposit – and its refund at the end of the lease term –
could be viewed as lease payments.
Consistent with other lease incentives, the amount received from the tenant, and the amount to be repaid to the tenant at the
end of the lease, would be included in the total lease payments to be recognised on a straight-line basis over the lease term.
IND FAQ 4.10.1 – How should an entity account for a refundable tenant deposit?
4.11. Tenant obligations to restore a property’s

condition
Lease agreements might include a clause requiring tenants, at the conclusion of the lease, to restore the property’s condition
to the same level as existed at commencement of the lease. In such cases, a tenant might make monthly payments to the
lessor in respect of bringing the building to its original pre-lease condition on the tenant’s behalf. These monthly payments
should be recognised as revenue by the lessor on a straight-line basis over the lease term.
IND FAQ 4.11.1 – How should an entity account for the reimbursement of recondition expenses?
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4.12. Lease modifications
IFRS 16 provides guidance on modifications of operating leases by lessors. Modifications to an operating lease should be
accounted for from the effective date of the modification, considering any prepaid or accrued lease payments relating to the
original lease as part of the lease payments for the new lease. [IFRS 16 para 87]. IFRS 16 defines the effective date of a
modification as the date on which the parties agree to the modification.
IFRS 16 defines a lease modification as ‘A change in the scope of a lease, or the consideration for a lease, that was not part
of the original terms and conditions of the lease (for example, adding or terminating the right to use one or more underlying
assets, or extending or shortening the contractual lease term)’. [IFRS 16 App A]. This definition includes agreements to
terminate a right of use, including terminations which reduce the remaining lease term to a short period, such as three or six
months. Therefore, lessors will need to follow the modification guidance to account for lease payments included in
termination agreements.
Modifications to an operating lease should be accounted for from the effective date of the modification, considering any
prepaid or accrued lease payments relating to the original lease as part of the lease payments for the new lease. [IFRS 16
para 87]. IFRS 16 provides clarity as to the effective date of a modification and defines this as the date on which the parties
agree to the modification.
Initial direct costs and lease modifications
Where the guidance in IFRS 16 is applied, while paragraph 87 specifies the accounting treatment for any prepaid or accrued
lease payments, it does not set out the treatment for any initial direct costs associated with the lease. This might imply that
initial direct costs relating to the original lease are derecognised on modification, and only prepaid or accrued lease
payments can be considered as payments related to the new lease. However, IFRS 16 requires a lessor to account for a
lease modification as a new lease, and so incremental costs incurred in modifying the lease that fit within the initial direct
costs definition could be capitalised, given that they are costs of obtaining the modified lease. These incremental costs
would not have been incurred if the lease had not been modified. An alternative view is that, whilst IFRS 16 requires a lessor
to account for a modification as a new lease, it contemplates a link to the previous lease by allowing previously recognised
prepaid or accrued lease payments to be accounted for as consideration for the modified lease. On this basis, it would follow
that any initial direct costs associated with the original lease would equally relate to the modified lease and, therefore, would
continue to be recognised and amortised over the remaining term of the modified lease. However, since the definition of
initial direct costs refers to costs of obtaining the lease initially, any incremental costs incurred in modifying the lease should
therefore be recognised as an expense. Given the absence of specific guidance in IFRS 16, either approach could be
followed. An entity therefore has an accounting policy choice. The policy chosen should be consistently applied and
disclosed where material.
If non-lease components exist within a contract, a change in the contract terms may modify both the lease and non-lease
components. The non-lease component modification would be dealt with under the other relevant standard (for example,
IFRS 15 for non-lease services).
For guidance on changes in lease payments that arise as a result of existing terms within a lease contract (for example,
exercise of a termination clause that was previously assessed as reasonably certain not to occur), see section 4.6.
IND FAQ 4.12.1 – How should an entity account for an existing accrued lease payment balance upon a lease modification?
IND FAQ 4.12.2 – How to account for a lease modification where payments are due to tenants on signing a lease
termination?
4.12.1. Accounting for lease concessions
In certain situations, for example government interventions, economic recession or tenant-specific factors, lessors may grant
concessions to lessees. Such concessions might take a variety of forms, including payment holidays, cash rebates and
deferral of lease payments. Judgement might be needed to determine the appropriate accounting treatment for these lease
concessions. Depending on the facts and circumstances, the substance of the concession might be appropriately accounted
for as (negative) variable lease payments, forgiveness of some of the lease payments, deferral of some of the lease payments
or a lease modification. Factors to consider in exercising this judgement include the following:
Pre-existing clauses in lease contracts. Some lease contracts contain pre-existing

force majeure or similar clauses. Where such a clause applies and results in
reduced payments, the substance might be appropriately accounted for as
negative variable lease payments that are not dependent on an index or a rate.
Under IFRS 16, the effect is recognised by the lessor in the period in which the
event or condition, that triggers the reduced payments, occurs.
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Actions of governments. IFRS 16 paragraph 2 requires an entity to consider both

the terms and conditions of contracts and all relevant facts and circumstances.
Relevant facts and circumstances might include contract, statutory or other law or
regulation applicable to lease contracts. When applying IFRS 16, an entity treats a
change in lease payments in the same way, regardless of whether the change
results from the contract itself or from applicable law and regulation. Accordingly,
the impact of a lease concession imposed only by law, regulation or government
actions might be similar to the impact of a concession required by a pre-existing
clause in the lease contract as described above. This might also be appropriately
accounted for as negative variable lease payments that are not dependent on an
index or a rate, with the effect being recognised by the lessor in the period in which
the event or condition, that triggers the reduced payments, occurs.
Forgiveness of lease payments. Where the concession takes the form of a
forgiveness of some of the payments, the required accounting for the lessor will
depend upon whether the forgiven payments have been recognised as operating
lease receivables at the point of forgiveness. IFRS 9 paragraph 2.1(b) requires IFRS
9’s impairment and derecognition requirements to be applied to lease
receivables. Consequently, prior to forgiveness, the lessor should consider if any
expected credit loss provision is required based on its expectations of forgiving
lease payments recognised as lease receivables. Upon forgiveness of any amounts
already recognised as lease receivables should be accounted for by derecognising
the receivable and recognising a loss in the income statement. Any amounts
forgiven that relate to future payments that have not been recognised as an
operating lease receivable should be accounted for applying the lease modification
requirements in IFRS 16. The lessor accounts for a lease modification as a new
lease. The concession will impact the total consideration to be received by the
lessor over the term of the lease and, as a result, it will change the amount of
revenue that the lessor records on a straight-line basis over the lease term. The
periods in which no payments are owed by the lessee would be similar to a rent-
free period granted by the lessor, and similar accounting would result.
Deferral of lease payments. Some concessions might be in the form of the lease
payments being rescheduled rather than reduced – such that, in nominal terms, the
consideration for the lease has not changed. An entity might judge that, where
such a deferral is proportionate, it is not a lease modification, since there is no
change in either the scope of the lease or the consideration for the lease. In this
case, an operating lessor would account for the nominal payments due under a
lease over the lease term on the same basis as before the change (which, for
operating leases, is typically straight-line), without considering the impact of the
time value of money on the related revenue. Since the modification does not
change the total consideration, the amount of revenue to be recognised in each
period throughout the lease will not change. However, to the extent that the
deferrals result in a build-up of an accrued rent receivable relating to straight-line
rent recognition, the lessor should apply the relevant impairment requirements
under IAS 36 (for further guidance please refer to section 4.4).
Entities should also consider what disclosures are required to enable users to understand what the accounting
consequences have been of significant lease modifications and any judgements made [IAS 1 paras 77, 79].
4.13. Revenue from managing real estate

property
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4.13.1. Overview
Real estate entities often provide management services to tenants that occupy the real estate that they hold. Management of
real estate might be performed by the real estate owners or by entities designed to provide this service. Real estate
management aims to preserve the value of the real estate. The manager is responsible for the oversight of the property,
payment of service charges (such as rates, security services and insurance), ensuring that the property is in good condition
and performing repairs and maintenance. Any related costs are usually recharged back to tenants. In turn, the manager
earns management fees, which can be fixed or directly linked to the performance of the property.
The rendering of services, such as the provision of management services, to customers by real estate managers is within the
scope of IFRS 15. IFRS 15 requires the real estate entity to:
identify the contract(s) with the customer(s);

identify separate performance obligations in the contract(s);
determine the transaction price;

allocate the transaction price; and
recognise revenue when the performance obligation is satisfied.
Further guidance on these steps and their application can be found in the PwC Manual of Accounting chapter 11 paragraphs
18–197.
Step 1: Identify the contract(s) with the customer(s)
IFRS 15 applies only to contracts with customers. A contract is defined as a written, verbal or implied (for example, by
customary business practice) agreement between two or more parties that creates enforceable rights and obligations.
Step 2: Identify separate performance obligations in the contract(s)
Performance obligations are promises in a contract to transfer distinct services, including those that a landlord can resell or
provide, to its tenant. A series of distinct services that are substantially the same and have the same pattern of transfer to the
tenant (for example, management services) are a single performance obligation, if the following criteria are met:
each service in the series meets the criteria for a performance obligation satisfied
over time; and
the same method would be applied to measure progress towards satisfaction of
the performance obligation to transfer each distinct service in the series to the
tenant.
Step 3: Determine the transaction price
The transaction price can be based on the expected value or the most likely amount, but it is constrained up to the amount
that is highly probable of no significant reversal in the future. The transaction price is also adjusted for the effects of the time
value of money if the contract includes a significant financing component.
Step 4: Allocate the transaction price
The transaction price should be allocated to distinct performance obligations, based on their relative stand-alone selling
prices.
Step 5: Recognise revenue when the performance obligation is satisfied
Revenue should be recognised when control over the promised goods or services is transferred to the customer. The
amount of revenue recognised is the amount allocated to the satisfied performance obligation.
It is common for real estate entities to involve third parties in providing services to tenants. Where another party is involved in
providing services to tenants, entities must assess whether they are acting as principal or agent (see section 4.13.4).
4.13.2. Measurement of revenue

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Revenue for a performance obligation satisfied is recognised in the amount of the transaction price. [IFRS 15 para 46].
Further guidance on the measurement of revenue can be found in the PwC Manual of Accounting chapter 11 paragraphs 72–
73.
The transaction price is the consideration that the seller expects to be entitled to in exchange for satisfying its performance
obligations, excluding amounts collected on behalf of third parties. Management must determine the amount of the
transaction price at contract inception and at each reporting date, taking into account the terms of the contract and its
customary business practice. The nature, timing and amount of the consideration promised by the customer determines the
transaction price; thus, special consideration is required if contracts contain:
variable consideration;
a significant financing component;
non-cash consideration; or
consideration payable to the customer.
Variable consideration
Variable consideration should be estimated and included in the transaction price to the extent that it is highly probable that
there will be no significant subsequent reversal in the cumulative amount of revenue recognised. This threshold for
recognising variable consideration is often referred to as the ‘constraint’ that must be met in order to recognise the variable
consideration as revenue.
Variable consideration should be estimated using the expected value approach (probability-weighted average) or the most
likely amount, whichever is more predictive in the circumstances. The approach used is not a policy choice, but management
should use the approach that it expects will best predict the amount of consideration to which the entity will be entitled,
based on the terms of the contract and taking into account all reasonably available information.
The following indicators suggest that including an estimate of variable consideration in the transaction price could result in a
significant reversal of cumulative revenue:
The amount of consideration is highly susceptible to factors outside the entity’s

influence.
Resolution of the uncertainty about the amount of consideration is not expected for
a long period of time.
The entity has limited experience with similar types of contract.

The entity has a practice of offering a broad range of price concessions or
changing payment terms and conditions in similar circumstances for similar
contracts.
There is a large number and broad range of possible consideration amounts.

[IFRS 15 para 57].
Management will need to determine if there is a portion of the variable consideration (that is, some minimum amount) that
should be included in the transaction price, even if the entire estimate of variable consideration is not included because it
does not pass the highly probable threshold. Management’s estimate of the transaction price will be reassessed each
reporting period, including any estimated minimum amount of variable consideration.
IND FAQ 4.13.2 – How should variable performance fees be recognised?
Significant financing component
In determining the transaction price, an entity should adjust the promised amount of consideration for the effects of the time
value of money if the payment includes a significant financing component. In most cases, payments for a service do not
include a significant financing component, because an entity (as a practical expedient) does not have to account for such
effects if the payment is received within one year after the service has been completed.
4.13.3. Revenue recognition
Revenue is recognised when a performance obligation is satisfied, which occurs when control of a service transfers to the
customer. Control transfers either at a point in time or over time, based on a range of criteria.
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Recognise revenue over time or at a point in time
Entities should consider whether they meet any of the three criteria necessary for recognition of revenue over time. A
performance obligation is satisfied over time where at least one of the following criteria is met:
The customer receives and consumes the benefits of the entity’s performance as
the entity performs.
The entity’s performance creates or enhances a customer-controlled asset.

The asset being created has no alternative use to the entity, but the entity has a
right to payment for performance completed to date.
For real estate management services, these will very likely satisfy the first criterion only, since the nature of the services
being provided does not create or enhance a customer’s asset.
A performance obligation is satisfied at a point in time if it does not meet the criteria above.
Measuring performance obligations satisfied over time

An entity should measure progress of a performance obligation that is satisfied over time using the method that best depicts
the transfer of services to the customer. Note that, for a series of distinct goods or services that are accounted for as a single
performance obligation (such as a management fee), the same method must be applied to measure progress in satisfying the
obligation.
The method selected should be applied consistently to similar contracts with customers. Once the metric to measure the
extent to which control has transferred is calculated, it must be applied to total contract revenue, to determine the amount of
revenue to be recognised.
4.13.4. Principal/agent relationships
It is common for real estate entities to charge tenants for service costs. Service costs billed to tenants are generally
presented gross in the income statement of the real estate entity, unless the entity is acting as an agent on behalf of a third
party (for example, as a collector for garbage fees). In line with IFRS 15, property managers will need to reconsider whether
they are acting as principal or agent in relation to goods or services that they provide to their tenants. The assessment of
whether the landlord is acting as an agent or as a principal with respect to such service costs is to be done on a case-by-
case basis, and might depend on the specific jurisdiction of operations.
Paragraphs B34 to B38 of IFRS 15 provide clear guidance on identification of principal-agent relationships. Where another
party is involved in providing goods or services to a customer, the entity determines whether the nature of its promise is:
a performance obligation to provide the specified goods or services itself

(principal); or
to arrange for the other party to provide those goods or services (agent).
An entity is a principal if the entity controls a promised good or service before the entity transfers the good or service to a
customer. However, an entity is not necessarily acting as a principal if the entity obtains legal title of a product only
momentarily before legal title is transferred to a customer.
The assessment of whether the landlord is acting as principal or as agent is to be determined by applying the two-step
approach in paragraph B34A of IFRS 15:
Step 1: Identify the specific goods or services to be provided to the customer by

another party.
Step 2: Assess whether the landlord controls each specific good or service before
that good or service is transferred to the customer.
In some areas, it might be obvious when a landlord is acting as a principal or as an agent. If this is not the case, IFRS 15
provides the following indicators that the entity is a principal:
The entity is primarily responsible for fulfilling the promise to provide the specified
good or service.
The entity has inventory risk before or after transfer of control to the customer.
The entity has discretion in establishing prices for the specified good or service
and, therefore, obtains substantially all of the remaining benefits.
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The indicators in paragraph B37 of IFRS 15 might be more or less relevant
IND FAQ 4.13.4.1 – Can an entity account for service costs billed to tenants on a net basis?
IND FAQ 4.13.4.2 – How should an entity account for taxes and rates received from a lessee?
IND EX 4.3.2.1 – Variable lease payments

based on an index or a rate
Reference to standard: IFRS 16 para 81, IFRS 16 para 42(b)

Reference to standing text: 15.134, 15.77, EX 15.134.5
Background
A lessor agrees an operating lease of office space with a lessee on the following terms:
Lease term: 10-year non-cancellable term.

Annual payment: C100,000 in the first year, with a CPI increase in every following
year.
Market rent review: beginning of year 6, with a CPI increase in every following year.
At the start of year 2, CPI has increased by 2% so the lease payment for year 2 will
be CU102,000.
In year 1, the lessor initially measures lease income as C100,000.
Question
How should the lessor determine the lease income to be recognised in year 2?
Answer
Paragraph 81 of IFRS 16 requires lessors to recognise lease payments from operating leases as income on either a straight-
line basis or another systematic basis. When determining in year 2 the (revised) lease payments for years 6–10, we believe
that the lessor has an accounting policy choice between the following two approaches:
1. not revising the lease payments for years 6–10; or

2. revising the lease payments for years 6–10.
This accounting policy choice is similar to the one available for the lessee which is further explained and illustrated in EX
15.77.3. However, there is no explicit requirement in IFRS 16 for a lessor to remeasure the lease payments in the same way
as a lessee measures the lease liability.
Approach 1
The rental income recognised by the lessor in year 2 would be C100,888 (being total lease payments of C908,000/9 years),
reflecting recognition of income without revising the lease payments for years 6–10 on a straight-line basis, in line with
paragraph 81 of IFRS 16.
Year 2 3 4 5
Lease payments (C) 102,000 102,000 102,000 102,000
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Approach 2
The rental income recognised by the lessor in year 2 would be C102,000 (being total lease payments of C918,000/9 years),
reflecting recognition of income based on the revised lease payments for years 6–10 on a straight-line basis, in line with
paragraph 81 of IFRS 16.
Year 2 3 4 5
Lease payments (C) 102,000 102,000 102,000 102,000
The policy chosen should be consistently applied and disclosed. If this choice represents a critical accounting judgement,
the entity should consider the IAS 1 disclosure requirements. See chapter 4 para 152 for further details.
IND EX 4.3.2.2 – Rent reviews

Background
Entity V, a tenant, has entered into a lease with entity Q. The terms of the lease are as follows:
The rent for the year ended 31 December 20X1 is C10,000, payable on a monthly
basis.
By 28 February 20X2, entity Q has the right to review the rent charged for the year
ended 31 December 20X1 and compare it to market prices for the period.
Accordingly, entity Q could request a catch-up payment from entity V, to
compensate for any lost income. The catch-up payment needs to be agreed by
both parties.
The determination of the catch-up payment was completed by 31 January 20X2,
and the amount was determined to be C500. The payment was agreed with entity V
on 15 February 20X2 and paid on the same date.
Question
When should entity Q recognise the catch-up rent payment?
Answer
The payment should be recognised when incurred (that is, when the lessor has the contractual right to receive payment). On
31 December and 31 January, entity Q does not have the right to receive payment. The right to receive payment is
established on 15 February 20X2, and the rent review catch-up payment is recognised on that date.
IND FAQ 4.4.1.1 – What are the expected credit

loss requirements for an operating lease
receivable?
Reference to standard: IFRS 9, 5.5.1, 5.5.18, B5.5.44, IAS 36 para 2

Reference to standing text: 15.134, 45.54, 45.55, FAQ 45.54.2
Question 1
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What type of lease balances are subject to IFRS 9’s expected credit loss requirements?
Answer
Lessors will need to determine whether lease balances are lease receivables (that is, net investments in finance leases and
operating lease receivables) that are within the scope of IFRS 9’s expected credit loss (ECL) model, or whether lease
balances are accrued lease payments, such as those that arise from accounting for lease incentives under IFRS 16, that are
within the scope of IAS 36’s impairment model.
See FAQ 15.134.2 for further discussion of the accounting for lease incentives.
Question 2
If a lessor expects a lessee to pay all operating lease receivables in full but later than the contractual due date, does this give
rise to an expected credit loss (ECL)?
Answer
It depends. Where contractual payments are expected to be received in full but later than contractually due, in isolation this
might not give rise to an ECL provision on the operating lease receivables; this is because operating lease receivables are
recognised on an undiscounted basis, and so the effective interest rate can be considered to be 0%.
However, more broadly, regardless of the specific considerations regarding time value of money arising from the expected
payment delay, paragraph 5.5.18 of IFRS 9 requires an entity to always consider the risk or probability that a credit loss
occurs.
IND EX 4.4.2.1.1 – How should lease incentives

be accounted for?

Payments made by a lessor to a lessee associated with a lease, or the reimbursement or assumption by a lessor of costs of
a lessee, as incentives for the agreement of new or renewed operating leases are included in the lease payments (as defined
in IFRS 16 appendix A). They are not considered to be part of the initial costs that are added to the carrying amount of a
leased asset. Instead, they are deducted from the lease payments , and allocated together with them, on either a straight-line
basis or another systematic basis.
Example 1 – Operating lease incentive: rent-free period
Under a 10-year lease agreement, the lessor gives a one-year, rent-free period followed by a fixed rent of C1.1m per annum
for nine years. This is equivalent to 10 years’ rent of C0.99m per annum. The cost of the incentive should be spread over the
lease term. Therefore, C0.99m of rental income will be recognised each year in the income statement. At the end of the first
year, the lessor will recognise accrued lease payments of C0.99m, which will be reduced by C0.11m each year for the next
nine years.
Example 2 – Operating lease incentive: lessor contribution to lessee fit-out costs
Alternatively, the lessor agrees with the lessee to make an upfront cash payment of C1m to contribute towards the lessee's
own fit-out costs, with a fixed annual rental of C1.1m per annum for the 10-year lease. This is also equivalent to an annual
rent of C1m per annum without the incentive. Therefore, C1m will be recognised as rental income each year of the lease. The
C1m incentive will initially be recognised as an asset for accrued lease payments, which will be amortised by C0.1m each
year to the income statement.
Accrued lease payments are not in scope of IFRS 9 impairment guidance and are within the scope of IAS 36’s impairment
model. See chapter 24 paragraph 6 for further details on the basic principles of impairment under IAS 36.
IND EX 4.4.2.2.1 – Loans issued to tenants at

off-market terms as a rent incentive
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Reference to standard: IFRS 16 para 81 and App B para B2

Background
Entity A entered into a five-year operating lease agreement over office property with tenant B. To persuade tenant B to rent
the property, entity A issued a low-interest rate loan (5%) of C100,000 to tenant B as an incentive. The term of the loan is
equal to the term of the lease (that is, five years), with equal annual payments of interest of C5,000, and the principal will be
repaid at the end of the five years. The market interest rate is 10%. Entity A has assessed the loan contract to be a separate
unit of account from the rights and obligations under the lease, and it is accounting for the loan under IFRS 9. [IFRS 16 App
B para B2].
The fair value of the loan on initial recognition is C81,050, which is the fair value for a loan with a market interest rate of 10%.
The fair value of the loan on initial recognition is C8,105, which is the fair value for a loan with a market interest rate of 10%.
Question
How should entity A account for the difference between the market interest rate and the interest rate on the issued loan?
Answer
The cost of incentives given in acquiring a lease should be recognised as a reduction of rental income over the lease
term. [IFRS 16 para 81]. In this case, the cost of the incentive is C18,950, which is the off-market element of the loan.
This incentive cost should be amortised over the lease term on a straight-line basis.
[Note that numerical entries are rounded for simplicity.]
Initial recognition (issue of the loan):

Dr (C) Cr (C)
.
Loan recognised on the balance sheet (BS) – fair value of the loan 81,050
Lease incentive (BS) 18,950
Cash 100,00
Subsequent measurement: loan at amortised cost (using the effective interest method)
The loan will be measured at amortised cost using the effective interest method. The journal entries for year 1 will be as
follows:
Dr (C) Cr (C)
Loan (BS) (C8,105 – C5,000) 3,105
Cash (BS) – payment of annual interest 5,000
Interest income (P&L) – (Carrying amount × Interest rate = 81,050 × 10%) 8,105
Amortisation of lease incentive (on a straight-line basis)
Dr (C) Cr (C)
Rental income (P&L) – (C18,950 / 5 years) 3,790
Lease incentive (BS) 3,790
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IND EX 4.4.2.3 – Rent incentives in foreign

currency
Reference to standard: IAS 21 para 16, IFRS 16 para 81

Background
Entity A entered into a 10-year operating lease with entity B on 1 January 20X1. To persuade entity A to sign the lease, entity
B has granted to entity A an initial rent-free period of two years. The rent for the remaining eight years is C750 per year.
Entity B’s functional currency is CAU. The C:CAU exchange rates are as follows:
Throughout 20X1 and as at 31 December 20X1 1:2
Throughout 20X2 and as at 31 December 20X2 1:3
Question
How should entity B recognise rental income for 20X1 and 20X2?
Answer
Entity B should recognise rent incentives as a monetary item on a straight-line basis as follows:
Entries for the year ended - 31 December 20X1
C CAU
Rent income (C750 x 8/10) (600) (1,200)
(C600 * 2)
Rent incentive asset 600 1,200
(C600 * 2)
Entries for the year ended 31 December 20X2
C CAU
Rent income (C750 * 8/10) (600) (1,800)
(C600 * 3)
Rent incentive asset 600 1,800
(C600 * 3)
Rent incentive asset: revaluation of balance 600
Difference between C600+C600 * 3 = CAU3,600 and CAU1,200 +

CAU1,800 = CAU3,000)
Foreign exchange gain on revaluation of rent incentive asset (600)
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IND FAQ 4.5.1 – Should an initial premium

received be recognised over the lease term?

Background
Entity A has developed a state-of-the-art shopping, entertainment and dining complex, which is the only one in its region.
Tenant B has entered into a 10-year lease with entity A. The tenant has agreed to pay an initial premium of C2 million in
addition to the annual rental of C1 million.
Question
Can entity A recognise the entire initial premium received in the first year of the lease or should it be recognised over the
lease term?
Answer
No, entity A should recognise the premium received on a straight-line basis over the lease term. This would result in lease
income of C1.2 million per annum ((C1 million × 10 years) + C2 million)/10).
IND FAQ 4.6.1 – Does a termination premium

paid to existing tenants represent an integral
part of the costs of redeveloping a property?
Reference to standard: IAS 16 para 16(b), IAS 40 para 17

Background
Entity A obtained all of the necessary authorisations to significantly redevelop an existing investment property for continued
future use as an investment property. The redevelopment is only possible if the property is vacant. After redevelopment, the
previously assessed standard of performance of the property will be enhanced, with significantly more rentable space. Entity
A negotiates a termination premium to remove the existing tenants, to enable it to perform the redevelopment. The entity has
chosen to apply the cost model to its investment properties.
Question
Does the termination premium paid to the existing tenants represent an integral part of the costs of redeveloping the
property in accordance with paragraph 17 of IAS 40?
Answer
The termination premiums are costs that are directly attributable to the redevelopment, and they should be capitalised as
part of the investment property. [IAS 16 para 16(b)]. The termination premium paid to incentivise the tenants to move out is a
cost of bringing the investment property to the condition necessary for it to be capable of operating in the manner intended
by management. [IAS 40 para BC B41].
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IND FAQ 4.6.2 – Does a termination premium

paid to existing tenants represent an integral
part of the costs of a property?
Reference to standard: IAS 16 para 81, IAS 40 para BC B41

Background
Entity A pays termination premiums to remove the existing tenants, to allow it to rent out the property to new tenants on
lease contracts with more favourable terms and conditions. The entity has chosen to apply the cost model to its investment
properties.
Question
Does a termination premium paid to existing tenants represent an integral part of the costs of the property in accordance
with paragraph 17 of IAS 40?
Answer
No. The investment property is already in use as intended by management, and so the incurred costs cannot be capitalised.
[IAS 40 para BC B41]. The termination premium is recognised as part of rental income, because it is not a cost of entering
into the (new) operating lease. If the surrender premium is payable as a result of a modification of the lease contract, the
payment is accounted for from the effective date of the modification (see further section 4.12).
If the surrender premium is payable as a result of an existing term contained in the lease contract, entity A could apply the
guidance in paragraph 81 of IFRS 16, either by accounting for the premium as if it was the result of a modification, or by
recognising a cumulative catch-up adjustment. The approach selected is an accounting policy choice that should be
consistently applied and disclosed where material. Both approaches are illustrated further in the example below.
IND FAQ 4.6.3 – How should a lessor account

for surrender premium when a break clause is
exercised?

Background
Entity A enters into a lease contract with a tenant where the lease term is 10 years. The lease contract contains a break
clause at year 5 which, if exercised, would require payment of a surrender premium. At commencement of the lease, entity A
considered that the break clause was reasonably certain not to be exercised and, as such, determined that the lease term
was 10 years. At the end of year 3, due to unforeseen circumstances, the tenant has formally communicated that it will
exercise the break clause in year 5.
In line with paragraph 21 of IFRS 16, this would result in a change in the lease term. In addition, the lessor previously did not
include a surrender premium payment within lease payments but, given exercise of the break clause, the premium would
now form part of lease payments to be recognised.
Question
How should the lessor account for the surrender premium, now that the break clause has been exercised and the lease term
shortened?
Answer
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Although not a modification, since the surrender premium and break clause were already included in the original lease
contract, there are two possible approaches for the recognition of the surrender premium based on the guidance in
paragraph 81 of IFRS 16. Entity A could account for the payment as if it was the result of a lease modification (see further
section 4.12), which would result in the surrender premium balance being recognised prospectively over the new revised
lease term of two years, along with the remaining lease payments receivable.
Alternatively, a cumulative catch-up adjustment could be recognised. Under this approach, entity A would calculate the
overall lease payments (including the surrender premium) that would have been recognised if the lease term had been
determined to be five years at the commencement date. Any difference between the lease payments recognised prior to
notification of the future exercise of the break clause and the revised lease payments calculated assuming the new, shorter
lease term would be recognised as a cumulative catch-up adjustment. Entity A would then recognise the remaining revised
lease payments over the remaining lease term.
The approach that entity A selects is an accounting policy choice that should be consistently applied and disclosed where
material.
IND FAQ 4.8.1 How does a lessor account for a

key money payment received?

Background
Entity B entered into a five-year operating lease with entity A for a store in a prime location. Entity A has paid an amount of
C500 to entity B to obtain the lease.
Question
How should entity B account for the amounts received?
Answer
Entity B should recognise the payment as part of the lease income to be received under the lease agreement. The key money
payment would be recognised as deferred rental income on the balance sheet, and it would be amortised over the lease term
of five years, resulting in additional rent of C100 per year (C500 over five years).
IND EX 4.9.1 – Letting fees incurred, fair value

model
Reference to standard: IAS 40 para 50(d)

Entity A leases out investment property under an operating lease, and it pays letting fees to an agent for attracting new
tenants. The agent receives a commission for this service when the tenant enters into a contract to rent the property. The
letting fees paid to the agent are directly attributable to the lease agreement with that specific tenant. The lease term is three
years.
Entity A initially measures its investment property on acquisition at cost (including transaction costs), and it adopts a policy
of fair value for subsequent measurement in accordance with IAS 40.
The acquisition cost of the property is C158. The fair value of the property as at the year end is C159.70.
Should entity A capitalise letting fees under the fair value model?
Analysis
Yes. The letting fees incurred should be added to the carrying amount of the investment property and recognised on a
straight-line basis over the lease term. Given that entity A applies the fair value model, the effect of capitalisation of letting
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fees on subsequent measurement of the property is illustrated below:
C Description
Acquisition cost 158
Capitalised letting 3 Fair value of the property immediately after letting = C161
fees
Amortisation of (1) Amortisation over 3 years

capitalised letting
fees
Fair value (0.30) The fair value gain/(loss) illustrated is effectively the residual
gains/(losses) movement in the property’s value over the year, after taking into
account the effect of capitalising and amortising letting fees (159.70
– 158 – 3 + 1 = –0.30)
Carrying value at 159.70 Fair value of property at year end, according to the valuation
31/12/X1 report = 159.70
IND FAQ 4.10.1 – How should an entity

account for a refundable tenant deposit?
Reference to standard: IFRS 9 para 3.2.3, 5.1.1, 5.3.1, 4.2.1, IFRS 16 para 81, IAS 32
para 11, 43
Background
Entity A has received a security deposit from tenant X of C500,000. Entity A is required to pay interest of 2% to tenant X on
the deposit received. Tenant X could receive interest of 5% from a similar type of instrument with similar credit risk in the
market. (The determination of the market interest rate considers whether there are any security or collateral arrangements
specified in the agreement, or if tenant X is exposed to unsecured credit risk of entity A.) The deposit is repayable at the end
of the five-year lease agreement. The lessor can apply the security deposit to remedy any breach in contractual conditions
and to indemnify the lessor from any consequential costs and losses incurred, or the deposit can be used to settle lease
receivables outstanding at the end of the lease. The lease is classified as an operating lease by entity A.
Question
How does entity A account for the refundable tenant deposit received?
Answer
An entity will have to determine whether the security deposit paid by a lessee is accounted for under IFRS 9 as a separate
unit of account from the rights and obligations under the lease, or whether it is within the scope of IFRS 16 (for example, as a
prepaid lease payment). For lessors, IFRS 9 excludes rights and obligations under operating leases to which IFRS 16 applies,
except for the impairment and derecognition of operating lease receivables, and embedded derivatives within leases.
Accounting under IFRS 9
Tenant deposits qualify as financial instruments where the contract gives rise to a financial asset of one entity (tenant X) and
a financial liability of another entity (entity A) [IAS 32 para 11], where this instrument is considered to be separate from the
lease rights and obligations. [IFRS 9 para 2.1(b)]. Under IFRS 9, entity A’s liability is initially recognised and measured at fair
value, and then subsequently at amortised cost using the effective interest method. [IFRS 9 paras 5.1.1, 5.3.1, 4.2.1]. The fair
value is calculated as the present value of the future cash flows, using the market interest rate of 5%, being the interest rate
that would be received from a similar type of instrument in the market. The fair value of the C500,000 deposit is C435,058.
The difference between the nominal value and the fair value of the liability of C64,942, at initial recognition, would be treated
as an initial lease payment and recognised on a straight-line basis over the lease term of five years.
Accounting under IFRS 16
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Tenant deposits qualify as part of the rights and obligations under the lease when they are considered to represent an
integral part of the lease contract rather than a separate unit of account that would be within the scope of IFRS 9.
Consistent with other payments made, the amount received from the tenant, less the amounts to be repaid to the tenant over
the lease term and at the end of the lease, would be included in the total lease payments to be recognised on a straight-line
basis over the lease term
Regardless of the approach taken in accounting for the tenant deposit, the receipt of the deposit might affect accounting for
any operating lease receivables recognised under the lease. For example, it could be taken in account when measuring
expected credit losses under the impairment model, and in determining whether the cash collateral received under the
deposit arrangements results in derecognition of any operating lease receivable balances in accordance with paragraph
3.2.3 of IFRS 9. However, in most cases, it is unlikely that the receipt of cash collateral in the form of a security deposit
would result in settlement of operating lease receivables and hence in their derecognition under paragraph 3.2.3 of IFRS 9.

account for the reimbursement of recondition
expenses?

