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ICAP
Financial accounting and reporting II
Sixth edition published by
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© Emile Woolf International ii The Institute of Chartered Accountants of Pakistan

Certificate in Accounting and Finance
C
Contents
Page
Chapter
1 Legal background to the preparation of financial statements 1
2 IAS 1: Presentation of financial statements 15
Consolidated accounts: Statements of financial position –

3 45
Basic approach
Consolidated accounts: Statements of financial position –

4 75
Complications
5 Consolidated accounts: Statements of comprehensive income 99
6 IAS 28: Investment in Associates and Joint Ventures 111
IAS 8: Accounting policies, changes in accounting estimates and

7 119
errors
8 IAS 12: Income taxes 131
9 IAS 21: Foreign Currency Transactions 159
10 IAS 38: Intangible assets 171
11 IAS 41: Agriculture 191
12 IFRS 9: Financial instruments-Recognition and measurement 195
13 IFRS 16: Leases 201
© Emile Woolf International iii The Institute of Chartered Accountants of Pakistan

Syllabus objectives and learning outcomes
Page
14 Other areas of IFRSs (IFRS 8, IAS 10, IAS 37) 231
15 Ethical issues in financial reporting 263
Index 271
© Emile Woolf International iv The Institute of Chartered Accountants of Pakistan

1
CHAPTER
Legal Background to the Preparation of
Financial Statements
Contents
1 Regulatory framework for accounting in Pakistan
2 Companies’ Act, 2017: Fourth Schedule
3 Companies’ Act, 2017: Fifth Schedule
© Emile Woolf International 1 The Institute of Chartered Accountants of Pakistan

1 REGULATORY FRAMEWORK FOR ACCOUNTING IN PAKISTAN
Section overview
 Accounting regulation in Pakistan

 Companies’ Act, 2017: Introduction to the third, fourth and fifth schedules
 International Financial Reporting Standards
 Classification of Companies
1.1 Accounting regulation in Pakistan

The objective of financial statements is to provide information about the financial position
(balance sheet), financial performance (profit and loss) and cash flows of an entity that is useful
to a wide range of users in making economic decisions.
The Securities and Exchange Commission of Pakistan
The Securities and Exchange Commission of Pakistan (SECP) was established under the
Securities and Exchange Commission of Pakistan Act, 1997 and became operational in 1999.
It is the corporate and capital market regulatory authority in Pakistan. Its stated mission is “To
develop a fair, efficient and transparent regulatory framework, based on international legal
standards and best practices, for the protection of investors and mitigation of systemic risk aimed
at fostering growth of a robust corporate sector and broad based capital market in Pakistan”
(SECP website).
One of the roles of the SECP is to decide on accounting rules that must be applied by companies
in Pakistan.
Companies must prepare financial statements in accordance with accounting standards
approved as applicable and notified in the official gazette by the Securities and Exchange
Commission of Pakistan (SECP) and in accordance with rules in the Companies’ Act 2017.
The Institute of Chartered Accountants in Pakistan (ICAP)
ICAP regulates the Chartered Accountancy profession. It is the body responsible for
recommending accounting standards for notification by the Securities and Exchange Commission
of Pakistan.
1.2 Companies Act 2017: Introduction to the third, fourth and fifth schedules
The Companies Act 2017 contains a series of appendices called schedules which set out
detailed requirements in certain areas.
The third schedule
This schedule lists the classification criteria of the companies on the basis of company size and
whether it is commercial or non-profit. It also specifies which companies are required to follow
requirements of fourth and fifth schedule of the Act.
The fourth schedule
This schedule sets out the disclosure requirements that must be complied with in respect of the
financial statements of a listed company.
The schedule specifies that listed companies must follow International Financial Reporting
Standards as notified for this purpose in the Official Gazette.
The fifth schedule
This schedule applies to the balance sheets and profit and loss accounts of non-listed companies
(including large, medium and small sized entities) and their subsidiaries. It also applies to private
and non-listed public companies that are a subsidiary of a listed company.

Chapter 1: Legal background to the preparation of financial statements
1.3 International Financial Reporting Standards

The International Accounting Standards Committee (IASC) was established in 1973 to
develop international accounting standards with the aim of harmonising accounting procedures
throughout the world.
The first International Accounting Standards (IASs) were issued in 1975. The work of the
IASC was supported by another body called the Standing Interpretation Committee. This body
issued interpretations of rules in standards when there was divergence in practice. These
interpretations were called Standing Interpretation Committee Pronouncements or SICs.
In 2001 the constitution of the IASC was changed leading to the replacement of the IASC and
the SIC by new bodies called the International Accounting Standards Board (IASB) and the
International Financial Reporting Interpretations Committee (IFRIC).
The IASB adopted all IASs and SICs that were extant at the time but said that standards written
from that time were to be called International Financial Reporting Standards (IFRS).
Interpretations are known as IFRICs.
The term IFRS is also used to refer to the whole body of rules (i.e., IAS and IFRS in total).
Thus IFRS is made up as follows:
Published by the IASC (up Published by the IASB

to 2001) (from 2001)
Accounting standards IASs IFRSs
Interpretations SICs IFRICs
Note that many IASs and SICs have been replaced or amended by the IASB since 2001.
International accounting standards cannot be applied in any country without the approval of the
national regulators in that country. All jurisdictions have some kind of formal approval process
which is followed before IFRS can be applied in that jurisdiction.
Adoption process for IFRS in Pakistan
The previous sections refer to the approval of IFRS by the SECP and notification of that approval
in the Official Gazette
Adoption of an IFRS involves the following steps:
 As a first step the IFRS/IAS is considered by ICAP’s Accounting Standards Board,
which identifies any issues that may arise on adoption.
 The Board also determines how the adoption and implementation of the standard can be
facilitated. It considers issues like how long any transition period should be and whether
adoption of the standard would requires changes in regulations.
 The Board also identifies the need for changes to regulations it refers the matter to the
Securities and Exchange Commission of Pakistan (SECP) (and/or the State Bank of
Pakistan (SBP) for matters affecting banks and other financial institutions). This process is
managed by the Coordination Committees of ICAP and SECP (SBP).
 After the satisfactory resolution of issues the Board and the Council reconsider the matter
of adoption.
 ICAP recommends the adoption to the SECP by decision of the Council. The decision to
adopt the standard rests with the SECP.

IFRSs are adopted by the Securities and Exchange Commission of Pakistan by notification in
the Official Gazette. When notified, the standards have the authority of the law.
Applicable in Examinable at
Standard
Pakistan? this level?
IAS 1 – Presentation of Financial Statements Yes Yes
IAS 2 – Inventories Yes Covered earlier
IAS 7 – Cash Flow Statements Yes Covered earlier
IAS 8 – Accounting Policies, Changes in Accounting
Estimates and Errors Yes Yes
IAS 10 – Events occurring after the reporting period Yes Yes
IAS 12 – Income Taxes Yes Yes (in part)
IAS 16 – Property, Plant and Equipment Yes Covered earlier
IAS 19 – Employee Benefits Yes No
IAS 20 – Accounting for Government Grants and
Disclosure of Government Assistance Yes Covered earlier
IAS 21 – The Effects of Changes in Foreign
Exchange Rates Yes Yes (in part)
IAS 23 – Borrowing Costs Yes Covered earlier
IAS 24 – Related Party Disclosures Yes No
IAS 26 – Accounting and Reporting by Retirement
Benefit Plans Yes No
IAS 27 – Consolidated and Separate Financial
Statements Yes No
IAS 28 – Investment in Associates and Joint Yes Yes
ventures
IAS 29 – Financial Reporting in Hyperinflationary Not relevant in
Economies Pakistan -
IAS 32 – Financial Instruments: Presentation Yes No
IAS 33 – Earnings Per Share Yes No
IAS 34 – Interim Financial Reporting Yes No
IAS 36 – Impairment of Assets Yes Covered earlier
IAS 37 – Provisions, Contingent Liabilities and
Contingent Assets Yes Yes
IAS 38 – Intangible Assets Yes Yes
IAS 39 – Financial Instruments – Recognition and Yes No
Measurement
IAS 40 – Investment Property Yes No
IAS 41 – Agriculture Yes Yes
IFRS 1 – First time adoption of IFRS Yes No
IFRS 2 – Share-based payment Yes No
IFRS 3 – Business combinations Yes Yes (in part)
IFRS 4 – Insurance contracts Yes No

Applicable in Examinable at
Standard
Pakistan? this level?
IFRS 5 – Non-current assets held for sale and
discontinued operations Yes No
IFRS 6 – Exploration for and evaluation of mineral
resources Yes No
IFRS 7 – Financial Instruments: Disclosures Yes No
IFRS 8 – Operating segments Yes Yes
IFRS 9 – Financial Instruments Yes Yes (in part)
IFRS 10 – Consolidated financial statements Yes Yes (in part)
IFRS 11 – Joint arrangements Yes No
IFRS 12 – Disclosure of interests in other entities Yes No
IFRS 13 – Fair value measurement Yes No
IFRS 15 – Revenue from Contracts with Customers Yes Covered earlier
(in part)
IFRS 16 – Leases Yes Yes (in part)
1.4 Classification of Companies

Applicable Schedule of
S. No. Classification criteria accounting Companies
framework Act, 2017
1. Public Interest Company (PIC)
Sub-categories of PIC:
a) Listed Company International Fourth
Financial Reporting Schedule
Standards
b) Non-listed Company which is: International Fifth
(i) a public sector company as defined in Financial Reporting Schedule
the Act; or Standards
(ii) a public utility or similar company
carrying on the business of essential
public service; or
(iii) holding assets in a fiduciary capacity for
a broad group of outsiders, such as a
bank, insurance company, securities
broker/dealer, pension fund, mutual
fund or investment banking entity.
(iv) having such number of members
holding ordinary shares as may be
notified; or
(v) holding assets exceeding such value as
may be notified.
2. Large Sized Company LSC
Sub-categories of LSC
a) Non-listed Company with: International Fifth
(i) paid-up capital of Rs. 200 million or Financial Reporting Schedule
more; or Standards

Applicable Schedule of
S. No. Classification criteria accounting Companies
framework Act, 2017
(ii) turnover of Rs. 1 billion or more; or
(iii) employees more than 750.
b) Foreign Company with turnover of Rs. 1
billion or more.
c) Non-listed Company licensed / formed under International
Section 42 / Section 45 of the Act having Financial Reporting
annual gross revenue (grants / income / Standards and
subsidies / donations) including other income Accounting
/ revenue of Rs. 200 million and above. Standards for NPOs
3. Medium Sized Company (MSC)
Sub-categories of MSC:
a) Non-listed Public Company with: International Fifth
(i) paid-up capital less than Rs.200 million; Financial Reporting Schedule
(ii) turnover less than Rs1 billion; Standards
(iii) Employees more than 250 but less than
750.
b) Private Company with:
(i) paid-up capital of greater than Rs. 10
million but not exceeding Rs. 200 million;
(ii) turnover greater than Rs. 100 million but
not exceeding Rs. 1 billion;
(iii) Employees more than 250 but less than
750.
c) A Foreign Company which has turnover less
than Rs. 1 billion.
d) Non-listed Company licensed / formed under Accounting
Section 42 or 45 of the Act which has annual Standards for NPOs
gross revenue
(grants/income/subsidies/donations)
including other income or revenue less than
Rs.200 million.
4. Small Sized Company (SSC)
A private company having: Revised AFRS for Fifth
(i) paid-up capital up to Rs. 10 million; SSEs Schedule
(ii) turnover not exceeding Rs.100 million;
(iii) Employees not more than 250.

2 COMPANIES ACT, 2017: FOURTH SCHEDULE

Section overview
 Fixed assets
 Long term investments
 Long term loans and advances
 Current assets
 Share capital and reserves
 Non-current liabilities
 Current liabilities
 Contingencies and commitments
 Profit and loss account
The following requirements must be followed in addition to those in IFRS.

Following items shall be disclosed as separate line items on the face of the financial statements;
(i) Revaluation surplus on property, plant and equipment;
(ii) Long term deposits and prepayments;
(iii) Unpaid dividend;
(iv) Unclaimed dividend; and
(v) Cash and bank balances.
2.1 Fixed assets

Where any property or asset acquired with the funds of the company and is not held in the name
of the company or is not in the possession and control of the company, this fact along with
reasons for the property or asset not being in the name of or possession or control of the
company shall be stated; and the description and value of the property or asset, the person in
whose name and possession or control it is held shall be disclosed;
Land and building shall be distinguished between free-hold and leasehold;
Forced sale value shall be disclosed separately in case of revaluation of Property, Plant and
Equipment.
In the case of sale of fixed assets, if the aggregate book value of assets exceeds five hundred
thousand rupees, following particulars of each asset shall be disclosed,
(i) cost or revalued amount, as the case may be;
(ii) the book value;
(iii) the sale price and the mode of disposal (e.g. by tender or negotiation);
(iv) the particulars of the purchaser;
(v) gain or loss; and
(vi) relationship, if any of purchaser with Company or any of its directors.
2.2 Long term investments

Investments in associated companies or undertakings have been made in accordance with the
requirements under the Act

2.3 Long term loans and advances

With regards to loans and advances to directors following shall be disclosed:
(i) that the loans and advances have been made in compliance with the requirements of the
Act;
(ii) the purposes for which loans or advances were made; and
(iii) reconciliation of the carrying amount at the beginning and end of the period, showing
disbursements and repayments;
In case of any loans or advances obtained/provided, at terms other than arm‘s length basis,
reasons thereof shall be disclosed
In respect of loans and advances to associates and related parties there shall be disclosed,
(i) the name of each associate and related party;
(ii) the terms of loans and advances;
(iii) the particulars of collateral security held, if any;
(iv) the maximum aggregate amount outstanding at any time during the year calculated by
reference to month-end balances;
(v) provisions for doubtful loans and advances; and
(vi) loans and advances written off, if any.
2.4 Current assets

In respect of debts/receivables from associates and related parties there shall be disclosed.
(ii) the maximum aggregate amount outstanding at any time during the year calculated by
(iii) receivables, that are either past due or impaired, along with age analysis distinguishing
between trade debts, loans, advances and other receivables;
(iv) debts written off as irrecoverable, distinguishing between trade debts and other
receivables;
(v) provisions for doubtful or bad debts distinguishing between trade debts, loans, advances
and other receivables; and
(vi) justification for reversal of provisions of doubtful debts, if any;
In respect of loans and advances, other than those to the suppliers of goods or services, the
name of the borrower and terms of repayment if the loan or advance exceeds rupees one million,
together with the particulars of collateral security, if any, shall be disclosed separately;
Provision, if any, made for bad or doubtful loans and advances or for diminution in the value of or
loss in respect of any asset shall be shown as a deduction from the gross amounts;
Definition
Executive: An employee, other than the chief executive and directors, whose basic salary exceeds
twelve hundred thousand rupees in a financial year.
2.5 Share capital and reserves

Capital and Revenue reserves shall be clearly distinguished. Any reserve required to be
maintained under the Act shall be separately disclosed. Any legal or other restrictions, on the
ability of the company to distribute or otherwise, shall be disclosed for all kind of reserves
maintained by the company;

In respect of issued share capital of a company following shall be disclosed separately:

(i) shares allotted for consideration paid in cash;
(ii) shares allotted for consideration other than cash, showing separately shares issued
against property and others (to be specified);
(iii) shares allotted as bonus shares; and
(iv) treasury shares;
Shareholders agreements for voting rights, board selection, right of first refusal and block voting
shall be disclosed
Definition
Capital reserve includes:
(i) share premium account;
(ii) reserve created under any other law for the time being in force;
(iii) reserve arising as a consequences of scheme of arrangement;
(iv) profit prior to incorporation; and
(v) any other reserve not regarded free for distribution by way of dividend
Revenue reserve means reserve that is normally regarded as available for distribution through
the profit and loss account, including general reserves and other specific reserves created out of
profit and un-appropriated or accumulated profits of previous years.
2.6 Non-current liabilities

Amount due to associated companies and related parties shall be disclosed separately
2.7 Current liabilities

Following items shall be disclosed as separate line items:
(i) Payable to provident fund;
(ii) Deposits, accrued liabilities and advances;
(iii) Loans from banking companies and other financial institutions, other than related parties;
(iv) Loans and advances from related parties including sponsors and directors along with
purpose and utilization of amounts; and
(v) Loans and advances shall be classified as secured and unsecured.
In respect of security deposit payable, following shall be disclosed:
(i) Bifurcation of amount received as security deposits for goods/services to be
delivered/provided, into amounts utilizable for company business and others;
(ii) Amount utilized for the purpose of the business from the security deposit in accordance
with requirements of written agreements, in terms of section 217 of the Act; and
(iii) Amount kept in separate bank account;
2.8 Contingencies and commitments

In describing legal proceedings, under any court, agency or government authority, whether local
or foreign, include name of the court, agency or authority in which the proceedings are pending,
the date instituted, the principal parties thereto, a description of the factual basis of the
proceeding and the relief sought;

2.9 Profit and loss account

Following items shall be disclosed as deduction from turnover as separate line items:
(i) trade discount; and
(ii) sales and other taxes directly attributed to sales.
The aggregate amount of auditors’ remuneration, showing separately fees, expenses and other
remuneration for services rendered as auditors and for services rendered in any other capacity
and stating the nature of such other services. In the case of joint auditors, the aforesaid
information shall be shown separately for each of the joint auditors;
In case, donation to a single party exceeds Rs. 500,000, name of donee(s) shall be disclosed
and where any director or his spouse has interest in the donee(s), irrespective of the amount,
names of such directors along with their interest shall be disclosed;
Management assessment of sufficiency of tax provision made in the company’s financial
statements shall be clearly stated along with comparisons of tax provision as per accounts viz a
viz tax assessment for last three years;
Complete particulars of the aggregate amount charged by the company shall be disclosed
separately for the directors, chief executive and executives together with the number of such
directors and executives such as:
(i) fees;
(ii) managerial remuneration;
(iii) commission or bonus, indicating the nature thereof;
(iv) reimbursable expenses which are in the nature of a perquisite or benefit;
(v) pension, gratuities, company's contribution to provident, superannuation and other staff
funds, compensation for loss of office and in connection with retirement from office;
(vi) other perquisites and benefits in cash or in kind stating their nature and, where practicable,
their approximate money values; and
(vii) amount for any other services rendered.
In case of royalties paid to companies/entities/individuals, following shall be disclosed:
(i) Name and registered address; and
(ii) Relationship with company or directors, if any.

