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SUBSTANCE OVER FORM
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Context
Application of the concept of substance over form is a requisite for fair presentation within the financial statements. Throughout this text, we have already seen examples of its application, such as the preparation of group accounts and accounting for finance leases.
This chapter explores further applications of substance over form, and also considers revenue recognition rules, to which the concept also relates.
Exam Hints
Practical applications of substance over form may be examined as part of the published accounts question (Q2) or in their own right within question 4 or 5 of the paper.
Key Learning Points
• The accounting principle of ‘substance over form’ means that the commercial substance of a transaction should be reflected in the accounts rather than its legal form.
• This is necessary in order to achieve fair presentation
• The importance of substance is recognised within the definitions of assets and liabilities within the Framework, for example an asset should be controlled, but not necessarily owned.
• Examples of the application of substance over form are: o The preparation of group accounts (chapter 1) o Finance leases (chapter 8)
o Redeemable preference shares (chapter 15) o Consignment inventory
o Sale and leaseback o Sale and repurchase o Factoring of receivables
Consignment Inventory
• Consignment inventory is inventory held by a selling party on behalf of a manufacturer until such time as it is sold to a customer. During the period in which the inventory is held by the selling party, it will be recorded as an asset in either the manufacturer or the selling party’s accounts, depending on who has the risks and rewards of ownership.
Sale and Leaseback
• A company may sell an asset in order to release funds and then lease it back for continued use.
• A sale and operating leaseback is recorded as a sale, with the resultant profit or loss recognised according to the following rules:
Sale price > Recognise ‘fair value’ profit or loss immediately fair value Recognise any excess profit over the lease term. Sale price = Recognise profit or loss on sale immediately fair value
Sale price < Recognise profit or loss on sale immediatelyunlessa loss is compensated for fair value by future below market lease payments, in which case the loss is recognised over
the lease term.
Sale and Repurchase
• A company may sell an asset and agree to repurchase it at a future date. The sale is recorded only where the risks and rewards of ownership of the asset are transferred on the date of the sale. If the selling company retains the risks and rewards of ownership of the asset until the repurchase date, no sale is recorded and instead the proceeds are accounted for as a secured loan.
Factoring of Receivables
• A further method by which a company may release funds is to sell its receivables ledger to a factor. The selling company should only derecognise its receivables where it transfers the risks and rewards associated with them to the factor.
• The principles of revenue recognition are also based on the concept of substance over form:
• Revenue from the sale of goods is recognised when all of the following conditions are met:
1 The selling company has transferred the significant risks and rewards of ownership of the goods to the buyer.
2 The selling company no longer has managerial involvement in the goods sold nor effective control over them
3 The amount of revenue can be measured reliably
4 It is probable that the economic benefits of the transaction will flow to the entity 5 The costs incurred in relation to the transaction can be measured reliably.
• Revenue from the provision of services is recognised by reference to the stage of completion when all of the following conditions are met:
1 The amount of revenue can be measured reliably
2 It is probable that the economic benefits of the transaction will flow to the entity
3 The stage of completion of the transaction at the reporting date can be measured reliably 4 The costs incurred in relation to the transaction can be measured reliably.
• When all of these conditions are not satisfied, revenue is recognised only to the extent that expenses recognised are recoverable.
Relevant Accounting Standards
IAS 1 Presentation of Financial Statements IAS 17 Leases
IAS 18 Revenue
IAS 27 Consolidated and Separate Financial Statements IAS 32 Financial Instruments: Presentation
IAS 38 Financial Instruments: Recognition and Measurement
Technical Articles
The following article explains IAS 18 Revenue and is available on ACCA’s website.
SUBSTANCE OVER FORM
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Substance Over Form – An Introduction
IAS 1 requires that financial statements represent faithfully the effects of transactions and events.
In order to achieve this, the commercial substance of transactions should be represented, rather than the legal reality. This accounting principle is known as ‘substance over form’.
At the F3 exam and in earlier chapters, we have met the following examples of substance over form:
Legal Form Commercial Substance
Redeemable Shares Possess the characteristics of debt and so are preference shares accounted for as a liability (IAS 32)
Groups of Individual companies which Operate as a single entity and therefore companies must prepare individual consolidated accounts are prepared (IAS 27)
company statutory accounts
Finance leases Asset is leased by lessee for Risks and rewards of asset are transferred to a period of time lessee and so the asset should be accounted
for as if owned by the lessee (IAS 17)
Exam Hint
Redeemable preference shares often feature in the published company accounts question (Q2). Ensure that you account for them as a liability in accordance with IAS 32.
1.1 THE IMPORTANCE OF RECORDING SUBSTANCE OVER FORM
If the legal form of the transactions listed above was reflected in the financial statements, rather than the commercial substance, then the overall objective of fair presentation would not be achieved.
In particular, users of the accounts:
• may not appreciate that redeemable preference shares amount to a liability and have cash flow implications in the year of redemption
• would have difficulties understanding the operations of a group of companies based on numerous individual company accounts.
• may not understand that a finance lease is generally a long term arrangement with an associated liability and ongoing costs for the upkeep of the leased asset.
1.1.1 THE PROBLEM OF OFF-BALANCE SHEET FINANCE
The problem of off-balance sheet finance provides a further example of the importance of recording substance over form.
Historically, preparers of financial statements have tried to keep financing liabilities out of their accounts, using the legal form of these liabilities as the underlying reason for this. This strategy meant that companies appeared to be healthier that they actually were. It is most famously exemplified in the case of Enron.
The application of the substance over form principle, and continually tightening accounting regulations reduces the issue of off-balance sheet finance.
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Substance Over Form: General Principles
Taking a backward step, we can see how the concept of substance over form is linked to the definition of assets and liabilities within the Framework:
• An asset is defined as:
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.
Note that this definition uses the word ‘controlled’ rather than ‘owned’, therefore meaning that assets such as those held under a finance lease fall within its scope.
• A liability is defined as:
A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
Again, this definition is worded to include instruments such as redeemable preference shares which possess the characteristics of debt.
The recognition criteria of the Framework promote the concept of substance over form in a similar way: An asset or liability should be recognised if:
• It is probable that any future economic benefit associated with the item will flow to or from the entity • The item can be measured reliably.
The first of these recognition criteria encompasses the idea of ‘rewards’.You will remember from chapter 8 that the main criteria for classifying a lease as a finance lease was whether the ‘risks and rewards’ of ownership had transferred.