Background
Entity T receives a monthly payment from tenant V for tenant V’s contractual obligation to bring the building to its original
(pre-lease) condition. This payment is included in the monthly lease payment from tenant V.
Entity T is planning to refurbish the property after the end of tenant V’s lease.
Question
How should entity T account for any payments received from tenant V for bringing the property to its pre-lease condition?
Answer
Tenant V has agreed to pay a higher lease payment each period in lieu of having to restore the building to its pre-lease
condition at the end of the lease. As such, the monthly payments should be recognised on a straight-line basis over the lease
term.
The fact that entity T is planning to refurbish the property prior to leasing it again does not impact the timing of recognition of
lease income, because it does not represent an obligation that entity T must perform under the lease contract with tenant V.

account for an existing accrued lease payment
balance upon a lease modification?
Reference to standard: IAS 16 paras 81 and 87

Background
Entity A owns and operates a shopping mall. It leases out the shopping mall space to a number of retailers under non-
cancellable leases.
Entity A has provided rent-free periods to the lessees during the initial lease period, the effect of which has been accounted
for over the lease term in accordance with paragraph 81 of IFRS 16. The leases are classified as operating leases in entity
A’s financial statements.
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Due to a market downturn, entity A has agreed with a number of its lessees to modify their lease agreements, reducing the
fixed rental payments and increasing the contingent rent component.
Prior to the modification, entity A had recognised an accrued lease payment balance that arose from the initial rent-free
period. This balance is not considered impaired. Entity A did not have any outstanding operating lease receivables due from
tenants at the effective date of the modification.
Question
How should entity A account for the accrued lease payment balance that arose from the initial lease agreement containing
the rent-free period following a lease modification?
Answer
The accrued lease payment balance from the original leases represents part of the lease payments for the new lease
agreements and, accordingly, it should be deferred and amortised over the new lease terms in accordance with paragraph
81 of IFRS 16.
IND FAQ 4.12.2 – How to account for a lease

modification where payments are due to
tenants on signing a lease termination?
Reference to standard: IAS 16 para 81, IFRS 16 para 87

Reference to standing text: 15.134, 15.136, FAQ 15.136.3
Background
Entity A owns a commercial investment property and leases out office space to a number of tenants. The leases are
generally for 10 years and do not contain any lessee or lessor extension or termination options. The lessor classifies the
leases as operating leases.
One of entity A’s tenants starts negotiations to exit their leases early. On 1 December, entity A and tenant X sign an
agreement to terminate their lease. Tenant X agrees to pay a termination penalty of C300, payable on 31 December. Tenant
X will vacate the premises on 31 May (six-month notice period) and will continue to pay rent of C100 per month (the normal
monthly lease payments) each month until it vacates the property.
Question
How should entity A account for a lease modification where payments are due from the tenants on signing a lease
termination?
Answer
The amount payable as a termination penalty is in respect of a modification to the lease agreement. The termination was
negotiated and amends the original lease agreement, shortening the lease period significantly. The original lease terms have
term has been changed in a manner that meets the definition of a lease modification: the lease term has been shortened and
there is an additional payment made under the agreement. Under IFRS 16, modifications of operating leases are accounted
for as ‘new leases’ from the effective date of the modification (being 1 December) [IFRS 16 para 87]. Any payments under the
modified lease, including the termination penalties, are lease payments that are recognised as income on a straight-line basis
over the term of the lease [IFRS 16 para 81].
This would result in entity A recognising the following amounts for the period to 31 December:
C150 in respect of December rental revenue (= (300 penalty + 6 x 100 monthly rent)/6 months).
IND FAQ 4.13.2 – How should variable

performance fees be recognised?
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Background
A real estate fund manager has a management contract with a fund to provide investment management services for three
years. In addition to a base management fee, the manager is entitled to a performance fee that is equal to 20% of profits
generated by the investments in the fund when it achieves a return of over 8% per annum. The management agreement
states that the performance fee should be calculated, and paid, on the last business day of the third calendar year.
Question
How should the performance fee be recognised?
Answer
The contractual measurement period is based on the terms of the contract, which in this case is three years. In determining
whether to include an amount of variable consideration in the transaction price at the end of the first financial period, the
manager must assess whether it is highly probable that the amount included will not result in a significant reversal of revenue
in future periods (the ‘constraint’). In other words, it is not an ‘all or nothing’ assessment, and entities must always record the
highest amount that is highly probable not to result in a significant future revenue reversal. This determination will require
judgement and, to the extent that the variable consideration constraint is not met until the end of the year when the
performance fee is known, the entire performance fee will only be recognised on the last day of the third calendar year.
Amounts received before the constraint criteria are met might need to be recognised as unearned revenue liability (that is, a
contract liability).
IND FAQ 4.13.4.1 – Can an entity account for

service costs billed to tenants on a net basis?

Background
Entity A is the owner and lessor of an office building. It is contractually obliged to maintain the premises’ car park and
provide cleaning, tenants’ insurance and security for the building under the terms of its lease contracts with its tenants. The
tenants are not charged separately for these services.
Question
Can Entity A report revenue net of the costs incurred to provide the above services given that these costs are not separately
reimbursed by tenants?
Answer
No. Revenue includes only the gross inflows of economic benefits received and receivable by the entity on its own account.
Amounts collected on behalf of third parties are excluded from revenue. However, entity A is not acting as an agent, because
it is itself contractually obliged to provide these services to its tenants. As such, it should report revenue on a gross basis.
Entity A is required to assess what lease components and service components are in the contract. Lessors are required to
account for the lease and non-lease components of a contract separately. In the case of non-lease components such as
service charges, these are accounted for under IFRS 15.
Equally, entity A should also report the costs associated with providing these services gross in the income statement.
Entity A should provide an analysis of the different components of revenue, separating revenue from the sale of services from
rental income, either on the face of the income statement or in the notes.
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IND FAQ 4.13.4.2 – How should an entity

account for taxes and rates received from a
lessee?

Background
Entity A collects local property taxes and water rates, and it pays these to the municipal authorities. These payments are not
part of the rental payments receivable by entity A and, in this jurisdiction, tenants retain the primary obligation to the
municipality.
Question
Can entity A recognise the receipt and payment of property taxes and water rates on a net basis?
Answer
Yes. Entity A should present the amounts received from its tenants for property taxes and water rates net of the payments
that it makes to the municipal authorities. This presentation is appropriate, because entity A acts as an agent on behalf of the
authorities. The amounts collected are not revenue, and they are presented in the income statement net of the amounts paid
to the municipal authorities. [IFRS 15 para 47].
5. Real estate structures and tax considerations
5.1. Consolidation
5.1.1. Overview
A reporting entity prepares consolidated financial statements where it meets the definition of a group as set out in IFRS 10.
The ‘group’ is ‘a parent and its subsidiaries’. IFRS 10 provides a single definition of control that applies to all entities. This
definition is supported by extensive application guidance that explains the different ways in which a reporting entity (investor)
might control another entity (investee).
The key principle is that control exists, and consolidation is required only if the investor possesses power over the investee,
has exposure to variable returns from its involvement with the investee, and has the ability to use its power over the investee
to affect its returns. Power over an investee is present where the entity has the right to direct the decisions over relevant
activities (that is, the decisions that affect returns).
Relevant activities for a real estate entity include, but are not limited to:
decision to purchase investment property;

approval of entering into finance agreements;
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approval of budgets, including maintenance and renovation plans;

selection of tenants and the approval of lease contracts;
approval of sale of investment property; and

investment decisions around investment property.
IFRS 10 provides certain exceptions to the consolidation requirements. One of these exceptions is where the reporting entity
is an investment entity. Investment entities are required not to consolidate particular subsidiaries; those subsidiaries are
measured at fair value through profit or loss in accordance with IFRS 9.
Determining whether a real estate entity meets the definition of an investment entity requires significant judgement, for which
all relevant facts and circumstances (including the purpose and design of the entity) should be considered.
5.1.2. Definition of an investment entity
An investment entity is an entity that:
obtains funds from one or more investors for the purpose of providing the
investor(s) with investment management services;
commits to its investor(s) that its business purpose is to invest funds solely for
returns from capital appreciation, investment income, or both; and
measures and evaluates the performance of substantially all of its investments on a
fair value basis. [IFRS 10 para 27].
The definition encompasses the following key elements:
business purpose including investment-related services;

exit strategies;
earnings from investments; and

fair value measurement.
5.1.2.1. Services
Part of an entity’s business purpose might be to provide investment-related services (including investment advisory services,
investment management, and investment support and administrative services), either directly or through a subsidiary. These
services could be provided to investors and/or third parties. Participating in such investment-related services does not
disqualify an entity from being an investment entity, even if these services form a substantial part of its business; this is
because such services are an extension of its operations.
The provision of other services that are not investment-related services (such as providing strategic advice or financial
support to investees) is one of the factors that differentiates investment entities from other entities. These activities need to
be undertaken to maximise investment returns (capital appreciation and/or investment income) from the entity’s investees.
They must not represent a separate substantial business activity or a separate substantial source of income.
Examples of permissible management and other services for real estate structures are:
providing management services and strategic advice to an investee;
providing financial support (such as a loan, capital commitment or guarantee) to an

investee;
other incidental services increasing or enhancing the value of investments; and
other administrative services (that is, accounting at property level).
[IFRS 10 App B paras B85C, B85D and para BC 240].
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For real estate structures, permitted services include the management of the structure and the properties within it,
acquisitions, arranging external financing, market analysis, strategic decisions, and marketing of assets for lease or sale.
Typical structures normally use third party service providers (such as property managers) to manage and run the properties,
and real estate agents for capital transactions. This has no impact on whether the investment entity exemption is met. Other
structures appoint related service providers, especially in portfolio management, who are remunerated at arm’s length.
Management services to third party investment property owners should not be a separate substantial business activity, or a
separate substantial source of income, for the investment entity definition to be met.
Outside management services, it is often the case that financing (in the form of equity or debt) or guarantees are granted to
related holding or property companies within the structure.
5.1.2.2. Business purpose
The definition of an investment entity requires the entity to commit to its investor(s) that its business purpose is to invest
funds solely for returns from capital appreciation, investment income, or both. For real estate structures, capital appreciation
is synonymous with the increase in fair value of the properties, culminating in the gains from disposal, whilst rental income
from lease contracts is considered as investment income.
The business purpose is normally presented in offering memorandums, prospectuses, term sheets, partnership agreements,
deeds or other corporate documents. The objectives are essential in assessing the structure’s purpose and whether this
purpose is consistent with the business purpose of an investment entity.
IND EX 5.1.2.2 – Business purpose of an investment entity
5.1.2.3. Exit strategy
Real estate structures are required to have a documented exit strategy for their assets, in order to meet the definition of an
investment entity. The presence of an exit strategy is essential evidence of an investment entity’s business purpose.
The fact that the investment entity does not plan to hold its investments indefinitely differentiates it from other entities. An
entity’s objective of investing for capital appreciation is not generally consistent with an objective of holding the investments
indefinitely. [IFRS 10 App B para B85F].
An example of an exit strategy includes the sale of the real estate through specialised property dealers or the open market.
[IFRS 10 App B para B85G].
Closed-ended real estate structures generally have a limited life, which is expressed in their offering documents, and so the
disposal timeframe is transparent. This can be documented in many different ways and in many different types of document
(for example, prospectus, marketing material, investor reports and term sheets).
There is no guidance within the standard on the period or the number of years for the exit strategy.
5.1.2.4. Fair value measurement
An essential element of the definition of an investment entity is that the entity measures and evaluates the performance of
substantially all of its investments on a fair value basis. Accordingly, presenting its investments at fair value results in more
relevant information than consolidation or using the equity method. [IFRS 10 App B para B85K].
To meet this criterion, an investment entity:
provides investors with fair value information;

measures substantially all of its investments at fair value in its financial statements
whenever it is required or permitted in accordance with IFRS; and
reports fair value information internally to the entity’s key management personnel,
who use the fair value as the primary measurement attribute to evaluate the
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performance of substantially all of its investments and to make investment

decisions.
[IFRS 10 App B para B85K].
A detailed analysis of the management decision-making process and of the reporting to investors might be required, to
understand the primary measurement attributes used.
Some real estate structures, while having other measures, might still use fair value as their primary measurement attribute to
evaluate and make investment decisions.
However, where a real estate structure generates substantial investment income (for example, rental income), management
might not measure and evaluate the performance of substantially all of its investments on the basis of fair value. In such a
case, management and investors might measure the entity’s returns in absolute terms, which would include fair value, but
fair value would not be the sole primary measurement attribute used in making investment decisions. Yield would typically be
another primary measurement attribute. In addition, other measures (such as the internal rate of return, equity multiple,
earnings ratio, net present value and EBITDA) might be used. This indicates that the definition of an investment entity is not
met, and that consolidation or the equity method would provide more relevant financial information
5.1.2.5. Typical characteristics of an

investment entity
In assessing whether an entity meets the definition described above, it should be considered whether the following typical
characteristics of an investment entity are present:
A. it has more than one investment;

B. it has more than one investor;
C. it has investors that are not related parties of the entity; and
D. it has ownership interests in the form of equity or similar interests.
[IFRS 10 para 28].
Further guidance on these characteristics can be found in the PwC Manual of Accounting chapter 27 paragraphs 33–40.
The absence of one or more of these typical characteristics does not necessarily disqualify the entity from being an
investment entity. However, it is highly unlikely that the definition of an investment entity will be met without having any of
these typical characteristics. [IFRS 10 para BC 234]. The typical characteristics have to be seen as a supplement to the
definition, and real estate structures have to consider whether they display these characteristics.
More than one investment
The purpose of an investment entity is to hold several investments to diversify its risk and maximise its returns. This
condition is met if a real estate entity is investing, via a holding company, into several properties or several property-holding
entities. [IFRS 10 App B para B85O].
Entities might qualify as investment entities even if they have just one single investment, although the purpose for which the
real estate structure has been set up must be taken into consideration.
For example, an entity might have just one single investment in the following situations: during its start-up period, when it
only has seed money available; when it is in the course of finding replacements for disposals; or when it is in the process of
liquidation. [IFRS 10 App B para B85P]. This can also occur where the entity is established to pool funds from a number of
investors to invest in an investment unobtainable by individual investors (for example, a club deal to acquire a substantial
iconic property in a core location). Typically, the investment would be out of reach for any single investor, due to its size and
risk, but not for a pool of investors.
More than one investor
Typically, an investment entity would have several unrelated investors. However, paragraph B85R of IFRS 10 permits a single
investor that represents or supports the interests of a wider group of investors (for example, a pension fund or family trust).
Other examples where an investment entity might have only a single investor include the following situations, where an
entity:
A. is within its initial offering period, and is actively identifying other suitable investors;
B. has not yet identified suitable investors to replace ownership interests that have been redeemed; or
C. is in the process of liquidation.
[IFRS 10 App B para B85S].
Other typical situations might include master-feeder structures, where there are multiple investors in the feeder funds.
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IND EX 5.1.2.5.1 – Real estate fund
IND EX 5.1.2.5.2 – Real estate entity
5.2. Joint arrangements
5.2.1.Overview
Entities in the real estate industry commonly use joint arrangements in structuring their business and operations.
Joint arrangements exist when joint control is present. Joint control is the agreed sharing of control where decisions over
relevant activities require the unanimous agreement of the parties sharing control. It provides entities with a mechanism by
which to:
manage their exposure to particular geographical regions and asset classes;

share risks in relation to the ownership and/or development of property; and/or
leverage the expertise, experience and knowledge of the joint arrangement

partners.
The structuring of joint arrangements in the real estate industry varies from straightforward arrangements (for example, direct
joint ownership of property assets) to more complicated arrangements (for example, joint arrangements to develop and
construct property structured through separate vehicles and subject to various contractual agreements).
5.2.2. Classification and measurement of a

joint arrangement
Under IFRS 11, there are two types of joint arrangement: joint operations and joint ventures. A joint arrangement is classified
as a joint operation where the investors have direct rights to the assets and obligations for the liabilities of the arrangement.
A joint arrangement is classified as a joint venture where the investors have rights to the net assets of the arrangement.
Classification of an arrangement determines its accounting treatment: joint operations are accounted for by recognising the
operator’s relevant share of assets, liabilities, revenues and expenses; joint ventures are accounted for using equity
accounting.
Entities need to assess their rights and obligations under the joint arrangement in order to determine the appropriate
classification as either a joint operation or a joint venture.
Investment property that is directly owned as ‘tenants in common’, and not through a separate vehicle, meets the joint
operation classification, where joint control exists.
Investment property or development projects undertaken through a separate vehicle (such as a trust, company or
unincorporated partnership) will need to be carefully assessed. The accounting for a joint arrangement is not driven solely by
its legal form. Operators will account for their involvement in a joint arrangement in a manner that is consistent with their
rights and obligations. As such, it is important to understand the contractual terms of the agreements.
IND EX 5.2.2.1 – Joint arrangements with no separate legal structure

IND EX 5.2.2.2 – Joint arrangements structured in a company
IND EX 5.2.2.3 – Joint arrangements structured in an unincorporated partnership
A summary of the requirements is as follows:
Type Rights and obligations Accounting

Joint Direct rights to the assets A joint operator will recognise its interest based on its
operations and obligations for the involvement in the joint operation (that is, based on
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Type Rights and obligations Accounting

liabilities of the its direct rights and obligations) rather than on the
arrangement. participation interest that it has in the joint
arrangement. The balance sheet and income
statement will be presented gross.
‘A joint operator shall recognise in relation to its

interest in a joint operation:
Its assets, including its share of

any assets held jointly.
Its liabilities, including its share
of any liabilities incurred jointly.
Its revenue from the sale of its
share of the output arising from
the joint operation.
Its share of the revenue from the
sale of the output by the joint
operation.
Its expenses, including its share
of any expenses incurred
jointly.’
[IFRS 11 paras 20, 26(a)].
Joint ventures No rights to individual Joint ventures are accounted for using the equity
assets or obligations for method in accordance with IAS 28 unless a scope
individual liabilities. exclusion applies. [IFRS 11 para 24].
Instead, joint venturers
share in the net assets In the consolidated financial statements, the net
and the profit or loss of investment in the venture, reflecting the share of net
the arrangement. assets, is a single line in the balance sheet; and the
share of profit or loss appears as a single line in the
income statement.
5.3. Taxation
5.3.1. Overview
The general principles of recognition and measurement of income taxes are set out in IAS 12. IAS 12 applies to all domestic
and foreign taxes that are based on taxable profits or taxes on distributions from subsidiaries, joint ventures or associates,
such as withholding taxes. [IAS 12 para 2].
5.3.2. Current tax
Current tax is generally recognised as income or expense, unless it arises from a transaction or event that is recognised in
other comprehensive income or equity. [IAS 12 para 58]. Since gains or losses on investment property are recognised in the
income statement, tax relating to the sale or use of investment property is recognised in the income statement.
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Current tax liabilities are recognised for any unpaid tax expense for the current and prior periods. They are measured at the
tax rates enacted or substantively enacted at the reporting date.
5.3.3. Deferred tax
Deferred tax arises when expenditure, gains and losses, assets and liabilities are recognised in one period but are included in
the computation of taxable profits in future periods. For example, fair value movements on investment property measured at
fair value in accordance with IAS 40 are often not taxed until the property is disposed of. The approach to determining a
deferred tax asset or liability can be found in the PwC Manual of Accounting chapter 14 paragraph 18.
This can broadly be summarised as follows:
1. Determine tax base.

2. Calculate temporary difference, being the difference between accounting carrying value and tax base.
3. Assess any deductible temporary difference for recoverability.
4. Determine the tax rate that is expected to apply when the temporary difference reverses.
5. Calculate deferred tax, being the temporary difference multiplied by the tax rate.
Deferred tax normally arises from:
A. fair value movements recognised on investment property carried at fair value; and
B. the difference between the tax base and carrying value of investment property measured at cost as a result of different
depreciation rates being used for tax and accounting purposes.
5.3.4. Deferred tax on investment property

measured at fair value
The general principle in IAS 12 is that entities should measure deferred tax using the tax bases and tax rates that are
consistent with the manner in which the entity expects to recover or settle the carrying amount of the item. For assets, the
carrying amount of an asset is normally recovered through use, or sale, or use and sale. The distinction between recovery
through use and sale is important since, in some jurisdictions, different rates might apply for income (recovery through use)
and capital gains (recovery through sale). However, for investment property carried at fair value, there is a rebuttable
presumption that recovery will be entirely through sale, even where the entity earns rentals from the property prior to its sale.
[IAS 12 para 51C].
In order to rebut this presumption, investment property must be depreciable and held as part of a business model whose
objective is to consume substantially all of the economic benefits embodied in the property through use over time. An
investment property might not qualify for tax depreciation, and no part of the property’s cost is deductible against taxable
rental income. Instead, the cost of the property (uplifted by an allowance for inflation, where applicable) is allowed as a
deduction against sales proceeds for the purpose of computing any taxable gain arising on sale. [IAS 12 para 51C].
Deferred tax for investment properties carried at fair value should generally be measured using the tax base and rate that are
consistent with recovery entirely through sale, and using capital gains tax rules (or other rules regarding the tax
consequences of sale, such as rules designed to claw back any tax depreciation previously claimed in respect of the asset).
If the presumption is rebutted, deferred tax should be measured reflecting the tax consequences of the expected manner of
recovery.
The presumption also applies where investment property is acquired in a business combination and the acquirer later uses
fair value to measure the investment property. [IAS 12 para 51D].
The freehold land component of an investment property can be recovered only through sale.
IND EX5.3.4.1 – Deferred tax on investment property at fair value: clawback of tax depreciation and 0% capital gains tax
IND EX 5.3.4.2 – Deferred tax on investment property at fair value: clawback of tax depreciation and capital gains tax
IND EX 5.3.4.3 – Deferred tax on investment property at fair value: no tax depreciation with capital gains tax

measured at cost
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Investment property carried at cost is depreciated over its useful life for accounting purposes. The rebuttable presumption
that the asset will be recovered through sale (noted in section 5.3.4) does not apply to investment property measured at
cost. The expected manner of recovery might be through a combination of use and sale. The asset’s carrying amount is split
between the use and sale elements, and these carrying amounts are compared to their respective tax bases. If the only tax
deduction available for the property is on sale, the tax base of the building’s use element carried at cost would be nil on
initial recognition and in all future periods. [IAS 12 para 51].
IND EX 5.3.5.1 – Deferred tax on investment property at cost
5.3.7. Uncertain tax positions
An uncertain tax position is any tax treatment applied by an entity where there is uncertainty over whether that treatment will
be accepted by the tax authority. For example, a decision to claim a deduction for a specific expense, or not to include a
specific item of income in a tax return, is an uncertain tax position if its acceptability is uncertain under tax law.
IFRIC 23 applies to all aspects of income tax accounting where there is an uncertainty regarding the treatment of an item,
including taxable profit or loss, the tax bases of assets and liabilities, tax losses and credits and tax rates:
If an entity concludes that it is probable that the tax authority will accept an uncertain tax treatment that has been
taken or is expected to be taken on a tax return, it should determine its accounting for income taxes consistently
with that tax treatment.
If an entity concludes that it is not probable that the treatment will be accepted, it should reflect the effect of the
uncertainty in its income tax accounting in the period in which that determination is made (for example, by
recognising an additional tax liability or applying a higher tax rate). The entity should measure the impact of the
uncertainty using the method that best predicts the resolution of the uncertainty (that is, the entity should use either
the most likely amount method or the expected value method when measuring an uncertainty).
Each uncertain tax treatment is considered separately or together as a group, depending on which approach better predicts
the resolution of the uncertainty. IFRIC 23 requires consistent judgements and estimates to be applied to current and
deferred taxes.

held in a corporate wrapper
In some jurisdictions, investment properties are held in individual legal entities, often referred to as ‘corporate wrappers’.
This allows entities to buy and sell properties without the need to change the legal title or incur any associated stamp duties.
Specific structures might also give rise to differences in tax treatment, particularly where the tax rate for the sale of property
is different from the tax rate for the sale of shares. These structures give rise to accounting issues around transaction costs
and deferred tax.
5.3.6.1. Consolidated financial statements
IAS 12 does not explicitly provide guidance on how to account for deferred taxes where investment properties are held in
corporate wrappers. However, in our view, consistent with an agenda decision issued by the IFRS Interpretations Committee
in July 2014, management should apply a two-step approach to considering provisions for deferred taxes:
Level of the legal entity that is the corporate wrapper: management should determine the expected manner of
recovery of the underlying property (that is, whether the underlying property will be recovered through use or sale by
the corporate wrapper). Management should then determine the temporary difference based on the expected
manner of recovery (referred to as the ‘inside basis’ difference) and calculate the deferred tax in the books of the
corporate wrapper.
Level of the consolidated financial statements: management should also identify any additional ‘outside basis’
difference between the accounting carrying value of the subsidiary and its tax base. Deferred tax on the outside
basis difference should be recognised if required by paragraph 39 of IAS 12.
This applies even where the group expects to recover its investment in the corporate wrapper without an impact on taxable
profit, or with a lesser impact than from selling the property itself (for example, by selling the corporate wrapper). Deferred
tax is recognised on the inside basis difference, being the difference between a property’s carrying amount and its tax base.
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The property itself (not the investment in the corporate wrapper) is recognised in the consolidated balance sheet, so the
relevant tax base is that of the asset and not that of the investment.
The outside basis difference arises where the carrying amount of the subsidiary in the consolidated financial statements is
different from the tax base, which is often the cost of the investment at the date of acquisition. Outside basis differences
usually arise where undistributed profits in the investee increase the carrying value of the parent’s investment in the investee
above its tax cost, where the investment’s carrying amount is impaired, or where the investment’s carrying amount changes
as a result of changes in foreign exchange rates (for example, where the investee has a functional currency different from the
reporting currency). In the context of corporate wrappers, unrealised profits might arise when the underlying property is
remeasured to fair value.
However, deferred tax on the outside basis difference might not need to be recognised, because IAS 12 provides an
exception from recognising the deferred tax arising on the outside basis difference. The exception applies if:
the parent controls the timing of the reversal of the temporary difference; and
it is probable that the temporary difference will not reverse in the foreseeable future.
[IAS 12 para 39].
The carrying amounts for such investments or interests can be recovered through distributions or disposal. Therefore, if the
parent has determined that the subsidiary’s profits or reserves will not be distributed in the foreseeable future and the entity
will not be disposed of, no deferred tax is recognised on the outside basis difference.
5.3.6.2. Separate financial statements
In the separate financial statements of the entity holding the investment in the corporate wrapper, prepared under IAS 27,
deferred tax would be determined on the basis of the carrying value of the investment in the corporate wrapper, since this is
the asset recognised on the balance sheet.
IND EX 5.3.6.2 – Deferred tax on properties held within corporate wrappers
5.3.6.3. Deferred tax on initial recognition of

corporate wrappers
IAS 12 does not permit the recognition of deferred tax on initial recognition of an asset. [IAS 12 paras 15, 24]. Note that, in
consolidated financial statements, this exception does not apply where assets held in corporate wrappers are acquired as
part of a business combination (see section 1.1). In the case of an asset acquisition, in line with an agenda decision issued
by the IFRS Interpretations Committee in July 2014, the exceptions in IAS 12 in respect of recognition of deferred tax apply.
Regardless of whether the acquisition price takes into consideration the benefit of tax implications, no deferred taxes should
be recognised. The acquisition price should be allocated solely to the acquired assets pro rata, ignoring any deferred taxes.
IND EX 5.1.2.2 – Business purpose of an

investment entity

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A real estate fund, fund F, is a closed-ended fund set up for a limited life of 10 years. The mandate and objective of fund F,
set up at inception, is to maximise total returns on capital by seeking consistent recurring income and capital appreciation
through acquiring and realising a diverse portfolio of income-producing industrial properties. As such, fund F will be focused
on maximising the fair value of its investments and rental income growth. The investments are owned through wholly owned
property subsidiaries.
Does the above meet the business purpose of an investment entity criterion?
Analysis
Yes. The objective of the fund is to invest funds solely for returns from both capital appreciation and investment income.
IND EX 5.1.2.5.1 – Real estate fund

A real estate fund is set up to invest in real estate assets for the benefit of institutional and retail investors. It is set up and
managed by an investment manager experienced in the real estate business. The fund invests in real estate companies and
other real estate investment funds which own, manage and lease out real estate assets.
The investment manager has a policy of acquiring and disposing of its real estate investments over a 5 to 10-year timeframe.
The fund earns dividends and it realises capital gains from its real estate investments.
The fund reports (internally and externally) all of its investments at fair value, and its performance is assessed based on those
fair values.
The fund issues redeemable participating units which are redeemable at a share of the fund’s net asset value. The founding
documents of the fund confirm its objectives and strategy as stated.
Is the fund an investment entity?
Analysis
Yes. The fund meets the definition of an investment entity for the following reasons:
Its objective is to generate returns from capital appreciation and investment income through investment management
services.
It manages its investments on a fair value basis, which is reported to its investors.
It displays the typical characteristics of an investment entity, which are: it has more than one unrelated investor; it holds
multiple investments; and it has ownership interests in the form of fund units which represent a proportionate share of its
underlying assets.
IND EX 5.1.2.5.2 – Real estate entity
Reference to standard: IFRS 10 para 27,para IE9

Real Estate Investments (‘REI’) was formed in order to develop, own and operate retail, office and other commercial
properties.
REI usually holds each of its properties in separate wholly owned subsidiaries. Those subsidiaries have no substantial assets
or liabilities other than borrowings used to finance the related investment property.
REI and each of its subsidiaries report their investment properties at fair value.
REI does not have a set timeframe for disposing of properties, although it uses fair value to help identify the optimal time for
disposal.
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REI and its investors also use measures other than fair value (including information about expected cash flows, rental
revenues and expenses) to assess performance and to make investment decisions.
The directors and managers of REI do not consider fair value information to be the primary measurement attribute in
evaluating investment performance; rather, they see that information as part of a group of equally relevant key performance
indicators.
REI undertakes extensive property and asset management activities (including property maintenance, capital expenditure,
redevelopment, marketing and tenant selection), some of which it outsources to third parties. This includes the selection of
properties for refurbishment, development, and the negotiation with suppliers for the design and construction work to be
done to develop such properties. This development activity forms a separate substantial part of REI’s business activities.
Is REI an investment entity?
Analysis
No. REI is not an investment entity for the following reasons:
It has a separate substantial business activity that involves the active management of its property portfolio, including lease
negotiations, refurbishments and development activities, and marketing of properties, to provide benefits other than capital
appreciation and/or investment income.
Its investment plans do not include specified exit strategies for its investments. As a result, it plans to hold those property
investments indefinitely.
Although it reports its investment properties at fair value under IAS 40, fair value is not the primary measurement attribute
used by management to evaluate the performance of its investments. Other performance indicators are used to evaluate
performance and make investment decisions.
(See also IFRS 10 para IE9, example 3.)
IND EX 5.2.2.1 – Joint arrangements with no

separate legal structure
Reference to standard: IFRS 11 para 14-17

An investment property with a value of C90 was purchased by three investors. Each investor has an equal interest in the
property and is listed on the title deed as a tenant in common. Each investor has funded their interest individually, either
through external borrowings or through capital. A joint ownership agreement has been signed between the investors to
govern their joint ownership of the investment property.
The arrangement is depicted as follows:
All parties must agree to decisions relating to:

the appointment/removal of the property manager;
capital expenditure, including the decision to redevelop part or all of the
investment property;
signing/re-signing major leases;
entering into service contracts greater than C0.10 in relation to the property
(for example, for cleaning services); and
the approval of building insurance.
Each party is liable for obligations and claims against the property.
The net property income (NPI) will be distributed to investors based on their
ownership interest. NPI is rental income collected by the property manager, less
property expenses not recovered by the tenants.
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Is the arrangement a joint operation or a joint venture?
Analysis
The above is a joint operation under IFRS 11.
The fact that the investors share in the NPI of the investment property does not preclude it from being a joint operation,
because each investor has direct rights to the investment property and is liable for obligations and claims arising. Each
investor recognises its share of:
investment property;
tenants’ receivables outstanding at period end;
trade creditors and accruals outstanding at period end;

property expenses incurred during the period; and
rental income generated during the period.
Each investor will also recognise the respective borrowings or additional capital obtained in order to fund the acquisition in
their financial statements.
Paragraph BC 27 of IFRS 11 clarifies that it is possible for parties to a joint arrangement, which is not structured through a
separate vehicle, to establish terms in the contractual arrangement under which the parties have rights only to the net assets
of the arrangement. However, such structures would be very rare in practice.
IND EX 5.2.2.2 – Joint arrangements

structured in a company

Company X was established in the current year by investors A and B, who own 60% and 40% respectively.
The company owns and operates a diversified property portfolio, which it has funded through external borrowings and
capital contributed by investors A and B. The legal form of the company restricts the liability of investors to any unpaid
capital contributions. Creditors of the company have no recourse against the investors.
The company’s articles of association outline that an 85% majority is required for decisions regarding the relevant activities
of the company. Each investor votes in proportion to their ownership interest; as such, both investors A and B must
unanimously agree on decisions in relation to the company.
Is the arrangement a joint venture or a joint operation?
Analysis
The above is a joint venture under IFRS 11. The company is a separate vehicle, which confers separation between the
investors and the company itself − that is, the investors are only entitled to their share of the net assets of the company.
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Both investors apply equity accounting to their interest in the joint venture.
IND EX 5.2.2.3 – Joint arrangements

structured in an unincorporated partnership

Companies A and B have entered into an arrangement to construct an office building on a parcel of land.
Company A currently owns the land that will be developed as part of the joint arrangement. It will also undertake the
development activities in order to construct the office building for a fee. Company A will retain legal title of the land. A
development deed is entered into between both companies that provides a beneficial interest in the land to company B. As a
result, both companies A and B will have a direct right to the land.
Company B identified the opportunity to partner with company A and will provide capital to the arrangement.
Companies A and B have established an unincorporated partnership to undertake the activities of the joint arrangement. The
unincorporated partnership does not create legal separation between the entity itself and companies A and B.
Third party financing has been obtained by companies A and B trading as the A&B Partnership. The financing is secured
against the land subject to development; however, companies A and B still have a direct obligation for the third party
financing.
A bank account has also been established by companies A and B trading as the A&B Partnership. All payments for the
development and receipt of income will pass through this bank account.
Separate books and records are maintained for the A&B Partnership, and financial statements are prepared on an annual
basis for distribution to both companies.
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Is the arrangement a joint venture or a joint operation?
Analysis
The above is a joint operation. While the A&B Partnership is a separate vehicle, companies A and B have direct rights to the
assets and obligations for the liabilities of the partnership, because the legal form does not confer separation. Each company
will recognise its share of the arrangement’s assets, liabilities, revenues and expenses.
The legal structure of an arrangement is not the most significant factor in determining the accounting. Understanding the
respective rights and obligations can be challenging, and arrangements need to be carefully considered.
IND EX 5.3.4.1 – Deferred tax on investment

property at fair value: clawback of tax
depreciation and 0% capital gains tax
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Reference to standard: IAS 12 para 51C