3 COMPANIES’ ACT, 2017: FIFTH SCHEDULE

Section overview
 Sundry requirements
 Fixed assets
 Long term investments
 Long term loans and advances
 Long term deposits and prepayments
 Current assets
 Non-current liabilities
 Contingencies and commitments
 Profit and loss account
3.1 Sundry requirements

Following items shall be disclosed as separate line items on the face of the financial statements;
(i) revaluation surplus on property, plant and equipment;
(ii) long term deposits and prepayment;
(iii) unpaid dividend;
(iv) unclaimed dividend; and
(v) cash and bank balances.
3.2 Fixed assets

Where any property or asset acquired with the funds of the company, is not held in the name of
the company or is not in the possession and control of the company, this fact along with reasons
for the property or asset not being in the name of or possession or control of the company shall
be stated; and the description and value of the property or asset, the person in whose name and
possession or control it is held shall be disclosed;
Land and building shall be distinguished between freehold and leasehold.
Forced sale value shall be disclosed separately in case of revaluation of property, plant and
equipment.
In the case of sale of fixed assets, if the aggregate book value of assets exceeds five hundred
thousand rupees, following particulars of each asset shall be disclosed,
(i) cost or revalued amount, as the case may be;
(ii) the book value;
(iii) the sale price and the mode of disposal (e.g. by tender or negotiation);
(iv) the particulars of the purchaser;
(v) gain or loss; and
(vi) relationship, if any of purchaser with company or any of its directors.
3.3 Long term investments

Investments in associated companies or undertakings have been made in accordance with the
requirements under the Act.

3.4 Long term loans and advances

With regards to loans and advances to directors, following shall be disclosed:
(i) the purposes for which loans or advances were made; and
(ii) reconciliation of the carrying amount at the beginning and end of the period, showing
disbursements and repayments;
In case of any loans or advances obtained/provided, at terms other than arm’s length basis,
reasons thereof shall be disclosed;
In respect of loans, advances to associates there shall be disclosed:
(i) the name of each associate and related parties;
(ii) the terms of loans and advances;
(iii) the particulars of collateral security held, if any;
(iv) the maximum aggregate amount outstanding at any time during the year calculated by
(v) provisions for doubtful loans and advances; and
(vi) loans or advances written off, if any.
3.5 Current assets

In respect of debts/receivables from associates there shall be disclosed:
(ii) the maximum aggregate amount outstanding at any time during the year calculated by
(iii) receivables, that are either past due or impaired, along with age analysis distinguishing
between trade debts, loans, advances and other receivables;
(iv) debts written off as irrecoverable distinguishing between trade debts and other
receivables;
(v) provisions for doubtful or bad debts distinguishing between trade debts, loans, advances
and other receivables; and
(vi) justification for reversal of provisions of doubtful debts, if any;
Provision, if any, made for bad or doubtful loans and advances or for diminution in the value of or
loss in respect of any asset shall be shown as a deduction from the gross amounts;

Capital and revenue reserves shall be clearly distinguished. Any reserve required to be
maintained under the Act shall be separately disclosed. Any legal or other restrictions on the
ability of the company to distribute or otherwise apply its reserves shall also be disclosed for all
kind of reserves maintained by the company;
In respect of issued share capital of a company following shall be disclosed separately;
Shareholder agreements for voting rights, board selection, rights of first refusal and block voting
shall be disclosed.

3.7 Non-current liabilities

Amount due to associated company shall be disclosed separately

Following items shall be disclosed as separate line items;
(i) payable to provident fund;
(ii) deposits, accrued liabilities and advances;
(iii) loans from banking companies and other financial institutions other than associated
company;
(iv) loans and advances from associated company, sponsors and directors along with purpose
and utilization of amounts; and
(v) loans and advances shall be classified as secured and unsecured.
In respect of security deposit payable, following shall be disclosed:
(i) bifurcation of amount received as security deposits for goods/services to be
(ii) delivered/provided, into amounts utilizable for company business and others;
(iii) amount utilized for the purpose of the business from the security deposit in accordance
with requirements of written agreements, in terms of section 217 of the Act; and
(iv) amount kept in separate bank account;
3.9 Contingencies and commitments

In describing legal proceedings, under any court, agency or government authority, whether local
or foreign include name of the court, agency or authority in which the proceedings are pending,
the date instituted, the principal parties thereto, a description of the factual basis of the
proceeding and the relief sought.
3.10 Profit and loss account

Following items shall be disclosed as deduction from turnover as separate line items;
(i) trade discount; and
(ii) sales and other taxes directly attributable to sales.
The aggregate amount of auditors’ remuneration, showing separately fees, expenses and other
remuneration for services rendered as auditors and for services rendered in any other capacity
and stating the nature of such other services. In the case of joint auditors, the aforesaid
information shall be shown separately for each of the joint auditors; In case, donation to a single
party exceeds Rs. 500,000 name of donee(s) shall be disclosed and where any director or his
spouse has interest in the donee(s) irrespective of the amount, names of such directors along
with their interest shall be disclosed;
Management assessment of sufficiency of tax provision made in the company’s financial
statements along with comparisons of tax provision as per accounts viz a viz tax assessment for
last three years;
Complete particulars of the aggregate amount charged by the company shall be disclosed
separately for the directors, chief executive and executives together with the number of such
directors and executives such as:
(i) fees;
(ii) managerial remuneration;
(iii) commission or bonus, indicating the nature thereof;
(iv) reimbursable expenses which are in the nature of a perquisite or benefit;

(v) pension, gratuities, company's contribution to provident, superannuation and other staff
funds, compensation for loss of office and in connection with retirement from office;
(vi) other perquisites and benefits in cash or in kind stating their nature and, where practicable,
their approximate money values; and
(vii) amount for any other services rendered.
In case of royalties paid to companies/entities/individuals following shall be disclosed:
(i) Name and registered address; and
(ii) Relationship with company or directors, if any.

2
CHAPTER
IAS 1: Presentation of
Financial Statements
Contents
1 The components of financial statements
2 General features of financial statements
3 Structure and content of the statement of financial position
4 Structure and content of the statement of comprehensive
income
5 Statement of changes in equity (SOCIE)
6 Notes to the financial statements
7 Accounting for share issues
8 Financial statements – Specimen formats

1 THE COMPONENTS OF FINANCIAL STATEMENTS

Section overview
 Preparing financial statements

 General purpose financial statements
 Complete set of financial statements
 Comparative information
 Identification of financial statements
 Reporting period
 Elements of financial statement
1.1 Preparing financial statements

You should already have studied the basic rules of financial accounting, so you ought to be
reasonably familiar with how a statement of financial position and a statement of comprehensive
income are prepared. The basic rules can be summarised as follows.
 The balances on all the accounts in the general ledger (nominal ledger or main) are
extracted. These are a list of balances on all ledger accounts for assets, liabilities, capital,
income and expenses.
 Adjustments are made for ‘period / year-end’ items, such as:
 Depreciation and impairment charges for tangible non-current assets;
 amortisation charge for intangible assets;
 accruals and prepayments for expense items;
 provisions
 adjusting the allowance for bad (irrecoverable) debts;
 closing inventory; and
 Adjustments are made for any items that have not been accounted for or have been
incorrectly accounted for. (Questions at this level might include lease accounting, deferred
taxation, provisions etc.).
 The adjusted income and expense balances are entered into a statement of
comprehensive income to establish the profit or loss for the period.
 The adjusted asset, liability and capital balances, together with the retained profit for the
year, are entered into a statement of financial position as at the end of the reporting period.
This process can be used to prepare the statement of comprehensive income and statement of
financial position of a sole proprietor, a partnership or a company.
Some entities must publish financial statements in accordance with international financial
reporting standards (international accounting standards). IAS 1 Presentation of Financial
Statements, sets out the rules on the form and content of financial statements which such entities
must comply with. The rules contained in international standards are known collectively as IFRS
or IAS.
The following sections explain and summarise the IAS 1 requirements. This exam will ask you to
prepare financial statements in accordance with IAS 1 and the Companies Act 2017 so
remember that the more specific guidance in the fourth or fifth schedule will need to be followed
in addition to what is explained in this chapter.

Chapter 2: IAS 1: Presentation of financial statements
1.2 General purpose financial statements
Definition
General purpose financial statements (referred to as ‘financial statements’) are those intended
to meet the needs of users who are not in a position to require an entity to prepare reports tailored
to their particular information needs.
The financial statements published by large companies as part of their annual reports are general
purpose financial statements.
Objective
The objective of general purpose financial statements is to provide information about the financial
position, financial performance and cash flows of a company that is useful to a wide range of
users in making economic decisions.
Financial statements also show the results of the management’s stewardship of the resources
entrusted to it.
To meet this objective, financial statements provide information about an entity’s:
 assets;
 liabilities;
 equity;
 income and expenses, including gains and losses;
 contributions by and distributions to owners in their capacity as owners; and
 cash flows.
This information, along with other information in the notes, assists users of financial statements in
predicting the entity’s future cash flows and, in particular, their timing and certainty.
1.3 Complete set of financial statements

IAS 1 Presentation of Financial Statements specifies what published ‘general-purpose’
financial statements should include, and provides a format for a statement of financial position,
statement of comprehensive income, and statement of changes in equity.
A complete set of financial statements consists of:
 a statement of financial position (balance sheet) as at the end of the period;
 a statement of comprehensive income for the period;
 a statement of changes in equity for the period;
 a statement of cash flows for the period (covered in earlier studies); and
 notes to these statements, consisting of a summary of significant accounting policies used
by the entity and other explanatory information; and
 comparative information.
A company can use other use titles for the above statements.
1.4 Comparative information

A company must disclose comparative information in respect of the previous period for all
amounts reported in the current period’s financial statements.
A company must present (as a minimum) statements of financial position, comprehensive income
cash flows and changes in equity for the previous accounting period in addition to those for the
current period.

Furthermore, when a company applies a new accounting policy retrospectively or retrospectively

restates or reclassifies items in its financial statements as per IAS 8, the financial statements
must also include a statement of financial position as at the beginning of the earliest comparative
period. This means that when one of the above circumstances occurs, the entity must present
statements of financial position, as at:
 the end of the current period;
 the end of the previous period; and
 the beginning of the earliest comparative period.
1.5 Identification of financial statements

Listed companies usually publish financial statements as part of an annual report.
The financial statements must be clearly identified and distinguished from other information in the
same published document. This is very important as the financial statements are audited
whereas other information in the annual report is not. Users must be able to identify the
information that has been audited.
Each component of the financial statements must be properly identified with the following
information displayed prominently:
 the name of the reporting entity;
 whether the financial statements cover an individual entity or a group (consolidated
accounts for groups are described in later chapters);
 the date of the end of the reporting period or the period covered by the statement,
whichever is appropriate;
 the currency in which the figures are reported;
 the level of rounding used in the figures (for example, whether the figures thousands of
rupees or millions of rupees).
1.6 Reporting period

Financial statements should be presented at least annually. If an entity changes the date of the
end of its reporting period, and a reporting period longer or shorter than one year is used, its
financial statements should disclose:
 the period covered by the financial statements
 the reason why the period is not one year, and
 the fact that the comparative figures for the previous year are not comparable.
1.7 Elements of financial statements

The objective of financial reporting is to provide useful information. In order to be useful
information must be understandable. A large company enters into thousands of transactions so in
order for users to be able to understand the impact of these they must be summarised in some
way.
Financial statements group transactions into broad classes according to their economic
characteristics. These broad classes are called the elements of financial statements.
 The elements directly related to the measurement of financial position in the statement of
financial position are assets, liabilities and equity.
 The elements directly related to the measurement of performance in the statement of
comprehensive income are income and expenses.

Assets
Definition: 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.
Control is the ability to obtain economic benefits from the asset, and to restrict the ability of
others to obtain the same benefits from the same item.
An entity usually uses assets to produce goods or services to meet the needs of its customers,
and because customers are willing to pay for the goods and services, this contributes to the cash
flow of the entity. Cash itself is an asset because of its command over other resources.
Many assets have a physical form, but this is not an essential requirement for the existence of an
asset.
Assets result from past transactions or other past events. An asset is not created by any
transaction that is expected to occur in the future but has not yet happened.
An asset should be expected to provide future economic benefits to the entity. Providing future
economic benefits can be defined as contributing, directly or indirectly, to the flow of cash (and
cash equivalents) into the entity.
Practice question
Hamid Co. has purchased a patent for Rs.100,000. The patent gives the company sole use of a
manufacturing process which will save Rs. 12,000 a year for the next 8 years.
Do we have an asset within the definition given by the Conceptual Framework and IAS 1? Please
justify your answer?
Answer
This is an intangible asset since it has no physical substance. Moreover, there is a past event
(purchase of an asset), controlled (power to obtain the economic benefits and restrict the access
of other to those benefits) and future economic benefits (through cost savings).
Liabilities
Definition: Liability
A present obligation of an entity, arising from past events, the settlement of which is expected to
result in an outflow of resources that embody economic benefits.
A liability is an obligation that already exists. An obligation may be legally enforceable as a result
of a binding contract or a statutory requirement, such as a legal obligation to pay a supplier for
goods purchased.
Obligations may also arise from normal business practice, or a desire to maintain good customer
relations or the desire to act in a fair way. For example, an entity might undertake to rectify faulty
goods for customers, even if these are now outside their warranty period. This undertaking
creates an obligation, even though it is not legally enforceable by the customers of the entity.
A liability arises out of a past transaction or event. For example, a trade payable arises out of the
past purchase of goods or services, and an obligation to repay a bank loan arises out of past
borrowing.
The settlement of a liability should result in an outflow of resources that embody economic
benefits. This usually involves the payment of cash or transfer of other assets. A liability is
measured by the value of these resources that will be paid or transferred.

Practice question
Umer Ltd. provides a warranty (50,000 kms / 3 years, whichever is earlier) with every new car sold.
Do we have a liability within the definition given by the Conceptual Framework and IAS 1? Please
justify your answer?
Answer
The warranty claims (best estimate) constitute a liability; the business has taken on an obligation.
It would be recognised when the warranty is issued rather than when a claim is made.
Equity
Definition: Equity
The residual interest in the assets of the entity after deducting all its liabilities.
Equity of companies may be sub-classified into share capital, retained profits and other reserves.
Income
Financial performance is measured by profit or loss. Profit is measured as income less expenses.
Definition: Income
Increase 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.
Income includes both revenue and gains.

 Revenue is income arising in the course of the ordinary activities of the entity. It includes
sales revenue, fee income, royalties’ income, rental income and income from investments
(interest and dividends).
 Gains include both realised and unrealised gains. Realised gains are often reported in the
financial statements net of related expenses. They might arise in the normal course of
business activities. Gains might also be unrealised. Unrealised gains occur whenever an
asset is revalued upwards, but is not disposed of. For example, an unrealised gain occurs
when marketable securities owned by the entity are revalued upwards.
Expenses
Definition: Expenses
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.
Expenses include:
 Expenses arising in the normal course of activities, such as the cost of sales and other
operating costs, including depreciation of non-current assets. Expenses result in the
outflow of assets (such as cash or finished goods inventory) or the depletion of assets (for
example, the depreciation of non-current assets).
 Losses include for example, the loss on disposal of a non-current asset, and losses
arising from damage due to fire or flooding. Losses are usually reported as net of related
income. Losses might also be unrealised. Unrealised losses occur when an asset is
revalued downwards, but is not disposed of. For example, and unrealised loss occurs
when marketable securities owned by the entity are revalued downwards.