2.1 FEATURES WHICH MAY INDICATE THAT SUBSTANCE DIFFERS FROM FORM
The following features of a transaction may indicate that substance differs from form:
1 it is linked to a number of other transactions, and should be viewed as a part of those rather than individually 2 the legal title of an asset is separated from the risks and rewards of that asset (e.g. finance leases)
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Further Practical Examples
The following are further examinable examples where the substance of a transaction may differ from its legal form:
• Consignment inventory • Sale and leaseback • Sale and repurchase • Factoring of receivables
3.1 CONSIGNMENT INVENTORY
The issue of consignment inventory is common in the motor industry. Often the manufacturer will enter into an arrangement with a car dealer to take and display some vehicles with a view to selling them to a customer. Legal title remains with the manufacturer until the date of the sale to the customer, at which point the vehicle is sold to the dealer who in turn sells it on to the customer.
SUBSTANCE OVER FORM
3.1.1 ACCOUNTING TREATMENT
The risks and rewards of ownership must be assessed:
• If the risks and rewards of ownership have passed to the dealer when the vehicles were transferred to the showroom, then the manufacturer has sold the vehicles and the dealer should recognise the vehicles as inventory in its accounts.
• If the risks and rewards of ownership have not passed to the dealer, but have been retained by the manufacturer, then no sale has been made and the manufacturer should continue to recognise the vehicles as assets.
Indicators that risks and rewards have Indicators that risks and rewards have transferred to the dealer been retained by the manufacturer
• Manufacturer can not require dealer to return • Manufacturer can require dealer to return vehicles without compensation vehicles
• Dealer is unable to return vehicles to • Dealer can return vehicles to manufacturer manufacturer without penalty without penalty
• Price charged to the dealer is based on list • Price charged to the dealer is based on list price on delivery date price on date of sale to customer
• Price charged to the dealer increases with the • Price charged to the dealer does not vary length of time for which vehicles held with the length of time for which the vehicles
are held.
Learning Example 13.1
McCulloch is a car dealership in the north of Scotland. On 17 September 20X8, a manufacturer delivers 10 new cars to McCulloch on the following terms:
- The manufacturer may require the cars to be returned if they are needed to meet an order from another dealer, although in practice this has never happened.
- Mc Culloch is required to insure the vehicles from the date of delivery
- Mc Culloch will be charged $10,000 per vehicle on the earlier of 31 January 20X9 or the date of a sale to a third party. This is the list price on 17 September 20X8.
- Mc Culloch may use the cars for test drive purposes.
Should Mc Culloch record the cars as inventory in its statement of financial position at 31 December 20X8?
Exam Hint
Where consignment inventory features in an exam, make sure that you read the question carefully, understand the arrangement, discuss the risks and rewards and conclude that the owner of the asset is the party who has these risks and rewards.
3.2 SALE AND LEASEBACK
The issue of sale and leaseback arises where a company wishes to release funds, and in order to do so, sells a large asset, such as a property, to a bank. It then leases the property back on an annual rental basis, and continues to occupy it.
The issue is whether this is a true sale, and subsequent lease, or whether the substance of the arrangement is a secured loan rather than a sale.
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3.2.1 ACCOUNTING TREATMENT
The type of lease should be determined in accordance with IAS 17 Leases, by considering the transfer of risks and rewards. The following rules then apply:
Sale and Operating Leaseback
A sale is recorded and the subsequent operating lease is accounted for in line with IAS 17. The profit or loss arising on sale is dealt with as follows:
Sale price > fair value Recognise ‘fair value’ profit or loss immediately Recognise any excess profit over the lease term.
Sale price = fair value Recognise profit or loss on sale immediately
Sale price < fair value Recognise profit or loss on sale immediatelyunlessa loss is compensated for by future below market lease payments, in which case the loss is recognised over the lease term.
Sale and Finance Leaseback
The substance of the transaction is a secured loan. Therefore no sale is recorded and the receipt on ‘sale’ is recorded as a loan.
Annual repayments are allocated between repayment of capital and interest.
Learning Example 13.2
On 30 June 20X8, Morningside sells two assets to a bank:
- A property sold for $400,000 is leased back under a finance lease with annual repayments in arrears. The property had a carrying value of $270,000 at 30 June 20X8.
- Land sold for $600,000 is leased back under a 10 year operating lease. The land had a carrying value of $300,000 and a fair value of $550,000.
How should these transactions be accounted for in the financial statements of Morningside for the year ended 31 December 20X8?
How would this differ if the land was sold for $500,000, and the future lease rentals were at less than market value?
3.3 SALE AND REPURCHASE
In order to release funds, a company may sell an asset to a finance house, with an agreement that it will be repurchased at a future date, often at a higher price. This is common in industries where stocks take a period of time to mature, such as malt whisky production. In this case, vats of whisky are sold to a bank for the pe-riod that they take to mature.
The issue is whether this is a true sale, and should be accounted for as such, or whether in substance it is a loan secured on the asset.
3.3.1 ACCOUNTING TREATMENT
As before, the risks and rewards of ownership should be considered, and in particular whether these have transferred to the finance house.
- If the risks and rewards of ownership have been transferred to the finance house, the transaction should be accounted for as a sale
SUBSTANCE OVER FORM
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Indicators that the transaction should Indicators that the transaction should be recorded as a sale be recorded as a secured loan
• There is no commitment to a repurchase • Sale price is not equal to market value of asset • Finance house benefits from any increase in at sale date
the market value of the asset (through a • There is commitment to the repurchase, repurchase price related to market value). normally through the seller having a call option • Seller has no rights over the asset after the and the finance house a put option such that
sale. one will exercise their option and the repurchase will occur.
• The repurchase price is not related to the market value of the asset and is simply the initial sale price plus interest.
• Seller retains the right to use the asset as they wish.
Learning Example 13.3
Edinglow imports special whisky ingredients which take five years to mature before being used in the manufacturing process.
During the year ended 31 May 20X8, it imported material at a cost of $40million. Edinglow then sold this inventory to Northrock Bank for $40 million, agreeing to buy it back in five years’ time for $56.1million.
The materials do not leave the premises of Edinglow.
Assuming an effective rate of interest of 7%, how should the above transaction be accounted for?
3.4 FACTORING OF RECEIVABLES
A further method by which a company may release funds is to sell its receivables ledger to a factor, often a bank.
The issue is whether the company should derecognise the receivables when they are transferred to the factor, or retain them as assets, recognising the bank advance as a loan.
3.4.1 ACCOUNTING TREATMENT
As before, the risks and rewards associated with the receivables should be considered:
- If the selling company has transferred the risks and rewards to the factor, then the receivables should be derecognised.
- If the selling company has not transferred the risks and rewards to the factor, then the receivables should not be derecognised.
Indicators that the risks and rewards Indicators that the risks and rewards have been transferred to the factor have not been transferred to the factor
• There is no recourse to the selling company • There is recourse to the selling company for for any irrecoverable debts irrecoverable debts
• The transfer is for a non-returnable sum • The selling company is required to pay finance • Selling company has no right to further costs to the factor based on unpaid debt.