On 1 January 20X1, entity A in jurisdiction X purchased an investment property for C100. The investment property does not
have a freehold land component. The investment property is subsequently measured at fair value.
At 31 December 20X3, the fair value of the investment property is C120. The tax written-down value is C88 (that is, the
accumulated tax depreciation is C12).
The tax legislation in jurisdiction X is as follows:
1. A tax allowance equal to purchase cost is claimed in annual instalments on an investment property held for use.
2. The income tax rate is 30%.
3. Cumulative tax depreciation claimed previously will be included in taxable income if the investment property is sold for more than
tax written-down value.
4. Sale proceeds in excess of original cost are not taxed.
What would the deferred tax liability be in each of the following scenarios?
A. Entity A expects to dispose of the investment property within the next year.
B. Entity A’s business model is to consume substantially all of the economic benefits of the investment property over time, rather
than through sale.
C. Entity A has no specific plans to sell the investment property and holds it to earn rental income, although the investment property
might be sold in the future.
Analysis
A. A. There is a rebuttable presumption that the carrying amount of an investment property measured at fair value will be recovered
entirely through sale. This presumption is consistent with management’s expected manner of recovery. Entity A recognises a
deferred tax liability as follows:
C
At 31 December 20X3
Carrying amount at fair value 120
Tax base (88)
Taxable temporary difference 32
Clawback of tax depreciation below cost (C100-C88 = C12 at 30%) 3.60
Fair value in excess of cost (C120 = C100 = C20) at 0% 0
Deferred tax liability 3.60
B. A. There is a rebuttable presumption that the carrying amount of an investment property measured at fair value will be recovered
C
At 31 December 20X3
Carrying amount at fair value 120
Tax base (88)
Taxable temporary difference 32
Deferred tax liability at 30% 9.60
C. A. There is a rebuttable presumption that the carrying amount of an investment property measured at fair value will be recovered
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property at fair value: clawback of tax
depreciation and capital gains tax
Reference to standard: IAS 12 para 24, 51C

Entity B owns an investment property in jurisdiction Y. The investment property does not have a freehold land component.
Entity B has a policy of carrying properties at fair value, and the carrying amount of the investment property is C50 at 31
December 20X0. Entity B acquired the investment property originally for C100 and has claimed tax deductions to date of
C40, hence the tax base is C60.
The tax legislation in jurisdiction Y is as follows:
1. Tax deductions claimed are clawed back when the property is sold.
2. Capital gains tax is charged at 15% on the excess of the selling price over the original purchase price.
3. Income is taxed at 30%.
4. Capital losses can only be offset against capital gains.
What would the deferred tax liability be in each of the following scenarios?
A. Entity B expects to dispose of the investment property within the next year.
B. Entity B’s business model is to consume substantially all of the economic benefits of the investment property over time, rather
than through sale.
C. Entity B has no specific plans to sell the investment property and holds it to earn rental income, although the investment property
might be sold in the future.
Analysis
A. Entity B expects to recover the carrying amount of the investment property from sale, which will result in a clawback of the
previously claimed allowances of C40. The deferred tax asset (DTA) and deferred tax liability (DTL) are calculated as follows:
Taxable Tax rate DTL/(DTA)

(deductible)
temporary
difference
Tax depreciation clawback 40 30% 12
Capital losses (fair value of C50 less (50) 15% (7.50)

purchase price of C100)
The tax relief on capital losses can only be utilised if there are sufficient capital gains to offset the loss. As such, the deferred
tax asset can only be recognised if the criteria in paragraph 24 of IAS 12 are met. Note that, in line with paragraph 74 of IAS
12, the deferred tax liability and deferred tax asset cannot be offset in this case, since jurisdiction Y only allows capital losses
to be offset against capital gains.
B. Entity B is able to rebut the presumption if it has a business model that it will consume substantially all of the property’s economic
benefits over time, rather than through sale. In this case, entity B will recognise a deferred tax asset of C3 [(C50 – C60) × 30%],
subject to the criteria in paragraph 24 of IAS 12.
C. Entity B has no plans to sell the investment property, and no business model to consume substantially all of the economic
benefits of the property over time, so presumption of recovery through sale is not rebutted. Deferred tax is determined based on
the tax consequences of sale, as in scenario A.

property at fair value: no tax depreciation with
capital gains tax
Reference to standard: IAS 12 para 51C

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Entity C acquired an investment property on 1 January 20X0. The investment property does not have a freehold land
component. The entity’s accounting policy is to measure investment properties at fair value. The cost of the investment
property is C50, which is its tax base for capital gains tax purposes.
Management expects to use the property for 10 years, to generate rental income, and to dispose of the property at the end
of year 10. The property’s residual value at the end of 10 years is estimated to be C20. The fair value of the property is C60
at 31 December 20X0.
The tax legislation in jurisdiction Z is as follows:
1. The cost of an investment property is not deductible against rental income, but any sales proceeds are taxable after deducting
the acquisition cost.
2. The tax rate is 30% for taxable income and 40% for capital gains.
3. No annual tax allowance is available on an investment property held for use.
What is the deferred tax liability on initial recognition and at the end of year 1?
Analysis
Entity C’s business model is not to consume substantially all of the economic benefits of the property over time, given its
intention to sell the property in year 10. As a result, the entire property is presumed to be recovered through sale. There is a
tax base available on sale, being the purchase price of the property of C50 at acquisition. There is no temporary difference
on initial recognition.
At the end of year 1, the fair value of the investment property has increased to C60, with no change in the tax base on
disposal. There is a taxable temporary difference of C10. Entity C would recognise a deferred tax liability of C4 (C10 × 40%)
at the end of year 1.

property at cost
Reference to standard: IAS 12 para 51A, 51C

Entity E in jurisdiction E acquired 100% of the shares in entity S for C500 on 31 December 20X0. The identifiable assets
acquired included an investment property with a fair value of C250 and other net assets with a fair value of C100.
Entity S purchased the investment property for C180. The cumulative tax depreciation at 31 December 20X0 is C45.
The tax legislation in jurisdiction E is as follows:
1. Gains on disposal (sales proceeds over the original purchase price) are not taxed, but the previously claimed tax allowance is
clawed back.
2. The income tax rate is 30%.
What would be the impact, in the consolidated financial statements of entity E, on the recognition of deferred tax on the
property and on the goodwill at acquisition, where entity E applies the cost model and assumes recovery of the property
through use?
Analysis
Entity E should apply the expected manner of recovery principle when the cost model is applied. Since recovery of the
property is assumed to be through use, entity E recognises a deferred tax liability on acquisition of C34.50 ((C250 – C180 +
C45) × 30%). The corresponding debit is recognised in goodwill.
IND EX 5.3.6.2 – Deferred tax on properties

held within corporate wrappers
Reference to standard: IAS 12 para 51A

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Entity Y holds property X within a corporate wrapper, entity W. The fair value of the property recognised in the consolidated
financial statements of entity Y is C10 million and its tax base is C5 million. Entity Y’s management expects the eventual
disposal of property X to take place through a sale of entity W, giving rise to a tax charge of C750,000 relating to sale of the
investment. If entity Y decided to sell the property by itself, this would give rise to a tax charge in entity W of C1.5 million.
This is based on the assumption that the expected manner of recovery of the property is through sale. In addition, entity Y
has determined that the exception in paragraph 39 of IAS 12 applies, so deferred tax is not recognised on any outside basis
differences in relation to entity Y’s investment in entity W.
How should entity Y recognise deferred tax:
A. in its consolidated financial statements?

B. in its separate financial statements?
Analysis
A. Entity Y should record a deferred tax liability of C1.5 million in its consolidated financial statements. In the consolidated financial
statements, the property is an asset that gives rise to a temporary difference, and the expected manner of recovery is through
selling the asset.
B. Entity Y should record a deferred tax liability of C750,000 (unless the exemptions in para 39 of IAS 12 apply). In the separate
financial statements, it is the investment balance in entity W that gives rise to a temporary difference. Note that, in cases where
the investment in a subsidiary is measured at cost and has not been remeasured subsequent to initial recognition, the deferred
tax liability might be nil.
6. Disposal of investment property
6.1. Classification as held for sale under IFRS 5
Investment property is classified as held for sale under IFRS 5 where its carrying amount will be recovered principally
through a sale transaction rather than continuing use. [IFRS 5 para 6].
6.1.1. Overview
For a property to be classified as held for sale, the following conditions need to be met:
the asset must be available for immediate sale in its present condition; and the sale must be highly probable.
[IFRS 5 para 7].
For a sale to be highly probable, management must be committed to a plan to sell the property and have an active
programme to locate a buyer and complete the plan. The property must be actively marketed at a price that is reasonable in
relation to its current fair value, and the sale should be expected to complete within one year of classification. [IFRS 5 para
8].
For investment property carried at fair value, the measurement provisions of IFRS 5 do not apply. [IFRS 5 para 5(d)]. For
investment property under the cost model, measurement under IFRS 5 is at the lower of the carrying amount and fair value
less costs to sell. However, for both – investment property under the cost model as well as the fair value model – the
presentation and disclosure requirements in IFRS 5 apply.
6.1.2. Property under construction
For property under construction to be classified as a non-current asset held for sale, it is required to be available for
immediate sale in its present condition, and the sale should be highly probable and it should occur under normal market
conditions.
The criterion of marketability should be particularly scrutinised. If the property cannot be sold as property under construction
but only following completion, the investment property is not available for immediate sale in its present condition, because
completion is required to reach marketability. If there is, in exceptional cases, a possibility to dispose of the property before
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the construction is completed, meaning that the property is transferable ‘as it is’, presentation as held for sale is required,
provided that all other conditions in IFRS 5 are met.
6.2. Sale of investment property
Revenue is recognised when a performance obligation is satisfied, which occurs when control of the property transfers to the
buyer. The standard provides a list of indicators to consider when determining the point in time at which control passes to
the customer, including but not limited to whether:
the entity has a present right to payment;

the customer has obtained legal title to the asset;
the entity has transferred physical possession of the asset to the customer;
the customer has significant risks and rewards of ownership of the asset; and
the customer has accepted the asset.
[IFRS 15 para 38]. Further guidance on the satisfaction of performance obligations can be found in the PwC Manual of
Accounting chapter 11 paragraphs 188.
Gains on disposal are the difference between the net disposal proceeds, measured in accordance with IFRS 15, and the
carrying value of the assets. Such gains are recognised in the income statement (unless IFRS 16 requires otherwise on a sale
and lease back). [IAS 40 para 69].
Whereas, in most cases, the disposal proceeds are readily determinable, complications might arise where:
the agreement includes deferred consideration;

consideration for the sale includes contingent consideration (that is, consideration
dependent on the occurrence of a specific event);
consideration is variable (for example, consideration that is a percentage of
revenue); or
additional services are provided to the buyer as part of the sale transaction. For
example, a vendor might provide transition or other management services to the
buyer on an ongoing basis. The vendor might also make head lease payments on
vacant space.
The amount of consideration to include in the gain or loss arising from derecognition of an investment property is determined
in accordance with the requirements for determining the transaction price in IFRS 15. The transaction price is the amount of
consideration to which an entity expects to be entitled in exchange for transferring the property to the customer. [IFRS 15
para 47]. Non-cash consideration received is measured at fair value. [IFRS 15 para 66]. The transaction price does not
include amounts collected on behalf of third parties. [IFRS 15 para 47].
The consideration promised in a contract to purchase an investment property might include fixed amounts, variable
amounts, or both. If the consideration promised in a contract includes variable amounts, an entity estimates the amount of
consideration to which it will be entitled in exchange for transferring the property to the customer, excluding amounts for
which it is not highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when
the uncertainty associated with the variable consideration is subsequently resolved.
[IFRS 15 para 56].
See section 2.6 for further information on accounting for variable consideration associated with rental guarantees.
6.2.1. Deferred sales proceeds
Deferred consideration receivable at a later date, for the sale of an investment property that is highly probable of being
received and includes a significant financing component, is discounted to present value to arrive at the cash price equivalent
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using the discount rate that would be reflected in a separate financing transaction at contract inception. This requires the
discount rate to include the market interest rate at contract inception as well as the customer’s credit risk. The discount rate
is not adjusted for changes in interest or other circumstances at a later stage. [IFRS 15 para 64]. The difference between this
amount and the amount receivable is treated as interest income, and it is recognised, over the period until the actual receipt,
using the effective interest method.
[IFRS 15 para 65].
However, for deferred consideration to include a significant financing component, the criteria in paragraph 61 of IFRS
15 need to be met. A significant financing component does not exist if:
the amount or timing of the deferred consideration varies on the basis of the
occurrence or non-occurrence of a future event that is not (substantially) in the
control of either the customer or the entity; or
the deferred consideration arises from reasons other than the provision of finance
to either the customer or the entity, and the difference between the promised
consideration and the cash selling price is proportional to the reason for the
difference.
[IFRS 15 para 62].
As a practical expedient, an entity need not adjust for the promised amount of consideration, for the effects of a significant
financing component, if the entity expects the financing period to be one year or less. [IFRS 15 para 63].
IND FAQ 6.2.1 – How should an entity account for deferred sales proceeds that contain a financing component?
6.2.2. Variable consideration on a sale of

property
IND FAQ 6.2.2 – Would deferred sales proceeds be discounted when they are in proportion to an outstanding service?
The entity needs to consider the accounting for more complicated recognition and measurement items in accordance with
relevant standards.
6.3. Sale of property under construction
Cash receipts do not necessarily indicate that the entity is able to recognise revenue. Revenue is recognised under IFRS 15
when a performance obligation is satisfied, which occurs when control of a good or service transfers to the customer.
Control can transfer either at a point in time or over time, based on a range of criteria. An entity should determine at contract
inception whether control of a good or service is transferred over time or at a point in time.
An entity might begin activities on an anticipated contract, prior to the arrangement meeting the criteria of IFRS 15 to be
recognised as a contract with a customer. Revenue should be recognised on a cumulative catch-up basis if subsequent
reassessment indicates that the criteria are met. This cumulative catch-up should reflect the performance obligation(s) that
are partially satisfied, or satisfied on the contract reassessment date. An entity will need to determine the goods or services
that the customer controls and, therefore, what portion of the costs are included in any measure of progress, to determine
the cumulative revenue recognised
6.3.1. Recognise revenue over time or at a

point in time
Real estate developers will need to consider whether they meet any of the three criteria necessary for recognition of revenue
over time.
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A performance obligation is satisfied over time where at least one of the following criteria is met:
The customer receives and consumes the benefits of the entity’s performance as
the entity performs.
The entity’s performance creates or enhances a customer-controlled asset.

The asset being created has no alternative use to the entity, but the entity has a
right to payment for performance completed to date.
Without discussing all of the indicators above, a common judgement in the real estate industry is whether the entity has an
enforceable right to payment for performance completed to date. This is discussed in the example below.
A performance obligation is satisfied at a point in time if it does not meet the criteria above.
Determining when control transfers will require significant judgement. Indicators that might be considered in determining the
point in time at which control of the good or service (asset) passes to the customer include, but are not limited to whether:
the entity has a present right to payment;

the customer has obtained legal title to the asset;
the entity has transferred physical possession of the asset to the customer;
the customer has significant risks and rewards of ownership of the asset; and
the customer has accepted the asset.
IND EX 6.3.1 – Right to payment
6.3.2. Significant financing component
An entity adjusts the promised amount of consideration where there is a significant financing component. If the contract
contains a significant financing component, the transaction price should reflect the time value of money. An entity is not
required to consider the time value of money if the period between payment and the transfer of the promised goods or
services is one year or less, as a practical expedient.
In assessing whether a contract contains a significant financing component, an entity should consider various factors,
including:
the length of time between when the entity transfers the goods or services to the
customer and when the customer pays for them;
whether the amount of consideration would substantially differ if the customer paid
cash when the goods or services were transferred; and
the interest rate in the contract and prevailing interest rates in the relevant market.
IND EX 6.3.2 – Time value of money
6.3.3. Measuring the progress towards

completion
An entity should measure progress toward satisfaction of a performance obligation that is satisfied over time using the
method that best depicts the transfer of goods or services to the customer. Methods for recognising revenue, when control
transfers over time, include the following:
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Output methods that recognise revenue on the basis of direct measurement of the
value to the customer of the entity’s performance to date (for example, surveys of
goods or services transferred to date, contract milestones, or appraisals of results
achieved).
Input methods that recognise revenue on the basis of the entity’s efforts or inputs
to the satisfaction of a performance obligation (for example, cost-to-cost, labour
hours, labour cost, machine hours, or material quantities).
The method selected should be applied consistently to similar contracts with customers. Once the metric is calculated to
measure the extent to which control has transferred, it must be applied to total contract revenue to determine the amount of
revenue to be recognised.
IND EX 6.3.3.1 – Measure of progress towards complete satisfaction of performance obligation

IND EX 6.3.3.2 – Partial satisfaction of performance obligations
IND FAQ 6.2.1 – How should an entity account

for deferred sales proceeds that contain a
financing component?

Background
Investment property entity T has recently sold a property for C12 million. The sale agreement provides for C10 million to be
remitted at the date of legal completion of the sale, with the remaining C2 million payable after one year. The market rate of
interest for 12-month loans to entities with a similar credit rating to the buyer is 7%.
Question
Is entity T required to discount deferred sales proceeds to their net present value?
Answer
Yes, the arrangement effectively constitutes a financing transaction. Entity T should record an amount receivable of
C1,869,159 (C2,000,000/1.07). It would recognise the difference between C1,869,159 and C2,000,000 as interest income
over the 12-month period using the effective interest method.
IND FAQ 6.2.2 – Would deferred sales

proceeds be discounted when they are in
proportion to an outstanding service?
Reference to standard: IFRS 15 para 32, para 60-65

Reference to standing text: 11.97-11.101, 11.154
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Background
Investment property entity U has recently sold a property for C12 million. The sale agreement provides for C10 million to be
remitted at the date of legal completion of the sale, with the remaining C2 million payable after the completion of the outdoor
facilities. The amount held back is equivalent to the calculated stand-alone selling price for the outstanding construction
works.
Question
Is entity U required to discount deferred sales proceeds to their net present value?
Analysis
No, the arrangement does not constitute a financing transaction. Entity U should assess whether the transfer of the
completed outdoor facilities is part of a separate performance obligation, or whether it is part of the single performance
obligation that transfers the property as a whole. Furthermore, the entity needs to assess whether the performance obligation
is, or the performance obligations are, satisfied at a point in time or over time.
If the entity concludes that there are two performance obligations (being the transfer of the property followed by the
completion of the outdoor facilities at the property), it would account for C10 million as revenue when the property is
transferred. The remaining C2 million would be recognised as revenue over time, because the completion of the outdoor
facilities enhances an asset that the customer controls.
If the entity concludes that the amount has been deferred with a view to protecting the customer from the entity inadequately
completing the outdoor facilities, the entity recognises C12 million if it expects to complete all of its obligations under the
contract.
IND EX 6.3.1 – Right to payment
Reference to standard: IFRS 15 para 35(c)

A property developer signed sales and purchase agreements to sell specific apartments in an apartment block to different
customers during the construction phase. Once the contract has been signed, the developer cannot redirect the unit to
another customer. All customers are required to pay a 10% non-refundable deposit, and pay the remainder of the transaction
price based on milestones as determined in the contract. The performance does not create an asset with an alternative use.
If a customer defaults, the property developer will be entitled to 10% of the contract price, and it can retain the work in
progress completed to date. Any cash received above 10% will be refunded to the customer. How should the developer
recognise revenue from the sale of the apartment to the customer?
Analysis
Revenue is recognised over time if the apartment being constructed has no alternative use and the seller has a right to
payment for the duration of the contract. While this assessment will need to be made on a contract-by-contract basis, in this
example the apartment will meet the ‘no alternative use’ test, because the specific unit cannot be redirected contractually.
The second criterion is that of a right to payment for performance to date. The entity must be entitled to an amount that at
least compensates it for performance completed to date, at all times throughout the duration of the contract, if the contract
is terminated by the customer or another party for reasons other than the entity’s failure to perform as promised. The right to
receive a penalty and the right to retain the work in progress are not considered to provide the developer with a right to
payment for work completed to date, but are merely a payment of a deposit or a payment to compensate the entity for
inconvenience of loss of profit. There is therefore no right to payment for work completed to date established in this contract.
The entity should evaluate when control passes to the customer, and it should recognise revenue on this date.
IND EX 6.3.2 – Time value of money
Reference to standard: IFRS 15 para 62(c), IFRS 15 para IE 141, IFRS 15 para IE 152
A contractor enters into a contract for the construction of a building on the customer’s land. This construction of the building
is a single distinct performance obligation. Control passes to the customer over the contract term. The contract terms
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indicate specific dates on which the customer is required to make certain payments. These payments do not necessarily
coincide with the performance by the contractor. The following milestones are established:
Month of Amount paid Month in which the

payment associated construction is performed
1 C10 million 0–6
15 C50 million 7–13
13 C20 million 14–18
The contract is set up in this way so that the contractor has the necessary funds to cover the cost of construction.
Analysis
The contractor charges the customer in advance. Management will need to consider the time period between payment and
the completion of the related performance, where the contractor is performing over time rather than at a specific point in
time, to assess whether there is a significant financing component, taking into account the 12-month practical expedient
offered by the standard. For example, the contractor might receive payment in month 5 but would perform over the period
between month 7 and month 13, and thus there might not be a 12-month period between the date of payment and the
associated performance. However, if there is a significant financing component, the contractor will need to assess whether a
significant financing transaction exists. If a significant financing transaction does exist, the entity should calculate this finance
component.
IND EX 6.3.3.1 – Measure of progress towards

complete satisfaction of performance
obligation

A developer is constructing a high-rise apartment building. All units have been sold off-plan before construction
commenced. The ground floor units are completed in December 20X1, but the top floor apartments are completed in June
20X2. There is a restriction on the purchasers from occupying the units until the entire building is complete, and the safety
inspection, which is required by the relevant regulations, has been performed.
Assume that there is only one performance obligation (the unit). Further, assume that the criteria for recognising revenue over
time have been met (since the units have no alternative use), and the developer has an enforceable right to payment for work
completed to date, based on the contractual terms and an assessment of applicable legislation and legal precedent in the
jurisdiction where the property is located. How should the developer recognise revenue from the sale of the units?
Analysis
The developer has sold the individual units to individual customers. Each individual unit is a separate contract that includes a
performance obligation that is satisfied over time. The developer would account for each contract separately; however, in
practical terms, the progress towards completion for each unit could be calculated by reference to the stage of completion
of the apartment block as a whole.
The analysis would be different if the developer had not sold all of the units off-plan before construction commenced.
Revenue would not be recognised on unsold apartments, and costs associated with unsold apartments would be recorded
as inventory.
It is also unlikely that this method would be appropriate if the developer was selling detached houses in a new estate, rather
than apartments in a single building. This is because the completion of one house would probably not be dependent on the
completion of another. Provided that the criteria for revenue recognition over time are met for the sale of each individual
house, revenue would be measured based on the stage of completion assigned to each individual house, rather than a single
stage of completion being assigned to the development as a whole, as in the case of an apartment block.
IND EX 6.3.3.2 – Partial satisfaction of

performance obligations
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An entity begins constructing an apartment building and pre-sells 60% of the units. The asset has no alternative use, and the
entity has a right to payment for work completed to date from the time at which the contract is signed. The remaining 40% of
the units are constructed for inventory. At a later date, after the shell of the rooms of all floors of the apartment building has
been completed, the entity enters into a new contract with a customer to sell one of the remaining units on the same terms
as the original contracts. Thus, at inception of the new contract, a portion of the new customer’s unit is already completed.
Analysis
A cumulative catch-up adjustment is consistent with the principle of the standard of recognising revenue to depict an entity’s
performance in transferring control of goods or services to the customer. Thus, if activities performed prior to the contract
establishment date have resulted in progress towards satisfying a performance obligation, the entity would recognise the
revenue that it expects to be entitled to for that progress completed to date.
7. Other reporting issues
7.1. Functional and presentation currency
7.1.1. Overview
IAS 21 requires an entity to determine its functional currency and to measure its results and financial position in that
currency. The functional currency serves as the basis for determining whether the entity is engaging in foreign currency
transactions. IAS 21 defines foreign currency as a currency other than the functional currency. Identifying the functional
currency has a direct impact on which transactions are foreign currency transactions that give rise to exchange gains and
losses and, thereby, on the reported results.
The standard permits an entity to present its financial statements in a currency other than its functional currency. The
currency in which the financial statements are presented is referred to as the ‘presentation currency’.
7.1.2. Functional currency
The functional currency is the currency of the primary economic environment in which the entity operates. [IAS 21 para 8].
The primary economic environment in which an entity operates is normally the one in which it primarily generates and
expends cash.
The functional currency determination is generally straightforward for a simple investment property entity operating in a
single country. As investment property entities become more complex, this can also increase the complexity of determining
A listed investment property fund might be domiciled in a particular country, its shares traded on the country’s stock
exchange and denominated in the local currency. However, it might not hold all or any of its investment properties in that
country. The currency of the primary operating environment is the most relevant factor in determining functional currency.
Further guidance on determining functional currency can be found in the PwC Manual of Accounting chapter 49 paragraph
10. The primary indicators of functional currency are:
It is the currency that mainly influences the sale prices of goods and services. For
example, if an entity owns only one property in country X, by which it earns rental in
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country X’s currency, this would indicate that country X’s currency would be the
functional currency of the entity.
It is the currency of the country whose competitive forces and regulations mainly
influence the sales prices of goods and services. In the above example, the
competitive forces in country X would drive the determination of sales price.
It is the currency that mainly influences labour, material and other costs.
[IAS 21 para 9].
Where the above factors are not clear, the following factors are also considered:
It is the currency in which funds from financing activities (such as issuing debt or
equity) are generated.
It is the currency in which receipts from operating activities are retained (that is, the
currency in which the entity maintains its working capital balance).
IAS 21 provides the following additional factors for consideration when determining the functional currency of foreign
operations held as subsidiaries:
The degree of autonomy of a foreign operation from its parent entity.

Whether transactions with the parent are significant.
Whether cash flows of the foreign operation are readily available for remittance to
the parent.
Whether the foreign operation can meet its debt obligations without the support of
the parent.
[IAS 21 para 11].
Further guidance on determining the functional currency of foreign operations can be found in the PwC Manual of
Accounting chapter 49 paragraph 11..
7.1.3. Presentation currency
An entity can choose to present its financial statements in any currency. There is no requirement in the standard for an entity
to present its financial statements in its functional currency.
Where the entity has a different presentation currency from its functional currency, it translates its financial statements from
functional currency to presentation currency as follows:
assets and liabilities are translated at the closing rate;

income and expenses are translated at exchange rates at the transaction dates; for
practical reasons, most entities use average rates of the period as an
approximation; and
all resulting differences are recognised in other comprehensive income.
IND EX 7.1.3.1 – Determination of functional currency: operations and capital in different countries
IND EX 7.1.3.2 – Determination of functional currency: investment properties in various countries (1)
IND EX 7.1.3.3 – Determination of functional currency: investment properties in various countries (2)
IND EX 7.1.1.4 – Functional currency of a special purpose entity
7.2. Cash flow statement

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7.2.1. Overview
IAS 7 requires all entities to prepare a cash flow statement as an integral part of their financial statements for each period for
which financial statements are presented. The cash flow statement reports changes in cash and cash equivalents in the
period, classifying these as arising from operating, investing or financing cash flows.
7.2.2 Definition of cash and cash equivalents
Cash and cash equivalents comprise cash on hand and demand deposits, as well as short-term, highly liquid investments
that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. [IAS
7 para 6]. Cash and cash equivalents are held for the purpose of meeting short-term cash commitments rather than for
investment or other purposes. [IAS 7 para 7].
Cash and cash equivalents must be readily convertible to known amounts. Funds subject to restrictions on use, such as
deposits received from lessees, or cash held in blocked accounts, will be presented as cash and cash equivalents in the
statement of financial position and in the cash flow statement when they meet the definition of either cash or cash
equivalents, which will depend on the nature and severity of the restrictions. An entity may disaggregate cash and cash
equivalents subject to contractual restrictions in the statement of financial position when this information is relevant to an
understanding of the financial position. Disclosure of restrictions on cash or cash equivalents may also be required.
Example – Accounting for blocked accounts in the statement of cash flows
Further guidance on cash flows from operating activities can be found in the PwC Manual of Accounting chapter 7
paragraphs 19–26.
Further guidance on cash flows from investing activities can be found in the PwC Manual of Accounting chapter 7
paragraphs 27–29.
Further guidance on cash flows from financing activities can be found in the PwC Manual of Accounting chapter 7
paragraphs 30–32.
7.2.3. Classification of lessor cash flows in the

cash flow statement
Generally, acquisitions and disposals of long-term assets would be classified as investing cash flows; however, entities that
routinely acquire or manufacture assets with a view to rent and subsequent sale should classify the relevant cash flows as
operating cash flows. Whether assets are ‘routinely’ held for sale is a matter of judgement.
[IAS 7 para 16]. [IAS 7 para 14].
For example, if a real estate entity routinely acquires investment property with a view to rent and then subsequently sell or
lease under finance leases (as part of the business model in making the investment), cash flows such as finance lease
receipts, payments to purchase the investment property and receipts from subsequent sale of the property would be
classified as operating cash flows. Occasional or opportunistic sales of investment property within a portfolio alone would
not indicate a business purpose to rent and subsequently sell investment property upon acquisition.
If entities do not routinely acquire investment properties with a view to rent and subsequent sale, for example, the business
model in acquiring the property is for long term rentals, the cash flows associated with the original purchase or the sale of
the underlying property would be investing. Similarly, if the property is disposed of through a finance lease, receipts
representing repayment of the principal would also be investing. This is on the basis that they are, in substance, the disposal
of a long-term asset, because the fair value of the underlying asset is recovered through regular payments over time with the
same counterparty. For operating leases, since they do not involve the disposal of a long-term asset, lease receipts would
generally be considered operating cash inflows.
Paragraph 14 of IAS 7 requires cash flows that are primarily derived from the principal revenue-producing activities of the
entity to be classified as operating activities. Paragraph 16 of IAS 7 requires acquisitions and disposals of long-term assets
to be classified as investing cash flows. So a contradiction arises when an entity has leasing as its principal operating
activity: paragraph 16 of IAS 7 would suggest that the cash outflow in acquiring assets to lease out would be investing, but
paragraph 14 of IAS 7 suggests that the cash outflow deriving from an entity’s primary operating activities would be
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operating. In this case, we consider it acceptable for entities either to classify the cash outflow as investing (in line with
paragraph 16 of IAS 7) and the rental inflow as operating, or to deem both the cash inflow and outflow as operating. An
accounting policy should be developed and applied on a consistent basis.
IND EX 7.1.3.1 – Determination of functional

currency: operations and capital in different
countries

Entity X invests primarily in investment properties in the United States. Entity X is incorporated in the Netherlands. All
acquisitions and divestments of properties are undertaken in US dollars (USD). Entity X is an autonomous entity and makes
all operational decisions in relation to the investment properties that it holds. Rental agreements are in USD. The entity is
financed in euros (EUR); reporting to the European-based investors is also in EUR. The shareholder base of Entity X is
relatively fixed, and changes in shareholders are infrequent.
What is the appropriate functional currency for an investment property entity with operations in different countries?
Analysis
The appropriate functional currency for entity X is USD. It represents the most relevant currency, because it is the currency
that mainly influences its rental revenue and expenses.
Given the nature of the entity, the primary indicators for this type of entity are significant. Provided that these indicators are
conclusive, there is no need to consider the currency in which its financing activities are generated and in which its receipts
from operating activities are usually retained.
Entity X can choose to present its financial statements in EUR.

currency: investment properties in various
countries (1)

Investment property entity Y is domiciled in Switzerland. Entity Y’s shares are denominated in Swiss francs (CHF) and are
traded on the local stock exchange. Entity Y invests principally in investment properties in countries having EUR as their
national currency. The entity also invests, directly, approximately 10% of its funds in Singapore, but 90% of its income and
revenue expenditure is determined and denominated in EUR. Entity Y is an autonomous entity. Its debt is denominated in
EUR and its financial statements are presented in CHF.
What is the appropriate functional currency for an investment property entity with investments in various countries?
Analysis
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The appropriate functional currency for entity Y is EUR. It represents the most relevant currency, because it is the currency
that mainly influences its rental revenue and related expenses.