2 GENERAL FEATURES OF FINANCIAL STATEMENTS

Section overview
 Introduction
 Fair presentation and compliance with IFRSs
 Going concern
 Accrual basis of accounting
 Materiality and aggregation
 Offsetting
 Frequency of reporting
 Comparative information
 Consistency of presentation
2.1 Introduction
IAS 1 describes and provides guidance on the following general features of financial statements:
 Fair presentation and compliance with IFRSs
 Going concern
 Accrual basis of accounting
 Materiality and aggregation
 Offsetting
 Frequency of reporting
 Comparative information
 Consistency of presentation
2.2 Fair presentation and compliance with IFRSs

Disclosure of compliance
An entity whose financial statements comply with IFRSs must disclose that fact.
Financial statements shall not be described as complying with IFRS unless they comply with all
the requirements of each applicable Standard and Interpretation.
Fair presentation
Financial statements must present fairly the financial position, financial performance and cash
flows of an entity.
This means that they must be a faithful representation of the effects of transactions and other
events in accordance with the definitions and recognition criteria for assets, liabilities, income and
expenses set out in IFRS.
The application of IFRSs, with additional disclosure when necessary, is presumed to result in
financial statements that achieve a fair presentation.
Fair presentation requires:
 the selection and application of accounting policies in accordance with IAS 8, Accounting
Policies, Changes in Accounting Estimates and Errors;
 the presentation of information, including accounting policies, in a manner that provides
relevant, reliable, comparable and understandable information; and,

 the provision of additional disclosures when the particular requirements in IFRSs are
insufficient to enable users to understand the impact of particular transactions or other
events on the entity’s financial position and financial performance.
True and fair override
In extremely rare circumstances, management might conclude that compliance with a
requirement in IFRS would be so misleading that it would conflict with the objective of financial
statements set out in IFRS.
In these cases the requirement should not be followed as longs as the relevant regulatory
framework requires or otherwise does not prohibit this.
When an entity departs from a requirement in IFRS it must disclose:
 that management has concluded that the financial statements present fairly the entity’s
financial position, financial performance and cash flows;
 that it has complied with applicable IFRS except that it has departed from a particular
requirement to achieve a fair presentation; and
 details of the departure:
 the Standard (or Interpretation) from which the entity has departed and:
 the nature of the departure (including the treatment that is required by IFRS);
 the reason why that treatment would be so misleading in the circumstances that it
would conflict with the objective of financial statements set out in the “Framework”;
 the treatment adopted; and,
 for each period presented, the financial impact of the departure on each item in the
financial statements that would have been reported in complying with the
requirement.
If the relevant regulatory framework prohibits departure from a requirement the entity must make
the following disclosures to reduce the misleading aspects of compliance “to the maximum extent
possible”:
 the Standard (or Interpretation) requiring the entity to report information concluded to be
misleading and:
 the nature of the requirement;
 the reason why management has concluded that complying with that requirement is so
misleading in the circumstances that it conflicts with the objective of financial statements;
and,
 for each period presented, the adjustments to each item in the financial statements that
management has concluded would be necessary to achieve a fair presentation.
2.3 Going concern

Financial statements must be prepared on a going concern basis unless management either;
 intends to liquidate the entity; or,
 to cease trading; or
 has no realistic alternative but to do so.
Management must assess an entity’s ability to continue as a going concern when preparing
financial statements.
In making this assessment management must take into account all available information about
the future. (This is for at least twelve months from the reporting date).

Disclosures
If management is aware, in making its assessment, of material uncertainties related to events or
conditions that may cast significant doubt upon the entity’s ability to continue as a going concern,
those uncertainties must be disclosed.
If the financial statements are not prepared on a going concern basis, that fact must be
disclosed, together with:
 the basis on which the financial statements are prepared; and,
 the reason why the entity is not regarded as a going concern.
Example:
Healthy Oil Limited (HOL) was experiencing cash flow problems and had accumulated losses. It
was ready to declare bankruptcy and close operations all over Pakistan. The Federal government
stepped in and gave HOL a bailout as well as a guarantee. In normal circumstances, HOL would
not be considered a going concern, but since the Federal government stepped in, there is no reason
to believe that HOL will cease to operate.
2.4 Accrual basis of accounting

Financial statements (except for cash flow information) must be prepared under the accrual basis
of accounting.
Under the accrual basis of accounting, revenues are reported in the profit or loss account when
they are earned and expenses are matched with the related revenues and/or are reported when
the expense occurs, not when the cash is paid.
2.5 Materiality and aggregation

Each material class of similar items must be presented separately in the financial statements.
Items of a dissimilar nature or function must be presented separately unless they are immaterial.
An item that is not sufficiently material to warrant separate presentation on the face of the
financial statements may nevertheless be sufficiently material for it to be presented separately in
the notes.
Information is material if its non-disclosure could influence the economic decisions of users taken
on the basis of the financial statements.
Materiality depends on the size and nature of the item or aggregation of items judged in the
particular circumstances of its omission.
Example: Materiality - Due to size

Tez Ltd’s total sales for the financial year 2017 amounts to Rs.100 million and its total assets are
Rs.50 million. The company’s external auditors have found out that Rs.5 million worth of sales
should not be recognized in financial year 2017 because the risks and rewards inherent in the sales
have not been transferred.
This amount of Rs.5 million is material in the context of total assets of Rs.50 million. The company
should adjust its financial statements.
Examples: Materiality - Nature of the event

1. Hasan Ltd. operates in a country which is about to enact a new legislation which would
seriously impair the company's operations in future. Although there are no figures involved,
the disclosure of the development is required in the financial statements for the period on
account of materiality because the new legislation can potentially end the revenues and profits
earned from the country.

Examples: Materiality - Nature of the event (continued)

2. The remuneration paid to a company’s executives and directors is material due to qualitative
reasons (even it is not material quantitatively). It is because the investors would like to make
sure that the management is not overcompensating itself.
3. The accounting policies are material and cannot be omitted because they help the users
understand how the management arrived at the amounts presented in the financial
statements.
2.6 Offsetting
Assets and liabilities must not be offset except when offsetting is required by another Standard.
The reporting of assets net of valuation allowances—for example, obsolescence allowances on
inventories and doubtful debts allowances on receivables—is not offsetting.
Items of income and expense must be offset when, and only when IFRS requires or permits it.
For example:
 gains and losses on the disposal of non-current assets are reported by deducting from the
proceeds on disposal the carrying amount of the asset and related selling expenses; and,
 expenditure that is reimbursed under a contractual arrangement with a third party (for
example, a subletting agreement) is netted against the related reimbursement.
Also gains and losses arising from a group of similar transactions are reported on a net basis (for
example, foreign exchange gains and losses or gains and losses arising on financial instruments
held for trading purposes).
Such gains and losses must be reported separately if their size, nature or incidence is such that
separate disclosure is necessary for an understanding of financial performance.

Monty Ltd. owes Rs.1,000 to Panesar Ltd. Panesar Ltd. owes Rs.800 to Monty Ltd. They have a
legally enforceable agreement stating that they can offset amounts that are due to each other in
all circumstances. They will settle the amounts owed by Monty Ltd. paying Panesar Ltd. Rs.200.
Monty Ltd. and Panesar Ltd. would be required to present net amounts in their statements of
financial position because they have an unconditional right of set-off and they will settle the
amounts net.
2.7 Frequency of reporting

Financial statements must be presented at least annually.
When an entity’s reporting date changes its financial statements are presented for a period
longer or shorter than one year. In such cases an entity must disclose, in addition to the period
covered by the financial statements:
 the reason for using a period other than one year; and,
 the fact that amounts presented in the financial statements are not comparable.
2.8 Comparative information

Comparative information must be disclosed in respect of the previous period for all amounts
reported in the financial statements unless IFRS permits or requires otherwise.
Comparative information must be included for narrative and descriptive information when it is
relevant to an understanding of the current period’s financial statements.

When the presentation or classification of items in the financial statements is amended,

comparative amounts must be reclassified (unless the reclassification is impracticable). When
comparative amounts are reclassified, an entity must disclose:
 the nature of the reclassification;
 the amount of each item or class of items that is reclassified; and,
 the reason for the reclassification.
The following must be disclosed when reclassification of comparative amounts is impracticable:
 the reason for not reclassifying the amounts; and,
 the nature of the adjustments that would have been made if the amounts were reclassified.
2.9 Consistency of presentation

The presentation and classification of items in the financial statements must be retained from one
period to the next unless:
 a significant change in the nature of the operations of the entity or a review of its financial
statement presentation demonstrates that a change in presentation results in a more
appropriate presentation of transactions or other events; or
 a change in presentation is required by an IFRS.

3 STRUCTURE AND CONTENT OF THE STATEMENT OF FINANCIAL POSITION

Section overview
 Introduction
 Current and non-current assets and liabilities
 Current assets
 Information to be presented on the face of the statement of financial position
3.1 Introduction
IFRS uses terms which are incorporated into this study text. However, it does not forbid the use
of other terms and you might see other terms used in practice.
IAS 1 sets out the requirements for information that must be presented in the statement of
financial position or in notes to the financial statements, and it also provides implementation
guidance. This guidance includes an illustrative format for a statement of financial position. This
format is not mandatory but you should learn it and use it wherever possible.
3.2 Current and non-current assets and liabilities

Current and non-current items should normally be presented separately in the statement of
financial position, so that:
 current and non-current assets are divided into separate classifications; and
 current and non-current liabilities are also classified separately.
Chapter 8 explains the concept of deferred taxation and how to account for it. Deferred tax
balances must not be classified as current assets or current liabilities.
Alternative
A company is allowed to use a presentation based on liquidity instead of current/non-current if
this provides information that is reliable and more relevant. Financial institutions often use this
approach.
Whichever method of presentation is used, a company must disclose the amount expected to be
recovered or settled after more than twelve months for each asset and liability that combines
amounts expected to be recovered or settled:
 no more than twelve months after the reporting period, and
 more than twelve months after the reporting period.
3.3 Current assets

IAS 1 states that an asset should be classified as a current asset if it satisfies any of the following
criteria:
 The entity expects to realise the asset, or sell or consume it, its normal operating cycle.
 The asset is held for trading purposes.
 The entity expects to realise the asset within 12 months after the reporting period.
 It is cash or a cash equivalent. (Note: An example of ‘cash’ is money in a current bank
account. An example of a ‘cash equivalent’ is money held in a term deposit account with a
bank.)
Examples of current assets include accounts receivable, inventories, cash etc. All other assets
should be classified as non-current assets.

Operating cycle
The operating cycle is the time between the acquisition of assets for processing and their
realisation in cash or cash equivalents. When the entity's normal operating cycle is not clearly
identifiable, it is assumed to be twelve months.
Current assets include assets (such as inventories and trade receivables) that are sold,
consumed or realised as part of the normal operating cycle even when they are not expected to
be realised within twelve months after the reporting period.
Illustration:
X Limited uses small amounts of platinum in its production process.
Platinum price has fallen recently so just before its year-end X Limited bought an amount of
platinum sufficient to cover its production needs for the next two years.
This would be a current asset. The amount expected to be used after more than 12 months should
be disclosed.
Current assets also include assets held primarily for the purpose of trading and the current
portion of non-current financial assets.
Non-current assets
These are tangible, intangible and financial assets of a long-term nature.
Examples of non-current assets include property, plant and equipment, intangibles etc.

IAS 1 also states that a liability should be classified as a current liability if it satisfies any of the
following criteria:
 The entity expects to settle the liability in its normal operating cycle.
 The liability is held primarily for the purpose of trading. This means that all trade payables
are current liabilities, even if settlement is not due for over 12 months after the end of the
reporting period.
 It is due to be settled within 12 months after the end of the reporting period.
 The entity does not have the unconditional right to defer settlement of the liability for at
least 12 months after the end of the reporting period.
All other liabilities should be classified as non-current liabilities.
Examples of current liabilities include accounts payable, accruals etc.
Examples of non-current liabilities include deferred tax liability, employment benefits etc.
Changing from non-current liability to current liability
Liabilities that were originally non-current may become current in a subsequent year, when they
become repayable within 12 months.
Example:
A company has a financial year end of 31 December. On 31 October Year 1, it took out a bank loan
of Rs. 50,000. The loan principal is repayable as follows:
1. Rs. 20,000 on 31 October Year 3
2. Rs. 30,000 on 31 October Year 4
As at 31 December Year 1
The full bank loan of Rs. 50,000 will be a non-current liability
A current liability of Rs. 20,000 repayable on 31 October Year 3 and a non-current liability of Rs.
30,000 repayable on 31 October Year 4.
Current liability of Rs. 30,000

There is an exception to this rule. A liability can continue to be shown as a long-term liability,
even if it is repayable within 12 months, if the entity has the ‘discretion’ or right to refinance (or
‘roll over’) the loan at maturity.
3.5 Information to be presented on the face of the statement of financial position

IAS 1 provides a list of items that, as a minimum, must be shown on the face of the statement of
financial position as a ‘line item’ (in other words, on a separate line in the statement).
Note that companies in Pakistan are also subject to the disclosure requirements of the fourth and
fifth schedules to the Companies’ Act 2017 which shall be presented in addition to the disclosure
requirements prescribed in IFRS.
The following table shows the minimum line items as per IAS 1:
Elements IAS 1 line items (minimum)

Assets Property, plant and equipment
Investment property
Intangible assets
Financial assets
Deferred tax assets
Investments accounted for using the equity method
Biological assets
Inventories
Trade and other receivables
Cash and cash equivalents.
The total of assets classified as held for sale and assets included in disposal
groups classified as held for sale
Liabilities Trade and other payables
Provisions
Financial liabilities
Current tax liabilities and assets
Deferred tax liabilities
Liabilities included in disposal groups classified as held for sale
Equity Non-controlling interests, presented within equity
Issued capital and reserves attributable to the owners of the entity.
Separate line items are also required in the statement of financial position in accordance with the
requirements of IFRS 5: Non-current assets held for sale and discontinued operations.
An entity must include additional line items if these are relevant to an understanding of the
entity’s financial position.
Information to be shown on the face of the statement of financial position or in notes
Some of the line items in the statement of financial position should be sub-classified into different
categories, giving details of how the total figure is made up. This sub-classification may be
presented either:
 as additional lines on the face of the statement of financial position (adding up to the total
amount for the item as a whole) or
 in notes to the financial statements.


 Tangible non-current assets should be divided into sub-categories, as required by IAS 16
Property, Plant and Equipment.
 Inventories are sub-classified in accordance with IAS 2 Inventories into categories such
as merchandise, materials, work-in-progress and finished goods.
 Equity capital and reserves must also be sub-categorised, into categories such as paid-up
share capital, share premium and reserves.
 Where liquidity provides more reliable and relevant information then arrange the line
items on increasing or decreasing liquidity
 If operating cycle is not determinable assume that is 12 months.
IAS 1 does not specify a format for a statement of financial position that must be used. However,
the implementation guidance includes an illustrative statement of financial position. The example
below is based on that example.
Illustration: Statement of financial position of an individual entity
Statement of financial position of ABCD Entity as at 31 December 20XX

Rs. m Rs. m
Assets
Non-current assets
Property, plant and equipment 205.1
Intangible assets 10.7
Investments 6.8
222.6
Current assets
Inventories 17.8
Trade and other receivables 15.3
Cash and cash equivalents 0.7
33.8
Total assets 256.4

Statement of financial position of ABCD Entity as at 31 December 20XX
Rs. m Rs. m
Share capital 50.0
Other reserves 31.9
Retained earnings (accumulated profits) 60.6
142.5
Total equity
Non-current liabilities
Long-term borrowings 30.0
Deferred tax 4.5
Total non-current liabilities 34.5

Current liabilities
Trade and other payables 67.1
Short-term borrowings (bank overdraft) 3.2
Current portion of long-term borrowing 5.0
Current tax payable 4.1
Total current liabilities 79.4

113.9
Total liabilities
Total equity and liabilities 256.4
A specimen format to incorporate the requirements of the fourth schedule to the Companies’ Act
2017 is given at section 8 of this chapter.

Capital and revenue reserves shall be clearly distinguished. Any reserve required to be
maintained under the Act shall be separately disclosed. Any legal or other restrictions on the
ability of the company to distribute or otherwise apply its reserves shall also be disclosed for all
kind of reserves maintained by the company; In respect of issued share capital of a company
following shall be disclosed separately;
Shareholder agreements for voting rights, board selection, rights of first refusal and block voting
shall be disclosed.