Learning Example 13.4
Telenorth factored the outstanding account receivable of a major customer amounting to $12million to Kwikfinance on 1 September 20X8. The terms of the factoring were as follows:
1 Kwikfinance paid 80% of the outstanding amount to Telenorth immediately
2 The balance will be paid (less the charges below) when the account is collected in full. Any amount of the account outstanding after four months will be transferred back to Telenorth at its full book value.
3 Kwikfinance will charge 1% per month of the net amount owing from Telenorth at the beginning of each month. Kwikfinance had not collected any of the amounts receivable at the 31 December year end.
Telenorth debited the cash from Kwikfinance to its bank account and removed the amount receivable from its sales ledger. It has prudently charged the difference as an administration cost.
How should the factoring arrangement be accounted for in the financial statements of Telenorth?
Exam Hint
A full exam question on one of the substance over form topics is likely to have a large written element. Write your whole thought process down, making sure that your points are clear and succinct and in bullet point format.
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Sales Revenue
18 Revenue provides guidance on accounting for revenue, which it defines as:
The gross inflow of economic benefits arising in the course of the ordinary activities of an entity, other than contributions from equity participants.
In other words, the standard addresses income other than that from the issue of shares, including: - Revenue from the sale of goods
- Revenue from the provision of services - Dividends receivable
- Interest receivable - Royalties receivable
IAS 18 requires that all income is recognised at its fair value and goes on to provide criteria for the recognition of each type of income as detailed in the following sections. These criteria take into account the concept of substance over form in considering when revenue should be recorded.
4.0.1 SALE OF GOODS
Revenue from the sale of goods is recognised when all of the following conditions are met:
6 The selling company has transferred the significant risks and rewards of ownership of the goods to the buyer.
7 The selling company no longer has managerial involvement in the goods sold nor effective control over them
8 The amount of revenue can be measured reliably
9 It is probable that the economic benefits of the transaction will flow to the entity
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Learning Example 13.5
Southside sells sofas with 2 year’s interest free credit. During the month of January 20X8, Southside sells 150 sofas with a price of $600. A subsidiary of Southside sells the same sofas for $560 without providing credit facilities.
How should Southside recognise the revenue in relation to the sofas?
Learning Example 13.6
Corstorphine recorded $200,000 sales revenue during the month of May 20X9, making a draft profit of $40,000 based on a mark up on 25%. $120,000 of revenue related to sales made to Dalkeith, who Corstorphine transact with on a sale or return basis. Dalkeith had sold two thirds of the goods on to customers by the end of the month, but had the right of return over the remaining third.
What revenue and profits should Corstorphine recognise for the month of May?
Exam Hint
A sale or return transaction featured in the June 2008 paper as part of the published accounts question, where candidates were required to adjust a profit figure for a number of items. The examiner commented that candidates commonly struggled with the adjustment for sale or return goods.
4.0.2 PROVISION OF SERVICES
Revenue from the provision of services is recognised by reference to the stage of completion when all of the following conditions are met:
5 The amount of revenue can be measured reliably
6 It is probable that the economic benefits of the transaction will flow to the entity
7 The stage of completion of the transaction at the reporting date can be measured reliably
8 The costs incurred in relation to the transaction can be measured reliably.
When all of these conditions are not satisfied, revenue is recognised only to the extent that expenses recognised are recoverable.
Learning Example 13.7
Gyle sells processing machines to the food industry. Each one comes with a two year service agreement included within the price of $300,000. After the two year period, annual service agreements may be purchased at a standard cost of $30,000.
Half way through the year ended 31 December 20X8, Gyle sold 40 machines in a single order to a Russian farm co-operative. How should the related revenue be recorded in Gyle’s financial statements for the year?
4.0.3 DIVIDENDS, INTEREST AND ROYALTIES
- Dividends are recognised when there is a right to receive payment. - Interest is recognised using the effective interest method (see chapter 15)
4.1 DISCLOSURE REQUIREMENTS
The following should be disclosed in relation to revenue:
• The accounting policies adopted for the recognition of revenue
• The amount of each significant category of revenue recognised during the period, including o The sale of goods
o The provision of services o Dividends
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Solution 13.1
The risks and rewards of ownership have transferred to McCulloch: - McCulloch must meet insurance costs
- the price charged to McCulloch is set on the date of delivery
- McCulloch is bound to buy the cars on 31 January 20X8 if they remain unsold - McCulloch has access to use the cars for test drives.
The fact that the manufacturer can require the cars to be returned is an indicator that the risks and rewards have not transferred to McCulloch. However, this has never happened in practice, and is outweighed by the factors suggesting that the risks and rewards have transferred to McCulloch.
Therefore the cars should be reflected as inventory in its statement of financial position at the 31 December 20X8.
Learning Example 13.2
Property
This is a sale and finance lease back. Therefore:
- The property remains in the statement of financial position and continues to be depreciated. At 31 December 20X8 it is therefore held at $270,000 less six months’ depreciation. - $400,000 is recognised as a loan, split between current and non-current amounts.
- Interest accruing on the first six months of the loan should be recorded as a current liability.
Land
This is a sale and operating lease back. Therefore:
- A sale is recorded: the profit of $250,000 based on fair value ($550,000 - $300,000) is recognised immediately; the profit in excess of fair value of $50,000 ($600,000 - $50,000) is spread over the 10 years of the lease, with $5,000 recognised as income each year.
- Operating lease payments are recognised as normal in accordance with IAS 17.
Solution 13.3
Edinglow has retained the risks and rewards associated with the inventory:
- Edinglow is obliged to repurchase the inventory at the pre-determined price of $56.1million (being the $40million capital repayment plus interest thereon). This price is fixed regardless of the market value or condition of the inventory, meaning that Edinglow bears the risk of falls in market value or damage.
- The inventory does not leave the premises of Edinglow.
The loan is recorded as follows throughout the 5 year term:
Balance Finance Balance b/f cost 7% c/f $000 $000 $000
y/e 31.5.X8 40,000 2,800 42,800 y/e 31.5.X9 42,800 2,996 45,796
y/e 31.5.Y0 45.796 3,206 49,002 y/e 31.5.Y1 49,002 3,430 52,432
y/e 31.5.Y2 52,432 3,670 56,100
Income Year end statement balance in finance cost statement of financial position
Solution 13.4
- Kwikfinance has paid $9.6million (80% x $12million) to Telenorth, however if Telenorth’s customers do not pay within four months, this is recoverable from Telenorth in full.
- Kwikfinance will only pay the balance of $2.4 million if Telenorth’s customers pay
- Kwikfinance charges 1% of the outstanding balance (i.e. the amount not recovered from customers) per month for this service.