currency: investment properties in various
countries (2)

A real estate entity operates in Switzerland. It owns several office buildings in Zurich and Basel that are rented to Swiss and
foreign entities. All lease contracts are denominated in USD, but payments can be made either in USD or in Swiss francs
(CHF). However, almost all of the lease payments are settled in CHF. This has also been the historical pattern of payment.
What is the appropriate functional currency for the investment property entity?
Analysis
The ‘sales and cash inflows’ indicators produce a mixed response:
a. The currency that mainly influences the pricing of the lease contracts is USD, whereas the cash inflows are in CHF.
b. Cash outflows (such as the principal operating costs, management of properties, insurance, taxes and staff costs) are likely to be
incurred and settled in CHFB.
The lease payments are denominated in USD, but US dollars are not considered to be significant to the entity’s operation,
because:
a. most of the collection is in CHF, which is subject to short-term changes in USD/CHF exchange rates; and
b. it is the local conditions and circumstances in Switzerland, and not in the US, that determine the rental yields of properties in
Zurich and Basel that mainly influence the pricing of the lease contracts, which are merely denominated in USD
It is, therefore, the currency of the Swiss economy, rather than the currency in which the lease contracts are denominated,
that most faithfully represents the economic effects of the real estate activity in Switzerland.
IND EX 7.1.3.4 – Functional currency of a

special purpose entity
Reference to standard: IAS 21 para 9-11

Entity B is a real estate entity that has been set up by a European-based investor to serve the specific business needs of this
investor. The functional currency of the investor is EUR.
In accordance with the agreed investment strategy set by the investor, entity B invests 85% of its net assets in US property.
The remaining investments are widespread. The redemption of shares will be executed in USD.
Analysis
The functional currency of entity B is EUR. Although the entity is mainly invested in the US market, its activities are simply an
extension of the activities of the investor. The entity does not operate with a significant degree of autonomy. Consequently,
its functional currency is that of the investor.
Example – Accounting for blocked accounts in

the statement of cash flows
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Entity A is generating property rental income. On 31 December 20X1, it sold real estate property X for C10, of which:
C8 is transferred from the purchaser directly to a blocked account; and

the remaining C2 is paid to entity A at the sale date.
The amounts in the blocked account will be used to settle Entity A's bank borrowings for property X in six months' time. This
will legally release Entity A from its obligation to settle the liability. Entity A is not able to use the amounts transferred to the
blocked account for any other purpose than to repay the bank borrowings and therefore the bank’s approval is required for
release of funds. The entity does not routinely sell real estate property.
How should the amounts held in the blocked account be recorded in Entity A's statement of cash flows?
Analysis
Entity A will first assess whether the funds in the blocked account meet the definition of cash. As they are not available on
demand by Entity A and require approval by a third party the funds do not meet the definition of cash. Given the nature of
Entity A's operating activities, it should present the cash inflow of C2 from the sale of the investment property as part of
investing activities. However, the amount of C8 should be considered a non-cash investing transaction, with adequate
disclosure given in the notes. [IAS 7 para 43]. When the entity receives the cash and repays the loan in the following year, it
should recognise the remaining proceeds and the repayment of borrowings.
Extract from the cash flow statement as of 31

December 20X1
Cash flow from investing activities Current year
Proceeds from sale of investment property C2
Cash inflow (outflow)from investing activities C2

Non-cash transactions in the notes to the cash flow statement:
Amount still to be received Restricted cash received for sale of property C8
Extract from the cash flow statement as of 30 June

20X2
Cash flow from investing activities Current year
Proceeds from sale of investment property C8
Cash inflow (outflow) from investing activities C8
Cash flow from financing activities Current year

Repayment of long-term borrowings (C8)
Cash inflow (outflow) from financing activities (C8)
8. Disclosures
8.1. Revenue and lease income
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The objective of the disclosure requirements is for an entity to disclose sufficient information in the notes that, together with
the information provided in the statement of financial position, income statement and statement of cash flows, enables users
of financial statements to:
understand the nature, amount, timing and uncertainty of revenue and cash flows
arising from contracts with customers; and
assess the effect that leases have on the financial position, financial performance
and cash flows of the lessor.
Additional information on the disclosure requirements
Please refer to PwC’s Illustrative IFRS consolidated financial statements 2023 for Investment Property.
8.1.1. Revenue income disclosures
Revenue income disclosures consist of qualitative and quantitative information about all of the following:
an entity’s contracts with customers;
the significant judgements, and changes in the judgements, made in applying IFRS
15 to those contracts; and
any assets recognised from the costs to obtain or fulfil a contract with a customer.
[IFRS 15 para 110].
For a real estate entity, this requires revenues recognised from contracts with customers to be disclosed separately from its
other sources of revenue and separately from the lease income received. [IFRS 15 para 113(a)]. The real estate entity also
provides disclosure on revenue that it disaggregates into categories. The extent to which an entity’s revenue is
disaggregated for the purpose of this disclosure depends on facts and circumstances and the nature of the entity’s contracts
with its customers.
Further information to be disclosed includes:
contract balances, such as opening and closing balances for receivables, contract
assets and contract liabilities;
performance obligations (for example, a description of when the company typically
satisfies its performance obligations, and the significant terms and conditions);
the allocation of transaction prices, including the aggregate amount of the

transaction price allocated to the performance obligations that are unsatisfied at
the end of the reporting period;
significant judgements in the application of the standard; and
assets recognised from the costs to obtain or fulfil a contract with a customer.
8.1.2. Lease income disclosures
IFRS 16 includes a number of disclosure requirements relating to leasing activity by lessors. Lessors must disclose
qualitative and quantitative information about leasing activities, namely:
the nature of the lessor’s leasing activities; and
how the lessor manages the risk associated with any rights that it retains in
underlying assets.
For operating leases, a lessor presents – in a tabular format – the lease income received, separately disclosing the income
relating to variable lease payments that do not depend on an index or rate. [IFRS 16 paras 90(b), 91]. The lessor also
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discloses a maturity analysis of lease payments. [IFRS 16 para 97]. This maturity analysis is of the undiscounted lease
payments to be received on an annual basis for a minimum of each of the first five years, and a total of the amounts for the
remaining years. The lessor is also within the scope of disclosure requirements in IAS 16, IAS 36, IAS 38 and IAS 40 for the
underlying assets provided under these leases. [IFRS 16 paras 95–96].
With respect to finance leases, the lessor discloses a qualitative and quantitative explanation of the significant changes in the
carrying amount of the net investment in finance leases. [IFRS 16 para 93]. With respect to the maturity analysis for a finance
lease, the lessor also reconciles the undiscounted lease payments to the net investment in the lease. [IFRS 16 para 94].
These disclosures are in addition to the disclosure requirements in IFRS 7 which requires disclosures for all finance lease
receivables as well as operating lease receivables. This requires, among other things, disclosure of information on the credit
risk of lease receivables and the maximum exposure to credit risk.
8.2. Segment disclosures
Public entities are required to disclose, in their financial statements, information regarding the nature and financial effects of
activities in which they engage and the economic environments in which they operate. The disclosures should be consistent
with the information presented to the entity’s chief operating decision-maker (CODM). Information is presented for the
entity’s reportable segments.
8.2.1. Definitions
An operating segment is a component of an entity:
that engages in business activities from which it can earn revenues and incur
expenses;
whose operating results are regularly reviewed by the entity’s CODM to make
decisions about resources to be allocated to the segment and assess its
performance; and
for which discrete financial information is available.
[IFRS 8 para 5].
A reportable segment is an operating segment that:
generates revenue – from both sales to external customers and inter-segment sales
or transfers – exceeding 10% of combined revenues;
has an absolute net profit of 10% of the combined reported profit of the segments
that report a profit;
has an absolute net loss of 10% of the combined reported loss of the segments
that report a loss; or
has assets exceeding 10% of combined assets of all operating segments.

Management discloses information about each reportable segment. Once an entity has identified the reportable operating
segments, it can combine information about the remaining operating segments to produce a reportable segment. This is
possible only if the operating segments have similar economic characteristics and share a majority of the aggregation criteria
in IFRS 8. [IFRS 8 para 14].
8.2.2. Considerations for operating segments

in real estate: managing properties on a
portfolio basis
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A real estate entity might have only one operating segment – for example, if the entity’s only business activity is that of
investing in similar real estate properties in a specific geographical area with similar tenants. In such a case, the properties
might be managed together, and the CODM might regularly review the portfolio’s operating results and performance on a
combined basis, with decisions about resources to be allocated also being made at that level.
Even if the real estate entity comprises less uniform properties, the CODM might review the performance of, and allocate
resources to, the portfolio together. Ultimately, an entity’s operating segments are determined ‘through the eyes of
management’.
Even if a real estate entity has only one operating segment, it will still need to present segment information to satisfy the
minimum requirements of IFRS 8. [IFRS 8 para 31]. Disclosure is required of revenues from external customers for each
product or service, or each group of similar products and services. However, if a real estate entity has only one operating
segment, it would not be required to disclose revenue on a property-by-property basis. [IFRS 8 para 32].
8.2.3. Considerations for operating segments

in real estate: managing real estate on a
property-by-property basis
In some cases, real estate entities manage their real estate portfolio on a property-by-property basis.
Each property would be an operating segment if the CODM reviews the results and performance of the properties on a
property-by-property basis and makes decisions about resources to be allocated to the properties on the same basis.
However, if only the day-to-day management is performed on a property-by-property basis, but the CODM does not use this
information and does not assess performance on a property-by-property basis, the entity’s operating segments would be
determined on the same basis as that used by the CODM.
There is, in theory, no limit on the number of operating segments that an entity can have, given that these are based on
reporting to the CODM. However, IFRS 8 states that an entity with more than 10 reportable segments should consider
whether a practical limit of reportable segments has been reached. [IFRS 8 para 19]. Entities with a significant number of
reportable segments should consider aggregating segments.
Examples of single properties which might be operating segments are as follows:
A single asset in the US could be an operating segment, if all other real estate
assets are located in Europe and information about the asset is reported separately
to the CODM.
A single logistics asset could be a stand-alone operating segment, if all other
assets in the real estate entity’s portfolio are office buildings, and information about
the logistics asset is reported separately to the CODM.
8.2.4. Matrix information provided to the

CODM
The CODM of a real estate entity might receive information that aggregates the portfolio of property according to different
criteria. Such information might be distinguished by property type or by geographical area.
If the CODM uses more than one set of segment information, the real estate entity needs to determine which component
constitutes the operating segment. Factors that can be considered include the nature of the business activities of each
component, the risks and rewards profile, the existence of managers responsible for them, and information presented to the
board of directors. [IFRS 8 para 8].
If the CODM uses overlapping sets of components (for example, it manages the company’s activities on a matrix basis), the
entity should determine which set of components best constitutes the operating segments by reference to the core principle
in IFRS 8. [IFRS 8 para 10].
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8.2.5. Criteria used to determine operating

segments
Depending on how a real estate entity is managing its properties, the CODM might receive information on the following
basis:
Types of property: office buildings, logistics, retail areas, warehouses, hotels, retail
housing, etc.
Nature of the attached business model: developed properties, properties under

development, non-development property.
Nature of management: individually managed properties, properties managed on a
portfolio basis.
Location of properties: Europe/US/Asia, town centre/inner suburbs/outer suburbs.
Types of tenant: retail, corporate, governmental.
Number of tenants: multiple-tenant property, single-tenant property.
Types of investment: direct property investments, indirect property investments.
8.2.6.Aggregation
Aggregation
Operating segments that meet the quantitative threshold (as explained in section 8.2) could be aggregated into a single
operating segment if aggregation is consistent with the core principle of paragraph 12 of IFRS 8, the economic
characteristics are similar, and segments are similar with regard to:
a. nature of services and products sold;

b. nature of production processes;
c. type or class of customers;
d. methods used to distribute products or provide services; and
e. nature of regulatory environment.
In some cases, the aggregation characteristics in IFRS 8 are not as relevant to a real estate entity as they would be for other
entities outside the industry (for example, the nature of the regulatory environment being similar). In such cases, a real estate
entity could still aggregate operating segments, provided that the other criteria that are relevant or meaningful, when applied,
are met.
In assessing the areas listed in paragraph 12 of IFRS 8 for a real estate entity, management should consider the relevant
attributes of the segments, including the nature of the investment properties and how they are managed, the economic
environment of the properties’ location, and the different types of tenant.
IFRS 8 requires disclosures of judgements relating to aggregation of segments, specifically the economic indicators that
have been assessed to determine that the aggregated segments share similar economic characteristics.
[IFRS 8 para 22].
8.2.7. Future plans in determining reportable

segments: abandonment of operations with a
view to reinvesting
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A real estate entity might sell all of its investment properties that are in one specific location, but have plans to buy another
property in the same location in the future.
The entity might continue to report the respective segment, even though it contains no assets. If the CODM continues to
review this segment and expects that the absence of assets in this segment will be temporary, management might choose to
continue to report a segment in the current period, even though separate reporting of the segment is no longer required.
[IFRS 8 para 17].
However, if the purchase of the new property takes more than one year, such that the segment results for all periods
presented are zero, management should assess whether continued reporting of this segment provides useful information for
users.
8.2.8. Transfers of investment property
A real estate entity might reclassify a property from investment property to inventory, due to the commencement of
development with a view to sale. The operating segment which now includes this inventory might not have previously met
the quantitative thresholds for separate reporting. If, after reclassification, the operating segment now meets the quantitative
thresholds, the entity is required to disclose the operating segment containing inventory as a separate segment, with prior
year comparative information.
Note that this does not mean that the entity should restate the comparative information to show the property as inventory in
the prior year. The property was investment property in the prior year, and the transfer only affects the current period.
Further, the property was not reflected as inventory in the reporting to the CODM in the previous year.
The transfer of one property to another segment is not a change in the internal structure of the entity in a manner that causes
the composition of the reportable segments to change. [IFRS 8 para 29].
8.2.9. Change in the manner in which

properties are managed
A real estate entity might change the way that it manages its investments for various reasons (for example, due to increasing
risk related to property investments in a geographical area). This might require a change in the reporting to the CODM, which
will result in a change of the composition of the reportable segments.
If the change in the internal organisation results in a change to the information that the CODM reviews to assess
performance of operating segments and allocate resources, the entity will need to change the composition of its operating
and reportable segments.
This requires a restatement of prior year segment data, unless this information is not available and the cost to develop the
information would be excessive. [IFRS 8 para 29]. In the latter case, the entity must disclose that fact and present segment
information on both the new and the old basis in the year in which the segment changes occur. [IFRS 8 para 30].
8.2.10. Use of non-IFRS information
An entity should report information using the same measures that are used in the reports regularly provided to the CODM.
If the report to the CODM uses non-IFRS information, the entity is required to use this information for its segment reporting.
For example, management in the industry often reviews performance of the business on a ‘look-through’ basis – that is, it
analyses and reviews the performance of not only the portfolio that is directly held but also those held jointly through
separate vehicles.
The amount of each segment item reported should be the measure reported to the CODM for the purpose of making
decisions about allocating resources to the segment and assessing its performance. [IFRS 8 para 25].
8.2.11 Measurement of reportable segments

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An entity should report information on reportable segments as presented to the CODM. Disclosures should be presented to
explain:
the basis of accounting for inter-segment transactions;

the nature of differences between reportable segments’ profit or loss before tax
from continuing operations and the reported IFRS profit;
the nature of differences between reportable segments’ assets/liabilities and the
assets/liabilities reported in the balance sheet;
any changes from prior years in measurement methods; and
the nature/effect of asymmetrical allocations to segments.
[IFRS 8 para 27].
If the CODM uses only one measure to allocate resources and assess performance, and this single measure is based on
non-GAAP information, this measure should be used for the purpose of segment reporting. In this case, the explanations of
the measurements used (as required by para 27 of IFRS 8) gain additional significance, and a reconciliation of the segments’
financial information to the consolidated IFRS financial statements will be necessary. [IFRS 8 para 28].
If the CODM uses both non-IFRS and IFRS-compliant information, the entity should report measures that are determined in
accordance with the principles most consistent with those used in measuring the corresponding amounts in the entity’s
financial statements. For example, if the CODM uses both net profit excluding unrealised fair value gains or losses on
investment property and net profit before tax, the latter measure would be more consistent with the profit figures used in the
financial statements. [IFRS 8 para 26].
8.2.12. Material items of income and expense

to be reported
A real estate entity should disclose several different financial measures if they are reviewed by the CODM when measuring
the performance of the segment. [IFRS 8 para 23]. The following are examples of typical financial information that a real
estate entity might disclose:
rental income from external customers;
interest income;
interest expenses;
depreciation and amortisation;
net gains or losses from fair value adjustments;
income tax;
property operating expenses; and
ground rents paid.
An entity might report items to the CODM on a net basis, although these are recorded on a gross basis in the income
statement – for example, the CODM reviews rental income net of rental expenses, but rental income is presented on a gross
basis in the income statement. In such cases, the entity should disclose the fact that the amounts are regularly provided to
the CODM on a net basis. It should present the amounts of revenue net and then reconcile those to the consolidated IFRS
revenue.
A similar example would be where a real estate entity enters into swap agreements to economically hedge the interest rate
cash flow risk of variable interest borrowings that finance its property investments.
IND EX 8.2.12 – Presentation of interest income
8.2.13. Geographical information
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Disclosure of revenue from external customers and certain non-current assets, such as investment properties, is required for
the entity’s country of domicile, and in total for all other countries. Revenue from external customers and non-current assets
attributed to an individual foreign country are disclosed separately, if they are material. Disclosure of revenue by continent
would normally not be acceptable. [IFRS 8 para 33].
8.2.14. Major customers disclosure
Entities should disclose the extent to which they rely on major customers. If the revenue of the real estate entity is driven by
a single tenant (10% or more of revenue), the entity is required to disclose that fact, and to state the total amount of revenue
from that tenant. However, the standard does not require disclosure of the name of the tenant or the property that it relates
to. If the revenue is driven by a large number of tenants, and no single tenant or group under common control contributes
more than 10% of the entity’s revenue, the real estate entity does not need to give this disclosure. However, the entity should
state that fact. [IFRS 8 para 34].
8.3. IFRS 13 disclosures
8.3.1. Overview
IFRS 13 requires entities to disclose detailed quantitative and qualitative information about assumptions made and
processes used when measuring assets or liabilities at fair value. Further guidance on the measurement requirements of
IFRS 13 is contained in section 3.6.
8.3.2. Fair value hierarchy
As noted in section 3.6.5, fair value measurements in IFRS 13 are categorised into a three-level hierarchy. The hierarchy is
based on the type of inputs and is defined as follows:
Level 1 inputs are unadjusted quoted prices in active markets for items identical to
the asset being measured. An entity uses that price without adjustment when
measuring fair value. A quoted price in an active market is a Level 1 input.
Level 2 inputs are inputs other than quoted prices in active markets included within
Level 1 that are directly or indirectly observable.
Level 3 inputs are unobservable inputs that are usually determined based on
management’s assumptions. However, Level 3 inputs have to reflect the
assumptions that market participants would use when determining an appropriate
price for the asset.
Fair value measurements of real estate are usually categorised as Level 2 or Level 3
valuations, with Level 3 being the most common categorisation. This is because of:
the nature of real estate assets, which are often unique and not traded on a
regular basis; and
the lack of observable input data for identical assets.
Certain IFRS 13 disclosures are only required for fair value measurements categorised as Level 2 or Level 3. For example,
Level 3 disclosures include a description of the valuation techniques used, how decisions are made in relation to valuation
procedures and for recurring fair value measurements, the sensitivity of fair value measurements to significant unobservable
inputs.
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Further guidance on the fair value hierarchy can be found in the PwC Manual of Accounting chapter 5 paragraphs 88–105.
8.3.3. Disclosure of valuation techniques
Paragraph 93(d) of IFRS 13 requires the following disclosures for recurring and non-recurring fair value measurements
categorised within Level 2 and Level 3 of the fair value hierarchy:
a description of the valuation technique(s) used; and

the inputs used in the fair value measurements.
Description of the valuation technique
As noted in section 3.6.4, IFRS 13 sets out three valuation techniques:
the income approach;

the market approach; and
the cost approach.
Whilst IFRS 13 does not indicate a preferred valuation technique, the standard requires an entity to choose valuation
techniques that are appropriate to the specific circumstances and to maximise the use of observable inputs. An income or
market approach will almost always be more suitable to measure fair value for real estate. This is because market
participants would usually estimate the price of an investment property based on their expectations about future income. The
entity should disclose information on the valuation techniques applied and how it determined that these are the most suitable
valuation techniques.
Since IFRS 13 encourages an entity to apply multiple valuation techniques, if appropriate, information should be provided on
how it evaluated the fair value out of a range of values.
Inputs used in the valuation technique

For fair value measurements categorised within Level 3 of the fair value hierarchy, an entity should provide quantitative
information about the significant unobservable inputs used in the fair value.
The direct capitalisation method and the discounted cash flow method are the most commonly used valuation techniques
within the income approach category. These methods are types of present value technique. The fair value is determined on
the basis of future income to be earned from the asset. A wide range of quantitative inputs are used in those valuation
techniques. Such inputs can generally be grouped into categories, for example:
income/growth rate;
yield/discount rate;
construction and other costs;
inflation rate;
capital value; and
vacancy rate.
8.3.4. Asset classes for disclosure purposes
For the purposes of presenting disclosures, entities are required to determine appropriate classes of asset on the basis of
the following:
1. the nature, characteristics and risks of the asset; and

2. the level of the fair value hierarchy in which the fair value measurement is categorised.
[IFRS 13 para 94].
The number of classes is expected to be greater for fair value measurements categorised within Level 3 of the fair value
hierarchy, because those measurements have a greater degree of uncertainty and subjectivity. Judgement is required for the
determination of appropriate classes of investment property for which disclosures about fair value measurements should be
provided.
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Companies often disaggregate the classes of properties in accordance with their disclosed segments.
Companies might also disaggregate properties on a basis other than their disclosed segments, usually providing more detail
compared to the segment reporting information. Quite often, companies disaggregate disclosures by geography, or class of
property, or both.
8.3.5. Sensitivities and sources of estimation

uncertainty
Paragraph 93(h) of IFRS 13 requires the following disclosures to be provided for investment properties measured at fair value
categorised within Level 3 of the fair value hierarchy:
‘… a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if a change in
those inputs to a different amount might result in a significantly higher or lower fair value measurement. If there are
interrelationships between those inputs and other unobservable inputs used in the fair value measurement, an entity shall
also provide a description of those interrelationships and of how they might magnify or mitigate the effect of changes in the
unobservable inputs on the fair value measurement. To comply with that disclosure requirement, the narrative description of
the sensitivity to changes in unobservable inputs shall include, at a minimum, the unobservable inputs disclosed when
complying with (d).’
IFRS 13 requires companies, at a minimum, to include a narrative description of the sensitivity to changes in significant
unobservable inputs used in the fair value measurement. The guidance does not explicitly require a quantitative sensitivity
analysis. However, such sensitivity analysis might be necessary in order to satisfy the requirements of IAS 1.
Paragraph 125 of IAS 1 requires that ‘an entity shall disclose information about the assumptions it makes about the future,
and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in
a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In respect of those
assets and liabilities, the notes shall include details of: (a) their nature; and (b) their carrying amount as at the end of the
reporting period’.
Where assumptions made in determining the fair value of investment property are significant assumptions in the context of
IAS 1, further information should be provided within the financial statements so that users understand the effect of estimation
uncertainty. The disclosure of the sensitivity of carrying amounts to significant assumptions is an example of information to
be provided in accordance with paragraph 129 of IAS 1. The format of the disclosure might be in a tabular or narrative
format.
8.4. Disclosure of fair value for properties

accounted for using the cost model
The disclosure of the fair value of investment property accounted for under the cost model is required, except for those
properties where the fair value cannot be determined reliably. In such a case, in addition to a description of the investment
property, management is required to explain why the fair value cannot be determined reliably and, if possible, the range of
estimates within which the fair value is highly likely to lie. [IAS 40 para 78(a)–(c)].
IND EX 8.2.12 – Presentation of interest

income
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The information reviewed by the CODM only presents the interest received from their swap, since the entity presents the
interest payments on the borrowings, and the interest received and paid from the swap, net.
Analysis
Even though the standard requires an entity to report interest income separately from interest expense for each reportable
segment, in the above scenario the interest expense should be presented net. This is because the CODM relies primarily on
the net interest expense to assess the interest rate cash flow risk. The entity should reconcile the net interest expense to the
figures presented in the primary financial statements.
Contact us
To have a deeper discussion on the content of this publication, please contact:

Argentina Cecilia Mas mas.cecilia@pwc.com
Argentina Eduardo Loiacano eduardo.loiacono@pwc.com
Australia Bianca Buckman bianca.buckman@pwc.com
Australia Erin Craike erin.craike@pwc.com
Australia Paul Shepherd paul.a.shepherd@pwc.com
Canada Rahim Lallani rahim.lallaniandrew.popert@pwc.com
Canada Lucy Durocher lucy.durocher@pwc.com
Chile Héctor Cabrera M. hector.cabrera@pwc.com
Cyprus Tasos Nolas tasos.nolas@pwc.com
France Thibault Lanselle thibault.lanselle@pwc.com
France Jean-Baptiste jean-baptiste.descrhyver@pwc.com
Deschryver
Germany Anita Dietrich anita.dietrich@pwc.com
Hong Kong Clarry Chan clarry.chan@hk.pwc.com
Ireland Aoife O'Connor aoife.oconnor@pwc.com
Italy Nicola Fierro nicola.fierro@pwc.com
Japan Takashi Yabutani takashi.yabutani@pwc.com
Luxembourg Frank Ballmann frank.ballmann@pwc.com
Netherlands Sidney Herwig sidney.herwig@pwc.com
Netherlands Tanja van de tanja.van.de.lagemaat@pwc.com
Lagemaat
Norway Stig Arild Lund stig.lund@pwc.com
Poland Mateusz Ksiezopolski mateusz.ksiezopolski@pwc.com
Singapore Magdelene Chua magdelene.wz.chua@pwc.com
Singapore David Lee david.zj.lee@pwc.com
South Africa Saaleha Moolla saaleha.moolla@pwc.com
Switzerland Phillipp Gnaedinger philipp.gnaedinger@pwc.ch
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The Channel Islands Lisa McClure lisa.mcclure@pwc.com
United Arab Michelle Amjad m.amjad@pwc.com
Emirates
United Kingdom Kathryn Donkersley kathryn.donkersley@pwc.com
USA Scott Tornberg scott.w.tornberg@pwc.com
USA Tom Wilkin tom.wilkin@pwc.com
Retail and consumer
IFRS issues and solutions for the consumer

markets industry
The IFRS Issues and Solutions for the Consumer Markets Industry (free registration required to view) is our collected insight
on the application of International Financial Reporting Standards (IFRS) in this industry. The last publication of similar
guidance was released in 2012. Since then, there have been significant changes to the industry and the adoption of some
new accounting standards, in particular the adoption of IFRS 16, ‘Leases’, and IFRS 15, ‘Revenue from Contracts with
Customers’.
Most recently, during the pandemic, consumers have had to pivot and adopt new habits, many of which are sticking –
signifying an historic and dramatic shift in consumer behaviour. We also know that consumers are evolving to be even more
digital and eco-friendly. These changes continue to introduce complexity to the accounting for consumer products entities,
including in particular as it relates to leasing arrangements, complex multi-party supply chains and impairment
considerations.
Foreword
The IFRS Issues and Solutions for the Consumer Markets Industry is our collected insight on the application of
International Financial Reporting Standards (IFRS) in this industry. The last publication of similar guidance was released in
2012. Since then, there have been significant changes to the industry and the adoption of some new accounting standards,
in particular the adoption of IFRS 16, ‘Leases’, and IFRS 15, ‘Revenue from Contracts with Customers’.
Most recently, during the pandemic, consumers have had to pivot and adopt new habits, many of which are sticking –
signifying an historic and dramatic shift in consumer behaviour. We also know that consumers are evolving to be even more
digital and eco-friendly. These changes continue to introduce complexity to the accounting for consumer products entities,
including in particular as it relates to leasing arrangements, complex multi-party supply chains and impairment
considerations.
We hope that you find this publication useful in understanding the accounting for common transactions. Each solution is
based on a specified set of circumstances. Entities must evaluate their own facts and circumstances which might well differ
from those in these solutions. The ongoing transformation of the industry might lead to variations, requiring an individual
case-by-case assessment of the accounting implications.
Acknowledgements
This publication would not have been possible without the input and cooperation of many people, both in the consumer
market industry and PwC specialists. Special thanks goes to Andrea Allocco, Maurizo Barbin, Gary Berchowitz, Stefano
Bravo, Adele De Vos, Gillian Dodsworth, Lucy Durocher, Ronel Fourie, Ibrahim Loutfi, Camille Phelizon, Olaf Pusch, Paul
Shepherd, Christopher Solomides, Katja van der Kuij, Michel Vique, Daniel Wilson and Sabina Zan.
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1 Revenue from the sale of goods
1.1 Transfer of control to retailer

Industry: Retail and consumer
Background
Entity X, a consumer products company, enters into a contract with Retailer Y, a supermarket chain, to supply its products to
the end-customers. Retailer Y receives legal title to the products and is required to pay for the products on receipt of the
products from Entity X. Retailer Y has standard rights of return of the products, as set out in its contractual agreement with
Entity X, as well as based on local statutory requirements.
Issue
When should Entity X recognise revenue?
Solution
Paragraph 38 of IFRS 15 requires an entity to consider certain indicators to assess whether control of the products has
transferred. Since Retailer Y has physical possession of the products, holds legal title to the products and has a present
obligation to pay for the products at the time of receipt of the products from Entity X, these are all indicators that control is
transferred by Entity X when the products are delivered to Retailer Y.
A right of return is not a separate performance obligation, but it affects the estimated transaction price for transferred goods.
Revenue is only recognised for those goods that are not expected to be returned by Retailer Y. Entity X needs to assess,
based on its historical information and other relevant evidence, whether there is a minimum level of sales for which it is highly
probable that there will be no significant reversal of cumulative revenue, because revenue needs to be recorded for those
sales.
[IFRS 15 App B para B23]. Based on historical information and other evidence, Entity X estimates that including 95% of its
sales in the transaction price will not result in a significant reversal of cumulative revenue.
Revenue is recognised by Entity X for 95% of the sales on delivery to Retailer Y when control of the products is transferred.
Revenue should not be recognised for the 5% of product sales, but Entity X should raise a refund liability and an asset (with a
corresponding adjustment to cost of sales) representing the right to recover the products from Retailer Y. The returns asset
will be presented and assessed for impairment separately from the refund liability. Entity X will need to assess the returns
asset for impairment, and adjust the value of the asset if it is impaired (see FAQ 1.4 for more on right of return).
1.2 Sale of goods with a shipping service

Background
Entity X, an electronics manufacturer, has an arrangement with Retailer Y to sell televisions. Retailer Y requests Entity X to
sell televisions and arrange for the shipping.
The contract states that legal title and risk of loss passes to Retailer Y when the televisions are picked up by the carrier at
Entity X's shipping dock. Entity X is precluded from selling the televisions to another retailer (for example, by redirecting the
shipment) once the televisions are picked up by the carrier at Entity X's shipping dock. Retailer Y concludes that it obtains
control of the televisions when they are shipped.
Issue
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How many performance obligations are in the arrangement, and when should Entity X recognise the revenue?
Solution
There are multiple promises in the contract, including the sale of televisions and shipping service. Entity X should determine
whether these are separate performance obligations. [IFRS 15 para 22].
Entity X should assess the explicit shipping terms to determine when control of the goods transfers to Retailer Y and whether
the shipping services are a separate performance obligation.
Shipping and handling services might be considered a separate performance obligation if control of the goods transfers to
the customer before shipment, whilst the entity has promised to ship the goods (or arrange for the goods to be shipped) to
the customer. In contrast, if control of a good does not transfer to the customer before shipment, shipping is not a promised
service to the customer. This is because shipping is a fulfilment activity, because the costs are incurred as part of
transferring the goods to the customer.
Performance obligations
Retailer Y can benefit from the televisions on their own without receiving the shipping service. Since control of the televisions
transfers to Retailer Y when the goods are picked up by the carrier at Entity X's shipping dock before shipment, and Entity X
has promised to arrange for the goods to be shipped, the shipping service is considered to be a distinct service, and so it is
a separate performance obligation.
There are therefore two performance obligations in the arrangement: (1) sale of the televisions; and (2) shipping services
Revenue recognition
Entity X should recognise revenue for the sale of the televisions when the televisions are picked up by the carrier at Entity X's
shipping dock. This is because control of the televisions transfers to Retailer Y at that point.
Entity X should recognise revenue for the shipping services rendered as Entity X satisfies its performance obligations in
terms of the contract. Since Entity X is arranging for the shipment to be performed by another party (that is, a third party
carrier), it should also evaluate whether to record the revenue allocated to the shipping services on a gross basis as
principal, or on a net basis as agent (that is, revenue recognised will only be the commission income received by Entity X).
1.3 Revenue from online sales