4 STRUCTURE AND CONTENT OF THE STATEMENT OF COMPREHENSIVE

INCOME
Section overview
 A single statement or two statements

 Information to be presented on the face of the statement of comprehensive income
 Analysis of expenses
 Material items
 Preparing a statement of financial position or statement of comprehensive income
4.1 A single statement or two statements

Total comprehensive income during a period is the sum of:
 the profit or loss for the period; and
 other comprehensive income.
IAS 1 requires an entity to present all items of income and expense during a period in a
statement of comprehensive income. (now known as a statement of profit or loss and other
comprehensive income).
This may be presented as a single statement with two parts:
 a statement of profit or loss which shows the components of profit or loss (beginning with
Revenue and ending with Profit (or Loss) for the year; and
 a statement of other comprehensive income.
Alternatively these two parts can be presented as two separate statements.
Whichever approach is used the following must be shown:
 profit or loss;
 total other comprehensive income;
 comprehensive income for the period (the total of profit or loss and other comprehensive
income).
Other comprehensive income
IFRS specifies what must be included as other comprehensive income. Such items include:
 amounts recognised on revaluation of a non-current assets in accordance with IAS 16
Property, plant and equipment and IAS 38 Intangible assets.
 The tax consequences of any such revaluation.
IAS 1 does not specify an exact format for the statement of comprehensive income but the
example below is based on a suggested presentation included in the implementation guidance.
(In this example, expenses are classified by function – See paragraph 4.3 of this section).

Example: statement of comprehensive income of an individual entity
XYZ Entity: Statement of comprehensive income for the year ended 31 December 20XX
Rs. 000
Revenue 678
Cost of sales 250
––––––
Gross profit 428
Other income 12
Distribution costs (98)
Administrative expenses (61)
Other expenses (18)
Finance costs (24)
Share of profit of associate 32
––––––
Profit before tax 271
Taxation (50)
––––––
Profit for the year from continuing operations 221
Loss for the year from discontinued operations (15)
––––––
PROFIT FOR THE YEAR 206
––––––
Gains on property revaluation 24
Share of other comprehensiveincome of associate 5
Foreign currency transaction - gains 17
––––––
Other comprehensive income for the year (net of tax) 46
––––––
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 252
––––––
4.2 Information to be presented on the face of the statement of comprehensive income

The statement of profit or loss and other comprehensive income should present in addition to the
profit or loss and other comprehensive income sections:
 Profit or loss;
 Total other comprehensive income;
 Comprehensive income for the period, being the total of profit or loss and other
comprehensive income.

Information to be presented in the profit or loss section or the statement of profit and loss
As per the requirements of IAS 1, the profit or loss section or the statement of profit or loss shall
include line items showing the following amounts for the financial period:
Line items
Revenue, presenting separately interest revenue calculated using the effective interest method
Gains or losses arising from the derecognition of financial assets measured at amortised cost
Finance costs
Impairment losses including reversals or impairment gains
Share of the profit or loss of entities accounted for by the ‘equity method’
If a financial asset is reclassified out of the amortised cost measurement category so that it is
measured at fair value through profit or loss, any gain or loss arising from a difference between
the previous amortised cost of the financial asset and its fair value at the reclassification date
If a financial asset is reclassified out of the fair value through other comprehensive income
measurement category so that it is measured at fair value through profit and loss, any
cumulative gain or loss previously recognised in other comprehensive income that is reclassified
to profit or loss.
Tax expense
A single amount for the total of discontinued operations
As per the requirements of IAS 1, the other comprehensive income section shall present line
items for the amounts for the period of:
Line items
Items of other comprehensive income

Share of the other comprehensive income of associates and joint ventures accounted for using
the equity method
Groups of companies must consolidate their financial statements. A consolidation is the

representation of the financial position and financial performance of a series of separate entities
as if they are a single entity.
For a consolidated statement of comprehensive income the following items should also be
shown on the face of the statement as allocations of profit or income in the period:
Line items
Profit or loss for the period attributable to non-controlling interests (also called minority interests)
Profit or loss attributable to the owners (equity holders) of the parent entity
Total comprehensive income attributable to non-controlling interests
Total comprehensive income attributable to the owners of the parent entity
Additional line items should be presented on the face of the statement of comprehensive income
when it is relevant to an understanding of the entity’s financial performance.
Recognition in profit or loss
With the introduction of a requirement to present a statement of comprehensive income, it is
important to distinguish between:
 items that should be included in the section of the statement between ‘revenue’ and ‘profit’;
and
 other comprehensive income.

A useful way of making this distinction is that if an item is included in the statement of
comprehensive income, between ‘revenue’ and ‘profit’, the item is ‘recognised within profit or
loss’. This term is now used in accounting standards.
Reclassification adjustments
A reclassification adjustment occurs when an item that has been recognised as ‘other
comprehensive income’ in the statement of comprehensive income is subsequently re-classified
as profit or loss.
Information to be shown on the face of the statement of comprehensive income or in the notes
The following information may be shown either on the face of the statement of comprehensive
income or in a note to the financial statements:
 material items of income and expense
 an analysis of expenses.
4.3 Analysis of expenses

Expenses should be analysed. Either of two methods of analysis may be used:
 according to the function of the expense.
 according to the nature of expenses; or
IAS 1 states that entities should choose the method that provides the more relevant or reliable
information. However, the fourth and fifth schedules to the Companies’ Act 2017 require
classification by function with additional information on nature.
IAS 1 encourages entities to show this analysis of expenses on the face of the statement of
comprehensive income rather than in a note to the accounts.
Analysis of expenses by their function
When expenses are analysed according to their function, the functions are commonly ‘cost of
sales’, ‘distribution costs’, ‘administrative expenses’ and ‘other expenses’. This method of
analysis is also called the ‘cost of sales method’.
Illustration: Statement of comprehensive income – Expenses analysed by function

Rs. m
Revenue 7,200
Cost of sales (2,700)
Gross profit 4,500
Other income 300
Distribution costs (2,100)
Administrative expenses (1,400)
Other expenses (390)
IAS 1 also requires that if the analysis by function method is used, additional information about
expenses must be disclosed including:
 depreciation and amortisation expense; and
 employee benefits expense (staff costs).
Analysis of expenses by their nature
When expenses are analysed according to their nature, the categories of expenses will vary
according to the nature of the business.
In a manufacturing business, expenses would probably be classified as:
 raw materials and consumables used;

 staff costs (‘employee benefits costs’);

 depreciation.
Items of expense that on their own are immaterial are presented as ‘other expenses’.
There will also be an adjustment for the increase or decrease in inventories of finished goods and
work-in-progress during the period.
Other entities (non-manufacturing entities) may present other expenses that are material to their
business.
An example of a statement of comprehensive income, showing expenses by their nature is
shown below for completeness, with illustrative figures included.
Illustration: Statement of comprehensive income – Expenses analysed by nature
Rs. m Rs. m
Revenue 7,200
Other income 300
7,500
Changes in inventories of finished goods and work-in-progress 90
(reduction = expense, increase = negative expense)
Raw materials and consumables used 1,200
Staff costs (employee benefits expense) 2,000
Depreciation and amortisation expense 1,000
Other expenses 2,300
6,710
4.4 Material items

Material items that might be disclosed separately include:
 a write-down of inventories from cost to net realisable value, or a write-down of items of
property, plant and equipment to recoverable amount;
 the cost of a restructuring of activities;
 disposals of items of property, plant and equipment;
 disposals of investments
 discontinued operations;
 litigation settlements;
 a reversal of a provision.
4.5 Preparing a statement of financial position or statement of comprehensive income

If you are required to prepare a statement of financial position, a statement of comprehensive
income in a format suitable for publication in accordance with IAS 1, you need to know the
appropriate format.
If you are preparing a statement of comprehensive income in the ‘cost of sales’ or ‘expenses by
function’ method, you might need to separate total costs for items such as employee benefits
costs and depreciation charges into cost of sales, distribution costs and administrative charges.
The basis for separating these costs between the functions would be given in the question.

5 STATEMENT OF CHANGES IN EQUITY (SOCIE)

Section overview
 The contents of a statement of changes in equity

 Retrospective adjustments
5.1 The contents of a statement of changes in equity

A complete set of financial statements must include a statement of changes in equity (SOCIE).
A SOCIE shows for each component of equity the amount at the beginning of the period,
changes during the period, and its amount at the end of the period.
Components of equity include:
 share capital;
 share premium;
 retained earnings;
 revaluation surplus.
In a SOCIE for a group of companies, the amounts attributable to owners of the parent entity and
the amounts attributable to the non-controlling interest should be shown separately. (Non-
controlling interest is a concept used in group accounts. This is covered in chapter 4)
For each component of equity, the SOCIE should show changes resulting from:
 profit or loss for the period;
 each item of other comprehensive income;
 transactions with owners in their capacity as owners.
Transactions with owners in their capacity as owners
These include:
 new issues of shares;
 payments of dividends;
 repurchases and cancellation of its own shares by the company.
These transactions are not gains or losses so are not shown in the statement so comprehensive
income but they do affect equity. The SOCIE highlights such transactions.
5.2 Retrospective adjustments

IAS 8 Accounting policies, changes in accounting estimates and errors requires that when
an entity changes an accounting policy or restates amounts in the financial statements to correct
errors, the adjustments should be made retrospectively (to the extent that this is practicable).
Retrospective adjustments result in changes in the reported amount of an equity component,
usually retained earnings. Retrospective adjustments and re-statements are not changes in
equity, but they are adjustments to the opening balance of retained earnings (or other component
of equity).
Where retrospective adjustments are made, the SOCIE must show for each component of equity
(usually retained earnings) the effect of the retrospective adjustment. This is shown first, as an
adjustment to the opening balance, before the changes in equity are reported. (This is covered in
more detail in chapter 12)

Illustration: statement of changes in equity
PQR Entity:
Statement of changes in equity for the year ended 31 December 20X9
Share Share General Retained profits
capital premium reserve Total
Rs.m Rs.m Rs.m Rs.m Rs.m
Balance at 31 December
20X8 200 70 80 510 860
Change in accounting
policy - - - (60) (60)
Restated balance 200 70 80 450 800
Changes in equity for
20X9
Issue of share capital 80 100 180
Dividend payments (90) (90)
Profit for the year 155 155
Other comprehensive 12
income for the year 12
Balance at 31 December
20X9 280 170 92 515 1,057
The statement reconciles the balance at the beginning of the period to that at the end of the period
for each component of equity.

6 NOTES TO THE FINANCIAL STATEMENTS

Section overview
 Introduction
 Structure
 Disclosure of accounting policies
 Other disclosures
6.1 Introduction
Notes contain information in addition to that presented in the statement of financial position,
statement of comprehensive income, statement of changes in equity and statement of cash
flows.
Notes provide narrative descriptions of items in those statements and information about items
that do not qualify for recognition in those statements. They also explain how totals in those
statements are formed.
6.2 Structure
The notes to the financial statements of an entity must:
 present information about the basis of preparation of the financial statements and the
specific accounting policies selected and applied for significant transactions and other
significant events;
 disclose the information required by IFRSs that is not presented elsewhere in the financial
statements; and
 provide additional information that is not presented on the face of the financial statements
but is relevant to an understanding of them.
Notes to the financial statements must be presented in a systematic manner. Each item on the
face of the statement of financial position, statement of comprehensive income, statement of
changes in equity and statement of cash flows must be cross-referenced to any related
information in the notes.
Notes are normally presented in the following order:
 a statement of compliance with IFRS;
 a summary of significant accounting policies applied;
 supporting information for items presented on the face of each financial statement in the
order in which each financial statement and each line item is presented; and
 other disclosures, including:
 contingent liabilities;
 unrecognised contractual commitments; and
 non-financial disclosures, e.g. the entity financial risk, management objectives and
policies.
6.3 Disclosure of accounting policies

An entity must disclose the following in the summary of significant accounting policies:
 the measurement basis (or bases) used in preparing the financial statements; and
 the other accounting policies used that are relevant to an understanding of the financial
statements.

 the judgements (apart from those involving estimations) made by management in applying
the accounting policies that have the most significant effect on the amounts of items
recognised in the financial statements. For example:
 when substantially all the significant risks and rewards of ownership of financial
assets and lease assets are transferred to other entities;
 whether, in substance, particular sales of goods are financing arrangements and
therefore do not give rise to revenue; and
 whether the substance of the relationship between the entity and a special purpose
entity indicates that the entity controls the special purpose entity.
Which policies?
Management must disclose those policies that would assist users in understanding how
transactions, other events and conditions are reflected in the reported financial performance and
financial position.
If an IFRS allows a choice of policy, disclosure of the policy selected is especially useful.
Some standards specifically require disclosure of particular accounting policies. For example,
IAS 16 requires disclosure of the measurement bases used for classes of property, plant and
equipment.
It is also appropriate to disclose an accounting policy not specifically required by IFRSs, but
selected and applied in accordance with IAS 8. (See chapter 7).
Key measurement assumptions
An entity must disclose information regarding key assumptions about the future, and other key
sources of measurement uncertainty, that have a significant risk of causing 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 must include details of:
 their nature; and
 their carrying amount as at the reporting date.
Examples of key assumptions disclosed are:
 future interest rates;
 future changes in salaries;
 future changes in prices affecting other costs; and,
 useful lives.
Examples of the types of disclosures made are:
 the nature of the assumption or other measurement uncertainty;
 the sensitivity of carrying amounts to the methods, assumptions and estimates underlying
their calculation, including the reasons for the sensitivity;
 the expected resolution of an uncertainty and 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 assumptions concerning those assets and
liabilities, if the uncertainty remains unresolved.

6.4 Other disclosures

An entity must disclose in the notes:
 the amount of dividends proposed or declared before the financial statements were
authorised for issue but not recognised as a distribution to owners during the period, and
the related amount per share; and
 the amount of any cumulative preference dividends not recognised.
 An entity must disclose the following, if not disclosed elsewhere in information published
with the financial statements:
 the domicile and legal form of the entity;
 a description of the nature of the entity’s operations and its principal activities; and
 the name of the parent and the ultimate parent of the group.

7 ACCOUNTING FOR SHARE ISSUES

Section overview
 Issue of equity shares

 Bonus issues
7.1 Issue of equity shares

When an entity issues new ordinary shares:
 the issued shares become a part of equity, and
 the entity receives cash from the issue, or possibly assets other than cash (for which a
carrying value is determined).
The issue price of new equity shares is usually higher than their face value or nominal value. The
difference between the nominal value of the shares and their issue price is accounted for as
share premium, and credited to a share premium reserve. (This reserve is a part of equity).
Illustration: Share issue double entry
Debit Credit
Bank (cash received) X
Share capital (nominal value of shares issued) X
Share premium (with the excess of the issue price of the shares over their
nominal value) X
Transaction costs of issuing new equity shares for cash should be debited directly to equity.
The costs of the issue, net of related tax benefit, are set against the share premium account. (If
there is no share premium on the issue of the new shares, issue costs should be deducted from
retained earnings).
Example:
A company issues 200,000 shares of Rs. 25 each at a price of Rs. 250 per share.
Issue costs are Rs. 3,000,000.
The share issue would be accounted for as follows:
Dr (Rs. 000) Cr (Rs. 000)
Cash (200,000 × 250) 50,000
Share capital (200,000 × 25) 5,000
Share premium (200,000 × 250 – 25) 45,000
Cash 3,000
Share premium 3,000
7.2 Bonus issues

When an entity issues new ordinary shares:
A bonus issue of shares (also called a scrip issue or a capitalisation issue) is an issue of new
shares to existing shareholders, in proportion to their existing shareholding, for no consideration.
In other words, the new shares are issued ‘free of charge’ to existing shareholders.
The new shares are created by converting an equity balance from the statement of financial
position into ordinary share capital.
Illustration: Share issue double entry
Debit Credit
Equity reserve X
Share capital (nominal value of shares issued) X

8 FINANCIAL STATEMENT – SPECIMEN FORMATS

Section overview
 Statement of comprehensive income (analysis of expenses by function)

 Statement of financial position
IAS 1 does not specify formats for financial statements. However, it includes illustrative
statements in an appendix to the Standard).
The illustrations below are based on the illustrative examples but have been modified to
incorporate elements required by the fourth schedule to the Companies Act, 2017.
8.1 Statement of comprehensive income (analysis of expenses by function)

Illustration: Statement of comprehensive income (analysis of expenses by function)
Statement of comprehensive income for the year ended 31 December 2015

Rs. m
Revenue X
Cost of sales (X)
Gross profit X
Other income X
Distribution costs (X)
Administrative expenses (X)
Other expenses (X)
Profit from operations X
Other operating income
Income from financial assets X
Income from debts loans and advances to related parties X
X
Finance costs (X)
Profit before tax X
Taxation (X)
Profit after tax X
Sundry gains and losses X
OTHER COMPREHENSIVE INCOME FOR THE YEAR X
TOTAL COMPREHENSIVE INCOME FOR THE YEAR X