- The risks and rewards relating to the $12m receivables ledger are therefore retained by Telenorth.
- The receivables should not be derecognised, and the $9.6million advance should be treated as a secured loan, which is the substance of the transaction.
- Interest charged by Kwikfinance should be recorded as a finance cost relating to the loan.
Accounting Entries
Telenorth has: Dr Cash $9.6m Dr Admin expenses $2.4m Cr Receivables $12m
In order to correct this entry and put through the correct entry:
Dr Receivables $12m (to reinstate the receivables) Cr Admin expenses $2.4m (to reverse the expenses charged) Cr Loan $9.6m (to create a loan account)
Interest at 1% per month must also be charged:
SUBSTANCE OVER FORM
Financial Statements
Statement of Financial Position at 31 December 20X8 $000
Receivables 12,000
Accrued interest 384
Loan 9,600
Income Statement for the Year Ended 31 December 20X8 $000
Finance costs 384
Solution 13.5
- The fair value of the sofas is $560. Therefore the extra $40 per sofa charged by Southside represents interest relating to the credit.
- Southside should therefore record revenue and corresponding receivables of $84,000 (150 x $560)
- This revenue should be recorded when the goods are delivered to the customer as this is likely to be the date on which the risks and rewards of ownership pass, and Southside cease to have effective control over the sofas.
- The $6,000 balance (150 x $40) is recorded as a finance cost spread over the two years of credit.
Learning Example 13.6
Where goods are sold on the basis of sale or return, the risks and rewards of ownership do not transfer from the seller until the goods are sold on to a third party.
Therefore, Corstorphine should not have recorded revenue in relation to the goods over which Dalkeith still has a right of return.
The revised amounts for inclusion within Corstorphine’s financial statements are therefore:
$000 Revenue ($200,000 – (1/3 x $120,000) 160 Profits ($40,000 – (25/125 x 1/3 x $120,000) 32
Solution 13.7
- The revenue associated with the machines must be split from that associated with the service agreements:
$000
Machine 240
2 years service agreement 60 300
- The machines were sold mid year and therefore revenue relating to 6months should be recorded - The balance of the revenue relating to the service agreements should be recorded as deferred income in
the statement of financial position.
Income Statement $000
Revenue (40 x $240,000) + (40 x 6/12 x $30,000) 10,200
Statement of Financial Position
Deferred income (40 x $45,000) 1,800
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Learning Summary
• Ensure that you understand the examples of substance over form, and how risks and rewards may be assessed
• Practise writing answers in bullet point format to questions on this topic
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CONCEPTUAL AND REGULATORY
Context
In previous chapters we have considered the application of a number of accounting standards. In this chapter, we now takes a step back and consider where the rules and principles governing accounting practice come from.
This is a topic previously seen at the F3 level, although it remains very examinable at F7.
This chapter includes discussion of:
• the regulatory bodies governing international financial reporting • underlying concepts which are relevant to all financial reporting • accounting policies, estimates and errors
Exam Hints
The regulatory and conceptual framework are normally examined within question 4 or 5 of the paper. The conceptual framework may be examined as a standalone theoretical topic or through its application to scenarios.
Key Learning Points
Regulatory Framework
• A regulatory framework may include IFRS, local laws, securities exchange rules, EU directives and local GAAP.
• It is necessary in order to ensure that financial statements are useful, reliable and comparable, and companies operate in an accountable way.
• The IASCF oversees, funds and monitors the work of :
o The IASB who are responsible for issuing new accounting standards and promoting convergence o The SAC who advise the IASB on their agenda and the impact of new standards
o The IFRIC who provide support to the IASB and guidance on emerging accounting issues o There is a six step due process to the setting of an accounting standard:
1. Setting the agenda 2. Project planning
3. Development and publication of a discussion paper 4. Development and publication of an exposure draft 5. Development and publication of an IFRS
6. Procedures after the IFRS
• National standard setters interact with international bodies through the adoption of IFRS into local GAAP, collaborative work, and the inclusion of national standard setters on the IASB
Conceptual Framework
• a principles based system of accounting is based on a conceptual framework and accounting standards set within the parameters of this conceptual framework.
• a rules based system is one where accounting standards are simply a set of rules which companies must follow.
• International GAAP is based on a principles based system, with a conceptual framework known as the Framework.
• The IASB’s Framework provides general guidelines and principles for preparing financial statements. • The qualitative characteristics of financial statements are understandability, relevance, reliability and
comparability.
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• Reliability refers to faithful representation, substance over form, neutrality, prudence and completeness. • Qualitative characteristics may conflict.Where this is the case, a balance should be achieved.
• The Framework requires that fair presentation is achieved within financial statements. This is achieved where accounting standards are followed. Departure is only allowed in rare circumstances where following guidance within a standard would be misleading. Such departures (a ‘true and fair override’) must be disclosed.
• The Framework provides definitions of assets, liabilities, equity, income and expenses. • These elements of the financial statements are recognised where:
o it is probable that any economic benefit associated with the item will flow to or from the entity, and o the item has a cost or value that can be measured with reliability.
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
• An accounting policy is a specific principle or rule applied by a company in preparing its financial statements. • Accounting policies can only be changed where required by an accounting standard or where the new policy
results in more reliable and relevant information.
• A change in accounting policy is applied retrospectively by way of a prior period adjustment. • An accounting estimate is a judgment required in the application of accounting policies. • If an accounting estimate changes, the new estimate is applied prospectively.
• If a prior period error is made, this is corrected retrospectively by way of a prior period adjustment. • A prior period adjustment results in restatement of the opening balance on retained earnings and restatement
of comparatives to reflect the amounts that would have been reported had the new accounting policy always been in place or the error never occurred.
Relevant Accounting Standards and Guidance
Framework for the Preparation and Presentation of Financial Statements IAS 1 Presentation of Financial Statements
CONCEPTUAL AND REGULATORY
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Regulatory Framework
1.0.1 WHY IS A REGULATORY FRAMEWORK NEEDED?
Regulations governing the preparation of financial statements are required in order to ensure that: - Financial statements can be relied upon by their various users
- The information provided within financial statements is useful and relevant - The financial information of entities is comparable
- Companies behave in a proper fashion towards their investors - Market confidence in companies and their accounts is maintained.
1.0.2 WHAT IS A REGULATORY FRAMEWORK?
Accounting standards alone can not provide a regulatory framework; particularly since they do not have legal standing. The regulatory framework of a jurisdiction adopting IFRS may therefore include all of the following: - IFRS themselves
- Local company law
- Local securities exchange regulations - EU directives (where relevant)
- Local GAAP (Generally Accepted Accounting Principles) where relevant
Within the UK, for example, listed companies are regulated by IFRSs, the Companies Act 2006, the Stock Exchange rules and EU directives. Unlisted companies are regulated by UK GAAP (UK accounting standards), the Companies Act 2006 and EU directives.