Background
An end-consumer decides to buy clothes directly on the website of a retail chain, Entity X. Full payment is made immediately
online. The website proposes delivery to the end-consumer's home for an additional fee. Alternatively, the end-consumer
can collect their purchases from any one of the chain's retail stores. Wherever possible, and in this case, the sale is
honoured by Entity X using the store's inventory which is put aside immediately following the sale. The customer does not
have the ability to change the shipping destination. They do not have physical possession and have not accepted the asset
until it is received.
Customer A: Customer A opts for store pick-up and goes to the selected store to pick up the clothes one week after the
payment is made.
Customer B: Customer B opts for delivery to their home for the additional fee.
Issue
When should the revenue be recognised by Entity X for Customer A and Customer B?
Solution
Customer A
Bill-and-hold arrangements arise where a customer is billed for goods that are ready for delivery, but the entity does not ship
the goods to the customer until a later date. Entities must assess in these cases whether control has transferred to the
customer, even though the customer does not have physical possession of the goods. Revenue is recognised when control
of the goods transfers to the customer.
Paragraph B81 of IFRS 15 presents the following additional criteria that all need to be met in order for the customer to have
obtained control in a bill-and-hold arrangement:
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1. The reason for the bill-and-hold arrangement must be substantive (for example, the customer has requested the arrangement);
2. The product must be identified separately as belonging to the customer;
3. The product currently must be ready for physical transfer to the customer; and
4. The entity cannot have the ability to use the product or to direct it to another customer.
In this case, Entity X has concluded that it is able to recognise revenue when the product (that is, the clothes) has been set
aside specifically for Customer A. This is because the product is physically available at the pick-up location for transfer to
Customer A, and the product cannot be used for another customer. Therefore, Customer A has obtained control over the
product in this bill-and-hold arrangement.
If goods still need to be delivered from the warehouse, the bill-and-hold criteria will not be met until the store has received
the product ordered by the end-consumer. Consideration might also need to be given to a 'returns' estimate that should
include goods that are never claimed.
Customer B
Entity X should recognise revenue when the products are delivered. Although Customer B has paid for the asset at the time
of purchase, they do not have the ability to direct the use of the asset until it is received. Indicators that control is transferred
when the products are delivered include that the customer does not have the ability to change the shipping destination and
that the customer does not have physical possession and has not accepted the asset until it is received.
1.4 Right of return

Background
Entity X
Entity X uses a retail network to supply its products to end-customers. Entity X sells 100 products to Retailer Y for CU50
each. The cost of each product is CU10. Revenue is recognised by Entity X at the point in time when Retailer Y obtains
control of the products on delivery to Retailer Y.
Entity X estimates, based on the expected value method, that 6% of the products sold will be returned, and that it is highly
probable that there will not be a significant reversal of cumulative revenue if the estimate of expected returns changes.
Retailer Y has a contractual right to return the products, for up to 120 days after Retailer Y has obtained control of the
products, for a full cash refund. Entity X has no further obligations with respect to the products sold, and Retailer Y has no
further return rights after the 120-day period.
Retailer Y
Retailer Y sells the products to end-customers through its retail stores. Revenue is recognised by Retailer Y when the
product is sold at the store (that is, when the customer has obtained physical possession and has paid in full). Retailer Y has
a returns policy which gives its customers a right to return the products for up to 90 days after the purchase.
Retailer Y estimates, based on the expected value method, that 10% of the products sold will be returned, and that it is
highly probable that there will not be a significant reversal of cumulative revenue if the estimate of expected returns changes.
Issue
How should Entity X and Retailer Y recognise revenue in this arrangement?
Solution
Entity X
The right of return is not a separate performance obligation for Entity X, but it affects the estimated transaction price of the
products sold. Paragraph B21 of IFRS 15 requires Entity X to recognise revenue only for those products that are not
expected to be returned by Retailer Y.
Entity X estimates that including 94% (that is, excluding 6% of expected returns) of its sales in the transaction price will not
result in a significant reversal of cumulative revenue. Therefore, Entity X recognises revenue for 94% of its sales to Retailer Y.
Entity X should recognise a refund liability for the amount of consideration that it does not expect to be entitled to (that is,
6%), because it will be refunded to customers. The refund liability is remeasured at each reporting date to reflect changes in
the estimate of returns, with a corresponding adjustment to revenue. A refund liability is an obligation to transfer cash.
Therefore, refund liabilities do not meet the definition of a contract liability.
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Entity X is also required to recognise a right to return asset, which represents the entity's right to receive goods (inventory)
back from Retailer Y. The right to return asset is initially measured at the carrying amount of the goods at the time of sale,
less any expected costs to recover the goods and any expected reduction in value. The right to return asset will therefore
reduce the cost of sales. In some instances, the asset could be immediately impaired if the entity expects that the returned
goods will have diminished, or no, value at the time of return.
The right to return asset is presented separately from the refund liability. The amount recognised as an asset should be
updated whenever the refund liability changes and for other changes in circumstances that might suggest an impairment of
the asset.
Revenue: Sales price per unit × number of units (excluding those expected to be returned):
CU50 x 94 units = CU4,700
Cost of sales: Cost per unit × number of units (excluding those expected to be returned):
CU10 × 94 units = CU940
Right to return asset: Former carrying amount per unit × number of units expected to be returned:
CU10 × 6 units = CU60
Refund liability: Return ratio × number of units sold × sales price per unit:
6% x 100 units× CU50 = CU300 for the refund obligation.
If Retailer Y did not have a contractual right to return the products purchased, but Entity X had a customary business
practice of accepting returns, the right of return is accounted for in the same manner as described above. This is
because paragraph 10 of IFRS 15 specifies that a contract can be written, oral, or implied by a reporting entity's
customary business practices.
Retailer Y
Similar to Entity X, Retailer Y should recognise revenue by including 90% (that is, excluding 10% of expected returns) of its
sales in the transaction price, recognise a refund liability for the amount of consideration that the entity does not expect to be
entitled to (that is, 10%), because it will be refunded to customers, and recognise a corresponding right to return asset.
Some retailers only offer returns in the form of an exchange. Paragraph B26 of IFRS 15 notes that exchanges by customers
of one product for another of the same type, quality, condition and price are not considered returns for the purposes of
recognising revenue.
1.5 Sales of goods – Agent versus principal

Background
Entity X operates a website that sells goods produced by a number of manufacturers. Entity X enters into a contract with
Manufacturer A to sell Manufacturer A's products online. Entity X's website facilitates payments between Manufacturer A
and the end-consumer. The sales price is established by Manufacturer A, and Entity X earns a commission equal to 5% of
the sales price.
Manufacturer A ships the goods directly to the customer and insures for loss/damage during shipment. Legal title is
transferred from Manufacturer A to Entity X when the goods leave Manufacturer A's warehouse. The end-consumer returns
the goods to Entity X if they are dissatisfied. Entity X has the right to return goods to Manufacturer A without penalty if they
are returned by the customer.
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 View image
Issue
Is Entity X the principal or agent for the sale of goods to the end-customer?
Solution
The specified good or service in this arrangement is the good which is produced by Manufacturer A. Entity X has considered
the following facts when assessing whether it is acting as agent or principal (that is, whether it takes control over the specific
good before it is transferred to the customer) [IFRS 15 paras B35-B37]:
Entity X only takes legal title once the end-customer has committed to and paid for
the goods.
Entity X does not have the ability to benefit from the goods in other ways, such as
redirecting the asset to another customer sale, given that Manufacturer A ships the
goods directly to the customer.
Entity X is reimbursed by Manufacturer A in the rare case of a dissatisfied
customer.
The sales price is established by Manufacturer A. Therefore, Entity X has no
discretion in establishing the price for the goods.
Entity X also considered indicators that it is acting as principal, including the fact that Entity X takes legal title and that
dissatisfied customers return the goods directly to Entity X. However, legal title is only retained by Entity X during a short
period of time before the goods are transferred to the customer, and so Entity X does not control the goods. Entity X has no
inventory risk before the goods have been transferred to the end-customer, and no inventory risk after transfer of control to
the customer, given that Entity X has a right to return goods to Manufacturer A without penalty. Hence, Entity X is acting as
the agent.
On this basis, Entity X should recognise commission revenue, on a net basis, when it has satisfied the promise to facilitate
the sale (that is, when the goods are purchased by a customer).
Manufacturer A should recognise revenue of CU100 and, simultaneously, a commission charge of CU5.
1.6 Bill-and-hold arrangements

Background
Entity X, a video game company, enters into a contract during 20X6 to supply 100,000 video game consoles to Retailer Y.
The contract contains specific instructions from the retailer about where the consoles should be delivered. Entity X should
deliver the consoles in 20X7 at a date to be specified by the retailer. Retailer Y expects to have sufficient shelf space at the
time of delivery.
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As at 31 December 20X6, Entity X has inventory of 120,000 game consoles, including the 100,000 relating to the contract
with Retailer Y. The 100,000 consoles are stored with the other 20,000 game consoles, which are all interchangeable
products; however, Entity X will not deplete its inventory below 100,000 units.
Issue
When should Entity X recognise revenue for the 100,000 units to be delivered to Retailer Y?
Solution
Bill-and-hold arrangements arise where a customer is billed for goods that are ready for delivery, but the entity does not ship
the goods to the customer until a later date. Entities must assess in these cases whether control has transferred to the
customer, even though the customer does not have physical possession of the goods. Revenue is recognised when control
of the goods transfers to the customer.
Paragraph B81 of IFRS 15 presents the following additional criteria that all need to be met in order for the customer to have
obtained control in a bill-and-hold arrangement:
The reason for the bill-and-hold arrangement must be substantive (for example, the
customer has requested the arrangement);
The product must be identified separately as belonging to the customer;

The product currently must be ready for physical transfer to the customer; and
The entity cannot have the ability to use the product or to direct it to another
customer.
Entity X should not recognise revenue until the bill-and-hold criteria are met, or until Entity X no longer has physical
possession and all of the other criteria related to the transfer of control have been met. Although the reason for entering into
a bill-and-hold transaction is substantive (such as lack of shelf space), the other criteria are not met, because the game
consoles produced for Retailer Y are not separated from other products.
1.7 Purchases made in instalments (‘layaways’)

Background
Retailer Y entered into an agreement with a customer whereby Retailer Y sets aside specific merchandise valued at CU500
and collects a cash deposit of CU50 from the customer on the day that the contract is entered into.
The merchandise will only be released to the customer once the purchase price is paid in full. The customer has three
months to finalise the purchase. There is no fixed payment commitment; that is, the customer can pay in several instalments
over that three-month period. The cash deposit and any subsequent payments are forfeited if the customer fails to pay the
entire purchase price by the end of the three-month period.
Retailer Y can use the merchandise to satisfy other customer orders and replace them with similar goods during the layaway
period. Retailer Y must refund the cash paid by the customer for merchandise that is lost, damaged or destroyed before the
merchandise transfers to the customer.
Issue
When should Retailer Y recognise revenue?
Solution
Layaway sales (sometimes referred to as ‘lay-buys’ or ‘will call’) involve the seller setting aside merchandise and collecting a
cash deposit from the customer. The seller might specify a time period within which the customer is required to finalise the
purchase, but there is often no fixed payment commitment. The merchandise is typically released to the customer once the
purchase price is paid in full. The cash deposit and any subsequent payments are forfeited if the customer fails to pay the
entire purchase price. The seller is required to refund the cash paid by the customer for merchandise that is lost, damaged or
destroyed before control of the merchandise transfers to the customer.
Retailer Y will first need to determine whether a contract exists in a layaway arrangement. It is likely that a contract does not
exist at the outset of a typical layaway arrangement, because the customer has not committed to perform its obligation (that
is, payment of the full purchase price). Retailer Y should not recognise revenue for these arrangements until the contract
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criteria are met [IFRS 15 para 9] or the entity has no remaining obligations and all, or substantially all, of the consideration
promised has been received or the contract has been terminated [IFRS 15 para 15].
Some layaway sales could be, in substance, a credit sale if management concludes that the customer is committed to the
purchase and a contract exists. Management will need to determine in those circumstances when control of the goods
transfers to the customer. An entity that can use the selected goods to satisfy other customer orders, and replace them with
similar goods during the layaway period, is likely to have retained control of those goods. Management should consider the
bill-and-hold criteria discussed in paragraph B81 of IFRS 15 to determine when control of the goods has transferred (see
FAQ 1.5 for more guidance on bill-and-hold sales).
1.8 Consignment arrangements

Background
Entity X sells teak furniture to Retailer Y, who operates a garden centre, on a consignment basis. The products are
immediately offered for sale in Retailer Y’s garden centre. Entity X retains legal title to the products until they are sold to the
end-customer. Retailer Y does not have an obligation to pay Entity X until a sale occurs, and any unsold products can be
returned to Entity X. Entity X also retains the right to take back any unsold products, or to transfer unsold products to
another retailer. Once Retailer Y sells the products to the end-customer, Entity X has no further obligations, and Retailer Y
has no further return rights.
Issue
When does Entity X recognise revenue?
Solution
Entity X should only recognise revenue when Retailer Y sells the product to the end-customer.
Although Retailer Y has physical possession of the products, it does not have control of the products when the goods are
delivered by Entity X. Retailer Y only has the right to sell the products and does not have an unconditional obligation to pay
Entity X until a sale to the end-customer occurs. Entity X also retains the right to call back any products that have not been
sold by Retailer Y. This therefore indicates that this arrangement is a consignment arrangement in terms of paragraph B78 of
IFRS
15. As a result, revenue is not recognised by Entity X when the goods are delivered to Retailer Y, in accordance with the
guidance in paragraphs B77 and B78 of IFRS 15.
Entity X should also assess who is their customer – Retailer Y or the end-consumer. If its customer is the end-customer (that
is, Retailer Y is acting as an agent), Entity X would recognise revenue in the amount that was received from the end-
customer, and the amount retained by Retailer Y would be recognised as a commission expense by Entity X. If Retailer Y is
the customer, Entity X would recognise revenue in the amount that was received from Retailer Y.
1.9 Sale of gift cards

Background
Entity X sells gift cards. The gift cards are valid for up to one year from the date of purchase and can only be redeemed at
Entity X outlets; furthermore, the customer cannot obtain a cash reimbursement for unspent amounts or unused cards.
Entity X expects 10% of the gift card’s value to expire unused, based on historical information. Unspent amounts after a year
are kept by Entity X and forfeited by the customer. Entity X has no obligation to remit unused gift card amounts to end-
customers or to a third party (for example, government).
On 31 August 20X1, 60 customers purchased CU100 gift cards from Entity X. At 31 December 20X1, 36 of those 60
customers fully redeemed their gift cards for Entity X products for a total of CU3,600.
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Issue
Should Entity X recognise revenue on the sale of gift cards or on their redemption?
Solution
Entity X should recognise revenue on redemption of gift cards. The customer’s non-refundable prepayment to an entity gives
them a right to receive a good or service in the future. Entity X should recognise a contract liability (and not revenue) for any
consideration received that is attributable to a customer’s unexercised rights. However, customers might not exercise all of
their contractual rights, which are often referred to as ‘breakage’. [IFRS 15 App B para B45]
Entity X expects to be entitled to a breakage amount and recognises the expected breakage amount as revenue in
proportion to the pattern of rights exercised by the customers [IFRS 15 App B paras B46–B47]. Entity X has assessed that it
has adequate historical information to estimate breakage revenue in proportion to the historical pattern of rights exercised by
the customer. In making this assessment, it has determined that recognising 10% breakage would result in recognition of
only that amount of revenue that is not highly probable of a significant reversal.
At the time of gift card purchase, Entity X should make the following entries:
Dr. – Cash (B/S) CU6,000
Cr. – Contract Liability – Gift Card (B/S) CU6,000
The total breakage estimate is CU600 for CU6,000 of gift cards. The expected value to be redeemed by customers is
CU5,400. For the period up to 31 December 20X1, Entity X should recognise the purchases made of CU3,600 in the
following manner:
Dr. – Contract liability CU4,000
Cr. – Revenue CU3,600 (reflecting the product’s selling price)
Cr. – Breakage revenue CU400 (CU3,600/CU5,400 * CU600)
The breakage revenue is calculated as follows: Value of gift cards redeemed/Total gift card value × total estimated breakage
revenue. Breakage estimates would usually be updated at each period-end, and adjustments would be made where
necessary.
Calculating breakage might be more complex for entities who sell gift cards regularly and with longer or no expiry date. IFRS
15 permits an entity to use a portfolio approach for practical application if the entity reasonably expects that the effects on
the financial statements would not differ materially from applying IFRS 15 to the individual contracts.
Advance payments for gift cards are generally not considered to result in the transaction having a significant financing
component, because the timing of redeeming the gift card is at the discretion of the customer. [IFRS 15 para 62(a)].
1.10 Extended warranties
Reference to standard: IFRS 15 para B32

Background
Retailer X sells electrical goods that come with a manufacturer’s one-year warranty against manufacturing defects. The
retailer also offers customers the option of purchasing an extended warranty to cover a further three years after the expiry of
the manufacturer’s warranty at the same date of sale as the electrical good.
The sales price of the product is CU500, and the extended warranty costs CU120.
This contract is excluded from the scope of IFRS 17, because it relates to ‘warranties provided by a manufacturer, dealer or
retailer in connection with the sale of its goods or services to a customer’. [IFRS 17 para 7a]
Issue
How should Retailer X account for this arrangement?
Solution
This arrangement with the customer includes the following goods or services: (1) electrical goods; and (2) an extended
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warranty.
A warranty that a customer can purchase separately from the related good or service (that is, it is priced or negotiated
separately) is a separate performance obligation. The fact that it is sold separately indicates that a service is being provided
beyond ensuring that the product will function as intended. Warranties that cannot be purchased separately should be
assessed to determine whether the warranty provides a service that should be accounted for as a separate performance
obligation.
Warranties that provide assurance that a product will function as expected and in accordance with certain specifications are
not separate performance obligations.
Retailer X should account for the product warranty (against manufacturing defect) in accordance with IAS 37 and recognise
an expense and liability for expected extended warranty obligation. Retailer X should account for the extended warranty as a
separate performance obligation, with revenue recognised as that obligation is satisfied over the three-year period.
A return in exchange for cash or credit should generally be accounted for as a right of return. If customers have the option to
return a defective good for cash, credit, or a replacement product, management should estimate the expected returns in
exchange for cash or credit as part of its accounting for estimated returns.
2 Customer incentives and other similar

transactions
2.1 Volume discounts

Background
Example 1
Entity X sells 1,000 products to Retailer Y for CU10,000. In addition, Retailer Y will receive a 5% discount on all purchases if
Retailer Y purchases more than 7,500 products (CU75,000 excluding the discount). Entity X forecasts that, due to the historic
seasonality of the revenue (which peaks in summer time), the annual sales will be CU100,000.
Example 2
Entity X sells 1,000 products to Retailer Z for CU10,000. In addition, Retailer Z will receive a 5% discount on any purchases
over and above 7,500 products (CU75,000 excluding the discount). Entity X forecasts that, due to the historic seasonality of
the revenue (which peaks in summer time), the annual sales will be CU100,000.
Issue
How should Entity X account for the volume discount arrangements?
Solution
Example 1– Retailer Y
The transaction price includes an element of consideration which is variable or contingent on future events. IFRS 15 requires
an entity to estimate an amount of variable consideration by using either the ‘expected value’ or the ‘most likely amount’,
whichever method is a better prediction of the final outcome. The transaction price includes variable consideration only to
the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur
when the uncertainty associated with the variable consideration is subsequently resolved.
The transaction price for the 1,000 products is CU9,500, reflecting an expected reimbursement of CU500. Entity X will
recognise a separate refund liability for the difference between the invoice price and the transaction price, because this
represents the cash that it expects to refund to Retailer Y. Entity X will update its estimate of expected reimbursement at
each reporting date until the uncertainty is resolved.
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Example 2 – Retailer Z
Entity X should account for the prospective volume discount as a separate performance obligation in the form of a material
right (option to purchase additional products at a discount) and allocate the transaction price to the goods and the option
based on their relative stand-alone selling prices.
Entity X would theoretically need to assess the stand-alone selling price of each option. However, because the future goods
are similar to the original goods, paragraph B43 of IFRS 15 permits an entity to include the optional goods or services that it
expects to provide (and corresponding expected customer consideration) for the purposes of allocating the transaction
price.
Assuming that Entity X elects to apply the practical alternative in paragraph B43 of IFRS 15, it would calculate the expected
consideration for those additional goods as CU97,500, reflecting the 5% discount on the expected purchase of CU25,000
over and above CU75,000, and it would recognise CU9.75 for each product (that is, CU97,500 total expected consideration
divided by 10,000 total products).
Entity X would therefore recognise revenue of CU9,750 for the initial sale of 1,000 products, with a contract liability of CU250
for the material right not yet satisfied. The CU250 represents the CU10 price paid by the customer in excess of the CU9.75
transaction price allocated to each product. The contract liability would accumulate until the discounted products are
delivered, at which time it would be recognised as revenue when the products are delivered.
Entity X would update its estimate of the total sales volume at each reporting date, with a corresponding adjustment to
cumulative revenue and the value of the separate contract liability.
2.2 Co-advertising arrangements

Background
Entity X has entered into agreements with two of its customers (Retailer Y and Retailer Z) for the sale of products totalling
CU100m. Each arrangement also includes obligations for the customer with respect to product advertising and promotion,
as described below.
Retailer Y
The arrangement with Retailer Y requires Retailer Y to publish advertisements of Entity X’s products in a local newspaper.
Entity X has entered into similar arrangements in the past, directly with the local newspaper. If Entity X had not entered into
this arrangement with Retailer Y, Entity X would advertise locally.
Retailer Y will contract with the local newspaper directly and pay for the full cost of the campaign. Entity X has committed to
reimburse Retailer Y for 50% of the advertising costs. In order for Entity X to reimburse Retailer Y, it requires Retailer Y to
place the adverts and to provide the associated proof of placement in the local newspaper.
Entity X is paying Retailer Y fair value, which can be reasonably estimated, for such services.
Retailer Z
The arrangement with Retailer Z entitles Retailer Z to an advertising allowance of CU10m from Entity X. The arrangement
requires Retailer Z to advertises Entity X’s goods on advertising boards and in its publicity mailings with certain regularity
throughout the year. Retailer Z only advertises brands that it sells.
Issue
How should Entity X account for these transactions?
Solution
Arrangement with Retailer Y
The payment made by Entity X to Retailer Y is for a distinct service, as described by paragraph 27 of IFRS 15. Entity X has
previously purchased similar advertising services at similar pricing, and the service is being provided by a third party. Entity X
could have also entered into this arrangement regardless of whether Retailer Y is a customer. Entity X is paying Retailer Y fair
value, which can be reasonably estimated, for such services. Entity X therefore recognises the advertising costs as an
expense in the income statement.
If the consideration that Entity X paid to Retailer Y for distinct advertising services had been in excess of the fair value of the
service received, the excess consideration is recognised as a reduction in the transaction price for the products sold,
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because the excess amount represents, in substance, a discount to Retailer Y.
It can be difficult to determine the fair value of the distinct goods or services received in some situations. If an entity is not
able to determine the fair value of the goods or services received, it should account for all of the consideration paid or
payable to the retailer as a reduction of the transaction price, because it is unable to determine the portion of the payment
that is a discount provided to the retailer.
Arrangement with Retailer Z
Entity X is unable to identify a distinct service and/or separate the arrangement from the sale of the products to Retailer Z.
Therefore, the amounts due by Entity X to Retailer Z would be recognised as a reduction of Entity X’s revenue.
In practice, it is often challenging to identify co-advertising as a distinct service. Such arrangements are usually negotiated
as part of the price of the products sold. Advertising activities might or might not be specifically agreed, and they often
include ‘in store’ or localised advertising that can only be delivered by the retailer in connection with selling the products.
These factors, therefore, often make it difficult to conclude that the services are distinct.
2.3 Slotting fees and other fee paid to retailers

Background
It is common practice, and often contractually agreed, that consumer products entities pay various fees in connection with
product sale arrangements. The fees come in many different forms, but they are generally designed to encourage the sales
of an entity’s products to end-customers by enabling the retailer to sell at a lower price, to reduce the retailer’s cost of
selling, or to increase advertising.
Some of the fees paid by consumer products entities to retailers include:
Slotting fees – paid for a product to be allocated to advantageous spaces in the

retailer’s premises for a defined period of time. For example, the products are
placed near the checkout counter, to be more noticeable by customers;
Pallet fee – a retailer buys a pallet of goods and places the pallet directly on its
store floor for display and sale of the products. The consumer products entity gives
a discount to the retailer justified by expectations of increased sales volumes and
reduced packaging and handling costs; and
Retail fixture compensation – a consumer products entity pays a retailer
compensation to cover their cost of their retail store renovation to meet the
standard required by the consumer products entity. This can be paid as a lump
sum or a discount offered on future sales.
The accounting considerations for all of these fees and rebates are similar, and they are captured in the following example:
Entity X sells energy drinks to Retailer Y for CU10,000. Simultaneously, Entity X is invoiced CU500 by Retailer Y as a fee to
ensure that its products receive prominent placement on store shelves (that is, a slotting fee), which will generate additional
sales. The fee is negotiated as part of the contract for sale of the energy drinks.
Issue
How should Entity X and Retailer Y account for this arrangement?
Solution
Entity X
Entity X does not receive a good or service that is distinct in exchange for the payment to Entity Y. Entity X should recognise
the slotting fees paid to Retailer Y as a reduction of the revenue recognised from the sale of goods to Retailer Y.
Similar to slotting fees, other fees such as pallet fees and retail fixed compensation that are linked to the sale of the product
and contribute to a retailer’s selling process are not a distinct service, and so they should be recognised as a reduction of
revenue. Paragraph 27 of IFRS 15 provides guidance on determining when a good or service is distinct. Determining whether
a payment is for a distinct good or service received from a customer requires judgement. An entity might be paying a
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customer for a distinct good or service if the entity is purchasing something from the customer that is normally sold by that
customer.
Retailer Y
Retailer Y should recognise the amounts received as a reduction in the cost of inventory acquired under this contract.
2.4 Price protection

Background
Manufacturer B enters into a contract to sell goods to Retailer C for CU1,000. Manufacturer B also offers price protection,
whereby it will reimburse the retailer for any difference between the sale price and the lowest price offered to any customer
by Manufacturer B during the six months following sale of the goods to Retailer C. This clause is consistent with other price
protection clauses offered in the past, and Manufacturer B believes that it has experience that is predictive for this contract.
Manufacturer B expects that it will offer a price decrease of 5% during the price protection period, and it concludes that it is
highly probable that a significant reversal of cumulative revenue will not occur if estimates change.
Issue
How should Manufacturer B determine the transaction price?
Solution
The transaction price includes an element of consideration which is variable or contingent on future events. IFRS 15 requires
an entity to estimate an amount of variable consideration by using either the ‘expected value’ or the ‘most likely amount’,
whichever method is a better prediction of the final outcome. The transaction price includes variable consideration only to
the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur
when the uncertainty associated with the variable consideration is subsequently resolved. [IFRS 15 paras 50–58]
The transaction price is CU950, because the expected reimbursement is CU50. The expected payment to Retailer C is
reflected in the transaction price at contract inception, because that is the amount of consideration to which the
manufacturer expects to be entitled after the price protection. Manufacturer B will recognise a liability for the difference
between the invoice price and the transaction price, since this represents the cash that it expects to refund to the retailer.
Manufacturer B will update its estimate of expected reimbursement at each reporting date until the uncertainty is resolved.
If an entity has no past practice or expectation of offering price protection, it accrues the rebate as a reduction of revenue for
any goods already sold as soon as it has offered the payment, based on the amount of inventory in the channel, as required
by paragraph 72 of IFRS 15.
It is also common for retailers to have a price protection policy in place to reimburse its customers for the difference between
the purchase price and the lower price offered by direct competitors. The arrangement with the customer is often offered for
a limited period following the sale. A retailer should follow the same accounting as described above, recognising a liability of
the expected reimbursement, applying the guidance in IFRS 15 for variable consideration.
2.5 Customer incentives – Discount coupons

Background
Retailer X has launched a promotional campaign offering discount coupons to any customers that purchase goods with a
total value exceeding CU1,500. The discount coupons entitle the customer to a 50% discount on the purchase of selected
items during the 90 days immediately following the campaign.
Retailer X has issued 60 of the 50% coupons to high-spending consumers who had purchased goods totalling CU100,000
during the campaign. Based on historical trends, Retailer X expects that:
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1. 75% of the consumers receiving 50% discount coupons will use the coupon; and
2. customers using the coupons will spend on average CU1,000.
Retailer X has concluded that it will still make a positive margin on the transactions when the coupons are used. Therefore,
Retailer X does not have an onerous contract to recognise in accordance with IAS 37.
Issue
How should Retailer X account for the discount coupon issued to customers?
Solution
Customer options to acquire additional goods or services include sales incentives, customer loyalty points, contract
renewal options, and other discounts. If the option provides a customer with a material right, the customer is purchasing
two things in the arrangement – the good or service originally purchased, and the right to a free or discounted good or
service in the future – and is effectively paying in advance for future goods or services. [IFRS 15 App B para B40]
Retailer X has sold goods for a total amount of CU100,000 and it has simultaneously granted to its customers 50% off
coupons that will be used in future purchases by an estimated 75% of customers. The discount coupons represent a
material right, and so they are accounted for as separate performance obligations in the arrangement.
Retailer X has decided to use the portfolio approach, on the basis that it reasonably expects that the effects on the
financial statements would not differ materially from applying IFRS 15 to the individual contracts.
In accordance with paragraph 74 of IFRS 15, the allocation of transaction price to performance obligations will be
undertaken on a relative stand-alone selling price basis. The estimated stand-alone selling price of the material right
should reflect the discount that the customer would be entitled to, adjusted for any discount that the customer could
receive without exercising the option (that is, any discount available to any other customer) and the likelihood that the
option will be exercised.
Determination of the stand-alone selling price of the options as a portfolio:
50% discount coupons = net price of additional products × discount × likelihood
CU1,000 × 60 × 50% × 75% = CU15,000
Allocation of the transaction price:
Total value of the transactions = price of initial purchase + option value granted
CU100,000 + CU15,000 = CU115,000
The transaction price is allocated to the material right, based on the relative stand-alone selling price:
Transaction price = CU100,000
Transaction price allocated to the discount coupons
CU15,000/CU115,000 × CU100,000 = CU13,040
Accounting entries on initial purchase:
Dr. Cash (B/S) CU100,000
Cr. Product sales (P/L) CU86,960
Cr. Contract liability – discount coupons (B/S) CU13,040
Accounting entries on redemption of coupons:
Dr. Cash (B/S) (50% of CU1,000 × 45) CU22,500
Dr. Contract liability – discount coupons (B/S) CU13,040
Cr. Products sales (P/L) CU35,540
An entity should consider the guidance on constraining variable consideration to determine whether or not it expects to be
entitled to a breakage amount with regard to redemption of the coupons. If the entity expects to be entitled to a breakage
amount, it recognises the expected breakage amount as revenue in proportion to the pattern of rights exercised by the
customer (that is, as coupons are redeemed). If the entity does not expect to be entitled to a breakage amount, it
recognises the expected breakage amount as revenue when the likelihood of the customer exercising its rights becomes
remote. The assessment of estimated breakage should be updated at each reporting period. Changes in estimated
breakage should be accounted for by adjusting the contract liability to reflect the remaining coupons expected to be
redeemed.
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Estimating breakage and updating these estimates could be complex, particularly for coupons, which might extend for
significant periods of time, or never expire. The accounting for these items will often require a significant amount of data
tracking in order to update estimates each reporting period. Management should not adjust the stand-alone selling price
originally allocated to a customer option when updating its estimate of breakage (for example, when updating the number
of coupons that it expects customers to redeem).
2.6 Customer incentives – Discounts offered

without purchase

Background
Retailer X, a clothing retailer, has launched a promotional campaign whereby a coupon is published in a national newspaper
giving a discount of 5% off any purchase over CU50 in any of Retailer X’s stores. Retailer X’s margin on similar transactions,
prior to the impact of the coupons, is between 30% and 40%. Therefore, Retailer X has determined that there is no onerous
contract to be recognised in accordance with IAS 37.
Issue
How does Retailer X account for these coupons?
Solution
The issuance of the coupons does not create a binding contract with a customer. This only occurs once the customer makes
the purchase exceeding CU50. Retailer X should not recognise a liability in its financial statements for the distribution of
coupons.
Retailer X should account for discount coupons as an adjustment to the transaction price only when the customers redeem
them.
2.7 Customer loyalty programme
2.7.1 Loyalty points are redeemed by the

retailer

Background
Retailer X operates retail stores and a website where customers can buy dresses.
Retailer X has a customer loyalty programme in place that awards customers 1
point for every CU1 spent on buying dresses.
Points are only redeemable for a CU0.10 discount on future purchases (that is, the
discount per loyalty point earned) and cannot be redeemed for cash.
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Retailer X expects 5% of points to expire unredeemed, based on historical trends.