8.2 Statement of financial position

Illustration: Statement of financial position format
Statement of financial position as at 31 December 2015
Assets Rs. m Rs. m
Non-current assets
Property, plant and equipment X
Intangible assets X
Goodwill X
Long term investments (Companies Act) X
Long term loans and advances (Companies Act) X
Long term deposits and prepayments (Companies Act) X
Total non-current assets X
Current assets
Stores, spare parts and loose tools (Companies Act) X
Stock-in-trade (Companies Act)
Trade debts (Companies Act) X
Current portion of long term loans and advances (Companies Act) X
Cash and bank balances (Companies Act) X
Total current assets X
Total assets X
Equity and liabilities

Capital and reserves
Share capital (Issued, subscribed and paid up capital) X
Share premium
Accumulated profits (Unappropriated profits) X
Other reserves X
Total capital and reserves X
Revaluation surplus (Companies Act) X
Non-current liabilities
Long-term financing X
Long term liabilites agains assets subject to a finance lease X
Deferred tax X
Total non-current liabilities X
Current liabilities
Trade and other payables X
Accrued interest / mark-up (Companies Act)
Short-term borrowings X
Current portion of long-term borrowing X
Current tax payable X
Total current liabilities X
Total liabilities X
Total equity and liabilities X


3
CHAPTER
Consolidated Accounts:
Statements of Financial Position
-Basic Approach
Contents
1 The nature of a group and consolidated accounts
2 Consolidated statement of financial position
3 Consolidation adjusting entries

1 THE NATURE OF A GROUP AND CONSOLIDATED ACCOUNTS

Section overview
 Group as a single economic entity

 A group of companies: parent and subsidiaries
 Situations where control exists
 Purpose and nature of consolidated financial statements
 The requirement to prepare consolidated accounts
 Other accounting issues
1.1 Group as a single economic entity

Illustration: Single economic entity
A Limited (a car manufacturer) buys 100% of B Limited (an automotive parts manufacturer).
The 100% ownership gives A Limited complete control over B Limited.
A Limited’s business has changed as a result of buying B Limited.
It was a car manufacturer. Now it is a car manufacturer and a manufacturer of automotive parts.
The two parts of the business are operated by two separate legal entities (A Limited and B Limited).
However, the two parts of the business are controlled by the management of A Limited.
In substance, the two separate legal entities are a single economic entity.
IFRS contains rules that require the preparation of a special form of financial statements
(consolidated financial statements also known as group accounts) in circumstances like the one
described above.
This chapter explains some of the rules contained in the following standards:
 IFRS 10: Consolidated financial statements
 IFRS 3: Business combinations.
1.2 A group of companies: parent and subsidiaries
Definitions: Group, parent and subsidiary
Group: A parent and its subsidiaries
Parent: An entity that controls one or more entities.
Subsidiary: An entity that is controlled by another entity.
A group consists of a parent entity and one or more entities that it has control over. These are
called subsidiaries.
The entity that ultimately controls all the entities in the group is called the parent.
Some parent companies have no assets at all except shares in the subsidiaries of the group. A
parent whose main assets (or only assets) are shares in subsidiaries is sometimes called a
holding company.
Control
An entity is a subsidiary of another entity if it is controlled by that other entity.
Definition: Control of an investee
An investor controls an investee when:
a. it is exposed, or has rights, to variable returns from its involvement with the investee; and
b. it has the ability to affect those returns through its power over the investee.

Chapter 3: Consolidated accounts: Statements of financial position - Basic approach
In other words, an investor controls an investee, if and only if, it has all the following:
 power over the investee;
 exposure, or rights, to variable returns from its involvement with the investee; and
 ability to use its power over the investee to affect the amount of its returns
1.3 Situations where control exists

The above definition of control is quite complicated.
In practice, the vast majority of cases involve a company achieving control of another through
buying a controlling interest in its shares.
Furthermore, in the vast majority of cases obtaining a controlling interest means buying shares
which give the holder more than 50% of the voting rights in the other company.
Power
Power arises from rights. To have power over an investee, an investor must have existing rights
that give the investor the current ability to direct the relevant activities. The rights that may give
an investor power can differ between investees.
Examples of rights that, either individually or in combination, can give an investor power include
but are not limited to:
(a) rights in the form of voting rights (or potential voting rights) of an investee;
(b) rights to appoint, reassign or remove members of an investee’s key management
personnel who have the ability to direct the relevant activities;
(c) rights to appoint or remove another entity that directs the relevant activities;
(d) rights to direct the investee to enter into, or veto any changes to, transactions for the
benefit of the investor; and (e) other rights (such as decision-making rights specified in a
management contract) that give the holder the ability to direct the relevant activities.
Relevant activities
These are activities of the investee that significantly affect the investee’s returns
For many investees, a range of operating and financing activities significantly affect their returns.
Examples of activities that, depending on the circumstances, can be relevant activities include,
but are not limited to:
(a) selling and purchasing of goods or services;
(b) managing financial assets during their life (including upon default);
(c) selecting, acquiring or disposing of assets;
(d) researching and developing new products or processes; and
(e) determining a funding structure or obtaining funding
Returns
Variable returns are returns that are not fixed and have the potential to vary as a result of the
performance of an investee. Variable returns can be only positive, only negative or both positive
and negative.
Examples of returns include:
(a) dividends, other distributions of economic benefits from an investee (eg interest from debt
securities issued by the investee) and changes in the value of the investor’s investment in
that investee.
(b) remuneration for servicing an investee’s assets or liabilities, fees and exposure to loss
from providing credit or liquidity support, residual interests in the investee’s assets and
liabilities on liquidation of that investee, tax benefits, and access to future liquidity that an
investor has from its involvement with an investee.

(c) returns that are not available to other interest holders. For example, an investor might use
its assets in combination with the assets of the investee, such as combining operating
functions to achieve economies of scale, cost savings, sourcing scarce products, gaining
access to proprietary knowledge or limiting some operations or assets, to enhance the
value of the investor’s other assets.
Illustration: Wholly owned subsidiary

A owns 100% of B’s voting share capital.
A
This 100% holding is described as a controlling interest and gives
100% A complete control of B.
B B would be described as a wholly owned subsidiary.
A company does not have to own all of the shares in another company in order to control it.
Illustration: Partly owned subsidiary

A This 80% holding is described as a controlling interest and gives
A complete control of B.
80% B would be described as a partly owned subsidiary.
B Other parties own the remaining 20% of the shares. They have an
ownership interest in B but do not have control.
This is described as a non-controlling interest.
Non-controlling interest (NCI) is defined by IFRS 10 as: “the
equity in a subsidiary not attributable, directly or indirectly, to a
parent.”
Control is assumed to exist when the parent owns directly, or indirectly through other
subsidiaries, more than half of the voting power of the entity, unless in exceptional circumstances
it can be clearly demonstrated that such control does not exist.
Illustration:
A
A owns a controlling interest in B.
60% B owns a controlling interest in C.
B Therefore, A controls C indirectly through its ownership of B.
70% C is described as being a sub-subsidiary of A.
Consolidation of sub-subsidiaries is not in this syllabus
C
In certain circumstances, a company might control another company even if it owns shares which
give it less than half of the voting rights. Such a company is said to have de facto control over
the other company. (De facto is a Latin phrase which translates as of fact. It is used to mean in
reality or to refer to a position held in fact if not by legal right).

The other shares are held by a large number of unrelated investors none of whom individually
own more than 1% of B.
A This 45% holding probably gives A complete control of B.
45% It would be unlikely that a sufficient number of the other
shareholders would vote together to stop A directing the
B company as it wishes.

A company might control another company even if it owns shares which give it less than half of
the voting rights because it has an agreement with other shareholders which allow it to exercise
control.
A further 10% is held by A’s bank who have agreed to use their vote as directed by A.
A
This 45% holding together with its power to use the votes
45%
attached to the banks shares gives A complete control of B.
B
It was stated above but is worth emphasising that in the vast majority of cases control is achieved
through the purchase of shares that give the holder more than 50% of the voting rights in a
company.
Loss of control
If a parent loses control of a subsidiary, the parent:
(a) derecognises the assets and liabilities of the former subsidiary from the consolidated
statement of financial position.
(b) recognises any investment retained in the former subsidiary at its fair value when control is
lost and subsequently accounts for it and for any amounts owed by or to the former
subsidiary in accordance with relevant IFRSs. That fair value shall be regarded as the fair
value on initial recognition of a financial asset in accordance with IFRS 9 or, when
appropriate, the cost on initial recognition of an investment in an associate or joint venture.
(c) recognises the gain or loss associated with the loss of control attributable to the former
controlling interest.
1.4 Purpose and nature of consolidated financial statements

An investment in a company is usually included in the statement of financial position of the parent
at cost. This does not reflect the substance of the situation. The directors have control of the net
assets of the subsidiary and use these to generate profit.
To solve this problem IFRS requires that where a company holds a subsidiary it must prepare
group financial statements in addition to its separate financial statements.
The type of group accounts specified by IFRS is called consolidation.
The purpose of consolidated financial statements is to provide financial statements that have
meaning and relevance to users. When a parent acquires a subsidiary, both the parent and the
subsidiary remain legally separate entities. However, in practice they operate as if they were one
organisation. Consolidated financial statements reflect the reality (or substance) of the situation:
the group is a single economic unit.
In preparing consolidated financial statements:
 the assets and liabilities of the parent and its subsidiaries are combined in a single
consolidated statement of financial position.
 the profits of the parent and its subsidiaries, and their other comprehensive income, are
combined in a consolidated statement of comprehensive income
In other words a lot of the numbers in the consolidated financial statements are constructed as a
simple cross cast of the balance in the financial statements of the parent and its subsidiary (or
subsidiaries).
Example: Consolidated figures
Parent Subsidiary Consolidated
Property, plant and equipment 1,000 + 500 = 1,500
Inventory 500 + 800 = 1,300
Sales 2,000 + 1,000 = 3,000

It is not always as straightforward as this. Sometimes there is a need for adjustments in the cross
cast. This will be explained later.
Note that the share capital and reserves for the consolidated balance sheet are not calculated
simply by adding the capital and reserves of all the companies in the group!). This is explained
later.
1.5 The requirement to prepare consolidated accounts

IFRS 10 states that, with certain exceptions, a parent must present consolidated financial
statements in which it consolidates its investments in subsidiaries. In other words, a parent must
prepare consolidated financial statements for the group as a whole.
Exception to this rule
There is an exception to this rule. This allows a parent that is itself a subsidiary not to prepare
consolidated financial statements.
A parent need not present consolidated financial statements if (and only if) all the following
conditions apply:
 The parent itself (X) is a wholly-owned subsidiary, with its own parent (Y). Alternatively, the
parent (X) is a partially-owned subsidiary, with its own parent (Y), and the other owners of
X are prepared to allow it to avoid preparing consolidated financial statements.
 The parent’s debt or equity instruments are not traded in a public market.
 The parent does not file its financial statements with a securities commission for the
purpose of issuing financial instruments in a public market.
 The parent’s own parent, or the ultimate parent company (for example, the parent of the
parent’s parent), does produce consolidated financial statements for public use that
comply with IFRS.
All subsidiaries
Consolidated financial statements must include all the subsidiaries of the parent (IFRS 10).
There are no grounds for excluding a subsidiary from consolidation.
1.6 Other accounting issues

Common reporting date
IFRS 10 requires that the financial statements of the parent and its subsidiaries that are used to
prepare the consolidated financial statements should all be prepared with the same reporting
date (the same financial year-end date), unless it is impracticable to do so.
If it is impracticable for a subsidiary to prepare its financial statements with the same reporting
date as its parent, adjustments must be made for the effects of significant transactions or events
that occur between the dates of the subsidiary's and the parent's financial statements. In
addition, the reporting date of the parent and the subsidiary must not differ by more than three
months.
Uniform accounting policies
Since the consolidated accounts combine the assets, liabilities, income and expenses of all the
entities in the group, it is important that the methods used for recognition and measurement of all
these items should be the same for all the entities in the group.
IFRS 10 therefore states that consolidated financial statements must be prepared using uniform
accounting policies. The policies used to prepare the financial statements in all the entities in the
group must be the same.

2 CONSOLIDATED STATEMENT OF FINANCIAL POSITION

Section overview
 The basic approach

 Example 1: To illustrate the basics
 Pre-acquisition and post-acquisition profits
 Introduction to IFRS 3
 Acquisition method
 Goodwill
 Non-controlling interest
 Suggested step by step approach
 Cost (consideration transferred)
 Acquisition date amounts of assets acquired and liabilities assumed
2.1 The basic approach
Definition
Consolidated financial statements: The financial statements of a group presented as those of a
single economic entity.
The technique of consolidation involves combining the financial statements of the parent and its
subsidiaries. We will first explain how to consolidate the statement of financial position.
Consolidation of the statement of comprehensive income will be covered in chapter 6.
Question structure
There are often two major stages in answering consolidation questions:
 Stage 1 involves making adjustments to the financial statements of the parent and
subsidiary to take account of information provided. This might involve correcting an
accounting treatment that has been used in preparing the separate financial statements.
 Stage 2 involves consolidating the correct figures that you have produced.
The early examples used to demonstrate the consolidation technique look only at step 2. It is
assumed that the financial statements provided for the parent and its subsidiaries are correct.
Approach in this section
This section will demonstrate the techniques used to consolidate the statements of financial
position using a series of examples introducing complications one at a time.
The examples will be solved using an approach that you might safely use to answer exam
questions. This approach is quick but it does not show how the double entry works. The double
entry will be covered in section 3 of this chapter so that you are able to understand the flow of
numbers in the consolidation and able to prepare journal entries if asked to do so.
Note the following features in following examples:
 The asset in the parent’s statement of financial position representing the cost of
investment in the subsidiary disappears in the consolidation.
 Each consolidated asset and liability is constructed by adding together the balances from
the statements of financial position of the parent and the subsidiary.
 The share capital (and share premium) in the consolidated statement of financial position
is always just the share capital (and share premium) of the parent. That of the subsidiary
disappears in the consolidation process.

Major workings
There are three major calculations to perform in preparing a consolidated statement of financial
position:
 Calculation of goodwill
 Calculation of consolidated retained earnings
 Calculation of non-controlling interest
In order to calculate the above figures (all of which will be explained in the following pages)
information about the net assets of the subsidiary at the date of acquisition and at the date of
consolidation is needed.
This is constructed using facts about the equity balances (as net assets = equity).
Illustration: Net assets summary of the subsidiary
At date of consolidation At date of acquisition
Share capital X X
Share premium X X
Retained earnings* X X
Net assets X X
* Retained earnings are also known as unappropriated profits or accumulated profits.
You are not yet in a position to fully understand this but all will be explained in the following
pages.
2.2 Example 1 - To illustrate the basics

Example:
P acquired 100% of the equity shares of S on incorporation of S (i.e. when S was first established
as a company).
The date of this transaction was 31 December 20X1 (this known as the date of acquisition).
The cost of this investment was Rs. 120,000.
S had net assets (total assets minus total liabilities) when it was first set up of Rs. 120,000.
The statements of financial position P and S as at 31 December 20X1 (the date of acquisition)
were as follows.
P S
Rs. Rs.
Non-current assets:
Property, plant and equipment 640,000 125,000
Investment in S 120,000 -
Current assets 140,000 20,000
900,000 145,000
Equity
Share capital 200,000 80,000
Share premium 250,000 40,000
Retained earnings 350,000 
800,000 120,000
Current liabilities 100,000 25,000
900,000 145,000

Example:(continued)
A consolidated statement of financial position as at 31 December 20X1 can be prepared as
follows:
P Group: Consolidated statement of financal position as 31 December 20X1
Non-current assets: Rs.
Property, plant and equipment (640,000 + 125,000) 765,000
Current assets (140,000 + 20,000) 160,000
925,000
Equity
Share capital (parent company only) 200,000
Share premium (parent company only) 250,000
Retained earnings 350,000
800,000
Current liabilities (100,000 + 25,000) 125,000
925,000
Note: In practice, there is no reason to prepare a consolidated statement of financial position

when a subsidiary is acquired. However, it is used here to illustrate the basic principles of
consolidation, before going on to consider what happens after the subsidiary has been acquired.
Observations
The asset in the parent’s statement of financial position representing the cost of investment in the
subsidiary disappears in the consolidation.
Each consolidated asset and liability is constructed by adding together the balances from the
statements of financial position of the parent and the subsidiary.
The share capital (and share premium) in the consolidated statement of financial position is
always just the share capital (and share premium) of the parent. That of the subsidiary
Closing comment
The cost of investment was the same as the net assets acquired (Rs. 120,000). This is very
rarely the case. Usually there is a difference. This difference is called goodwill. It will be
explained later.
2.3 Pre-acquisition and post-acquisition profits

Subsidiaries are usually acquired after they have been in business for some time rather than
when they were incorporated.
This means that the acquired subsidiary will have retained earnings at the date of the acquisition.
These are called pre-acquisition profits.
Only profits earned by the subsidiary since the date of acquisition are included as retained
earnings in the consolidated financial statements. These are called post-acquisition retained
earnings.
Pre-acquisition profits of a subsidiary are not included as retained earnings in the consolidated

The working for the consolidated retained earnings balance is as follows:
Illustration: Consolidated retained earnings
Rs.
All of P’s retained earnings X
P’s share of the post-acquisition retained earnings of S X
Consolidated retained earnings X
Other reserves
Sometimes a subsidiary has reserves other than retained earnings. The same basic rules apply.
Only that part of a subsidiary’s reserve that arose after the acquisition date is included in the
group accounts (and then only the parent’s share of it).
Example:
P acquired 100% of the share capital of S on 1 January 20X1 for Rs. 200,000.
The balance on the retained earnings account of S was Rs. 80,000 at that date.
The statements of financial position P and S as at 31 December 20X1 were as follows.
P S
Rs. Rs.
Non-current assets:
1,055,000 335,000
Equity
Retained earnings 470,000 140,000
900,000 260,000
1,055,000 335,000

follows:
P Group: Consolidated statement of financial position at 31 December 20X1
Rs.
Non-current assets:
Current assets (175,000 + 90,000) 265,000
1,190,000
Equity
Share capital (parent company only) 150,000
Share premium (parent company only) 280,000
Consolidated retained earnings (see working) 530,000
960,000
1,190,000

Example (continued): Workings

Net assets summary of S:
At date of At date of
consolidation acquisition Post acqn
Retained earnings 140,000 80,000 60,000
Net assets 260,000 200,000
Consolidated retained profits: Rs.