The International stream of F7 is concerned with the international regulatory framework, and the various bodies involved in the setting of international accounting guidance.
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1.1 THE STRUCTURE OF THE INTERNATIONAL REGULATORY FRAMEWORK
The international regulatory framework includes 4 main bodies, structured as follows:
International Accounting Standards Committee
Foundation (IASCF)
22 trustees from varied professional backgrounds and
geographical locations
Oversees, funds and monitors the operational
effectiveness of:
1.1.1 THE OBJECTIVES OF THE IASCF AND IASB
The objectives of both the IASCF and IASB are :
1 to develop a single set of high quality, understandable and enforceable global accounting standards to help users make economic decisions;
2 to promote the use and rigorous application of those standards;
3 to take account of the special needs of SMEs and emerging economies
4 to bring about the convergence of national and international accounting standards to high quality solutions.
International
Accounting Standards Board (IASB)
14 members from varied professional backgrounds and geographical locations
• Develop new accounting standards (known as IFRS)
• Liaise with national standard-setting bodies to promote convergence of international and national accounting standards
Standards Advisory Council (SAC)
About 40 members
• advice to IASB on
- their agenda and work prioritisation
- the impact of proposed standards
International Financial Reporting Interpretations Committee (IFRIC)
12 voting members plus a non-voting chair
• Assist the IASB to establish and improve standards
• Issues Interpretations (known as IFRICs) which provide timely guidance on emerging accounting issues not addressed in full standards
CONCEPTUAL AND REGULATORY
1.1.2 THE STANDARD SETTING PROCESS
The IASCF has identified six stages in the standard setting process:
1 Setting the agenda Possible new projects are identified by: - IASB staff members
- Other IASCF bodies
- Requests from practising accountants
The IASB will add projects to its agenda by reference to meeting the needs of users of the financial statements.
2 Project planning A decision is made as to whether the project should be worked on in collaboration with a national standard setter and a working party is established.
3 Development and A DP is not a mandatory step in the due process, however the IASB publication of a discussion normally issues a DP where a project addresses a major issue. The DP paper (DP) explains the issue and possible accounting solutions and invites
constituents to comment. After the comment period (normally 120 days) comments are analysed and further discussions and round tables may take place.
4 Development and An ED is a mandatory step in due process and sets out the draft publication of an exposure proposals for a standard. When 9 of the members of the IASB have draft (ED) approved the ED, it is published for public comment. This comment
period normally lasts 120 days, and afterwards, comments are analysed, and if required, the ED is amended and re-exposed.
5 Development and When any issues arising from the ED are concluded, the final IFRS is publication of an IFRS subject to approval by the IASB. Nine members must approve it before
it is issued.
6 Procedures after an IFRS After an IFRS is issued, the IASB monitors its application and any areas is issued that may need clarification, and addresses these when the standard is
revised or as part of its annual improvements project cycle.
1.1.3 THE INTERACTION OF INTERNATIONAL AND NATIONAL STANDARD SETTERS
National standard setters may interact with the IASCF and its bodies in the following ways:
- through the adoption of IFRS into local GAAP (for example UK FRS 21 is a rebranded IFRS 10)
- through collaborative work: the initial research stages of the IASB standard setting due process are often conducted by a national standard setter (for example the UK ASB has been involved in the IASB’s Leasing project)
- through the inclusion of most of the important national standard setters within the membership of the IASB
Learning Example 14.1
Historically, financial reporting throughout the world has differed widely. The International Accounting Standards Committee Foundation (IASCF) is committed to developing, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements. The various pronouncements of the IASCF are sometimes collectively referred to as IFRS GAAP.
(a) describe the functions of the various internal bodies of the IASCF, and how the IASCF interrelates with other national standard setters
(b) describe the IASCF’s standard setting process including how standards are produced, enforced and occasionally supplemented.
(c) comment on whether you feel the move to date towards global accounting standards has been successful.
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2
Conceptual Framework
As well as issuing accounting standards specific to particular issues, the IASB has issued a general conceptual framework for financial reporting. This is referred to as the Framework.
It provides the concepts that underlie financial statements and the qualitative characteristics that a set of financial statements should possess, as well as key definitions of the elements of financial statements and recognition criteria to be applied to them.
IFRS are set within the parameters of this Framework, adopting the principles within it.
2.0.1 WHY IS A CONCEPTUAL FRAMEWORK REQUIRED?
A conceptual framework is required in order that:
- certain basic issues such as the definition of an asset are addressed, and then applied consistently throughout standards
- new standards can be developed along the same principles as existing standards
- complex and unusual transactions, not addressed within an IFRS can be accounted for according to basic principles
- the number of alternative accounting treatments is reduced
2.0.2 PRINCIPLES V RULES BASED SYSTEMS OF ACCOUNTING
International GAAP is an example of a principles based system of accounting, which is based on a conceptual framework (the Framework) and accounting standards set within the parameters of this conceptual framework.
An alternative system of accounting is a rules based system whereby accounting standards are simply a set of rules which companies must follow. This is the case in the US.
Principles Based Rules Based
Advantages Flexible with regard to changing More consistent and comparable environments results across entities
Disadvantages Entities may not interpret and apply Less flexible and adaptable to change principles consistently
May lead to problems when rules are Individuals may interpret principles in applied literally without regard to the such a way as to manipulate results spirit of a standard, resulting in
mis-representation of balances. This is particularly true in the light of
accounting scandals such as Enron, Worldcom and Parmalat.
2.1 QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS
Qualitative characteristics are the attributes of financial statements that make them useful to users. There are four main characteristics:
Characteristics which make
CONCEPTUAL AND REGULATORY
These characteristics should be present in financial statements subject to amateriality threshold.
Items in the financial statements are material if their omission or misstatement could influence users of the accounts. It is therefore particularly important that the characteristics above are applied to material items.
2.1.1 UNDERSTANDABILITY
Financial statements should be understandable to users. For this purpose, users are assumed to have reasonable knowledge of business and economics.
However, items should not be excluded from the financial statements simply because they are perceived to be complex.
Practical Examples of Understandability
- financial instruments are included in the financial statements despite being perceived as complex
2.1.2 RELEVANCE
Financial statements are relevant where they provide information which is useful to users for decision making purposes.
Such information may have a confirmatory value (and so confirm the users’ understanding of past events) or a predictive value (and so help them to predict future events).