Retailer X has sold dresses for CU1,000 during the period and customers have
therefore earned a total of 1,000 loyalty points during the period.
Issue
How should Retailer Y account for the loyalty points issued to its customers?
Solution
The transaction involves Retailer X committing to two performance obligations:
1. The goods purchased; and

2. The rights related to the loyalty points, because Retailer X has effectively provided the customer with an option (that is, a material
right that it would not receive without entering into that contract) to purchase additional goods in the future in terms of paragraphs
26 and B40 of IFRS 15.
Retailer X has decided to use the portfolio approach, on the basis that it reasonably expects that the effects on the financial
statements would not differ materially from applying IFRS 15 to the individual contracts.
In accordance with paragraph 74 of IFRS 15, the allocation of transaction price to performance obligations will be
undertaken on a relative stand-alone selling price basis. The estimated stand-alone selling price of the material right should
reflect the discount that the customer would be entitled to, adjusted for any discount that the customer could receive without
exercising the option (that is, any discount available to any other customer) and the likelihood that the option will be
exercised.
Determination of the stand-alone selling price of the option:
Total discount on future purchases = Discount × loyalty points awarded
CU0.10 × 1,000 points = CU100
Stand-alone selling price of the option granted = Total discount on future purchases – expected breakage of points
CU100 – (5% × 1,000 points × CU0.10) = CU95
Allocation of the transaction price:
Retailer Y has to allocate customer payments of CU1,000 between product sales and loyalty points, based on their
relative stand-alone selling prices.
Total transaction value = Price of initial purchase + stand-alone selling price of the option granted
= (CU1,000 + CU95)
= CU1,095
Customer payment allocated to the loyalty programme = CU1,000 × CU95/CU1,095 = CU87
Customer payment allocated to the products sales = CU1,000 × CU1,000/CU1,095 = CU913
Accounting entries at initial purchase:
Dr. Cash (B/S) CU1,000
Cr. Products Sales (P/L) CU913
Cr. Contract Liability – Loyalty points (B/S) CU87
Retailer Y would recognise revenue of CU913 when the products are sold to the customer. It would defer revenue of
CU87 and recognise it on redemption of the points by the customer or expiration.
An entity should consider the guidance on constraining variable consideration to determine whether or not it expects to be
entitled to a breakage amount with regard to redemption of the loyalty points. If the entity expects to be entitled to a
breakage amount, it recognises the expected breakage amount as revenue in proportion to the pattern of rights exercised by
the customer (that is, as loyalty points are redeemed). If the entity does not expect to be entitled to a breakage amount, it
recognises the expected breakage amount as revenue when the likelihood of the customer exercising its rights becomes
remote.
The assessment of estimated breakage should be updated at each reporting period. Changes in estimated breakage should
be accounted for by adjusting the contract liability to reflect the remaining loyalty points expected to be redeemed.
Estimating breakage and updating these estimates could be complex, particularly for customer loyalty programmes, which
might extend for significant periods of time, or never expire. The accounting for these programmes will often require a
significant amount of data tracking in order to update estimates each reporting period. Management should not adjust the
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stand-alone selling price originally allocated to a customer option when updating its estimate of breakage (for example, when
updating the number of loyalty points that it expects customers to redeem).
2.7.2 Loyalty points are solely redeemable by

another party
This question is covered by the FAQ 11.199.2. To see it go to the link here.
(full Viewpoint subscription required, see here for details).
2.7.3 Loyalty points are redeemable by

multiple parties
This question is covered by the FAQ FAQ 11.199.3. To see it go to the link here.
(full Viewpoint subscription required, see here for details).
3 Other revenue transactions
3.1 Licensing brands

Background
Entity X is a well-known design house which designs, manufactures, distributes and sells luxury products branded with its
famous trademark. Entity X grants a real estate developer a licence to use its brand name in connection with the sale of
apartments for four years.
The real estate developer’s intention is to construct and sell private luxury apartments using a ‘stylistic concept’ aligned to
Entity X’s brand. The real estate developer agrees to provide Entity X with an opportunity to influence the interior design,
which is the primary responsibility of the real estate developer’s design team. Entity X agrees to continue to promote the
brand through national advertising campaigns.
Entity X receives a fixed fee of CU2 million, a royalty of 2% of the sales of the apartments, and a marketing fee of 1% of the
sales of the apartments.
Issue
How should Entity X recognise the payments that it receives from the real estate developer as compensation for the use of
its brand name?
Solution
The licence is a ‘right to access the IP’. This is because the benefit for the real estate developer is dependent on the ongoing
activities performed by Entity X that support or maintain the value of the brand. [IFRS 15 App B para B58]
Entity X needs to assess whether advertising represents a distinct performance obligation. In most cases, such activities are
designed to support the brand rather than to provide a distinct service to the customer. Entity X has concluded that its
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obligation to continue to promote the brand through national advertising campaigns does not provide a distinct service to
the real estate developer.
Entity X has also determined that the design oversight is not a separate performance obligation, but rather a protective right
to ensure that the real estate developer uses the brand in a reasonable manner.
The total of the fixed amounts (CU2 million) is allocated to the licence, and it is recognised over time during the licence
period.
Paragraph B63 of IFRS 15 provides an exception for the recognition of revenue of sales- or usage-based royalties promised
in exchange for a licence of intellectual property. Revenue is recognised at the later of when the performance obligation is
satisfied and when the sales or usages occur. Therefore, this royalty and marketing fee are recognised by Entity X when the
apartments are sold, provided that this approach does not result in the acceleration of revenue ahead of the entity’s
performance.
3.2 Franchise agreement in multiple locations

Background
On 1 January 20X1, Entity Y grants a franchisee the exclusive right to operate a restaurant using Entity Y’s brand in Country
A for three years, and a licence to operate another branded restaurant in Country B for three years. However, because of an
existing arrangement with another franchisee, the right in Country B does not begin until 1 January 20X2. The licence fee is
equal to CU150,000 for each of the two licences.
Issue
How should Entity Y account for the licensing arrangements, in particular the contractual provisions that restrict the use of
the brand for a period of three years and defer the starting period of the licence in Country B?
Solution
Restrictions of time, geographical region or use define the attributes of the promised licence, rather than whether the entity
satisfies its performance obligation at a point in time or over time. Entity Y concludes that there are two separate
performance obligations due to the different attributes in the licences (that is, different locations and time periods) [IFRS 15
App B para B62(a)]. The transaction price should be allocated between the two licences.
There is a reasonable expectation that Entity Y will undertake activities that will significantly affect the brand name to which
the franchisee has rights, and the franchisee is directly exposed to any positive or negative effects of that brand and image
throughout the franchise period. Therefore, the licences are rights to access intellectual property, and they are recognised
over time [IFRS 15 App B para B58]. As noted above, the fact that the licences are for a period of three years is not
considered in the assessment of whether the fee is recognised over time or at a point in time.
The licence fee allocated to the right to operate a restaurant in Country A is recognised from 1 January 20X1 on a straight-
line basis over a period of three years. The licence fee allocated to the licence to operate the restaurant in Country B is
recognised from 1 January 20X2 on a straight-line basis over a period of three years.
3.3 Franchise arrangement with product sales

Background
Entity X, a franchisor, grants a five-year franchise to an entity in exchange for an up-front payment of CU120,000, to
accelerate Entity X’s global expansion. Entity X specialises in clothing which is normally sold for CU100 per unit. As part of
the franchise arrangement, Entity X agrees to sell this product to the franchisee for CU70 throughout the franchise period – a
30% discount on usual market prices to third parties. At this stage, no other services will be provided by the franchisor.
Issue
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How does the Entity X account for the arrangement?
Solution
Entity X has transferred two performance obligations under the arrangement: a licence of the brand for five years, and a
material right to acquire goods at a 30% discount to the market price. The transaction price of CU120,000 should be
allocated by Entity X between the two performance obligations, based on the relative stand-alone selling prices.
Entity X calculates a stand-alone selling price of the franchise right of CU100,000. Entity X determines the stand-alone selling
price of the material right based on the expected value of the discounts from planned purchases. Entity X expects that the
customer will purchase 1,000 units at CU70, resulting in a material right equal to CU30,000.
The relative stand-alone selling price would be calculated as follows:
Licence = CU92,308 (CU120,000 * CU100,000/CU130,000)

Material right = CU27,692 (CU30,000 * CU100,000/CU130,000)
There is a reasonable expectation that the franchisor will undertake activities that will significantly affect the brand name to
which the franchisee has rights, and the franchisee is directly exposed to any positive or negative effects of that brand and
image throughout the franchise period. Therefore, the revenue from the franchise rights is recognised over the duration of the
franchise arrangement, and the right to discounted products is recognised as the units are sold.
3.4 Franchise arrangement with non-

refundable up-front fee

Background
Entity X is a franchisor for restaurants that are operated by franchisees. Entity X requires a franchisee to pay a non-
refundable up-front fee of CU200,000 on the signing of the contract.
The franchisee obtains the right to operate a restaurant using the Entity X brand name, concept and menus for a period of
two years, during which time Entity X must maintain the brand through endorsements and regional advertising.
In addition, Entity X provides branded front-of-house fixtures, cooking equipment and cash registers, valued at CU50,000
(that is, the stand-alone selling price of these goods).
Issue
How should Entity X recognise revenue for this arrangement?
Solution
Entity X determines that it has two performance obligations: (1) a promise to grant a licence; and (2) a promise to transfer
fixtures and equipment.
There is a reasonable expectation that Entity X will undertake activities that will significantly affect the brand name to which
the franchisee has rights, and the franchisee is directly exposed to any positive or negative effects of that brand and image
throughout the franchise period [IFRS 15 App B para B58]. Therefore, Entity X recognises the revenue from the franchise
rights on a straight-line basis over the duration of the franchise arrangement, and the revenue from the fixtures and
equipment as control is transferred.
At the signing of the contract, there is no transfer of goods or services to the customer; therefore, no revenue is recognised,
even if the up-front fee is non-refundable. Entity X should not recognise revenue on receipt of an up-front fee, even if it is
non- refundable, because the fee does not relate to the satisfaction of a performance obligation. The non-refundable fee is
an advance payment for future goods or services, and it should be included in the transaction price and allocated to the
separate performance obligations identified in the contract [IFRS 15 App B para B51].
Assuming that CU50,000 represents the stand-alone selling price of the fixtures and equipment, and CU150,000 represents
the stand-alone selling price of the licence, Entity X would recognise CU50,000 on transfer of the fixtures and equipment,
and CU150,000 for the licence over the two years.
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3.5 Telecommunications sales by retailers

Background
Telecommunications providers often sign up new prepaid customers through third party distributors such as retailers in order
to benefit from the retail store footprint of the retailer. The customer of the retailer is the end-user of the telecommunication
products.
In this example, Retailer Y earns a nominal fee from selling the SIM card and continuing commission from the end-
customers' continued use of the SIM card. Retailer Y sells SIM cards to its customers in its store, and it recognises revenue
for the sale when control of the SIM card transfers to the customer.
Retailer Y earns a fee when the end-customer activates the SIM card, as well as when the end-customer loads additional
airtime or data onto the card. End-customers load airtime through any channel in the form of physical vouchers, virtual top-
ups, mobile top-ups, banking applications, etc. These SIM cards are included on Retailer Y’s base of activated cards.
Retailer Y is not itself a telecommunications provider, and so it acts as agent by providing a distribution channel. At the point
of sale of the SIM card, Retailer Y has fulfilled its performance obligation to its customer, because it is an agent in the
arrangement for the provision of telecommunications services.
Issue
How does Retailer Y account for ongoing commission?
Solution
IFRS 15 requires an entity to estimate an amount of variable consideration by using either the ‘expected value’ or the ‘most
likely amount’, whichever method is a better prediction of the final outcome. The transaction price includes variable
consideration only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue
recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
The commissions earned by Retailer Y on prepaid contracts are variable in nature, because the entitlement to these amounts
is dependent on the future spending patterns of the prepaid customers, and therefore contingent on a future event occurring
or not occurring. Therefore, Retailer Y should estimate the amount of variable consideration to which it will be entitled for the
contracts that it has entered into with its customers.
It is likely that the ‘expected value’ method would be the most appropriate method to estimate variable consideration. This is
because the future customer spend, and therefore the ongoing commission earned by Retailer Y, could be any one of a large
range of possible outcomes, and there is a large portfolio of customers. This includes consideration given to all of the
information available to an entity, which might include information gathered on other similar contracts.
Retailer Y should apply the revenue constraint, which is based on an entity only recognising variable consideration to the
extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when
the uncertainty associated with the variable consideration is subsequently resolved. Considerations to take into account in
assessing the extent of the constraint include: whether the revenue is highly susceptible to factors outside Retailer Y’s
influence; the period over which the uncertainty will be resolved; and whether Retailer Y’s experience is limited or has limited
predictive value.
3.6 Concession outlets

Background
Entity A operates a large department store that contains concession outlets. Entity A provides the concessionaire with
serviced space in the store, sales staff, point of sale equipment and stock-room space. Entity A also administers the sales of
the products, including collecting cash from the end-customers.
The concessionaire pays a fixed contractual fee to Entity A of CU10,000 per annum plus 20% of the outlet’s total product
sales. The concessionaire determines the products sold and the prices charged to customers, and it has the right to move
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stock between its concessions in different stores. At the end of a season, the concessionaire must take back any unsold
products.
Entity A has the right to change the location of the space allocated to the concessionaire at any time, and so the
arrangement is not considered a lease.
Issue
How does Entity A account for this arrangement?
Solution
The specified good or service in this arrangement is the products sold in the concession outlet. Entity A does not, at any
point, have control of the products which are sold. Although Entity A transacts with the end-customer, it does not set prices
or take inventory risk [IFRS 15 App B paras B36–B37]. Therefore, Entity A is acting as an agent in selling to the end-customer
and is receiving a ‘commission’ in consideration for the service that it is performing for the concessionaire.
Entity A recognises the ‘commission’ receivable from the concessionaire as revenue, rather than the gross revenue from the
sale of the concessionaire’s goods.
3.7 Excise duties and taxes

Background
Example A
Entity A is a global producer and distributor of branded alcoholic spirits. Entity A pays an excise duty based on the value, as
well as the volume, of products that leave a bonded warehouse. The movement of products from the bonded warehouse for
customs clearance is the triggering event of the obligation to pay excise duty. In the event that a customer fails to make
payment, or if products are not sold, Entity A cannot claim a refund of the excise duty that it has paid. Entity A collects from
its customers the gross revenue and duty amounts.
Entity A has no legal or constructive obligation to reflect any change of the rate of excise duty in the selling price of products.
An increase in the rate of excise duty can lead the entity to increase its selling price, but such increases are a commercial
decision and would not be automatic. The tax is not separately presented on the invoice.
Example B
Entity B sells widgets to customers in various jurisdictions. In a particular jurisdiction, the manufacturer pays a sales tax
calculated based on the number of widgets sold. The triggering event of the obligation is each individual sale to a customer.
The tax is separately identified on the invoice to the customer, and any increase in the tax rate would result in an equivalent
increase of the tax charged to the customer. The manufacturer receives a refund of the tax if the receivables are not
collected.
Issue
How should Entity A and Entity B recognise the taxes that they collect from their customers gross (that is, as revenue and
expense) or net of the amount remitted to a third party (such as governmental agencies)?
Solution
Entities often collect amounts from customers that are required to be remitted to a third party (for example, collecting and
remitting taxes to a governmental agency). Taxes collected from customers could include sales, use, value-added and some
excise taxes. Amounts collected on behalf of third parties, such as certain sales taxes, are not included in the transaction
price, because they are collected from the customer on behalf of the government. The entity is the agent for the government
in these situations.
Taxes that are based on production, rather than sales, are typically imposed on the seller and not on the customer. An entity
that is obligated to pay taxes based on its production is the principal for those taxes, and so it recognises the tax as an
operating expense, with no effect on revenue.
Management needs to assess each type of tax, on a jurisdiction-by-jurisdiction basis, to conclude whether to net these
amounts against revenue or to recognise them as an operating expense. The intention of the tax, as written into the tax
legislation in the particular jurisdiction, should also be considered.
The name of the tax (for example, sales tax or excise tax) is not always determinative when assessing whether the entity is
the principal or the agent for the tax. Whether or not the customer knows the amount of tax also does not necessarily impact
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the analysis. Management needs to look to the underlying characteristics of the tax and the tax laws in the relevant
jurisdiction to determine whether the entity is primarily obligated to pay the tax or whether the tax is levied on the customer.
This could be a significant undertaking for some entities, particularly those that operate in numerous jurisdictions with
different tax regimes.
Indicators that taxes are the responsibility of the entity, and therefore should be recorded as an expense (as opposed to a
reduction of transaction price), include but are not limited to the following:
The triggering event to pay the tax is the production or the importation of goods.
Conversely, where the triggering event is the sale to a customer, this might indicate
that the entity is collecting the tax on behalf of a governmental entity.
The tax is based on the number of units or on the physical quantity (for example,
number of cigarettes or volume of alcoholic content) produced by the entity, rather
than the selling price to customers.
The tax is due on accumulated earnings during a period of time, as opposed to
each individual sale transaction.
The entity cannot claim a refund of the tax in the event that the related inventory is
not sold or the customer fails to pay for the goods or services being sold.
The entity has no legal or constructive obligation to change prices in order to reflect
taxes. Conversely, where the tax is clearly separate from the selling price, and a
change in the tax would result in an equivalent change in the amount passed
through to the customer, this might indicate that the entity is collecting the tax on
behalf of the government.
The above indicators should be considered along with the intended purpose of the tax, as written into the tax legislation in
the particular jurisdiction. The existence (or non-existence) of one of the above indicators might not be determinative on its
own.
Example A: Entity A is the principal for the excise duty, because the triggering event is the movement of products (as
opposed to sales to customers), Entity A makes a decision whether to adjust the selling price of products to pass the tax on
to the customer, and it cannot claim a refund in the event of a customer’s failure to pay. Entity A should therefore recognise
the excise duty as an expense, as opposed to a reduction of transaction price.
Example B: Entity B is likely collecting the sales tax as an agent on behalf of a governmental agency. The triggering event is
sales to customers, the tax is separately charged to customers, and Entity B receives a refund if the receivables are not
collected. Entity B should therefore exclude the sales tax collected from customers from the transaction price, and no
expense would be recognised for the tax. The collection and payment of the tax would only impact balance sheet accounts.
4 Property and Impairment
4.1 Determining CGUs for multi-site retailers

Background
Retailer A owns many stores, both domestic and international. The stores are generally located in different neighbourhoods
or airports; however, Stores X and Y are located in the same neighbourhood. All retail purchases, pricing, marketing,
advertising and human resource policies (except for hiring of individual store cashiers and sales staff) are performed for all
stores centrally. In addition, the products sold by each store are the same.
Issue
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Should Stores X and Y be combined for impairment testing purposes?
Solution
No. Conventional retail stores would typically be separate cash-generating units (CGUs), because each store generates cash
inflows that are independent of other stores in the chain. A CGU is defined as the ‘smallest identifiable group of assets that
generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets’ [IAS 36 para
6]. IAS 36 Illustrative Examples [Example 1] consider CGUs for a chain retailer with multiple stores in the same city, although
based in different neighbourhoods, and concludes that the CGU is at a store level.
An IFRS Interpretations Committee Agenda Decision in March 2007 states that ‘independent cash inflow’ in IAS 36 does not
mean net cash flow. Cash outflows are therefore not taken into consideration in the analysis. In the case of Stores X and Y,
the fact that costs are incurred centrally is not relevant.
Where independent cash inflows cannot be clearly identified and judgement is required, it might be useful to consider other
indicators, including how management monitors operations. Further guidance can be found in FAQ 24.32.7.
4.2 Impairment – Value in use for retail outlet

Background
Retailer X has a number of individual retail stores which are leased. Each store has a right-of-use (RoU) asset as well as
property, plant and equipment which has been added to the leased retail store in the form of leasehold improvements.
Issue
How should leased retail stores be tested for impairment?
Solution
A lessee applies IAS 36 to determine whether the leased retail store is impaired and to account for any impairment loss
identified. In most cases, each leased retail store will comprise an RoU asset, as well as property, plant and equipment
which has been added to the leased retail store, such as leasehold improvements and store fixtures and fittings. It is unlikely
that any one of these assets could generate cash inflows independently from the others, but it is likely that together they will.
Therefore, the combined store assets should be assessed for impairment as one CGU, along with an allocation of assets
(such as corporate assets) that are indirectly attributable to the CGU where such an allocation can be made, on a reasonable
and consistent basis.
The assets (and liabilities, where appropriate) attributed to each CGU should be consistent with the estimated future cash
flows that are identified for calculating the recoverable amount. In determining the store’s recoverable amount using a value-
in-use (ViU) model, all future cash inflows and outflows associated with the store are included.
While RoU assets are included in a CGU when testing using a ViU model, the related lease liabilities should be excluded.
This is because these are a form of financing, and all financing cash flows are explicitly excluded from ViU in accordance
with paragraph 50(a) of IAS 36.
In some circumstances, liabilities cannot be separated from the related assets (for example, where a purchaser could not, or
would not, acquire the asset or business without the liability). This apparent conflict was considered by the IFRIC in 2016,
which noted that IAS 36 requires the carrying amount of a recognised liability to be deducted from both the carrying amount
of a CGU and the amount determined under ViU without the cash outflows associated with the liability. What this means is
that including the lease liabilities in the CGU would have a neutral impact on a ViU test.
The expected cash flow model will:
Include the RoU asset in the carrying amount of the CGU;

Exclude the lease liability from the carrying amount of the CGU because it relates
to financing;
Exclude the lease payments included in the lease liability in the ViU calculation;
Include cash outflows to replace leased assets at the end of the lease term which
are essential to the ongoing operation of the CGU (that is, the RoU asset being
tested for impairment only reflects the existing lease) – refer to section 4.6 below
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for further guidance on cash outflows to replace leased assets in a value in use
model; an
Include cash outflows for expected future variable rents and short-term and low-
value leases that are not included in the lease liability. [IAS 36 para 75]
Projected future pre-tax cash flows are discounted at a pre-tax rate that reflects both current market assessments of the
time value of money and the risks specific to the asset/CGU for which the future cash flow estimates have not been
adjusted. The weighted average cost of capital (WACC) might serve as a reference point, but it should reflect a market
assessment of an adequate capital structure, represented by the respective peer group companies and not the entity’s own
capital structure.
Lease liabilities would be expected to be considered as an additional debt-like element of the capital structure, in addition to
existing debt and equity.
The WACC needs to reflect the peer group’s capital structure. Therefore, retailers should take care to identify an appropriate
peer group. In particular, the peer group should reflect entities which have a similar mix of freehold and leasehold properties
in the store portfolio.
In practice, impairment testing is often performed using a post-tax discount rate. This is because observable market rates of
return are generally post-tax rates, so in practice ViU is typically calculated by discounting post-tax cash flows at a post-tax
discount rate as a proxy for discounting pre-tax cash flows with a pre-tax discount rate. This only works if the pre-tax
discount rate is the post-tax discount rate adjusted to reflect the specific amount and timing of the future tax cash flows.
Where there are significant temporary differences (recognised and unrecognised), the tax cash flows need to be adjusted to
remove the discrepancies in this calculation. A way to deal with temporary differences when post-tax cash flows are used in
practice to determine value in use, is to calculate the tax cash flows as if the tax base of the CGU’s assets and liabilities were
equal to their carrying amount.
4.3 Impairment – Flagship stores

Background
Retailers might invest in a cash-generating unit (CGU) that not only generates its own independent cash inflows but also
provides benefits to other store CGUs within the group (‘cross-subsidisation CGUs’). The cross-subsidisation CGUs can
often be loss making; however, when taken together with the benefit that they provide to other CGUs, they add economic
value to the entity.
For example, Retailer A opens a new flagship store in an attractive location. The store will generate independent cash
inflows, but it is also designed to increase publicity for the brand and drive sales growth in other stores or increase online
sales.
Issue
How should Retailer A perform an impairment test on a flagship store CGU which benefits other store CGUs in the group?
Solution
A flagship store, acting as a cross-subsidisation CGU, generates cash inflows that are independent of the cash inflows from
other assets or groups of assets [IAS 36 para 6], and so it meets the definition of a CGU in its own right. An impairment test
will therefore need to be performed for the flagship store if there is an indicator of impairment.
An entity generally identifies that a flagship store is a cross-subsidisation CGU when the store is initially established. It would
generally be inappropriate to identify the flagship store as a cross-subsidisation CGU at a later date (for example, when there
was a potential risk of impairment).
Retailer A should analyse the benefits that the flagship store provides to other store CGUs to determine what cash flows
should be included in the flagship store’s recoverable amount. For example, a flagship store might bear costs (cash outflows)
which benefit the other stores, such as advertising and showcasing of the group’s brand. In this case, the flagship store can
impute an internal transfer cash inflow in the recoverable amount calculation [IAS 36 Example 1B]. This notional cash inflow
should be based on ‘management's best estimate of future prices that could be achieved in an arms-length transaction’ [IAS
36 para 71]. It might be challenging to quantify accurately the cost savings that the flagship store generates for other CGUs.
The approach to estimating the notional cash flow might depend on whether there is external evidence available for the
services provided. Where there is no external or public information available, an acceptable approach might be to use the
business plan approved by management at the time of investing in the flagship store (for example, the signing of the new
lease contract for a flagship store), since this might help to determine what notional cash flows would be required in order to
arrive at a return on investment similar to other stores in the group. The estimated internal transfer cash inflow allocated to
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the flagship store should be carefully monitored on an ongoing basis, in order to ensure that the flagship store provides
incremental benefit to the broader business and that the notional recharge is reasonable.
Where an impairment does arise from a test, the flagship store's impairment would be the incremental loss that is not
covered by actual flagship store sales plus the notional recharges.
Management should also consider if an impairment indicator is identified for the other store CGUs which benefit from the
presence and activities of the flagship store. The individual impairment assessments for those store CGUs should reflect
their share, on a reasonable and consistent basis, of the notional cash outflow.
4.4 Impairment – Online sales allocation

Background
Retailer X has traditionally only sold goods physically in its 50 retail stores. However, over the last 10 years, it has invested
heavily in its online presence and seen exponential online sales growth in recent years as consumers continue to move their
shopping preferences from store to online. Retailer X’s customers are able to order their goods online from:
Home and have them delivered to their home or other convenient collection point
(that is, not one of Retailer X’s stores);
Home and pick them up from a store;

An in-store order point and have them delivered to their home/collection point; or
An in-store order point and pick them up from a store.
Online sales that are delivered to the customer’s home can be sourced from the Retailer X’s central distribution centre or
from an individual store’s inventory.
In the case where goods purchased online are returned, customers have the option to return the goods by post or by taking
the goods to a store.
Issue
How should online sales and returns be allocated to a retail store when assessing that store (CGU) for impairment?
Solution
IAS 36 requires identification of CGUs for impairment testing purposes that are the ‘smallest identifiable group of assets that
generate cash inflows that are largely independent of the cash inflows from other assets or groups of assets’ [IAS 36 para 6].
Typically, this will be individual retail stores, because each location is considered to operate independently. The growth of
online sales introduces cash flows that might or might not be independent of physical stores, and determining CGUs as well
as allocating such online sales to stores/CGUs can be difficult to apply in practice, and judgement might be required.
In order to evidence that a sale is derived from a particular retail store, it is important that there is a demonstrable and direct
link between the sale and the store.
In the fact pattern outlined in the question above, Retailer X concludes that it is appropriate to include the following cash
inflows in an impairment assessment of a store CGU as follows:
Goods ordered online from the customer’s home and delivered directly from a
specific store to the customer or to an agreed collection point serviced by a
specific store would be allocated to the specific store CGU – the link between
online order and store is established, because the store provides the goods.
However, sales ordered online from the customer’s home and delivered from a
central warehouse would not typically be allocated to a specific store, even if the
customer has them shipped to a location in the vicinity of a specific retail store or
the customer’s shipping address is closest to a particular store.
Goods ordered online from home by the customer and picked up by the customer
directly from a store CGU – the link between sale and store is established, because
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the store typically sells the product and the customer picks it up from that store.
Goods ordered online from an in-store order point (that is, in the store CGU under
review) and delivered directly to the customer’s home – in this case, it might not
matter whether the goods are shipped from a central warehouse or from the store
directly, because the link between sale and store has been established by the fact
that the customer ordered the goods from the store’s premises itself and the store
typically sells these products.
Goods ordered online from an in-store order point (that is, in the store CGU under
review) and picked up from that store – in this case, the link between the sale and
store is clearly established.
In these cases, Retailer X has a demonstrable and direct link that evidences that these sales are derived from a particular
store (in other words, the goods are either ordered from that store and/or picked up from that store), with the exception of
the case where a customer orders from home and the goods are being shipped from a centralised warehouse to the
customer’s home.
There might be other, different ways in which customers can order and receive products, and different ways in which
retailers will distribute the product. Each entity needs to make a judgement about whether there is a demonstrable and direct
link between a store and an online sale. Only if such a link is established and evidenced can online sales be allocated to a
particular store. To the extent that it is material, entities should disclose the approach as part of their accounting policies and
consider whether the policy represents a significant accounting judgement, as defined by IAS 1.
The principle of comparing ‘like for like’ applies to the cash outflows associated with returns. Cash outflows associated with
goods that are returned to a store should be deducted from the store’s cash flows for the purposes of impairment only if the
cash flows from the original sale were recognised as part of that store’s cash inflows when assessing impairment.
4.5 Impairment – Allocation of head office

costs and assets

Background
Entity X has 20 leased retail stores. The stores offer in-store sales, and customers can also order shopping online. Entity X
owns a separate headquarter building and a central warehouse. These corporate assets house various typical functions such
as marketing, advertising, IT, HR, payroll, accounting, administration etc. One of the stores (Store Y, a CGU) is loss-making,
and management is looking at testing this store for impairment.
Issue
What should be considered – with regard to online sales, head office costs and corporate recharges – in determining the
value in use for the purpose of testing Store Y for impairment?
Solution
Online sales that are directly attributable to Store Y should be allocated when assessing that store for impairment. Such
sales would include sales that were ordered online and subsequently collected in Store Y. See FAQ 4.4 for more guidance on
allocating online sales and returns.
Cash flows should also include projections of future overheads in relation to head office functions, as well as central
warehousing that can be attributed directly, or allocated on a reasonable and consistent basis, to the use of the store, in
accordance with paragraph 41 of IAS 36.
In accordance with paragraph 102 of IAS 36, corporate assets that relate to the Store Y CGU should be identified, and a
portion of the carrying amount should be allocated to Store Y if it can be allocated on a reasonable and consistent basis to
this store.
Any allocation is inherently judgemental and it is important to ensure that corporate overheads are not omitted or double
counted in the value in use calculations. For example, if part of the carrying value of a corporate property is allocated to
Store Y for the purpose of the impairment review, any internal management charges paid by Store Y relating to the use of
that property should be excluded from their cash outflows, where inclusion would result in double counting.
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4.6 Impairment – Replacement cash flows for

leased assets

Background
Entity A has a right-of-use (RoU) asset within a cash generating unit (CGU). The lease cash outflows in respect of this lease
should be excluded from the CGU cash flows in a value in use (ViU) model, because paragraph 50 of IAS 36 excludes cash
flows from financing activities. The CGU requires an equivalent asset after the lease ends to continue operating, and so
Entity A should include the replacement of the lease asset as a cash outflow in a ViU model. If the use of replacement assets
is expected to continue for the foreseeable future, cash outflows might need to be reflected in the terminal value.
Issue
What are the practical ways to include cash outflows to replace leased assets in a ViU model?
Solution
Entity A has the option to either purchase a replacement asset via capital expenditure or enter into another lease for a similar
asset.
Irrespective of the method chosen by management for financing the acquisition of the replacement asset (that is, purchase
or lease renewal), the ViU model should include cash outflows for replacement of the asset in the year in which the existing
lease expires and in subsequent years. The modelling might be complex for CGUs with large RoU asset portfolios.
One of the possible practical solutions is to use annual depreciation of the CGU’s RoU assets as a proxy for replacement
asset cash outflows after the lease term. This simplification is only possible for ‘steady state’ lease portfolios (relatively
constant flow of renewals). Inflation should also be considered, because depreciation is a historical measure. Where inflation
is not negligible, depreciation should be inflation-adjusted to avoid understatement of future cash outflows.
This method can be illustrated by the following simplified example. At 31 December 20X0, Entity A has a lease with an
annual lease payment of CU100 a year and an RoU asset of CU190 with a useful life of 2 years (the remaining lease term)
and annual depreciation charge of CU95. The existing RoU asset would depreciate to nil over Years 1 and 2
ViU model Year 1 Year 2 Year 3 Year 4
CGU assets Existing RoU asset in CGU Replacement leased asset not in the CGU ass
Lease payments excluded from cash flow Cash outflows will be included for replacemen
asset annual depreciation charge might be us
ViU cashflows Exclude cash outflow Exclude cash outflow Include cash outflow Include cash outflow
of CU100 of CU100 of CU95 adjusted for of CU95 adjusted fo
inflation inflation
This method is only one of the possible approaches, and other methods might be appropriate. For example, this method
might not be appropriate for lumpy lease portfolios, in which case more detailed forecasting would be required.
4.7 Depreciation of an idle asset

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Background
As a result of government regulations, Retailer Y is not permitted to open its leased store for a period of time. In addition,
access to the store is limited, and Retailer Y is not permitted to do any renovation work in the store or use the store as a
warehouse for online sales; however, goods remain stored in the premises. Retailer Y depreciates the right of use (RoU)
asset in accordance with IAS 16, which results in depreciation on a straight-line basis or another systematic basis that is
more representative of the pattern in which the entity expects to consume the RoU asset. For this RoU asset, the
predominant limiting factor is the period of time for which the lessee has contractual rights to use the underlying asset over
the lease term, so it is therefore depreciated on a straight-line basis.
Issue
Can Retailer Y stop depreciating an asset if it is idle?
Solution
During the period of the closure, it would not be appropriate for Retailer Y to stop depreciating the RoU asset or to change
its method of depreciation. This is because depreciation does not cease when the asset becomes idle under the straight-line
method of depreciation.
Retailer Y applies the guidance in IAS 16 in depreciating the RoU asset. Paragraph 55 of IAS 16 requires depreciation of an
asset to begin when it is available for use, and to cease at the earlier of the date when the asset is classified as held for sale
(or included in a disposal group that is classified as held for sale) in accordance with IFRS 5 and the date when the asset is
derecognised. Therefore, depreciation does not cease when the asset becomes idle, unless the asset is fully depreciated.
4.8 Sub-letting of retail space – Investment

property classification

Background
Retailer C owns a property that it partially uses for its own operations as a supermarket, but some separated shops are sub-
leased to other entities.
Issue
Should Retailer C treat the sub-leased areas as investment property?
Solution
An investment property is a building which Retailer C owns or leases with the intention of earning rent or holding for capital
appreciation, or both. A building which is held for use in the supply of goods or for administrative purposes is not an
investment property, and it is within the scope of IAS 16.
A property could be partly owner-occupied and partly held for rental income or capital appreciation. Paragraph 10 of IAS 40
acknowledges that properties can include a portion that is held to earn rentals or for capital appreciation, and another
portion that is held for use in production or supply of goods or services, or administration. If the portions could be leased out
separately under a finance lease or sold, an entity accounts for the portions separately.
Retailer C needs to determine if the portion consisting of the separated shops that are currently sub-leased could be sold or
leased out under a finance lease. If that is the case, and Retailer C holds this portion of the property to earn rentals, that
portion would be accounted for separately as investment property.
The whole supermarket would be treated as owner-occupied where the portions could not be sold or leased out as a finance
lease separately unless only an insignificant portion is owner-occupied. If an insignificant portion is owner-occupied the
whole building could be classified as an investment property. This assessment might require judgement.
5 Leases
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5.1 Definition of a lease – Retail units