All of P’s retained earnings 470,000
P’s share of the post-acquisition retained
earnings of S (100% of 60,000 (see above)) 60,000
530,000
Observations
subsidiary disappears in the consolidation.
The consolidated retained profits is made up of the parent’s retained profits plus the parent’s
share of the growth in the subsidiary’s retained profits since the date of acquisition.
Closing comment
The cost of investment was the same as the net assets acquired (Rs. 120,000). This is very
rarely the case. Usually there is a difference. This difference is called goodwill. It will be
explained later.
2.4 Introduction to IFRS 3

Definitions
A business combination is a transaction or other event in which an acquirer obtains control of one
or more businesses.
A business is an integrated set of activities and assets that is capable of being conducted and
managed for the purpose of providing a return in the form of dividends, lower costs or other
economic benefits directly to investors or other owners, members or participants.
Objective of IFRS 3
The objective of IFRS 3 is to improve the relevance, reliability and comparability of information
reported about business combinations and their effects.
It establishes principles and requirements for:
 the recognition and measurement of identifiable assets acquired, liabilities assumed and
non-controlling interest in the acquiree;
 the recognition and measurement of goodwill (or a gain from a bargain purchase); and
 disclosures that enable users to evaluate the nature and financial effects of a business
combination.

Transactions under common control are not within the scope of IFRS 3.This means that transfers
of ownership of a subsidiary within a group (for example in group reconstructions) are not subject
to the rules in this standard. Companies engaging in such transactions must develop accounting
policies in accordance with the guidance given in IAS 8.
2.5 Acquisition method

All business combinations are accounted for by the acquisition method which involves:
 identifying the acquirer;
 determining the acquisition date;
 recognising and measuring the identifiable assets acquired, the liabilities assumed and any
non-controlling interest in the acquiree; and
 recognising and measuring goodwill or a gain from a bargain purchase
Identifying the acquirer
It might be difficult to identify an acquirer:
 The acquirer is usually the combining entity whose relative size is significantly greater than
that of the other(s).
 In a business combination affected by transferring cash (other assets) or by incurring
liabilities the acquirer is usually the entity that makes the transfer or incurs the liabilities.
 In a business combinations affected by exchange of equity interests the acquirer is usually
the entity that issues equity (however, in a “reverse acquisition” the issuing entity is the
acquiree).
Also note that the acquirer is usually the entity:
 whose owners have the largest portion of the voting rights in the combined entity;
 whose owners have the ability to determine the composition of the governing body of the
combined entity;
 whose (former) management dominates the management of the combined entity;
 that pays a premium over the pre-combination fair value of the equity interests of the
others
Determining the acquisition date
Acquisition date is the date on which the acquirer effectively obtains control of the acquiree.
This generally the closing date (date of transfer of consideration and when net assets are
acquired) but might be before or after this date depending on circumstances.
2.6 Goodwill
In each of the two previous examples the cost of investment was the same as the net assets of
the subsidiary at the date of acquisition.
In effect what has happened in both examples is the cost of investment has been replaced by the
net assets of the subsidiary as at the date of acquisition.
The net assets have grown since acquisition to become the net assets at consolidation. These
have been included as part of the net assets of the group, but remember that the consolidated
retained earnings includes the parent’s share of post-acquisition retained earnings so everything
balances.
Consolidation adjusting entries have been explained in section 3 of this chapter.
In almost all cases the cost of investment will be different to the net assets purchased. The
difference is called goodwill. IFRS 3 is largely about the calculation of goodwill.

Definition: Goodwill
Goodwill: An asset representing the future economic benefits arising from other assets acquired in
a business combination that are not individually identified and separately recognised.
When a parent buys a subsidiary the price it pays is not just for the assets in the statement of
financial position. It will pay more than the value of the assets because it is buying the potential of
the business to make profit.
The amount it pays in excess of the value of the assets is for the goodwill.
IFRS 3 Business combinations, sets out the calculation of goodwill as follows:
Illustration: Goodwill
N.B. All balances are as at the date of acquisition.
Rs.
Consideration transferred (cost of the business combination) X
Non-controlling interest X
X
The net of the acquisition date amounts of identifiable assets acquired and
liabilities assumed (measured in accordance with IFRS 3) X
Goodwill recognised X
The above calculation compares the total value of the company represented by what the parent
has paid for it and the non-controlling interest to the net assets acquired at the date of
acquisition.
The guidance requires the net of the acquisition date amounts of identifiable assets
acquired and liabilities assumed (measured in accordance with IFRS 3). This will be
explained later.
The guidance also refers to non-controlling interest. This will be explained later but first we will
present an example where there is no non-controlling interest.
Example:
P acquired 100% of S on 1 January 20X1 for Rs. 230,000.
The retained earnings of S were 100,000 at that date.
The statements of financial position of P and S as at 31 December 20X1 were as follows:
P S
Rs. Rs.
Assets:
Investment in S, at cost 230,000 -
Other assets 570,000 240,000
800,000 240,000
Equity
740,000 195,000
800,000 240,000

Example (continued): Net assets summary of S

A consolidated statement of financial position as at 31 December 20X1 can be prepared as follows:
Rs.
Assets
Goodwill (see working) 60,000
Other assets (570,000 + 240,000) 810,000
Total assets 870,000
Equity
Share capital (P only) 200,000
Share premium (P only) 100,000
765,000
Total equity and liabilities 870,000
Net assets 195,000 170,000*
Goodwill Rs.
Cost of investment 230,000
Non-controlling interest nil
230,000
Net assets at acquisition 100% of 170,000* (see
above) (170,000)
60,000

P’s share of the post-acquisition retained
earnings of S (100% of 25,000 (see above)) 25,000
465,000
Observations
subsidiary disappears in the consolidation. It is taken into the goodwill calculation.

The consolidated retained profits is made up of the parent’s retained profits plus the parent’s
share of the growth in the subsidiary’s retained profits since the date of acquisition.
Accounting for goodwill
Goodwill is recognised as an asset in the consolidated financial statements.
It is not amortised but is tested for impairment on an annual basis.
2.7 Non-controlling interest

When a parent entity acquires less than 100% of the equity shares in a subsidiary, the remainder
of the shares in the subsidiary are held by other shareholders. These are called the non-
controlling interest (NCI) in the subsidiary. The abbreviation NCI is used for non-controlling
interests. It is also known as minority interest.
For example, P might acquire 60% of the shares in S.
 It has acquired 60% of the ‘equity’ ownership of S.
 The remaining 40% of the equity in S is owned by the non-controlling interest.
Non-controlling interest (NCI) is defined by IFRS 10 as: ‘the equity in a subsidiary not attributable,
directly or indirectly, to a parent.’
All of the assets and liabilities of S are consolidated just as before. However, part of the net
assets that have been consolidated belongs to the NCI. A figure for the NCI is recognised in
equity to show their ownership interest in the net assets.
Measuring the NCI
The NCI at the reporting date made up as follows:
Illustration: Non-Controlling Interest
Rs.
NCI at the date of acquisition X
NCI’s share of the post-acquisition retained earnings of S X
NCI’s share of post-acquisition reserves of S (if any) X
Non-Controlling Interest X
There are two ways of measuring the NCI at the date of acquisition.
 As a percentage of the net assets of the subsidiary at the date of acquisition; or
 At fair value as at the date of acquisition.
The first technique is the easier of the two because it allows for the use of a short cut. Also, it is
far the more common in practice.
The different approaches will obviously result in a different figure for NCI but remember that the
NCI at acquisition is also used in the goodwill calculation. This is affected also.

Example:
P acquired 80% of S on 1 January 20X1 for Rs. 230,000.
The retained earnings of S were 100,000 at that date.
It is P’s policy to recognise non-controlling interest at the date of acquisition as a proportionate
share of net assets.
The statements of financial position P and S as at 31 December 20X1 were as follows
P S
Rs. Rs.
Assets:
Investment in S, at cost 230,000 -
Other assets 570,000 240,000
800,000 240,000
Equity
740,000 195,000
800,000 240,000
A consolidated statement of financial position as at 31 December 20X1 can be prepared as follows:

Rs.
Assets
Other assets (570,000 + 240,000) 810,000
Equity
760,000
Non-controlling interest (see working) 39,000
799,000

Net assets 195,000* 170,000


Non-controlling interest Rs.
NCI’s share of net assets at the date of acquisition
(20%  170,000) 34,000
NCI’s share of the post-acquisition retained earnings of S
(20% of 25,000 (see above)) 5,000
NCI’s share of net assets at the date of consolidation 39,000
Goodwill Rs.
Non-controlling interest at acquisition 34,000
264,000
Net assets at acquisition (see above) (170,000)
94,000

P’s share of the post-acquisition retained earnings of S (80%
of 25,000 (see above)) 20,000
460,000
The NCI at the date of consolidation has been calculated as NCI share of net assets at
acquisition plus the NCI share of profit since the date of acquisition.
NCI share of profit since the date of acquisition is the same as the NCI share of net assets since
the date of acquisition.
Therefore, the NCI at the date of consolidation is simply the NCI share of net assets at the date
of consolidation.
Net assets 195,000* 170,000
NCI’s share of net assets at the date of consolidation

(20%  195,000*) 39,000
This short cut is not available if the NCI at acquisition is measured at fair value.

NCI at fair value at the date of acquisition
Example: NCI at date of acquisition measured at fair value

Continuing the earlier example with the extra information that the fair value of the NCI at
acquisition was Rs. 40,000.
Net assets summary of S
At date of At date of acquisition Post acqn
consolidation
Net assets 195,000 170,000
Figures under both methods are shown so that you can see the difference between the two.
NCI at fair NCI as share
value of net assets
Non-controlling interest Rs. Rs.
NCI at the date of acquisition
at fair value 40,000
share of net assets (20%  170,000) 34,000
NCI’s share of the post-acquisition retained earnings of
S
(20% of 25,000 (see above)) 5,000 5,000
NCI’s share of net assets at the date of consolidation 45,000 39,000
Goodwill Rs. Rs.

Cost of investment 230,000 230,000
Non-controlling interest at acquisition 40,000 34,000
270,000 264,000
Net assets at acquisition (see above) (170,000) (170,000)
100,000 94,000
2.8 Suggested step by step approach

To prepare a consolidated statement of financial position as at the acquisition date, the following
steps should be taken.
Step 1. Establish the group share (parent company share) in the subsidiary and the percentage
owned by non-controlling interests.
Step 2: Perform double entry to record any individual company adjustments that might be
necessary. Mark these in the face of the question. The information can be lifted into workings
later so that the marker can understand what you have done.
Step 3: Set out a pro-forma (skeleton) statement of financial position and fill in the easy numbers
(for example those assets and liabilities that are a straight cross cast and the share capital)
Step 4. Calculate the net assets of the subsidiary S at the acquisition date and at the end of the
reporting period
Step 5. Calculate the goodwill (at the date of acquisition)
Step 6. Calculate the non-controlling interest (at the end of the reporting period)
Step 7. Calculate consolidated retained earnings (at the end of the reporting period)

2.9 Cost (consideration transferred)

IFRS 3 states that the purchase consideration for an acquisition (business combination) is the
sum of:
 the fair values, at the acquisition date, of the assets transferred by the acquirer, such as
cash
 the liabilities incurred by the acquirer to the former owners of the acquiree
 equity instruments issued by the acquirer in exchange for control of the acquiree.
The purchase consideration may include some deferred consideration.
When the acquirer issues shares as part of the purchase consideration and the shares are
quoted equity instruments, they are normally valued at their market price at the acquisition date
for the purpose of measuring the consideration/acquisition cost.
If the consideration includes assets or liabilities of the acquirer carried at amounts that differ from
their fair values at the acquisition date, these are revalued with gains and losses taken to P&L.
Consideration includes any asset or liability resulting from a contingent consideration
arrangement:
 recognised at acquisition-date fair value; and
 classified as a liability or equity on the basis of guidance in IAS 32 or other applicable
IFRSs.
A right to the return of previously transferred consideration is classified as an asset if specified
conditions are met.
Costs of acquisition: transaction costs
Transaction costs incurred in making an acquisition, such as the cost of the fees of advisers and
lawyers, must not be included in the cost of the acquisition. These costs must be treated as an
expense as incurred and written off to profit or loss.
The amount of transaction costs associated with an acquisition and written off during the period
to profit or loss must be disclosed in a note to the financial statements.
Example: Cost of acquisition

Company P acquired 80% of the shares of Company S when the fair value of the net assets of S
was Rs. 800,000.
The purchase price was Rs. 300,000 in cash plus 10,000 new shares in Company P.
The new shares were to be issued 1 month after the date of acquisition.
The market value of P’s shares at the date of acquisition was Rs.40 each. One month later the
market value had increased to Rs.45.
The costs of making the acquisition were Rs. 80,000.
The cost of the investment in the shares of S = Rs. 300,000 + (10,000 × Rs.40 = Rs. 700,000. The
share price at the date of acquisition is used not that at the date of issue.
The costs of making the acquisition should be written off to profit or loss.
The parent company’s share of the net assets of S at the acquisition date was Rs. 640,000 (80%
× Rs. 800,000). Purchased goodwill attributable to owners of the parent company is therefore Rs.
60,000 (Rs. 700,000 - Rs. 640,000).

Deferred consideration
Sometimes all or part of the cost of an acquisition is deferred and does not become payable until
a later date.
The amount of any deferred consideration (the amount not payable immediately) is discounted to
its present value at the acquisition date.
Contingent consideration
Sometimes the final cost of the combination is contingent on (depends on) a future event. For
example, an acquirer could agree to pay an additional amount if the acquired subsidiary’s profits
exceed a certain level within three years of the acquisition.
In a situation such as this, the contingent payment should be included in the cost of the
combination (discounted to present value if the payment will occur more than 12 months in the
future).
Under the rules of IFRS 3, contingent consideration must be recognised at fair value at
acquisition, even if it is not probable that the consideration will actually have to be paid.
Example: Contingent consideration

Company X purchased 100% of the issued capital of Company S on 1 January Year 4.
The purchase agreement required Company X to pay Rs. 300,000 in cash immediately and an
additional sum of Rs. 100,000 on 31 December Year 6 if the earnings of Company S increase at
an annual rate of 25% per year in each of the three years following the acquisition.
How should the contingent payment be recognised in calculating the goodwill arising at the date
of acquisition?
Answer
The contingent consideration should be included in the cost of investment (the purchase
consideration) whether or not it is probable that it will have to be paid. The contingent consideration
of Rs. 100,000 should be measured at fair value.
If it is fairly certain that the contingent consideration will have to be paid, an appropriate measure
of fair value might be the present value of the future payment, discounted at an appropriate cost
of capital. The purchase consideration is therefore Rs. 300,000 plus the present value of the
contingent (deferred) consideration.
If there is still contingent consideration at the end of an accounting period, it might be necessary
to re-measure it.
If the contingent consideration will be payable in cash, it should be re-measured to fair value at
the end of the reporting period. Any gain or loss on re-measurement should be taken to profit or
loss.
If the contingent consideration will take the form of debt, the amount of the debt is re-measured
at fair value at the end of the reporting period and the change in value is recognised in profit or
loss in the period.
If the contingent consideration will take the form of equity, it is not re-measured at the end of the
reporting period. The eventual settlement of the payment will be accounted for as an equity
transaction (i.e. a transaction between the entity and owners of the group in their capacity as
owners).
A reason for re-measuring the contingent consideration is that the amount payable might depend
on the performance of the subsidiary after its acquisition.
If the profits are higher than expected, the contingent consideration might be re-measured to a
higher value, increasing the liability (the contingent payment) and reducing the reported profit for
the period.