Practical Examples of Relevance
- properties may be revalued to market value
- discontinued operations are reported separately
2.1.3 RELIABILITY
The financial statements must be reliable in order to be useful. Reliability can be subdivided into:
• Faithful Representation
Information must faithfully represent transactions and events, in accordance with their economic substance rather than legal form
• Substance Over Form
The commercial substance of a transaction is more important than its legal form. As far as possible, the financial statements should reflect commercial substance.
• Neutrality
In order to be reliable, financial statements should be free from bias. • Prudence
Prudence means to exercise caution when recording transactions. Assets and income should not be overstated, and liabilities and expenses not understated.
• Completeness
Information presented in the financial statements should be complete.
Practical Examples of Reliability
- inventory is valued at the lower of cost and NRV (prudence) - irrecoverable debts are derecognised (prudence)
- development costs are only recognised as an asset when the recognition criteria are met (prudence) - an asset under a finance lease is recognised as a non-current asset (substance over form)
- redeemable preference shares are recognised as debt (substance over form)
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2.1.4 COMPARABILITY
In order for financial statements to be useful, they should be comparable: • With the financial statements of other businesses
• With the financial statements of the same business over time.
This is achieved by consistency of accounting policies and disclosure of accounting policies, including any changes in them for fairer presentation.
Practical Examples of Comparability
- IAS 1 formats enable the comparison of entities
- disclosure of accounting policies enables the financial statements of two entities to be compared taking into account different policies
- depreciation estimates should be applied consistently
2.1.5 THE BALANCE BETWEEN QUALITATIVE CHARACTERISTICS
Conflicts between qualitative characteristics may be apparent. For example:
• Financial statements may be less understandable if they are more complete (i.e. including a complex transaction)
• Relevant information may not be reliable.
The Framework requires that in these cases, a balance is achieved.
Learning Example 14.2
(a) The qualitative characteristics of relevance, reliability and comparability identified in the IASB’s Framework for the Preparation and Presentation of Financial Statements are some of the attributes that make financial information useful to the various users of financial statements.
Explain what is meant by relevance, reliability and comparability and how they make financial information useful.
(b) During the year ended 31 March 20X6, Porto experienced the following:
(i) entered into a finance lease to rent an asset for substantially the whole of its useful economic life (ii) the company’s income statement prepared using historical costs showed a loss from operating its hotels, but the company is aware that the increase in value of its properties during the period far outweighed the operating loss.
Explain how you would treat the items above in Porto’s financial statements and indicate on which of the Framework’s qualitative characteristics your treatment is based.
(F7 Pilot paper)
Exam Hints
In December 2007, 5 marks were available for an explanation of faithful representation and how it enhances reliability. The examiner commented that some candidates regurgitated what they had been taught about comparability, relevance and so on rather than answering the question. Weaker candidates were unable to link faithful representation with substance over form.
CONCEPTUAL AND REGULATORY
2.2 FAIR PRESENTATION
The Framework requires that financial statements give a ‘fair presentation’ of financial position and performance. In the UK this is referred to as a ‘true and fair view’ of financial position and performance.
Fair presentation has no legal definition but is assumed to be achieved where accounting standards and the Framework are followed.
2.2.1 TRUE AND FAIR OVERRIDE
Departure from accounting standards is allowed in the rare circumstance that compliance with a requirement of a standard would be so misleading that it would conflict with the Framework’s objectives of financial statements. This departure is commonly known as a ‘true and fair override’.
IAS 1 requires the following to be disclosed when the requirements of a standard are departed from:
- the nature of the departure, including the treatment required by the standard, the reason why this would be misleading, and the treatment adopted
- the financial impact of the departure.
2.3 ELEMENTS OF FINANCIAL STATEMENTS AND THEIR RECOGNITION
The elements of financial statements are: - Assets
- Liabilities - Equity - Income, and - Expenses
The definitions of each are as follows:
Asset 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.
Liability A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
Equity The residual interest in the assets of the entity after deducting all its liabilities.
Income Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants
Expense Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants
2.3.1 RECOGNITION OF ELEMENTS OF THE FINANCIAL STATEMENTS
An item that meets the definition of an element should be recognised if:
- it is probable that any economic benefit associated with the item will flow to or from the entity, and - the item has a cost or value that can be measured with reliability.
These recognition criteria are used as a basis for the specific recognition criteria within certain standards, such as:
IAS 37 Provisions, Contingent Liabilities and Contingent Assets (provisions)
IAS 38 Intangible assets (development costs)
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Exam Hint
In December 2008, 5 marks were available for the definition of a liability, explanation of when a provision should be recognised and two examples of how the definition of a liability enhances reliability. The examiner commented that candidates were generally able to provide definitions, however their examples were ‘rather trivial’ rather than concentrating on areas where a definition was key to reliability, such as provisions.
3
Accounting Policies and Estimates
Anaccounting policyis a specific principle or rule applied by a company in preparing its financial statements. They are generally driven by accounting standards and the Framework.The following are examples of accounting policies:
• The capitalisation of development costs meeting the recognition criteria • The depreciation of non-current assets
• The revaluation of certain classes of non-current assets
Anaccounting estimateis a judgement required in the application of accounting policies. For example • The method of and rate at which non-current assets are depreciated
3.1 CHANGE IN ACCOUNTING POLICY
In order to achieve comparability, accounting policies should be applied consistently over time and across similar assets/liabilities.
A change in accounting policy is only allowed if it: • Is required by an accounting standard, or
• Results in more reliable and relevant financial statements.
A change in accounting policy is evident if there is a change in:
1 recognition (e.g. an item previously recognised as an expense is now capitalised as an asset)
2 presentation (e.g. an amount previously recognised within distribution costs is now recognised within cost of sales), or
3 measurement basis (e.g. assets held at historical cost are now held at a revalued amount)
Where an accounting policy is changed, the change is appliedretrospectivelyi.e. the financial statements are changed so that balances are as they would be had the new policy always been in place. This is achieved through a prior period adjustment (see section 3.4)
3.2 CHANGE IN ACCOUNTING ESTIMATES
By its nature, an estimate may need to be revised if circumstances change. For example, 10% straight line depreciation of a non-current asset is based upon an estimated 10 year useful life. It may however become apparent after using the asset for a few years that the total useful life is less than 10 years.
IAS 10 therefore allows changes in accounting estimates, and requires that they are accounted for
prospectively.In other words, the revised estimate is applied going forward but does not result in a prior period adjustment.
Learning Example 14.3
CONCEPTUAL AND REGULATORY
3.3 ERRORS
If a current period error is discovered during the current period, it can be corrected before the financial statements are issued.