Background
Retailer A enters into a contract with a property owner that provides Retailer A the right to use an explicitly specified retail
unit for a period of five years. The property owner can require Retailer A to move into another retail unit; there are several
retail units of similar quality and specification available.
Because the property owner has to pay for any relocation costs, it can benefit economically from relocating Retailer A only if
there is another entity that wants to occupy a large amount of retail space at a rate that is sufficient to cover the relocation
costs. Those circumstances might arise, but they are not considered likely to occur.
The contract requires Retailer A to sell goods during the opening hours of the larger retail space. Retailer A decides on the
mix of goods sold, the pricing of the goods sold and the quantities of inventory held. Retailer A also controls physical access
to the retail unit throughout the five-year period of use.
The rent that the Retailer A pays includes a fixed amount plus a percentage of the sales from the retail unit.
Issue
Solution
IFRS 16 states that ‘a contract is, or contains, a lease if the contract conveys the right to control the use of an identified
asset for a period of time in exchange for consideration’. In order to assess whether it has a lease, Retailer A needs to
determine whether there is an identified asset and then assess whether it has both the right to obtain substantially all of the
economic benefits and the right to direct the use of the identified asset.
Is there an identified asset?
The retail unit is explicitly specified in the contract. The property owner has a right to substitute the asset; however,
the substitution right is not substantive, because the property owner would benefit from the exercise of the right only under
certain circumstances that are not considered likely to occur. The retail unit is an identified asset. [IFRS 16 App B para B13]
Does Retailer A have the right to obtain substantially all of the economic benefits from the use of the retail unit?
Retailer A has the exclusive use of the retail unit throughout the period of use. The fact that a part of the cash flows received
from the use are passed to the property owner as consideration does not prevent Retailer A from having the right to
substantially all of the economic benefits from the use of the retail unit. [IFRS 16 App B para B21]
Does Retailer A have the right to direct the use of the retail unit?
During the period of use, all decisions on how, and for what purpose, the retail unit is used are made by Retailer A.
The restriction that goods can only be sold during the opening hours of the larger retail space defines the scope of the
contract, but it does not limit Retailer A’s right to direct the use of the retail unit. [IFRS 16 App B para B24]
The contract contains a lease of a retail unit.
5.2 Retail units – Identifying components

within an arrangement

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Background
Retailer B leases a retail unit within a shopping mall together with shop fixtures and a storage bay. The lessor charges a fixed
payment on a monthly basis. The contract indicates that the fixed payment includes: (a) the rent for the retail unit, fixtures
and loading/storage bay; (b) property taxes and insurance; (c) security and cleaning; and (d) maintenance of the retail unit.
Issue
What are the components in this arrangement?
Solution
The lease components in the arrangement are the retail unit with the loading/storage bay and the fixtures. The non-lease
components are the security and cleaning, and the maintenance services. [IFRS 16 para 12]
Property taxes and insurance
Applying paragraph B33 of IFRS 16, the lessee has determined that, in its specific situation, the payments for property taxes
and insurance do not transfer a separate good or service, so they are not accounted for as a separate non-lease component.
They are instead considered as part of the total consideration allocated to the separately identified components of the
contract.
Fixtures
The fixtures are considered a separate lease component, since they are neither dependent on, nor highly interrelated with,
the retail unit or loading/storage bay. This is because they can be sourced from other providers and be used in other retail
units. Accordingly, the right to use the fixtures is a separate lease component.
Security and cleaning services
Security and cleaning services involve the provision of separate services to Retailer B, and they are considered as separate
non-lease components. Retailer B can either:
Separate the lease from the non-lease components, and allocate consideration to
each component; or
Apply the practical expedient, and account for both the lease and the associated
non-lease component as a single, combined lease component.
Due to the significance of the maintenance services, Retailer B elects not to apply the practical expedient of combining the
non- lease components with the associated lease components.
Once the lease and non-lease components are identified, contract consideration is allocated to each component. A lessee
should allocate the contract consideration to the separate lease and non-lease components, based on their relative stand-
alone prices.
The lessor should allocate contract consideration to the separate lease and non-lease components in accordance with the
transaction price allocation guidance in IFRS 15. The practical expedient available to a lessee, for lease and non-lease
components, is not available to a lessor. IFRS 15 specifies that amounts payable by the lessee for activities and costs that
do not transfer a good or service to the lessee (for example, property taxes and insurance) are not separate components of
the contract, but they are considered as part of the total consideration allocated to the separately identified components of
the contract.
5.3 Lease term – Incidence of a termination

option with a more than insignificant penalty

Background
Entity B enters into a lease contract with a lessor to lease a building on 1 January 20X1. The contract does not specify a
particular contractual term but continues indefinitely until either party gives notice to terminate. Entity B and the lessor each
have a right to terminate the contract, without permission from the other party, at the end of June in each calendar year,
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starting from 30 June 20X2, with a six-month termination notice (that is, the earliest right to terminate would be at 30 June
20X2, and the six-month notice period means that it would be effective at 31 December 20X2).
In the case where Entity B terminates the contract before the end of year 10, it has to pay a termination penalty to the lessor
equivalent to two years of lease payments, which is a more than insignificant penalty. If Entity B terminates the lease after
that period, no penalty is incurred. For the lessor, no termination penalty is incurred, regardless of when it terminates the
contract.
Issue
What is the lease term of the contract at the commencement date?
Solution
The following diagram illustrates the lease term, and associated non-cancellable and enforceable periods:
 View image
The lease term is determined taking into account the following:
Paragraph B34 of IFRS 16 explains that a lease is no longer enforceable when the
lessee and the lessor each have the right to terminate the lease without permission
from the other party with no more than an insignificant penalty. Before 10 years, the
lessee would incur a more than insignificant penalty to terminate. After 10 years,
both parties can terminate with no more than an insignificant penalty. The
enforceable period is therefore 10 years.
The non-cancellable period is 24 months, because the lessee cannot terminate the
lease with effect from a date earlier than 31 December 20X2 (considering the notice
period).
The guidance for lessee termination options should be applied, to decide what the
lease term is, between a minimum of the non-cancellable period of two years (18
months + 6 months’ notice) and a maximum of the enforceable period (10 years).
The lessee’s termination right within the first 10 years of the contract affects the
lease term if the lessee is not reasonably certain to continue to lease the building
during the first 10 years (that is, if it is reasonably certain not to exercise the
termination option) [IFRS 16 App B para B37]. If the lessee is reasonably certain to
continue the lease for the full enforceable period (after having taken into account all
relevant facts and circumstances creating an economic incentive not to exercise
the termination option), the lease term is 10 years. Conversely, if the lessee is not
reasonably certain to continue the lease at a certain point in time, despite the
termination penalty, the lease term ends at that point in time (taking into account
the notice period).
When evaluating whether the lessee is reasonably certain to not terminate, the
termination penalty is one relevant factor. [IFRS 16 App B para B37(c)]. In this case,
the magnitude of the penalty is likely to make the lessee reasonably certain to not
terminate the lease before 10 years, but the entity should consider all relevant facts
and circumstances (such as contractual terms and conditions for optional periods
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compared with market rates, significant leasehold improvements undertaken, and

the importance of the underlying asset to the lessee’s operations).
The IFRS Interpretations Committee (‘IC’) was asked how to determine the lease term of a cancellable or renewable lease,
and whether ‘penalty’ in paragraph B34 includes only contractual termination penalty payments or should also take into
account the broader economics of the contract. [IFRIC update November 2019]
The IC observed that the broader economics of the contract should be considered, and not only contractual penalty
payments. Such considerations include, for example, the cost of dismantling or abandoning leasehold improvements, costs
relating to the termination of the contract (such as the costs of finding a replacement lease, renegotiating or relocating), and
the importance of the asset to the lessee’s operations. Consequently, if either party would incur a penalty on termination that
is more than insignificant at any point in time, the enforceable period would include those periods.
5.4 Perpetual leases with bilateral termination

options

Background
Entity A enters into a lease of retail space. The lease continues in perpetuity, but both the lessor and the lessee have
termination options. The termination options are exercisable at any time; the entity exercising the termination option will bear
no more than an insignificant penalty. For both options, there are notice periods:
If the lessee exercises its option, the termination will be effective six months after
exercise.
If the lessor exercises its option, the termination will be effective 18 months after
exercise.
Issue
What is the lease term of the contract at the commencement date, and when is the lease term reassessed?
Solution
According to paragraph 18 of IFRS 16, an entity should determine the lease term as the non-cancellable period of a lease,
together with both the periods covered by an option to extend the lease (if the lessee is reasonably certain to exercise that
option) and the periods covered by an option to terminate the lease (if the lessee is reasonably certain not to exercise that
option).
First, Entity A should determine what the non-cancellable period is, which in this case is six months. Entity A should then
determine the enforceable period. A lease is no longer enforceable when the lessee and the lessor each have the right to
terminate the lease without permission from the other party with no more than an insignificant penalty. [IFRS 16 App B para
B34]
In this example, the enforceable period of the lease at the commencement date is 18 months. This is the period from the
commencement date of the lease to the earliest point in time at which both parties can terminate the contract with no more
than an insignificant penalty.
The guidance for lessee termination options should be applied to decide what the lease term is, between a minimum of the
non- cancellable period (six months, the lessee’s notice period) and a maximum of the enforceable period (18 months). If the
lessee is reasonably certain to continue (that is, not terminate) the lease for 18 months, the lease term would be 18 months.
At the commencement date, the non-cancellable period of the contract is six months (the lessee’s termination notice), and
the enforceable period is 18 months. The enforceable period is effectively the period from the commencement date of the
lease to the earliest point in time at which both parties can leave the contract and their contractual obligations with no more
than an insignificant penalty and without permission from the other party. The lease term will therefore be determined based
on the facts and circumstances specific to the lessee, between six and 18 months.
According to paragraph 21 of IFRS 16, the lease term is revised if the non-cancellable period of the lease changes. In this
example, provided that no party terminates the contract, the remaining non-cancellable period of the lease is maintained at
six months (such that the date on which the non-cancellable period ends changes every day to be one day later), with the
remaining enforceable period maintained at 18 months (such that the date on which the enforceable period ends also
changes every day to be one day later). Consequently, the remaining lease term will always be at least six months.
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Alternative scenario – same facts as above, except that the lessee is reasonably certain to ‘renew’ for 60 months
A lessee that is reasonably certain to continue the lease during 60 months has an economic incentive to remain in the
premises during that period [IFRS 16 App B para B37]. Consequently, Entity A would suffer a more than insignificant penalty
if it terminated the contract before the end of the 60-month period; and, based on paragraph B34 of IFRS 16, the contract is
enforceable for 60 months. The lease term is therefore 60 months (that is, the period during which the lessee is reasonably
certain to remain in the premises).
5.5 Reassessment of the lease term other than

when the lease contract is modified
Reference to standard: IFRS 16 App B para B41(c

Background
The assessment of the lease term is made at the commencement date, which corresponds to the date on which the lessor
makes the underlying asset available for use by a lessee.
When a lease is not modified, the lease term should be reassessed only in limited circumstances. In particular, IFRS 16
requires a lessee to reassess extension options and termination options when a significant event or change in circumstances
occurs that is within the control of the lessee and affects whether the lessee is reasonably certain to exercise an option.
[IFRS 16 para 20]
Issue
Which events trigger a reassessment of the lease term?
Solution
The significant events or changes that could result in a reassessment of the lease term in the retail industry could be:
Significant leasehold improvements undertaken, or expected to be undertaken,

after the commencement date: it is more likely that a lessee will exercise an
extension option if a lessee makes significant investments to improve the leased
asset or to tailor it for its special needs.
Decision to extend the lease of some retail stores, when the initial term expires,
taken during the preparation of the business plan that has been specifically
discussed in detail and disclosed to the relevant level of governance as a key
assumption of the business plan.
Decision to sub-lease the retail store, or a significant part of it, for a period beyond
the end of the initial lease term.
Decline in the attractiveness of a commercial area, leading to the decision to close
a store.
Business decisions that are directly relevant to exercising, or not exercising, an

option (such as a decision to close retail stores to focus on online sales, or the
outsourcing of warehouses).
A lessee is not required to continually reassess the lease term if there is no significant event or change in circumstances.
A change in market-based factors alone (for example, increases in market rents such that rents during the renewal period
would now be considered a bargain) should not trigger reassessment of the lease term.
A five-year business plan signed off by the board, that assumes that the entity will exercise the extension option at the end of
the initial term, is not enough to trigger a reassessment of the lease term. The board signing off the business plan is within
the control of the lessee. However, the passage of time increasing the likelihood of the entity extending the lease, or an
implicit assumption that the entity will extend, cannot be considered alone as a triggering event.
IFRS 16 also requires the lease term to be reassessed:
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Where the lessee exercises or does not exercise an option in a different way than
the entity had previously determined was reasonably certain; or
Where an event occurs that contractually obliges the lessee to exercise an option
that was not previously included in the determination of the lease term, or prohibits
the lessee from exercising an option that was previously included in the
determination of the lease term.
5.6 Lease liability – Extensions option at

market rates

Background
On 1 January 20X1, Entity A (lessee) enters into a lease of retail space. The non-cancellable lease term is seven years.
The annual lease payment is CU10,000 in the first year, with a 5% increase in every following year, and CU10,000 reflects the
market rent at the commencement date. Entity A has the option to extend the lease term for another five-year period. At the
commencement date, it concludes that it is reasonably certain to exercise the extension option.
Issue
How does Entity A determine the lease payments that are included in the lease liability in the examples below?
Solution
Example A – Cap on market rent at the date when the option is exercised
The revised rent for the extension period will be agreed by the lessor and the lessee at the date when the option is exercised,
based on the market rent at that time. The revised rent will, however, be no more than 105% of the rent at the end of the
preceding period.
Since Entity A is reasonably certain to exercise the extension option, the lease term is 12 years. All lease payments within
that period are included in the lease liability.
Because both lessor and lessee have to agree to the revised rent for the extension period, it can be assumed that the rent
will be the market rent at that time. Variable lease payments that depend on an index or a rate, such as payments that vary to
reflect changes in market rental rates, are initially measured using the index or rate as at the commencement date [IFRS 16
para 27]. The lease payments for the extension period that are included in the initial measurement of the lease liability are
therefore CU10,000 (market rent at the commencement date) for each year of the renewal period.
1 2 3 4 5 6 7 8–12
Lease payment [CU] 10,000 10,500 11,025 11,577 12,155 12,763 13,401 10,000
When Entity A agrees the amount of the first lease payment of the extension period (that is, the payment for year 8), it
remeasures the lease liability to reflect the market rent at that time.
Example B – Cap and floor on market rent at the date when the option is exercised
The revised rent for the extension period will be agreed by the lessor and Entity A at the date when the option is exercised,
based on the market rent at that time. There is, however, a cap and a floor such that the revised rent cannot be below 85%
or higher than 115% of the rent at the end of the preceding period. The lease payment throughout the extension period is
therefore at least (CU10,000 × 1.05^6) × 0.85 = CU11,391.
In scenario B, the payments throughout the extension period are not fully variable but floored. Since the floor of CU11,391 is
higher than the market rental rate at commencement date (CU10,000), the amount that is included in the initial measurement
of the lease liability for years 8–12 is CU11,391.
1 2 3 4 5 6 7 8–12
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Lease payment [CU] 10,000 10,500 11,025 11,577 12,155 12,763 13,401 11,391
When Entity A agrees the amount for the first lease payment of the extension period (that is, the payment for year 8), it
remeasures the lease liability to reflect the market rent at that time.
Example C – Higher of year 7 rent and market rent at the date when the option is exercised
The revised rent for the extension period is the higher of (i) the rent paid in year 7 (CU13,401), and (ii) the current market rent
at the date of the commencement of the extension period (either to be agreed by the lessor and the lessee, or determined by
an independent surveyor).
Similar to scenario B, the payments throughout the extension period are not fully variable but floored. In scenario C, the floor
is the lease payment made in year 7 (CU13,401). Since the floor of CU13,401 is higher than the market rental rate at the
commencement date (CU10,000), the amount that is included in the initial measurement of the lease liability for years 8–12 is
CU13,401.
1 2 3 4 5 6 7 8–12
Lease payment [CU] 10,000 10,500 11,025 11,577 12,155 12,763 13,401 13,401
When Entity A agrees the amount of the first lease payment of the extension period (that is, the payment for year 8), it
remeasures the lease liability to reflect the market rent at that time if that is higher than CU13,401.
5.7 Lease modification that is not accounted

for as a separate lease

Background
Retailer C enters into an agreement to modify an existing lease contract to grant the lessee the right to use additional retail
space. The increase in rent is lower than the stand-alone price for the additional retail space and any appropriate
adjustments.
Issue
How does Retailer C account for the modification if the effective date of the modification is before the commencement date
of the new lease component?
Solution
Since the increase in consideration is not commensurate with the stand-alone price for the increased space, the lease
modification is not accounted for as a separate lease. In this context, the respective discount relates to both the new lease
component (additional retail space) and the existing lease component. Thus, the modification affects both the existing and
the additional right of use, and it needs to be allocated to the respective components.
The lease liability relating to the existing lease is remeasured at the date of the modification. [IFRS 16 para 45]. Retailer C
should remeasure the lease liability at the effective date of the modification, using a revised discount rate, and it makes a
corresponding adjustment to the right-of-use asset. The revised discount rate is the interest rate implicit in the lease for the
remainder of the lease term. Retailer C uses its incremental borrowing rate at that time if the interest rate implicit in the lease
is not readily determinable.
With respect to the new lease component, where the commencement date deviates from the effective date of the lease
modification, the measurement of the lease liability takes place at the date of the modification [IFRS 16 para 45], whereas
recognition of the additional lease component takes place at the commencement date. [IFRS 16 para 22]
5.8 Lease modification – Decrease in scope of a

lease
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Background
Entity B enters into a lease for 5,000 square metres of retail space for 10 years. The lease payments are fixed at CU50,000
per annum. After five years, the parties amend the contract to reduce the office space by 2,500 square metres. From year 6
onwards, the annual lease payments will be CU30,000. At the beginning of year 6, the lessee’s incremental borrowing rate is
5% (assume that the rate implicit in the lease at that date is not readily determinable).
The carrying amounts of the lease liability and right-of-use asset before modification are as follows:
Right-of-use asset CU184,002

Lease liability CU210,61
Issue
How is the modification accounted for?
Solution
The value of the lease liability after the modification is CU129,884:
 View image
In a first step, the right-of-use asset and the lease liability are reduced by 50%, because the original retail space is reduced
by 50%. The difference between these two amounts is recognised as a gain in profit or loss:
Lease liability (50% of the carrying amount before modification) CU105,309

Right-of-use asset (50% of the carrying amount before modification) CU92,001
Gain CU13,308
In a second step, the right-of-use asset has to be adjusted to reflect the updated discount rate and the change in the
consideration. Accordingly, the difference between the remaining lease liability (CU105,309) and the modified lease liability
(CU129,884) is recognised as an adjustment to the right-of-use asset:
Right-of-use asset CU24,575

Lease liability CU24,575
5.9 Voluntary forgiveness of lease payments
The IASB issued an amendment to IFRS 16, ‘Leases’, to make it easier for
lessees to account for COVID-19-related rent concessions such as rent holidays
and temporary rent reductions. The amendment exempts lessees from having to
consider individual lease contracts to determine whether rent concessions
occurring as a direct consequence of the COVID-19 pandemic are lease
modifications, and it allows lessees to account for such rent concessions as if
they were not lease modifications. It applies to COVID-19-related rent
concessions that reduce lease payments due on or before 30 June 2022. In the
following example, the lessee does not apply the practical expedient on rent
concessions related to COVID-19.
Background
Lessors might agree to forgive some amount of payments contractually due under a lease contract, without changing the
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scope of the lease or any other terms (for example, to support a lessee who is in financial difficulty).
Issue
How should such a forgiveness of lease payments be accounted for by the lessee where such reductions are not required by
the contract or by laws or regulation?
Solution
IFRS 9 and IFRS 16 contain different guidance for the treatment of such voluntary forgiveness of lease payments. Therefore,
we believe that a policy choice exists for such reductions.
A lessee could consider the rent reduction to be a partial extinguishment of the lease liability. Paragraph 2(b)(ii) of IFRS 9
notes that lease liabilities recognised by a lessee are subject to the derecognition requirements in IFRS 9. Paragraph 3.3.1 of
IFRS 9 establishes that a financial liability should be derecognised when it is extinguished, and that includes when the
obligation specified in the contract is cancelled. Under this accounting, the forgiveness would be recognised as a gain in the
income statement, with a corresponding reduction in the lease liability in the period in which the reduction is contractually
agreed.
Alternatively, a lessee could consider that the rent reduction is a lease modification, because there is a change in the
consideration for the lease (that is, the reduction was not part of the original terms of the lease), and it could apply
paragraphs 44–46 of IFRS 16. In this case, the lessee would remeasure the present value of the remaining payments
required under the lease using a revised discount rate (that is, the rate implicit in the lease or the incremental borrowing rate,
as appropriate) at the date of the modification, and any difference from the previous carrying value would adjust the right-of-
use asset.
Entities should choose their treatment as an accounting policy and apply it consistently to amendments to contracts with
similar characteristics and in similar circumstances. Entities should also take into consideration local regulators' views when
selecting their accounting policy.
5.10 Lease modification following Company

Voluntary Arrangement (CVA)

Background
Retailer X is in financial difficulty and has entered into a Company Voluntary Arrangement (CVA) to restructure and to
hopefully avoid entering administration. As a result, Retailer X has renegotiated its lease contracts, moving from fixed lease
payments to a fully revenue-based payment model. The lease contracts are for leases with terms between three and five
years remaining on them.
Issue
How should the change in lease payments be accounted for?
Solution
This would be considered a lease modification, because the consideration for the lease has been changed from the original
lease contracts. The modification is not accounted for as a separate lease, since the conditions in paragraph 44 of IFRS 16
are not met; there is no right of use added. Instead, the lease liability is remeasured using a revised discount rate determined
at the effective date of the modification. Variable lease payments that are not based on an index or rate are not part of the
lease liability, but they are recognised in the income statement when the event or condition that triggers those payments
occurs. In this example, the revenue-linked lease payments would be recognised as the revenue is earned. The lease liability
would therefore be fully derecognised at the date of the modification, with a corresponding adjustment to the right-of-use
asset. [IFRS 16 paras 44–46].
5.11 Accounting for ‘key money’

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Background
Retailer C entered a long-term lease agreement for a store in a prime location. Retailer C paid ‘key money’ to the incumbent
tenant to take over the space. Under local law, Retailer C has the right to ask for renewal of the lease at the end of the initial
lease term (at rates which do not necessarily reflect market terms). If the lessor refuses the renewal, it must indemnify the
lessee for the damages suffered. Alternatively, Retailer C might choose not to ask for a renewal at the end of the initial lease
term, in which case it could allow a new tenant to take over the premises and would be entitled to receive key money from
the new lessee.
The retailer expects to be able to recover the original amount paid when it vacates the premises, through either an
indemnification from the lessor or key money from a new lessee.
Issue
How should Retailer C account for the key money paid?
Solution
Payments from a new lessee to an old lessee qualify as initial direct costs, and they are included in the initial measurement of
the right-of-use asset.
When determining the subsequent measurement of the right-of-use asset, one acceptable approach is to treat the key
money as a separate component of the right-of-use asset when applying the depreciation requirements of IAS 16, as
required by paragraph 31 of IFRS 16. Such a treatment, in line with paragraphs 43 and 44 of IAS 16, recognises that the key
money provides financial benefits over a period longer than the IFRS 16 lease term. Paragraph 52 of IAS 16 states that
depreciation is recognised, provided that the residual value does not exceed the asset’s carrying amount. If the retailer
expects that the residual amount will be equal to, or exceed, the key money component, the depreciation charge will be zero
for this component. [IAS 16 para 54]
An alternative approach is to treat the right-of-use asset (that is, including the key money) as a single asset, viewing the key
money as linked to the right-of-use asset itself. The contract as a whole (including the key money) gives several rights to the
tenant, which would not be distinguished under this approach, and the right-of-use asset has a residual value based on what
the lessee expects to recover when it vacates the premises. Under this approach, subsequent increases in the expected
recoverable amount of the key money will therefore increase the residual value of the right-of-use asset as a whole, and
hence reduce the total depreciation charge.
Applying IFRS 16 to key money might represent a critical accounting judgement, in which case the lessee should consider
the IAS 1 disclosure requirements.
5.12 Accounting for dilapidation and

restoration costs related to a leased asset

Background
Retailer A leases a retail store and, as part of the lease contract, it is obliged to return the store in the same condition that it
received it.
Issue
How should Retailer A account for obligations associated with dilapidation and restoration for a leased asset?
Solution
Mezzanine floor
Retailer A installs a mezzanine floor and recognises a provision under IAS 37 to remove it at the end of the lease. The
obligation arises when Retailer A completes the improvements, which is the past event. Retailer A includes the
corresponding entry as part of the right-of-use asset, applying paragraph 24(d) of IFRS 16.
Although the guidance in paragraph 24(d) of IFRS 16 is in the initial measurement section, paragraph 25 states that the
restoration costs should be recognised as part of the cost of the right-of-use asset when the retailer incurs an obligation for
those costs. For example, if the mezzanine floor is installed midway through the lease term, the retailer can still capitalise it
into the right-of-use asset.
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Dilapidations (that is, ‘wear and tear’)
During the lease term, Retailer A incurs wear and tear damage which it will need to repair at the end of the lease term. A
provision should be made for the estimated costs of the repairs over the period of the tenancy, because:
The tenant has a present contractual obligation, arising from the lease agreement.
The obligating event is the wear and tear to the property, which arises over the
period of the tenancy.
The obligation arises from the wear and tear to the property, and it is not related to
future operating costs.
It is probable that the obligation will result in an outflow of economic benefits.

It is possible to make a reliable estimate of the obligation arising from the wear and
tear.
It should be clear from the lease whether or not an obligation exists. A provision
should be recognised when any damage is identified.
Retailer A should recognise the corresponding entry as an expense. The provision for wear and tear does not create an
asset. The Basis for Conclusions to IFRS 16 explains that the measurement of right-of-use assets at cost is intended to be
consistent with IAS 16, which only allows restoration and removal costs to be capitalised if they relate to an asset’s
installation, construction or acquisition.
6 Inventory and other expenditure
6.1 Accounting for distribution costs

Background
Retailer A purchases finished goods from a manufacturer and sells those goods to end-consumers in retail stores. It
operates a distribution network that requires both transportation as well as storage. The storage costs include charges for
depreciation of right-of-use assets and lease interest, expenses for packaging and handling as well as utilities.
Issue
Can Retailer A capitalise the costs of distribution and storage into inventories?
Solution
Paragraph 10 of IAS 2 specifies that the cost of inventories includes the cost of materials and the cost of converting those
materials into finished goods. This includes the purchase price as well as all other costs necessary to bring them to their
present location and condition. In this case, it would be reasonable for Retailer A to conclude that the costs incurred to
transport the goods from the manufacturer to the retail store could be included in the cost of inventories. This is because the
transportation is essential to put the goods on sale at a particular location in an appropriate condition.
Storage costs are generally expensed, because they are deemed unnecessary in the production process. [IAS 2 para 16(b)].
In limited cases, storage activities might constitute an unavoidable part of the supply chain necessary to bring the inventories
to their present location (and be capitalised into the cost of inventory). This could be the case if they represent necessary
intermediate storage for a short period to facilitate transfer of goods to the point of initial sale.
The assessment of which costs are capitalised as inventory might require judgement, to determine which costs are
necessary to get the inventories to their present location and condition. For example:
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Costs incurred in transporting an item to its initial point of sale can generally be
capitalised as part of the cost of inventories; but
Costs associated with moving inventories from one point of sale to another (for
example, transport of goods between stores) should generally not be included in
the cost of inventories, because the goods were already in a condition and location
for sale before the move.
The judgement about which cost elements are necessary costs to get the inventories to their present location and condition
might be challenging in the context of a complex supply chain and/or several distribution channels.
Where an entity analyses expenses by function, paragraph 38 of IAS 2 specifies that ‘cost of sales’ should include costs
previously included in the measurement of inventory that has now been sold, unallocated production overheads, and
abnormal amounts of production costs of inventories.
6.2 Rebates and other variable consideration

paid to suppliers

Background
Retailer B purchases goods for resale from a manufacturer for CU100 per unit. Retailer B receives rebates from the
manufacturer based on the volume of goods purchased during each calendar period (1 January to 31 December). The rebate
agreement is summarised as follows:
Scenario 1 – Rebate is on entire units purchased during the year
Rebate on all units Average price per unit
0–100,000 units 0% CU100
100,000–500,000 units 10% CU90
500,000+ units 20% CU80
Scenario 2 – Rebate is graduated and only available on units above the threshold
Rebate only on units above all Average price per unit

threshold
0–100,000 units 0% CU100
100,000–500,000 units 10% CU92 (if 500,000 units purchased)
500,000+ units 20% CU86 (if 1,000,000 units purchased)
Retailer B prepares its annual financial statements as at 31 March. During the period from 1 January to 31 March 20X0,
Retailer B purchased 200,000 units. During the period from 1 April to 31 December 20X0, the retailer expects to purchase
another 400,000 units.
Issue
How should Retailer B measure the cost of inventory for the 200,000 units purchased prior to 31 March 20X0?
Solution
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IAS 2 does not provide specific guidance on the recognition and measurement principles for variable rebates. The right to
the cash flows from the rebate is contingent on future purchases and, therefore, does not represent a financial asset. The
general principles around asset recognition in other IFRS standards rely on the concept of expected cash flows (estimated
based on either a weighted average or an expected outcome approach). Therefore, it would be appropriate to apply these
concepts to estimating cost of inventory. IE paragraph B23 of IAS 34 supports this approach by requiring that volume
rebates or discounts – and other contractual changes in the prices of raw materials, labour, or other purchased goods and
services – are anticipated in interim periods, by both the payer and the recipient, if it is probable that they have been earned
or will take effect.
The determination of what is probable is a judgement that might depend on a number of factors, such as the entity’s
experience with similar products and the factors outside the entity’s control that could affect the entity’s ability to make
future purchases. Therefore, in some cases, it might only become probable that the rebate will be earned when the threshold
is close to being met. If it is deemed probable, the scenarios would lead to the following cost of inventory:
Scenario 1 – Retailer B would recognise the cost of inventory for 200,000 units
purchased in Q4 at CU16m, based on an average cost of CU80.
Scenario 2 – Retailer B would recognise the cost of inventory for 200,000 units
purchased in Q4 at CU18m, based on an average cost of CU90. This is calculated
based on total estimated purchases of 600,000 for a total of CU54m (CU10m
(100,000 units at CU100) + CU36m (400,000 units at CU90 per unit) + 8m (100,000
units at CU 80 per unit).
Estimating the amount of the rebate to be received is often judgemental. If this judgement is significant, disclosure should be
provided in accordance with paragraph 122 of IAS 1 in addition to the required disclosure about estimates in accordance
with paragraph 125 of IAS 1.
6.3 Allocating overhead costs to inventory

Background
The following is relevant information for Entity A:
Full capacity is 10,000 labour hours in a year.
Normal capacity is 7,500 labour hours in a year.

Actual labour hours for the current period are 6,500 hours.
Total fixed production overhead is CU1,500.
Total variable production overhead is CU2,600.
Total opening inventory is 2,500 units.