Similarly if the profits are lower than expected, the contingent consideration might be re-
measured to a lower value, reducing the liability (the contingent payment) and increasing the
reported profit for the period.
(Note: Under the previous accounting rules, before the introduction of IFRS 3, any increase in the
value of contingent consideration was charged to goodwill.)
Share options given to the previous owners
When an entity acquires a subsidiary that was previously managed by its owners, the previous
owners might be given share options in the entity as an incentive to stay on and work for the
subsidiary after it has been acquired. IFRS 3 states that the award of share options in these
circumstances is not a part of the purchase consideration. The options are post-acquisition
employment expenses and should be accounted for as share-based payments in accordance
with IFRS 2.
2.10 Acquisition date amounts of assets acquired and liabilities assumed
Core principle
An acquirer of a business must recognise assets acquired and liabilities assumed at their
acquisition date fair values and disclose information that enables users to evaluate the nature
and financial effects of the acquisition.
To support this IFRS 3 sets out:
 a recognition principle;
 classification guidance; with
 a measurement principle.
There are specified exceptions to each of these.
Any asset acquired or liability assumed is subsequently measured in accordance with applicable
IFRS. There are also exceptions to this rule.
Recognition principle
An acquirer must recognise (separately from goodwill), identifiable assets acquired, liabilities
assumed and any non-controlling interest in the acquiree as of the acquisition date.
To qualify for recognition identifiable assets acquired and liabilities assumed must meet the
definitions of assets and liabilities set out in The Conceptual Framework as at the acquisition
date.
This might result in recognition of assets and liabilities not previously recognised by the acquiree.
When a company acquires a subsidiary, it may identify intangible assets of the acquired
subsidiary, which are not included in the subsidiary’s statement of financial position. If these
assets are separately identifiable and can be measured reliably, they should be included in the
consolidated statement of financial position as intangible assets, and accounted for as such.
This can result in the recognition of assets and liabilities not previously recognised by the
acquiree.
Illustration: Identifiable asset on acquisition

If a company bought 100% of the Coca-Cola Corporation they would be buying a lot of assets but
part (perhaps the largest part) of the purchase consideration would be to buy the Coca Cola brand.
Coca Cola does not recognise its own brand in its own financial statements because companies
are not allowed to recognised internally generated brands.
However, as far as the company buying the Coca-Cola Corporation is concerned the brand is a
purchased asset. It would be recognised in the consolidated financial statements and would be
taken into account in the goodwill calculation.

Contingent liabilities
Many acquired businesses will contain contingent liabilities such as contingent liabilities for the
settlement of legal disputes or for warranty liabilities. IFRS 3 states that contingent liabilities
should be recognised at acquisition ‘even if it is not probable that an outflow of resources
embodying economic benefits will be required to settle the obligation.’
The contingent liabilities should be measured at fair value at the acquisition date. (Contingent
assets are not recognised).
Restructuring costs
An acquirer should not recognise a liability for the cost of restructuring a subsidiary or for any
other costs expected to be incurred as a result of the acquisition (including future losses).
This is because a plan to restructure a subsidiary after an acquisition cannot be a liability at the
acquisition date. For there to be a liability (and for a provision to be recognised) there must have
been a past obligating event. This can only be the case if the subsidiary was already committed
to the restructuring before the acquisition.
This means that the acquirer cannot recognise a provision for restructuring or reorganisation at
acquisition and then release it to profit and loss in order to ’smooth profits’ or reduce losses after
the acquisition.
Measurement principle
Identifiable assets acquired and the liabilities assumed are measured at their acquisition date fair
values.
Definition: Fair value

Fair value: The price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.
The net assets of a newly acquired business are subject to a fair valuation exercise.
The table below shows how different types of asset and liability should be valued.
Item Fair value
Marketable investments Current market value
Non-marketable Estimated values that take into consideration features such as:
investments (a) price earnings ratios
(b) dividend yield
(c) expected growth rates of comparable investments
Trade and other Present values of the amounts to be received. This is normally
receivables the same as the book value. Discounting is not usually required
because amounts are expected to be received within a few
months.
Inventories: finished Selling price less the sum of:
goods (a) the costs of disposal, and
(b) a reasonable profit allowance for the selling effort of the
acquirer based on profit for similar finished goods.
Inventories: work in Selling price of finished goods less the sum of:
progress (a) costs to complete,
(b) costs of disposal, and
(c) a reasonable profit for the completing and selling effort
based on profit for similar finished goods.
Inventories: raw materials Current replacement costs

Item Fair value
Land and buildings Market value
Plant and equipment Normally market value. Use depreciated replacement cost if
market value cannot be used (e.g., because of the specialised
nature of the plant and equipment or because the items are rarely
sold, except as part of a continuing business).
Intangible assets As discussed above
Trade and other payables; Present values of amounts to be disbursed in meeting the liability
long-term debt and other determined at appropriate current interest rates. For current
liabilities. liabilities this is normally the same as book value.
Exceptions
Note that this table only shows the exceptions to the above principles and guidance.
Topic Recognition Measurement at Measurement at later
principle acquisition dates
Contingent liability Defined by IAS 37 Fair value At the higher of the original
and not recognised. amount and the amount
Contingent liability that would be reported
due to a present under IAS 37.
obligation is
recognised
Income taxes IAS 12 applies IAS 12 applies IAS 12 applies
Employee benefits IAS 19 applies IAS 19 applies IAS 19 applies
Indemnification This is a right to be Measurement of Measurement of the asset
assets compensated by the asset mirrors mirrors the recognition of
the seller if a the recognition of the liability
defined the liability
contingency occurs
Recognition of the
asset mirrors the
recognition of the
liability
Reacquired rights n/a Recognised as an The asset recognised is
intangible asset amortised over the
and measured on remaining contractual
the basis of the period of the contract in
remaining which the right was
contractual term of granted.
the related contract
regardless of
whether market
participants would
consider potential
contractual
renewals in
determining its fair
value
Share based IFRS 2 applies
payments
Assets held for sale IFRS 5 applies

Deferred tax
Deferred income tax assets and liabilities are recognised and measured in accordance with IAS
12 Income Taxes, rather than at their acquisition-date fair values.
Measurement period
Initial accounting for goodwill may be determined on a provisional basis and must be finalised by
the end of a measurement period.
This ends as soon as the acquirer receives the information it was seeking about facts and
circumstances that existed at the acquisition date but must not exceed one year from the
acquisition date.
During the measurement period new information obtained about facts and circumstances that
existed at the acquisition date might lead to the adjustment of provisional amounts or recognition
of additional assets or liabilities with a corresponding change to goodwill.
Any adjustment restates the figures as if the accounting for the business combination had been
completed at the acquisition date.
Classification guidance
Identifiable assets acquired and liabilities assumed must be classified (designated) as necessary
at the acquisition date so as to allow subsequent application of appropriate IFRS.
The classification is based on relevant circumstances as at the acquisition date with two
exceptions:
 classification of a lease contract in accordance with IFRS 16 Leases; and
 classification of a contract as an insurance contract in accordance with IFRS 4 Insurance
Contracts.
Classification in these cases is based on circumstances at the inception of the contract or date of
a later modification that would change the classification.

3 CONSOLIDATION ADJUSTING ENTRIES

Section overview
 Calculating goodwill
 Calculating NCI
 Calculating consolidated retained earnings
 Tutorial note
Introductory comment
The learning outcomes include a requirement to prepare journals necessary to calculate goodwill
and non-controlling interest.
Usually journals are prepared to process changes in the general ledger. This is not the case of
the journals in this section. There is no general ledger for the group accounts. Consolidated
financial statements are prepared from independent sets of financial statements which are
extracted from separate general ledgers. Information from these independent financial
statements is transferred to working papers where the consolidation is performed.
The journals described in this refer to adjustments made to numbers in those working papers.
3.1 Calculating goodwill

The cost of investment account is renamed the cost of control account. This is the account used
to calculate goodwill.
P’s share of net assets is compared with the cost of investment in this account by transferring in
P’s share of each of S’s equity balances at the date of acquisition.
Illustration:
Debit Credit
Share capital of S 40,000
Cost of control 40,000
Being: Transfer of P’s share of S’s share capital to cost of control account as at the date of
acquisition (80% of 50,000)
Share premium of S 16,000
Being: Transfer of P’s share of S’s share premium to cost of control account as at the date of
acquisition (80% of 20,000)
Retained earnings of S 80,000
Being: Transfer of P’s share of S’s retained earnings to cost of control account as at the date
of acquisition (80% of 100,000)
The balance on the cost of control account is the goodwill figure.

Example:
Cost of control (goodwill)
Rs. Rs.
1) P’s share of S’s share
Cost of investment 230,000 capital 40,000
2) P’s share of S’s share
premium 16,000

Example: (continued)
3) P’s share of S’s retained
earnings at acquisition 80,000
Balance c/d 94,000
230,000 230,000
Balance b/d 94,000
3.2 Calculating NCI

The NCI’s share of net assets of S is constructed by transferring in their share of each of S’s
equity balances at the date of consolidation into an NCI account.
Illustration:
Debit Credit
Share capital of S 10,000
Being: Transfer of NCI’s share of S’s share capital as at the date of acquisition to cost of control
account (20% of 50,000)
Share premium of S 4,000

Being: Transfer of NCI’s share of S’s share premium as at the date of acquisition to cost of
control account (20% of 20,000)
Being: Transfer of NCI’s share of S’s retained earnings as at the date of acquisition to cost of
control account (20% of 125,000)
The balance on this account is the non-controlling interest
Example:
Non-controlling interest
Rs. Rs.
4) NCI’s share of S’s share
capital
(20% of 50,000) 10,000
5) NCI’s share of S’s share
premium
(20% of 20,000) 4,000
6) NCI’s share of S’s
retained earnings
Balance b/d 39,000 (20% of 125,000) 25,000
39,000 39,000
Balance b/d 39,000
3.3 Calculating consolidated retained earnings

P’s share of S’s retained earnings since the date of acquisition is credited to the P’s retained
earnings account.

Illustration:
Debit Credit
P’s retained earnings 20,000
Being: Transfer of P’s share of post-acquisition profits of S into retained earnings. (80% of
(125,000 – 100,000))
The balance on this account is the consolidated retained earnings.
Example (continued):
Retained earnings
Rs. Rs.
P’s balance 440,000
P’s share of S’s 20,000
Balance b/d 460,000
460,000 460,000
Balance b/d 460,000
3.4 Tutorial note

The balances on S’s share capital, share premium and retained earnings have all been removed
elsewhere.
Share capital (of S)

Rs. Rs.
P’s share at acquisition (to
cost of control) 40,000 Balance b/d 50,000
S’s share (to NCI) 10,000
50,000 50,000
Share premium (of S)

Rs. Rs.
20,000 20,000
Retained earnings (of S)

Rs. Rs.
P’s share since acquisition
(consolidated retained
profits) 20,000
125,000 125,000

Practice question 1
H Ltd acquired 80% of S Ltd several years ago for Rs. 30 million.
The balance on S Ltd’s retained earnings was Rs. 5,000,000 at the date of acquisition.
H Ltd’s policy is to measure non-controlling interest at the date of acquisition as a
proportionate share of net assets.
The draft statements of financial position of the two companies at 31 December 20X1 are:
H (Rs. 000 ) S (Rs. 000)
Non-current assets:
Total assets 103,000 27,000
Equity
81,000 11,000
Non-current liabilities 2,000 6,000
Total equity and liabilities 103,000 27,000
Prepare a consolidated statement of financial position as at 31 December 20X1.

SOLUTIONS TO PRACTICE QUESTIONS

Solutions 1
H Group: Consolidated statement of financial position at 31 December 20X1
Rs.
Assets
Goodwill (W3) 25,200
85,200
Current assets (28,000 + 12,000) 40,000
Equity
Share capital 5,000
Retained earnings (W4) 80,000
85,000
Non-controlling interest (W2) 2,200
87,200
Non-current liabilities (2,000 + 6,000) 8,000
Solution: Workings 1
W1: Net assets summary of S
At date of
Consolidation Acquisition Post acqn
Net assets 11,000 6,000
W2: Non-controlling interest Rs.000

(20%  6,000) 1,200
NCI’s share of the post-acquisition retained earnings of S (20% of 5,000 (see
above)) 1,000
W3: Goodwill Rs. 000

Non-controlling interest at acquisition (20%  6,000) 1,200
31,200
Recoverable amount of goodwill 25,200
W4: Consolidated retained profits: Rs.

All of H’s retained earnings 76,000
H’s share of the post-acquisition retained earnings of S
(80% of 5,000 (see above)) 4,000
80,000


4
CHAPTER
Statements of Financial Position -
Complications
Contents
1 Possible complications: Before consolidation
2 Possible complications: During consolidation
3 Possible complications: After consolidation

1 POSSIBLE COMPLICATIONS: BEFORE CONSOLIDATION

Section overview
 Acquisition-related costs
 Acquired intangible assets
 Fair value exercise at acquisition
1.1 Acquisition-related costs

Acquisition-related costs are costs the acquirer incurs to effect a business combination. They
include advisory, legal, accounting, valuation and other professional or consulting fees.
These costs are not capitalised as part of the cost of acquisition but expensed in the periods in
which they are incurred. (This is different rule to that which applies to the purchase of property,
plant and equipment or intangibles).
A question may incorrectly capitalise the costs. You would have to correct this before
consolidating.
1.2 Acquired intangible assets

A question might provide information about an unrecognised asset of the subsidiary. You would
have to include the asset in the subsidiary’s financial statements before consolidating them.
Reason
Goodwill is recognised by the acquirer as an asset from the acquisition date.
It is initially measured as the difference between:
 the cost of the acquisition plus the non-controlling interest; and
 the net of the acquisition date amounts of identifiable assets acquired and liabilities
assumed (measured in accordance with IFRS 3).
When a company acquires a subsidiary, it may identify intangible assets of the acquired
subsidiary, which are not included in the subsidiary’s statement of financial position. If these
assets are separately identifiable and can be measured reliably, they should be included in the
consolidated statement of financial position as intangible assets, and accounted for as such.
This can result in the recognition of assets and liabilities not previously recognised by the
acquiree.
Illustration:
If a company bought 100% of the Coca-Cola Corporation, they would be buying a lot of assets but
part (perhaps the largest part) of the purchase consideration would be to buy the Coca Cola brand.
Coca Cola does not recognise its own brand in its own financial statements because companies
are not allowed to recognised internally generated brands.
However, as far as the company buying the Coca-Cola Corporation is concerned the brand is a
purchased asset. It would be recognised in the consolidated financial statements and would be
taken into account in the goodwill calculation.