If, however, a material prior period error is discovered during the current period, it should be corrected
retrospectivelyi.e. the financial statements are changed so that they appear as they would had the error never occurred.This is achieved through a prior period adjustment (see section 3.4)
3.4 PRIOR PERIOD ADJUSTMENTS
Prior period adjustments are made where: • There is a change in accounting policy, or • There is a prior period error.
In both cases:
1 the balance on retained earnings at the start of the current period is adjusted (in the SOCE), and 2 comparative information is restated
to reflect the situation had the new policy always been in place / the error never occurred.
Restatement of the opening retained earnings balance is disclosed in the statement of changes in equity:
Learning Example 14.4
Monkman has discovered that closing inventory at the end of the previous period was overvalued by $20,000. This is considered to be a material error requiring adjustment. The following information is relevant:
Retained earnings as reported at previous period end $433,900 Cost of sales in current period (before adjustment for error) $127,655 Inventory as reported in previous period’s statement of financial position $67,000
What adjustments must be made to the current year financial statements in respect of the error?
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Solution 14.1
(a) IASCF – International Accounting Standards Committee Foundation
The Trustees of the IASCF oversee the whole organisation. They arrange funding, appoint the members of the IASB, IFRIC and SAC, and set the agenda for the IASB. The aims of the IASCF are:
- to develop a single set of high quality global accounting standards - to promote the use of these standards
- to bring about convergence of national and international accounting standards
IASB – International Accounting Standards Board
The IASB develops and issues IFRS in its own right. It reports to the IASCF. Members of the IASB are appointed for their technical competence and independence.
IFRIC – International Financial Reporting Interpretations Committee
IFRIC provides rapid guidance on accounting issues where divergent or unacceptable treatments are likely to arise. It reports to the IASB. Membership of IFRIC is drawn from a diverse range of geographical and professional backgrounds.
SAC – Standards Advisory Council
The SAC provides a forum for organisations or individuals to take part in the standard setting process. It advises the IASB on agenda decisions, priorities and its views on standard setting projects. Membership is drawn from a diverse range of geographical and professional backgrounds.
Advisory Committeesare set up to advise the IASB On specific issues.
National Standard Setters
Although the IASCF is an independent organisation, it works closely with national standard setters. The IASB, SAC and advisory committees draw heavily on personnel from national bodies. In return, many national standard setters incorporate IFRSs into their own accounting standards.
(b) Setting Standards
The IASCF sets the agenda for producing accounting standards, but the IASB produces and issues these standards. The process is as follows:
1 The IASCF, taking into account advice from the SAC and others, identifies an issue requiring an accounting standard.
2 The IASB sets up an Advisory Committee to investigate the issue and report back to the IASB.
3 The IASB may issues a Discussion Draft for public comment (this is not a mandatory step in the due process). A Discussion Draft needs a simple majority to be issued. Comments must normally be received within 120 days.
4 The IASB issues an Exposure Draft; comments must normally be received within 120 days. The Exposure Draft must be approved by eight of the 14 members of the IASB.
5 If necessary, based on comments received, the ED may be amended and re-exposed.
6 The IASB issues an IFRS. It must be approved by eight of the 14 members of the IASB.
CONCEPTUAL AND REGULATORY
Enforcing Standards
The IASB has no legal power to enforce adoption or compliance with standards, but enforcement of a sort is achieved in a number of ways:
- Quoted companies within the EU must comply with IFRS, but it is up to each member state to police compliance. Some countries have a formal process to review published financial statements and punish non-compliance (for example the Financial Reporting Review Panel in the UK), but this is not universal. To a certain extent, the onus is on the auditors to police compliance, but auditing standards themselves are not globally consistent.
- Companies using IFRS to obtain cross-border listings are required to have their financial statements audited in accordance with International Auditing Standards. This will help to ensure that these companies are complying with IFRS.
- Many countries are bringing their own standards into line with IFRS, but again policing of national standards is inconsistent.
Supplementing Standards
The IFRIC issues interpretations when divergent or unacceptable accounting treatments arise, whether through misinterpreting an existing standard or on an important issue not yet covered by a standard. Financial statements must comply with all of these interpretations if they claim to comply with IFRS.
Has the move towards Global Accounting Standards been successful?
On a practical level the move towards global accounting standards has been one of the accounting successes of the last decade. The standards themselves have improved, with the elimination of contradictory alternatives and the creation of an open and independent standard setting organisation.
This in turn has led to greater acceptance of these standards, illustrated by, for example, the adoption of IFRS for consolidated accounts by all quoted companies in the EU in 2005, in Chile in 2009, the upcoming adoption of IFRS for listed companies in Brazil in 2010 and Canada in 201. In all, including the EU countries, 89 jurisdictions currently require the use of IFRS for domestic listed companies.
However, as mentioned earlier, there is no global system of enforcement, and so it is too early to say if IFRS are being adopted properly.
Some countries with their own highly developed accounting standards see the adoption of IFRS as a backward step, whereas other countries see IFRS as unnecessarily complicated.
There is also the assumption that the globalisation of accounting standards is a good thing. Recent developments in IFRS have often focussed on quoted companies in the western world; they may not be suitable for all types and sizes of business organisation, or for all stages of economic development, although the IFRS for SMEs, published in June 2009 should address this to some extent.
Solution 14.2
(a) Relevance
The relevance of information must be considered in terms of the decision-making needs of users. It is relevant when it can influence their economic decisions or allow them to reassess past decisions and evaluations. Economic decisions often have a predictive quality – users may make financial decisions on the basis of what they expect to happen in the future. To some degree past performance gives information on expected future performance and this is enhanced by the provision of comparatives, so that users can see the direction in which the company is moving. The separate presentation of discontinued operations also shows how much profit or loss can be attributed to that part of the operation which will not be there in the future. This can also affect valuation of assets. One aspect of relevance is materiality. An item is material if its omission or misstatement could influence the economic decisions of users. Relevance would not be enhanced by the inclusion of immaterial items which may serve to obscure the important issues.
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Reliability
Information can be considered to be reliable when it is free from error or bias and faithfully represents what it is expected to represent. The income statement must be a reliable statement of the results of the entity for the period in question and the statement of financial position must faithfully represent its financial position at the end of the period. Financial statements in which provision had not been made for known liabilities or in which asset values had not been correctly stated could not be considered reliable. This also brings in the issue of substance over form. Transactions should be represented in accordance with their economic substance, rather than their legal form. This principle governs the treatment of finance leases, sale and leaseback transactions and consignment inventory. If these types of transactions are not accounted for in accordance with their economic substance, then the financial statements are unreliable.