Total units produced in a year are 6,500 units.
Total units sold in a year are 6,700 units.
Total ending inventory is 2,300 units.
The cost of inventories is assigned by using FIFO cost formula.
Issue
How should Entity A allocate overhead costs to inventory at normal capacity?
Solution
IAS 2 states that the cost of inventories should comprise all costs of purchase, costs of conversion, and other costs incurred
in bringing the inventories to their present location and condition. Entity A should allocate fixed overhead costs and variable
overhead costs to units produced at a rate of CU0.2 per hour and CU0.4 per hour respectively.
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Fixed production overhead absorption rate:
= fixed production overhead/labour hours for normal capacity
= CU1,500/7,500
= CU0.2 per hour.
Therefore, fixed production overhead allocated to 6,500 units produced during the year (one unit per hour) = 6,500 × CU0.2 =
CU1,300. The remaining CU200 of overhead incurred that remains unallocated is recognised as an expense.
The amount of fixed overhead allocated to inventory is not increased as a result of low production by using normal capacity
to allocate fixed overhead.
Variable production overhead absorption rate:
= variable production overhead/actual hours for current period
= CU2,600/6,500
= CU0.4 per hour.
The above rate results in the allocation of all variable overheads to units produced during the year.
Since each unit has taken one hour to produce (6,500 hours/6,500 units produced), total fixed and variable production
overhead recognised as part of cost of inventory:
= number of units of closing inventory × number of hours to produce each unit × (fixed production overhead absorption rate
+ variable production overhead absorption rate)
= 2,300 × 1 × (CU0.2 +CU0.4) = CU1,380.
The remaining CU2,720 ((CU1,500 + CU2,600) – CU1,380) is recognised as an expense in the income statement as follows:
Absorbed in cost of goods sold (FIFO basis) (6,500 – 2,300) = 4,200 × CU0.6 2,520
Unabsorbed fixed overheads, also included in cost of goods sold 200
Total 2,720
6.4 Determining ‘normal capacity’ when

allocating overhead to inventory

Background
Entity A manufactures business attire. Because of recent market conditions, the demand for its products has significantly
decreased. As such, Entity A is projecting to operate at 50% of its manufacturing capacity for the next 12 months, and to
resume full capacity thereafter. This is consistent with most other business attire manufacturers in the territory in which Entity
A operates.
Entity A was unable to reduce its fixed production overheads for the next 12 months, and it was also unable to increase the
selling price of its products to compensate for the higher fixed production costs per unit produced.
Issue
What factors should be considered in determining the ‘normal capacity’?
Solution
Paragraph 13 of IAS 2 requires fixed production overheads to be allocated to the costs of conversion, based on the normal
capacity of the production facilities. Abnormal amounts of wasted materials, labour or other production costs are recognised
as expenses in the period in which they are incurred. [IAS 2 para 16]. Therefore, the costs of unused capacity and additional
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costs which represent wasted materials, labour or other production costs should be written off to profit or loss in the period
in which they occur.
IAS 2 does not specify in detail the factors to be considered in determining the ‘normal capacity’. We consider that the
governing factor is that the cost of unused capacity should be written off in the current year, where such cost does not
constitute a part of ‘normal’ capacity and where the entity does not have a fully operating facility. In determining what
constitutes ‘normal’, the following factors might be considered:
The volume of production that the production facilities are intended, by their
designers and by management, to produce under the working conditions (for
example, single or double shift) prevailing during the year;
The budgeted level of activity for the year under review and for the ensuing years;
The level of activity achieved both in the year under review and in previous years;
and
Although temporary changes in the load of activity can be ignored, persistent
variation from the range of normal activity should lead to revision of the previous
normal level of activity.
Even though Entity A expects that it will operate at a reduced capacity for the next 12 months, the normal production
capacity of its manufacturing facility and the long-term plan in operating the manufacturing facility has not changed. The fact
that most other business attire manufacturers have also decided to reduce production due to reduced demand does not
impact this either.
Accordingly, the amount of fixed overhead allocated to each unit of production should not increase because of low
production or idle capacity. Unallocated overheads are recognised as an expense in the period in which they are incurred.
Management should disclose any significant judgements and estimates made in assessing whether the overhead absorption
rates should be revised, or whether the additional costs should be capitalised or expensed in profit and loss, in accordance
with IAS 1. Entities should also consider whether any changes in business practice might be indicators of impairment in
cases where assets might become idle, or there might be plans to discontinue or restructure the operation to which an asset
belongs.
It might emerge over time that the lower demand becomes a permanent feature of the market, and that Entity A as well as its
competitors are unable to reduce fixed production overheads in the mid to long term. This could result in a change in what is
considered to be normal capacity.
6.5 Inventory valuation – Retail inventory

method

Background
Retailer C values inventory using the retail inventory method. The cost/retail value ratio used to calculate the value of
inventory is based on the gross margin earned in the previous four weeks, and so it incorporates permanent markdowns.
Original inventory cost CU60 Cost/retail value ratio for previous 4 weeks 67%
Original retail value CU100 Current retail value CU90
Issue
How should Retailer C apply the retail inventory method?
Solution
IAS 2 requires inventory to be valued at the lower of cost and net realisable value. The retail inventory method is a
mechanism that some retailers use to value inventory, basing that valuation on the cost/retail value ratio to the retail value of
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closing inventory. Paragraph 22 of IAS 2 recognises the retail inventory method for inventory valuation as an approximation
for cost, noting that the cost/retail value ratio should include permanent markdowns.
Retailer C should value inventory at CU60 (current retail value × 67%), using its retail inventory method. This results in an
inventory valuation that approximates cost, since both the current retail value and the cost/retail value ratio used in the
calculation include permanent markdowns. The cost/retail value ratio should include permanent markdowns, because
excluding such markdowns could result in inventory being written down below original cost where net realisable value is in
excess of original cost, which would not be acceptable under IFRS.
6.6 Inventory provisioning for expected returns

Background
Retailer A sells products for CU50 each. Customers have the right to return the products for a full refund for any reason
within 90 days of purchase, with no additional restocking fees. The cost of each product is CU40. Retailer A estimates,
based on the expected value method, that 10% of sales will be returned, and it is highly probable that returns will not be
higher than 10%.
In accordance with paragraph B21 of IFRS 15, Retailer A only recognises revenue for those products that it does not expect
will be returned. For each 1,000 products sold, Retailer A recognises revenue of CU45,000 (CU50 × 900 products), cost of
sales of CU36,000 (CU40 × 900 products), and a liability of CU5,000 (10% of the sales price) for the refund obligation. It also
recognises an asset of CU4,000 (CU40 × 100 products) for expected returns (with a corresponding adjustment to cost of
sales).
Issue
Does Retailer A need to consider products expected to be returned when considering inventory for impairment?
Solution
Yes, Retailer A should consider the inventory expected to be returned for impairment. Paragraph B25 of IFRS 15 requires the
asset to be initially measured at the carrying amount of the goods at the time of sale, less any expected costs to recover the
goods and any expected reduction in value. The amount recorded as an asset should be updated for changes in the refund
liability and for other changes in circumstances that might suggest an impairment of the asset.
In some instances, the asset could be immediately impaired if the entity expects that the returned goods will have diminished
(or no) value at the time of return. For example, this could occur if the inventory is expected to have expired when returned,
or if the inventory is expected to be ‘out of season’ when returned and, therefore, might need to be sold for less than cost
or be destroyed.
6.7 Inventory provisioning for shrinkage

Background
Retailer B experiences shrinkage through theft or other loss. Experience shows that approximately 0.5% of all shelved stock
is subject to shrinkage.
Issue
How should Retailer B account for shrinkage?
Solution
Inventories are measured at the lower of cost and net realisable value. [IAS 2 para 9]. Experienced shrinkage should be
accounted for as a cost of sales. Management should measure inventories based on the actual quantities, which should be
reduced to reflect any shrinkage that has occurred since the last physical count of inventory. Therefore, shrinkage should be
estimated to reflect any shrinkage that has occurred since the last physical count of inventory. The entity should consider
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whether estimated shrinkage is a significant estimate which requires the additional disclosure required by paragraph 125 of
IAS 1.
6.8 Inventory valuation – Consideration of post

balance sheet events

Background
Entity C supplies certain parts to a major car manufacturer. At the year end, the entity had inventories of such parts with a
carrying value of CU1 million. However, after the year end the car manufacturer changed some of their models and, as a
result, the inventories became obsolete (the parts were not interchangeable between models).
Issue
Should Entity C recognise a provision against the inventories at the year end?
Solution
An entity has to determine whether developments after the reporting date provide management with better information about
a condition that already existed at the balance sheet date [IAS 10 para 3]. This requires judgement and an analysis of the
facts and circumstances in order to distinguish between adjusting and non-adjusting information. IAS 10 gives examples of
events that require an adjustment to amounts recognised at the balance sheet date. One such example, given in paragraph
9(b) of IAS 10, refers to the sale of inventories after the balance sheet date as giving evidence of the net realisable value at
the balance sheet date. The assessment of net realisable value should be updated after the reporting date if material
developments provide better information than existed at the reporting date.
In this case, the entity should assess whether the car manufacturer’s decision to change models was a condition that existed
at the end of the reporting period. In making that assessment, the entity should consider whether the customer’s decision to
change the model is based on information available at the reporting date and, therefore, could have been reasonably
expected at the end of the reporting period, even though the change was not completed until after the balance sheet date. If
that was the case, the provision would be reflected in the carrying value of the inventories at the year end. If the entity could
not have reasonably expected the change to the model, the model change would be a non-adjusting post balance sheet
event.
Judgement might be required to determine whether the customer’s plans could have been anticipated by the supplier entity.
The impact on the inventory would require disclosures to the extent material.
6.9 Inventories acquired in a business

combination

Background
Retailer A acquires Retailer B in a business combination. Retailer B has material levels of inventory in its numerous stores.
Issue
How is Retailer B’s inventory measured in the purchase price allocation?
Solution
IFRS 3 requires inventory acquired in a business combination to be measured at fair value. The fair value of finished goods
inventory is measured by determining net realisable value (that is, estimated selling prices of the inventory, less the sum of (i)
costs of disposal, and (ii) a reasonable profit allowance for the selling effort), because this represents an exit price. This can
be measured by reference to the price at which the inventory could be sold to customers in a retail market, or purchased
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from a wholesale market, adjusted for differences between the condition and location of the inventory item and comparable
inventory items. Conceptually, the fair value measurement will be the same, whether adjustments are made to a retail price
(downward) or to a wholesale price (upward). The price that requires the least amount of subjective adjustments should be
used for the fair value measurement. [IFRS 13 App B para B35(f)]
Work in progress inventory is measured similarly to finished goods inventory except that, in addition, the estimated selling
price is further reduced for the costs to complete the manufacturing process and a reasonable profit allowance for that effort.
Raw materials inventory is generally measured based on the price that a market participant would pay currently for the
inventory.
The market participant price of raw materials is generally already reflected in the acquired entity’s carrying value, particularly
for inventory recently purchased.
The amount recognised for inventory acquired in a business combination at fair value will generally be higher than the
amount recognised by the entity being acquired before the business combination. This is likely to be the case where an
entity acquires another entity that manufactures products. In the case of Retailer A’s acquisition of Retailer B, however,
careful consideration would be required of other factors to determine the adjustment to historical cost. For example, in the
case of inventory with a short shelf life (such as fresh food), there are generally no significant future selling efforts. Therefore,
a significant portion of the difference between the historical cost and the ultimate selling price could be considered a
‘reasonable profit allowance’ for selling efforts, and therefore historical book value could approximate fair value.
6.10 Capitalisation of development costs

Background
Entity C, a detergent manufacturer, incurs significant costs developing a new technology that allows consumers to wash
clothes significantly quicker.
Issue
Are the development costs incurred by Entity C capitalised as an intangible asset?
Solution
Development activities are defined in IAS 38 as ‘the application of research findings or other knowledge to a plan or design
for the production of new or substantially improved materials, devices, products, processes, systems or services before the
start of commercial production or use’.
Paragraph 57 of IAS 38 specifies that development costs should be capitalised as an intangible asset if, and only if, an entity
can demonstrate all of the following:
(a) the technical feasibility of completing the intangible asset so that it will be available for use or sale.
(b) its intention to complete the intangible asset and use or sell it.
(c) its ability to use or sell the intangible asset.
(d) how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate
the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the
usefulness of the intangible asset.
(e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the
intangible asset.
(f) its ability to measure reliably the expenditure attributable to the intangible asset during its development.
An intangible asset must be identifiable and attributable to a specific product or project in order to meet the recognition
criteria for an intangible asset. Management should be able to identify the future economic benefits that will flow from each
separate intangible asset that it recognises. It is not possible to meet the recognition criteria for an intangible asset if
management is unable to identify the individual product or project.
Entity C should capitalise costs after the criteria are met. It is sometimes difficult to determine the point at which the criteria
are met. The entity would need to map its development ‘stage-gate’ process to the above criteria, to determine if and when
the criteria to capitalise costs are met.
In that process, Entity C would also need to clearly differentiate between research and development costs. IAS 38 defines
‘research’ as the ‘original and planned investigation undertaken with the prospect of gaining new scientific or technical
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knowledge and understanding’. Research costs are expensed as incurred; this is because, in the research phase of the
project, the entity will not yet be able to demonstrate that an intangible asset exists that will generate probable future
economic benefits.
Expenses incurred before a project meets the criteria for recognition as an intangible asset must be expensed as incurred.
Previously written-off costs cannot be reinstated as part of the intangible asset if the project has reached the stage at which
an asset must be recognised.
6.11 Useful life of brands

Background
Entity A sells luxury goods and has acquired two fragrance brands for its product range:
A perfume that is a timeless classic and has been a flagship product for many
decades; and
A new perfume named after a newly famous music star who has been actively
involved in promoting and marketing the fragrance.
Issue
An intangible asset has been recognised for each brand. Should Entity C account for brands as having an indefinite life?
Solution
Intangible assets have an indefinite useful life where there is no foreseeable limit to the period over which, based on an
analysis of all relevant factors, the asset is expected to generate net cash inflows for the entity [IAS 38 para 88]. In this
situation, factors that might be considered separately for each fragrance include:
The entity’s commitment to support the brand;
The extent to which the brand has long-term potential that is not underpinned by
short-term fashion or market trends but has been proven by its success over an
extended period; and
The extent to which the products carrying the brand are resistant to changes in
operating environments. The products should, for example, be resistant to changes
in the legal, technological and competitive environment.
The timeless classic brand is likely to have an indefinite life. The brand has already proven its longevity by having been
successful in the market for many decades.
The perfume named after the newly famous music star is most likely linked to the popularity of the star; therefore, it is difficult
to assess whether the brand would survive beyond the life, or even the media life, of the star. It is also a new product, and its
longevity has not been proven. It is unlikely that this brand has an indefinite life.
Indefinite-lived intangible assets should be reviewed annually, to confirm whether or not events and circumstances still
support the assumption of an indefinite life. If they do not, the change from indefinite to finite useful life should be accounted
for as a change in estimate under IAS 8. [IAS 38 para 109].
6.12 Advertising expense and catalogues

Background
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Entity B advertises through an annual catalogue which is mailed to existing and potential customers.
Issue
Can Entity B recognise an asset for a catalogue that has been prepared but not yet sent?
Solution
The primary objective of mail order catalogues is to advertise goods to customers rather than to give rise to a distribution
network. Mail order catalogues are an example of advertising activities and cannot be capitalised [IAS 38 para BC46G].
Further, if the catalogue of products was marketed through other means (such as television, internet or the entity’s website),
costs to produce and develop this marketing should be expensed immediately, unless the spend was on services not yet
received (for example, prepaid advertising), in which case a prepayment would be recognised on the balance sheet until
those services are received.
An entity should not recognise an asset in respect of an advertisement that it has obtained but has not yet published. The
only economic benefits that might flow to the entity as a result of publishing the advertisement are the same as those that
might flow to the entity as a result of the brand or customer relationship that it would enhance or create. The entity should
not recognise as an asset goods or services that it has received in respect of its future advertising or promotional activities.
[IAS 38 paras BC46B–BC46C]
Advertising and promotional activities enhance or create brands or customer relationships, which in turn generate revenues.
Goods or services acquired to be used in advertising or promotional activities have no other purpose. The only benefit of
those goods or services is to develop brands or customer relationships, which in turn generate revenues. Internally
generated brands and customer relationships are not recognised as intangible assets.
IFRS 17 – A Guide for Audit Committees
IFRS 17 – A Guide for Audit Committees (Free registration required to view)
This Guide has been prepared for audit committees to assist them in fulfilling their responsibilities relating to the effective
implementation of IFRS 17. It is intended to help audit committee members to evaluate and challenge management's
assessment relating to the key judgements needed in applying IFRS 17.
In the Spotlight - IFRS 17 – A Guide for Audit

Committees
IFRS 17 – A Guide for Audit Committees
This Guide has been prepared for audit committees to assist them in fulfilling their responsibilities relating to the effective
implementation of IFRS 17. It is intended to help audit committee members to evaluate and challenge management's
assessment relating to the key judgements needed in applying IFRS 17.
Climate related risks - what do insurers need to

know?
Key points
Climate change is a high profile issue and a focus area for investors and
regulators. The insurance industry is accustomed to reflecting the effects
of assumptions about climate change in underwriting and reserving
practices. However, reflecting the effects of climate change in risk
disclosures is a less-familiar area.
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This document outlines the factors for insurers to consider in providing

disclosures about climate-related risks in financial statements.
For further details see below.
Issue
The impact of climate change is a high-profile issue and a key focus area for investors and regulators. There are two broad
categories of risk: the first is the threat of exposure to the physical risks of climate change, such as severe weather events
and the effects of rising temperatures. The second is the risk created by what many call the transitional impacts, i.e. the
policy changes and economic consequences of efforts to decarbonise the economy. With respect to transitional risk, there is
both a ‘top down’ impact - in the form of changes in legislation and policy - as well as a ‘bottom up’ shift in consumer
preferences for low- or no-emissions products.
Table of contents (Free registration required to view)
1. Overall considerations
1.1. Need for transparent disclosures
1.2. Consistency of information about climate-related risks
2. Detailed considerations for insurers
2.1. How assumptions about climate-related risks could affect insurers
2.2. What do IFRS Standards require?
• Liabilities
• Assets
• Fair value considerations
• Disclosures about climate-related risks
1. Overall considerations
Contents:
1.2. Consistency of information about climate-related risks
Insurers have considerable experience in incorporating the effect of climate-related risks into assumptions underlying
underwriting and reserving. However, there is an increasing need to ensure that the financial statements tell a consistent,
coherent story about how insurers incorporate assumptions about climate-related matters in key areas of the financial
statements affected by climate-related risks. Investors need transparency about how insurers use information about climate-
related matters, so they can fully assess the information in financial statements and allocate capital according to their
objectives.
Such transparency would provide investors with enough information to understand:
how climate-related risks, in particular physical and transition risks, are reflected in
financial statements; and
the significant judgements and estimation of uncertainty regarding climate risks.
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1.2. Consistency of information about climate-

related risks
Regulators and investors are also increasingly focused on consistency in the use of information about climate-related
matters and climate-related risks. They are looking for consistency not only regarding information within the IFRS financial
statements, but also between the information disclosed within the IFRS financial statements and the non-financial
information provided alongside those financial statements, e.g. in management commentary.
Many companies discuss climate scenarios as part of their narrative reporting. These scenarios may stem from the Paris
Agreement, net zero targets or from TCFD reporting requirements. An insurer’s narrative reporting may also include
statements that the business plans and strategy are to be net zero by a certain date or to be aligned with the Paris
agreement.
The disclosures and discussion in such narrative reporting may interact with disclosures required in the financial statements,
in particular disclosures relating to the measurement of insurance contracts and financial assets. While narrative disclosures
may not be identical to financial statement disclosures, the assumptions used in financial statements should not be
inconsistent with such disclosures.
Paris aligned assumptions and financial reporting
Questions often arise about whether an entity’s financial statements are ‘Paris Aligned’. This refers to whether they comply
with the legally binding instrument that many nations have signed relating to limiting carbon emissions to a level designed to
cap global temperature rises. Whether accounts are ‘Paris Aligned’ is not easy to determine because of the variety of
measurement techniques required by IFRS depending on the item being considered in the statement of financial position. It
might be easier for recognition and measurement of some items to be more closely aligned to Paris assumptions than
others.
PwC Guidance:
In brief -The Impact of the Paris Agreement on Financial Reporting under IFRS
In depth - Impact of ESG matters on IFRS financial statements, Section 2 Paris
Aligned Financial Statements and Consistency of Assumptions
2. Detailed considerations for insurers
2.1. How assumptions about climate-related risks could affect insurers
2.1. How assumptions about climate-related

risks could affect insurers
For insurers, assumptions about climate-related risks - both physical- and transition risks - could affect the amounts that
insurers will need to pay to settle insurance contract liabilities.
Physical risks are the direct effect of climate-related changes and can affect the likelihood and severity of claims made under
existing insurance contracts. Such physical risks can be either chronic (i.e. the long-term effect of climate change) or acute,
caused by a one-off physical event (e.g. an earthquake or a flood).
When we consider non-life business, physical risks are relevant to both direct
insurance and reinsurance, because such risks materialize in a direct increase in
claims, e.g. for cover over business interruption, property damage or injury.
Examples of such claim events include extreme weather events such as the floods
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in Germany in Summer 2021 or the California or Australian wildfires in the past few
years. Climate-related risks might increase the frequency or magnitude of such
events or accelerate the timing of their occurrence.
When we consider life business, physical risks can lead to direct effects on
mortality, e.g. drought and other natural disasters can have a direct impact on
agriculture and access to food. Similarly, physical risks, such as rising average
temperatures, or increased morbidity rates, can also cause chronic effects that will
affect health insurance.
As customers better understand physical risks, their demand for coverage of such physical risks may change, leading to
changes in product offerings, underwriting and pricing by insurers.
Transition risks, which translate into the regulatory and social pressure to adapt operations and activities to mitigate climate
change, are less likely to affect claims liabilities in the short term.
However, transition risks may affect insurers through:
Changes in migration patterns, which will cause demographic changes that affect
all territories and will have consequent effects on assumptions about life insurance.
A shift in consumer preferences towards more sustainable products. Reputational
risk can arise as consumers examine more closely the sustainability credentials of
companies. Customers increasingly consider ESG impact when purchasing
products and services, and the same is true for policyholders when purchasing
insurance products. This could have an effect on future product offerings by
insurers.
The effects these risks have on a company's operations, including the useful
economic life of assets in use and whether internal process systems are advanced
enough to deal with any ESG-related changes in the business.
In addition, insurers are significant holders of financial instruments in the global economy, and will need to reflect the effect
of climate-related risks in the measurement, and impairment, of financial assets held to back those liabilities if they are not
carried at fair value. The same considerations that apply to all holders of financial instruments are relevant here. In addition:
insurers may be subject to possible actions by regulators as they respond to ESG

risks, e.g., whether they may disregard certain assets for regulatory reporting
purposes.
insurers may need to respond to the consequences of investor demand for ESG-
linked assets, and increasing consumer interest in the investments that insurers
make to back insurance policies. Insurers may face reputational damage by
investing in financial and non-financial assets without considering the ESG
implications of such investments.
Finally, to the extent that the same risks affect the measurement of both insurance contract liabilities and assets, consistent
assumptions need to be used.
IFRS Standards do not refer explicitly to climate-related matters. However, companies must consider climate-related matters
in applying IFRS where the effect of those matters is material in the context of the financial statements taken as a whole.
Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that
primary users of financial statements make on the basis of those financial statements. For example, information about how
management has considered climate-related matters in preparing a company’s financial statements might be material with
respect to the most significant judgements and estimates that management has made. 1
For insurers, critical judgements and estimates about the impact of climate-related risks could affect the following line items:
In measuring insurance contract liabilities.
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In measuring financial and non-financial assets held by insurers to enable them to

meet their obligations to policyholders.
In the accounting for other assets and liabilities held by insurers, such as fixed
assets used in operations.
Thus insurers will need to consider how climate-related risks affect the application of a number of IFRS Standards. In
addition to IFRS 17 Insurance contracts (IFRS 17), the requirements of IFRS 7 Financial Instruments: Disclosures (IFRS 7),
IFRS 9 Financial Instruments (IFRS 9), IAS 1 Presentation of Financial Statements (IAS 1), IAS 16 Property, Plant and
Equipment and IAS 36 Impairment of Assets (IAS 36) are particularly relevant.
Liabilities
Assets
Fair value considerations
Disclosures about climate-related risks
1
Source: IASB educational material
Liabilities
Applying IFRS 17, an entity measures insurance contracts on the basis of a current, probability-weighted estimate of the
future cash flows arising from insurance contracts, in a way that reflects conditions existing at the time of the assessment.
Furthermore, the measurement of insurance contracts reflects a risk adjustment for non-financial risk, defined as the
compensation an insurance company requires for bearing the uncertainty about the amount and timing of the cash flows that
arises from non-financial risk, and reflecting all non-financial risk associated with the insurance contracts.
Reasonable and supportable information
In measuring insurance contracts, insurers should use reasonable and supportable information about the future cash flows
arising from insurance contracts. As discussed further in the context of expected credit losses (ECL) for assets, the longer
term impact of climate change risk may create challenges and the need for judgement. Nonetheless, reasonable and
supportable information about climate-related risks is available and cannot be ignored.
Multiple probability-weighted scenarios
When measuring insurance contract liabilities, IFRS 17 requires an insurer to:
- consider assumptions about the multiple scenarios needed to project future cash flows, including scenarios that are not
considered likely; and
- update its assumptions to reflect any changes in expected severity and frequency of expected claims.
Risk adjustment for non-financial risk
IFRS 17 requires an insurer to adjust the present value of cash flows by a risk adjustment for non-financial risk. The risk
adjustment for non-financial risk is defined as the compensation the entity requires for bearing the uncertainty about the
amount and timing of the cash flows that arise from non-financial risk as the entity fulfils insurance contracts. Thus, the
insurer would need to consider how it factors climate risk in determining the risk adjustment for non-financial risk, ensuring
that that effect is not double counted if already reflected in other sources of risk.
To the extent that those effects and risks are not fully compensated by premiums charged (e.g. due to market pressure in the
short term), insurers should also consider the effect of their assessment of whether contracts are onerous or have a
significant possibility of being onerous.
Assets
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Insurers are key holders of financial assets. They also increasingly hold non-financial assets to back insurance contracts (e.g.
real estate), in addition to non-financial assets held for own use. In common with other holders of financial and non-financial
assets, the effects of climate-related risks need to be considered, in particular on their impairment. In addition, changes in
the types of assets held by insurers may have consequences for the insurer’s accounting considerations. The following
sections describe some considerations.
Financial assets - Expected credit losses
Debt instruments measured at amortised cost and at fair value through other comprehensive income are in the scope of the
impairment requirements of IFRS 9 Financial Instruments. Climate change may affect an entity’s exposure to credit losses for
its financial instruments, and the assumptions that are made to estimate ECL.
The key areas of ECL measurement to consider in the context of ESG are:
Reasonable and supportable information

Forward-looking information and multiple economic scenarios
Significant increase in credit risk (SICR)

For more information about these areas, see PwC’s In Depth - Impact of ESG matters on IFRS financial statements, Section
3 Financial Instruments.
Non-financial assets - Impairment and other considerations
Insurers should consider the impact that ESG-related matters may have on their assumptions and assessments performed
relating to non-financial assets, whether these are held as investments or for use. Matters to consider include:
Non-financial assets: impairment

PP&E and Intangibles: Useful life and residual value
For more information about these areas, see PwC’s In Depth - Impact of ESG matters on IFRS financial statements, Section
4 Non-financial Assets and Liabilities.
Fair value considerations
Fair value measurements of both financial and non-financial assets can be impacted wherever fair value is used, because a
market participant view might include assumptions about climate-related risk. Matters to consider include:
the extent to which fair value measurements using observable inputs might already
appropriately reflect market participant views of any climate change inputs.
the extent to which valuation models for items not traded in an active market
adequately represent market participant assumptions for the particular item being
valued.
IFRS 13 Fair Value Measurement requires disclosure of the inputs used in fair value measurements and, for recurring fair
value measurements with significant unobservable inputs, a description of the sensitivity of those measurements to changes
in unobservable inputs.
For more information about these areas, see PwC’s In Depth- Impact of ESG
matters on IFRS financial statements, Section 3.4 Fair value measurements
Disclosures about climate-related risks
Climate change can introduce significant uncertainty about the future. Given the significance of financial instruments and
insurance contracts on the balance sheets of insurers, transparent disclosure about those uncertainties and assumptions is
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important.
IFRS 17 requires an insurer to disclose information that enables users of its financial statements to evaluate the nature and
extent of risks arising from insurance contracts. Such disclosures should include the extent to which climate change affects
the risks arising from insurance contracts, and hence the assumptions used to measure insurance contracts. To comply with
these requirements, information disclosed would include:
the insurer’s objectives, policies and processes for managing risks arising
from insurance contracts;
information about risk exposures, concentrations of risk, how an entity manages

those risks and the sensitivity analysis showing the effect of changes in risk
variables; and
the significant judgements and changes in those judgements as a result of
assumptions about climate risks.
In addition, climate change is expected to be relevant in the following areas of disclosure:
Judgements, assumptions and sources of estimation uncertainty, as required by

IAS 1.
Information about the nature and extent of risks arising from financial instruments
to which the insurer is exposed during the period, and how the company is
managing those risks, as required by IFRS 7 Financial Instruments: Disclosures.
Fair value disclosures required by IFRS 13 Fair Value Measurement.
Sensitivity analysis related to impairment testing as required by IAS 36.
Any additional disclosures required by IAS 1 Presentation of Financial Statements
to ensure the disclosures are sufficient to enable investors to understand the
impact of particular transactions, other events and conditions on the company’s
financial position and financial performance.
Those requirements do not specifically refer to climate-related matters, but could nonetheless be relevant where climate-
related matters are material to the company’s financial position and performance. For more information about these
disclosures, see PwC’s In Depth- Impact of ESG matters on IFRS financial statements, Section 6 Disclosures about
Judgements and Assumptions, including Going Concern Assumption.
In the Spotlight - Determining CSM allocation

using coverage units
In the Spotlight - Determining CSM allocation using coverage units
IFRS 17, ‘Insurance Contracts’, introduces the concept of ‘coverage units’ for determining how an insurer allocates to
different reporting periods the expected profit for providing insurance contract services (that is, the contractual service
margin).
Different insurance contracts are likely to provide different insurance contract services, with different relative weightings of
the benefits provided by each service. The pattern of delivery of each of those services might also differ. There is little
specific guidance in IFRS 17 on how to determine coverage units where more than one service is provided in a contract or
group of contracts. An insurer will need to apply judgement in determining the allocation of coverage units, and those
judgements might have a significant effect on system requirements and reported results.
This publication summarises the guidance relating to coverage units, along with related frequently asked questions (‘FAQs’).
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In the Spotlight - Transition to IFRS 17 - Aug

2023
In the Spotlight - Transition to IFRS 17 - Aug 2023
Frequently asked questions on IFRS 17
IFRS 17 specifies complex transition requirements for entities that are applying IFRS 17 for the first time. Entities will need to
evaluate the choices that are available to them and exercise judgement in applying many of the requirements. Those choices
and judgements will have an ongoing, long-term effect on amounts recognised on transition, with a corresponding effect on
shareholder equity and reported revenue and profit reported in subsequent years for some insurers.
This publication summarises the requirements relating to transition, along with frequently asked questions (‘FAQs’) related to
the topic.
In the Spotlight - Eligibility for the Variable Fee

Approach
In the Spotlight - Eligibility for the Variable Fee Approach
IFRS 17, 'Insurance Contracts', specifies that some participating contracts should be accounted for using the variable fee
approach ('VFA'), to reflect that those contracts provide investment-related services which are integrated with insurance
coverage, and that the entity receives a variable fee for those services. Given the difference in accounting between the VFA
and the general model applied to other contracts, the determination of eligibility for the VFA will have a significant effect on
system requirements and reported results. There are a number of key interpretative questions and significant judgements in
determining eligibility. This publication summarises the criteria for testing the eligibility for the VFA and the accounting for
contracts applying the VFA, along with frequently asked questions ('FAQs').
Revenue Recognition : An IFRS 15 Guide for

Software and SaaS sellers
The guide for recognising revenue in the software industry is our collected insight on the application of International
Financial Reporting Standards (IFRS) in this industry. This industry continues to be an area of rapid development in terms of
products and sales strategies, and recent guidance from the IFRS Interpretations Committee shows that the accounting for
this industry is also developing at pace. These new developments continue to introduce new complexities in accounting for
software sales, in particular as it relates to cloud-based solutions, sales by intermediaries and renewals and modifications.
Football
Accounting for typical transactions in the

football industry
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Accounting for typical transactions in the football industry – IFRS Accounting Standards guide is our collective
insight on the application of IFRS® Accounting Standards in the football industry. It reflects the typical financial reporting
challenges faced by many football clubs, ranging from player transfer-related issues and stadium leases to how to recognise
revenue from various sources. The original publication from 2018 has been updated with two new solutions: one on player
exchanges, and the other on player contract term options. We hope that you find this updated publication useful in
understanding the accounting for common transactions that you encounter in your business.
© 2024 PricewaterhouseCoopers LLP. This content is copyright protected. It is for your own use only - do not redistribute.
These materials were downloaded from PwC's Viewpoint (viewpoint.pwc.com) under licence.
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Click the Table of Contents icon above ( ) to navigate to an industry.

Questions and answers by industry

Industry Illustrative financial statements

Banking and capital markets

Spotlight on IFRS 9 - Assessing Islamic

What are the key features of Islamic financing arrangements?

prohibition of interest/time value of money (‘riba’);

transactions should generally be backed by or linked to a tangible asset.

The technical requirements

Step 1 – How to determine the characteristics of the contractual cash flows?

Substance of the contractual rights and obligations: In terms of IFRS 9, Islamic

contract and contractual as an agreement which has clear economic

Prepayment options: On early settlement of an instrument, the contractual terms

Appendix 1 – Example of assessment of Islamic financing arrangements: Murabaha

Appendix 2 – Example of assessment of Islamic financing arrangements: Sukuk

There is currently only one series of sukuk issued.

Appendix 3 – Example of assessment of Islamic financing arrangements: Musharakah

Financial institution would only be entitled to principal and a return on investment if

In the Spotlight: Changing criteria for a

quantitative thresholds (for example, a specified percentage increase in PD);

qualitative factors (for example, put on a watchlist, or enter forbearance); and

What does IFRS say?

Drivers for change

1. Monitoring and review of outputs.

Monitoring. It would generally be expected that the monitoring required by

Review. A review of actual outcomes against those expected might identify

Change in PD methodology. For example, an entity might change its

Where do I get more details?

Question 1: Change in policy versus change in estimate

Impact on the impairment methodology

Impact on current and future reporting periods

Offsetting financial instruments for financial

Appendix A – Bank acting as clearing member for derivative contracts

Appendix B – Industry FAQs

Mark Randall (UK); Marie-Claude Kling (US)

Typically relevant to:

IND Does daily posting of cash X X

3. Currently enforceable right of set off

IND Can cash collateral posted X X

IND What impact does the ability X X

IND What impact does the X X

IND What impact might a ‘one X X

IND Where daily cash X X

IND Do financial assets and X

IND Can repos and reverse X

Typically relevant to:

IND If a clearing house/exchange X X X

IND In what circumstances will X

IND What evidence is required to X X X

2. Balances that should be considered for offsetting

General FAQs of particular relevance to the industry

3. Currently enforceable right of set-off

[IAS 32 para AG38B].

4. Intention either to settle on a net basis or to realise the asset and

[IAS 32 para AG38E].

5. Disclosure of offsetting financial assets and financial liabilities

Appendix A – Bank acting as clearing member for derivative contracts

Consideration Relevant guidance

Even though the bank is acting as a

For those circumstances where collateral

IND FAQ 3.3 – What impact does the

IND FAQ 3.4 – What impact might a ‘one