Comparability
Comparability operates in two ways. Users must be able to compare the financial statements of the entity with its own past performance and they must also be able to compare its results with those of other entities. This means that financial statements must be prepared on the same basis from one year to the next and that, where a change of accounting policy takes place, the results for the previous year must also be restated so that comparability is maintained. Comparability with other entities is made possible by use of appropriate accounting policies, disclosure of accounting policies and compliance with IFRS. Revisions to standards have to a large degree eliminated alternative treatments, so this has greatly enhanced comparability.
(b) (i) The substance of a finance lease is that the lessee has acquired an asset using a loan from the lessor. Porto should capitalise the asset and depreciate it over its useful life (which is the same as the lease term). A finance lease liability should be set up for the same amount. The liability will be reduced by the lease payments, less the notional finance charge on the loan, which will be charged to profit or loss. This presents the transaction in accordance with its substance, which is a key aspect of reliability.
(ii) This issue has to do with relevance. It could be said that the use of historical cost accounting dies not adequately reflect the value of assets in this case. This can be remedied by revaluing the properties. If this is done, all properties in the category will have to be revalued. This will probably give rise to a higher revaluation charge, so it will not improve the operating loss in the income statement, but the excess can be credited back to retained earnings in the statement of financial position.
Solution 14.3
Old depreciation: $90,000 x 5% = $4,500
New depreciation: $90,000 – (2 x $4,500) = $8,100 10 years
Solution 14.4
Income Statement
Cost of sales ($127,655 - $20,000) $107,655
Statement of Changes in Equity Retained earnings $
Opening balance 433,900
Prior period adjustment (20,000)
Restated 413,900
Statement of Financial Position (Prior Year Comparative)
CONCEPTUAL AND REGULATORY
Learning Summary
• Learn the structure of the IASCF and the roles of each of the bodies within it • Learn due process for the development of a new standard
• Ensure that you understand the qualitative characteristics of the Framework, and can identify practical examples of them
• Learn the definitions of the elements of the financial statements and the associated recognition criteria • Ensure that you:
o understand the difference between an accounting policy and accounting estimate o Know how to apply a prior period adjustment
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15
FINANCIAL INSTRUMENTS
Context
Financial instruments is a new topic at the F7 level. It is a very complex area of financial reporting. At the F7 level, it is covered only at a very basic level – more detail and complexity is added at P2.
This chapter introduces and defines financial instruments, explains how they are classified for reporting purposes and how each classification of financial instruments should be accounted for.
Exam Hints
Financial Instruments may be examined as: - a consolidation adjustment;
- part of the published accounts question (Q2);
- with calculation and discussion elements as part of Q4 or Q5.
Key Learning Points
o A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
o IAS 39 requires that financial assets are classified as one of four types and financial liabilities as one of two types.The accounting treatment of a financial instrument depends on its classification.
Financial Assets Includes Initial Subsequent Gains and
Measurement Measurement Losses
Fair value through Shares or debt held Re-measured to FV Income statement profit or loss for the short term at reporting date
Held to maturity Fixed interest debt Amortised cost n/r intended to be held
to maturity
Loans and Receivables Amortised cost Other
receivables comprehensive
Fixed interest loan income to another company
Available-for-sale Ordinary shares Re-measured to FV n/r held for the at reporting date
long-term
Financial Liabilities
Fair value through Derivatives Re-measured to FV Income statement profit or loss at reporting date
Financial liabilities Redeemable debt Amortised cost n/r
o Financial assets, other than those classified as fair value through profit or loss should be reviewed for impairment at each reporting date. If evidence exists that an impairment has arisen, then the asset should be written down to its recoverable value, and the loss recognised in the income statement.
o Where a financial asset or liability is sold or discharged, it should be derecognised from the financial statements. The difference between the carrying value of the instrument and the proceeds received or amount paid for the discharge should be recognised in the income statement for the period. In addition the cumulative gains or losses relating to AFS investments, which are accumulated in reserves on year-end re-measurement are ‘recycled’ to the income statement.
o IAS 39 requires that a compound instrument is split into its equity and liability elements and both are recognised in the statement of financial position.
o The liability element is recognised as the present value of the bond assuming that there were no conversion rights, using an effective interest rate for a similar non-convertible bond
o The equity element is the balance of the proceeds.
Relevant Accounting Standards
IAS 32 Financial instruments: Presentation
IAS 39 Financial instruments: Recognition and Measurement
Technical Articles
The following article on financial instruments is available on ACCA’s website:
FINANCIAL INSTRUMENTS
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15
1
Financial Instruments – An Introduction
IAS 32 defines financial instruments as:
Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
A financial asset is:
Any asset that is: - cash;
- an equity instrument of another entity;
- a contractual right to receive cash or another asset from another entity;
- a contractual right to exchange financial assets or liabilities with another entity under conditions that are potentially favourable;
- a contract that will be settled in the entity’s own equity instruments.
A financial liability is:
Any liability that is a contractual obligation:
- to deliver cash or another financial asset to another entity;
- to exchange financial assets or liabilities with another entity under conditions that are potentially unfavourable;
- that will or may be settled in the entity’s own equity instruments.
An equity instrument is:
Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities
Practically, these definitions may include the following:
Financial Assets Financial Liabilities Equity
- cash - payables - ordinary shares issued - ordinary shares held - redeemable loan stock - irredeemable preference
in another company issued shares issued
- loan stock held in another - Convertible loan stock
company issued
- receivables - Redeemable preference shares issued
The classification of cash, receivables and payables as financial instruments does not change their accounting treatment as seen in your earlier studies.
Exam Hint
The most examinable financial instruments are: - Loan stock (redeemable and convertible)
2
Financial Assets
IAS 39 requires that financial assets are classified as one of four types:
1 Fair value through profit or loss (FVTPL) 2 Held to maturity (HTM)
3 Loans and receivables 4 Available-for-sale (AFS)
2.0.1 FAIR VALUE THROUGH PROFIT OR LOSS
A financial asset is classified as fair value through profit or loss where it is - Held for trading (i.e. acquired principally for resale); or
- Is designated as fair value through profit or loss at acquisition.
Examples
- A holding of ordinary shares in another company held for the short term - A holding of loan stock in another company held for the short term
2.0.2 HELD TO MATURITY
A financial asset is classified as held to maturity where it has - Fixed or determinable payments
- Fixed maturity, and
- The entity intends to hold the asset to maturity
Example
- A holding of fixed interest loan stock in another company intended to be held until redemption
2.0.3 LOANS AND RECEIVABLES
A financial asset is classified as loans and receivables where it - Has fixed or determinable payments
- Is not quoted in an active market
- Is not classified as held for trading (as there is no intention to sell in the short term), and - Is not designated as available-for-sale
Examples
- A trade receivable
FINANCIAL INSTRUMENTS
2.0.4 AVAILABLE-FOR-SALE
A financial asset which is not classified as FVTPL, HTM or loans and receivables is classified