Chapter 4: Consolidated accounts: Statements of financial position - Complications
Example:
P bought 80% of S 2 years ago.
At the date of acquisition S’s retained earnings stood at Rs. 600,000. The fair value of its net assets
was not materially different from the book value except for the fact that it had a brand which was
not recognised in S’s accounts. This had a fair value of Rs. 100,000 at this date and an estimated
useful life of 20 years.
The statements of financial position P and S as at 31 December 20X1 were as follows:
P S
Rs. Rs.
Property, Plant and Equipment 1,800,000 1,000,000
Investment in S 1,000,000 -
Other assets 400,000 300,000
3,200,000 1,300,000

Retained earnings 2,900,000 1,000,000
Liabilities 200,000 200,000
3,200,000 1,300,000

follows:
Rs.
Assets
Brand (see working) 90,000
Property, plant and equipment (1,800,000 + 1,000,000) 2,800,000
Other assets (400,000 + 300,000) 700,000
Total assets 3,950,000
Equity
Consolidated retained earnings (see working) 3,212,000
3,312,000
Non-controlling interest 238,000
3,550,000
Total equity and liabilities 3,950,000

Retained earnings
Given in the question 1,000,000 600,000
Extra amortisation on
brand
(100,000 × 2 years/20 years) (10,000) 
990,000 600,000 390,000
Consolidation reserve on
recognition of the brand 100,000 100,000
Net assets 1,190,000 800,000

(20%  800,000) 160,000
NCI’s share of the post-acquisition retained earnings of S [(20%
of 390,000 (see above))] 78,000
Goodwill Rs.
Cost of investment 1,000,000
1,160,000
360,000

All of P’s retained earnings 2,900,000
P’s share of the post-acquisition retained earnings of S [(80% of
390,000 (see above))] 312,000
3,212,000
Brand Rs.
On initial recognition 100,000
Amortisation since acquisition (100,000 × 2 years/20 years) (10,000)
90,000

1.3 Fair value exercise at acquisition

A question might provide information about the fair value of a subsidiary’s assets at the date of
acquisition. You might have to revalue the assets in the subsidiary’s financial statements before
consolidating them.
Reason
Goodwill is recognised by the acquirer as an asset from the acquisition date.
It is initially measured as the difference between:
 the cost of the acquisition plus the non-controlling interest; and
 the net of the acquisition date amounts of identifiable assets acquired and liabilities
assumed (measured in accordance with IFRS 3).
IFRS 3 requires that most assets and liabilities be measured at their fair value.
Definition: Fair value

Fair value: The price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.
In every example so far it has been assumed that the fair value of the assets and liabilities of the
subsidiary were the same as their book value as at the date of acquisition. In practice this will not
be the case.
In other cases, a question will include information about the fair value of an asset or assets as at
The net assets of a newly acquired business are subject to a fair valuation exercise.
Where the subsidiary has not reflected fair values at acquisition in its accounts, this must be
done before consolidating. Note that this is almost always the case.
Revaluation upwards
The asset is revalued in the consolidation working papers (not in the general ledger of the
subsidiary). The other side of the entry is taken to a fair value reserve as at the date of
acquisition. This will appear in the net assets working and therefore become part of the goodwill
calculation.
The reserve is also included in the net assets working at the reporting date if the asset is still
owned by the subsidiary.
If a depreciable asset is revalued the post-acquisition depreciation must be adjusted to take
account of the change in the value of the asset being depreciated.
Revaluation downwards
Write off the amount to retained earnings in the net assets working (book value less fair value of
net assets) at acquisition and at the reporting date if the asset is still owned.
Example:
P bought 80% of S 2 years ago.
At the date of acquisition S’s retained earnings stood at Rs. 600,000 and the fair value of its net
assets were Rs. 1,000,000. This was Rs. 300,000 above the book value of the net assets at this
date.
The revaluation was due to an asset that had a remaining useful economic life of 10 years as at

P S
Rs. Rs.
Property, Plant and Equipment 1,800,000 1,000,000
Investment in S 1,000,000 -
Other assets 400,000 300,000
3,200,000 1,300,000

Retained earnings 2,900,000 1,000,000
3,200,000 1,300,000

follows:
Rs.
Assets
PP and E (see working) 3,040,000
Other assets (400,000 + 300,000) 700,000
Total assets 3,940,000
Equity
Consolidated retained earnings (see working) 3,172,000
3,272,000
3,540,000
Total equity and liabilities 3,940,000

At date of At date of Post
consolidation acquisition acquisition
Retained earnings
Given in the question 1,000,000 600,000
Extra depreciation on
fair value adjustment
(300 × 2 years/10 years) –
see explanation on next
page (60,000) 
940,000 600,000 340,000
Fair value reserve 300,000 300,000
Net assets 1,340,000 1,000,000

(20%  1,000,000) 200,000
(20% of 340,000 (see above)) 68,000
Goodwill Rs.
Cost of investment 1,000,000
Non-controlling interest at acquisition (20%  1,000,000) 200,000
1,200,000
Net assets at acquisition (see above) (1,000,000)
200,000

All of P’s retained earnings 2,900,000
P’s share of the post-acquisition retained earnings of S
(80% of 340,000 (see above)) 272,000
3,172,000
Property plant and equipment Rs.

Parent’s 1,800,000
Subsidiary’s
Given in question 1,000,000
Fair value adjustment 300,000
Extra depreciation on fair value adjustment
(300,000 × 2 years/10 years) (60,000)
1,240,000
To statement of financial position 3,040,000

Explanation of extra depreciation

If a depreciable asset is revalued (which is usually the case) the post-acquisition depreciation
must be adjusted to take account of the change in the value of the asset being depreciated.
In this example, two years ago the subsidiary had an asset which had a fair value Rs.300,000
greater than its book value. This valuation was not recorded in the financial statements of the
subsidiary so the subsidiary’s figures need to be retrospectively adjusted, for the purposes of
consolidation, at each year end.
Depreciation of an asset is based on its carrying amount. Depreciation of an asset increases
when it is revalued. Therefore, the extra depreciation necessary as a result of the fair value
adjustment is Rs. 30,000 per annum (Rs. 300,000/10 years).
The acquisition was 2 years ago so extra depreciation of Rs. 60,000 (Rs. 30,000  2 years) must
be recognised retrospectively.

2 POSSIBLE COMPLICATIONS: DURING CONSOLIDATION

Section overview
 Mid-year acquisitions
 Types of intra-group transaction
 The need to eliminate intra-group transactions on consolidation
 Unrealised profit – Inventory
 Unrealised profit – Transfers of non-current assets
2.1 Mid-year acquisitions

Goodwill is measured at the date of acquisition of the subsidiary.
H may not acquire S at the start or end of a year. If S is acquired mid-year, it is necessary to
calculate the net assets at date of acquisition in order to calculate goodwill, non-controlling
interest and consolidated retained earnings.
This usually involves calculating the subsidiary’s retained earnings at the date of acquisition. The
profits of the subsidiary are assumed to accrue evenly over time unless there is information to the
contrary.
Illustration: Retained earnings at the date of acquisition
Rs.
Retained earnings at the start of the year X
Retained earnings for the year up to the date of acquisition X
Retained earnings at the date of acquisition X
Example:
P bought 70% of S on 31st March this year.
S’s profit for the year was Rs. 12,000
P S
Rs. Rs.
PP and E 100,000 20,000
Other assets 30,000 12,000
180,000 32,000

180,000 32,000

follows:
Rs.
Assets
PP and E (100,000 + 20,000) 120,000
Other assets (30,000 + 12,000) 42,000
Equity
176,300
185,600

Retained earnings
Given in the question 30,000
See working below 21,000
30,000 21,000 9,000
Net assets 31,000 22,000
Retained earnings of the subsidiary as at the date of acquisition

Rs.
Retained earnings at the start of the year
Retained earnings at the end of the year 30,000)
Profit for the year (12,000)
18,000
Profit from the start of the year to the date of acquisition
(3/12  12,000) 3,000

(30%  22,000) 6,600
NCI’s share of the post-acquisition retained earnings of S (30%
of 9,000 (see above)) 2,700

Goodwill Rs.
56,600
34,600

P’s share of the post-acquisition retained earnings of S (70% of
9,000 (see above)) 6,300
166,300
2.2 Types of intra-group transaction

In many groups, business and financial transactions take place between entities within the group.
These ‘intra-group’ transactions might be:
 the sale of goods or rendering of services between the parent and a subsidiary, or
between two subsidiaries in the group
 transfers of non-current assets between the parent and a subsidiary, or between two
subsidiaries in the group
 the payment of dividends by a subsidiary to the parent (or by one subsidiary to another
subsidiary)
 loans by one entity in the group to another and the payment of interest on intra-group
loans.
2.3 The need to eliminate intra-group transactions on consolidation

Intra-group transactions should be eliminated on consolidation. In other words, the effects of
intra-group transactions must be removed from the financial statements on consolidation.
The purpose of consolidated accounts is to show the financial position and the financial
performance of the group as a whole, as if it is a single operating unit. If intra-group transactions
are included in the consolidated financial statements, the statements will show too many assets,
liabilities, income and expenses for the group as a single operating unit.
The consolidated financial statements represent the financial position and performance of a
group of companies as if they are a single economic entity. A single economic entity cannot owe
itself money.
IFRS 10 therefore requires that:
 Intra-group balances and transactions, including income, expenses and dividends, must be
eliminated in full.
 Profits or losses resulting from intra-group transactions that are recognised in inventory or
non-current assets must be eliminated in full.

Example: Elimination of intra-group transactions on consolidation

H owns 80% of S. H sells goods to S amounting to Rs. 1,000.
Consolidated
statement of
Adjustment financial position
P S Dr Cr
Receivables:
From S 1,000 1,000 
Payables:
To H 1,000 1,000 
The above adjustment is simply a cancellation of the inter-company receivable in one group
member’s statement of financial position against the inter-company payable in another group
member’s statement of financial position.
Items in transit
At the year-end current accounts may not agree, owing to the existence of in-transit items such
as goods or cash.
The usual convention followed is to follow the item through to its ultimate destination and adjust
the books of the ultimate recipient.
2.4 Unrealised profit – Inventory

Inter-company balances are cancelled on consolidation. The main reason for these arising is
inter company (or intra group) trading. The other example you will come across is inter-company
transfers of non-current assets.
If a member of a group sells inventory to another member of the group and that inventory is still
held by the buying company at the year end:
 The company that made the sale will show profit in its own accounts.
 This is fine from the individual company viewpoint but the profit has not been
realised by the group.
 The company that made the purchase will record the inventory at cost to itself.
 This is fine from the individual company view but consolidation of this value will
result in the inclusion in the financial statements of a figure which is not at cost to
the group.
IFRS 10 requires that the unrealised profit be removed in full from the closing inventory valuation.
It gives no further guidance on how this should be done.
This is an inventory valuation adjustment and can be processed in the consolidated financial
statements.
Illustration:
Debit Credit
Closing inventory – Statement of comprehensive income X
Closing inventory – Statement of financial position X
There is a complication to think about. If S is the selling company the purpose of the above
adjustment is to reduce the profit of the subsidiary because there is unrealised profit on the inter-
company transaction and reduce the inventory held by P as it is not at cost to the group.

If the profit of the subsidiary is being reduced then NCI should share in that reduction. This
implies a second journal as follows:
Illustration:
Debit Credit
NCI in the statement of financial position X
NCI in the statement of comprehensive income X
With their share of the adjustment
The two journals can be combined as follows to produce a composite adjustment in questions
which only require the preparation of the statement of financial position.
Illustration:
Debit Credit
Consolidated retained earnings X
NCI in the statement of financial position X
Example:
P bought 80% of S 2 years ago. At the date of acquisition S’s retained earnings stood at Rs.
16,000
During the year S sold goods to H for Rs. 20,000 which gave S a profit of Rs. 8,000. H still held
40% of these goods at the year end.
P S
Rs. Rs.
Other assets 110,000 50,000
260,000 91,000

260,000 91,000


follows:
Assets Rs.
PP and E (100,000 + 41,000) 141,000
Other assets (110,000 + 50,000 – 3,200) 156,800
Equity
279,440
296,000
At date of At date of Post acqn

consolidation acquisition
Net assets 86,000 46,000
Unrealised profit
Rs.
Total profit on transaction 8,000
Inventory held at year end (therefore the profit on this is unrealised
by the group) 40%
Adjustment 3,200

Double entry in consolidated financial statements Dr Cr

Consolidated retained earnings (80%  3,200) 2,560
NCI – Statement of financial position (20%  3,200) 640
Closing inventory – Statement of financial position 3,200

(20%  46,000) 9,200
(20% of 40,000 (see above)) 8,000
NCI share of unrealised profit adjustment (640)
Goodwill Rs.
59,200
Recoverable amount of goodwill (given) 13,200

of 40,000 (see above)) 32,000
Unrealised profit adjustment (2,560)
229,440
2.5 Unrealised profit – Transfers of non-current assets

One member of a group may sell a non-current asset to another member of the group.
The company making the sale will recognize a profit or loss on disposal.
The company buying the asset will include the asset at purchase cost in its own accounts and
depreciation will be based on that amount.
As far as the group is concerned no transfer has occurred. The consolidated accounts must
reflect noncurrent assets at the amount they would have been stated at had the transfer not been
made.
This will require consolidation adjustments:
 to remove the part of unrealized profit or loss on disposal from retained earnings of seller,
similar to the adjustment required in respect of unrealized profit in inventory.
 to adjust accumulated depreciation so that depreciation is based on the asset's cost to the
group.

In practice, a combined entry is passed so that the adjustment is effected in the retained earnings
of the entity making the unrealized profit.
The amount of adjustment can be calculated through the following methods:
 profit on disposal, less additional depreciation; or
 carrying value at reporting date with transfer, less carrying value without transfer
If Sale by parent : If Sale by subsidiary:

DEBIT Group retained earnings DEBIT Group retained earnings (Parent's share in
CREDIT Non-current assets Subsidiary)
DEBIT Non-controlling interest (Non-controlling Interest
in Subsidiary)
CREDIT Non-current assets
Example 1:
H owns 80% of S.
There was a transfer of an asset within the group for Rs. 15,000 on 1 January 20X3.
The original cost to H was Rs. 20,000 and the accumulated depreciation at the date of transfer
was Rs. 8,000.
Assets had a remaining useful life of 3 year on the date of transfer.
The effect of the above transfer in Consolidated Financial statements for the year ended 31
December 20X3 would be:
Method 1:
Gain on disposal (15,000 – 12,000) 3,000
Additional depreciation till reporting date (3,000 / 3) (1000)
Unrealised gain (Directly 3000 × 2/3) 2000
Method 2:
Carrying value of the asset with transfer (15,000 ×2/3) 10,000
Carrying value of the asset without transfer (12,000 × 2/3) (8,000)
Unrealised gain 2,000
If the transfer was from H to S Dr Cr

Group retained earnings 2,000
Non-current asset 2,000
If the transfer was from S to H Dr Cr
NCI in the statement of financial position 400

Example 2:
H owns 80% of S.
There was a transfer of an asset within the group for Rs. 15,000 on 1 January 20X3.
The original cost to H was Rs. 30,000 and the accumulated depreciation at the date of transfer
was Rs. 12,000.
Assets had a remaining useful life of 3 years on the date of transfer.
The effect of the above transfer in Consolidated Financial statements for the year ended 31
December 20X4 would be:
Solution:
The amount of the adjustment would be:
Method 1:
Loss on disposal (15,000 – 18,000) 3,000
Additional depreciation till reporting date (3,000 ×2 / 3) (2,000)
Unrealised loss (Directly 3000 × 1/3) 1,000
Method 2:
Carrying value of the asset with transfer (15,000 × 1/3) 5,000
Carrying value of the asset without transfer (18,000 × 1/3) (6,000)
Unrealised loss 1,000
If the transfer was from H to S – Full journal

Consolidated financial statements Dr Cr
If the transfer was from S to H – Full journal

Consolidated financial statements Dr Cr
Group retained earnings 800
NCI in the statement of financial position 200

3 POSSIBLE COMPLICATIONS: AFTER CONSOLIDATION

Section overview
 Accounting for goodwill

 Negative goodwill and bargain purchases
3.1 Accounting for goodwill

Goodwill is carried as an asset. It is not amortised but instead it is subject to an annual
impairment review.
This means that the recoverable amount of goodwill must be estimated on an annual basis. If the
recoverable amount is less than the carrying amount, the goodwill is written down to the
recoverable amount.
The amount of the impairment is included as a charge against profit in the consolidated
statement of comprehensive income.
Example:
P acquired 80% of S when the retained earnings of S were Rs. 20,000.
The values for assets and liabilities in the statement of financial position for S represent fair values.
A review of goodwill at 31 December 20X1 found that goodwill had been impaired, and was now
valued at Rs. 55,000.
The statements of financial position of a parent company P and its subsidiary S at 31 December
20X1 are as follows:
P (Rs. ) S (Rs. )
Non-current assets:
670,000 140,000
Equity
600,000 130,000
Bank loan 70,000 10,000
670,000 140,000


follows:
Rs.
Assets
Property, plant and equipment (508 + 100) 508,000
Current assets (120,000 + 40,000) 160,000
Equity
617,000
643,000
At date of
Net assets 130,000 90,000

(20%  90,000) 18,000
(20% of 40,000 (see above)) 8,000

Goodwill Rs.
160,000
70,000
Write down of goodwill (balancing figure) (15,000)
Recoverable amount of goodwill (given) 55,000

of 40,000 (see above)) 32,000
Write down of goodwill (see goodwill working) (15,000)
417,000
2.2 Negative goodwill and bargain purchases

A bargain purchase is a business combination in which the calculation of goodwill leads to a
negative figure.
When this happens the acquirer must then review the procedures used to measure the amounts
recognised at the acquisition date for all of the following:
 the identifiable assets acquired and liabilities assumed;
 the non-controlling interest in the acquiree (if any); and
 the consideration transferred.
Any amount remaining after applying the above requirements is recognised as a gain in profit or
loss on the acquisition date.
This means that in most cases when a bargain purchase occurs, the ‘negative goodwill’ should
be added to the consolidated profit for the group for the year.

Practice question 1
Haidar plc acquired 75% of Saqib Ltd’s ordinary shares on 1 April for an agreed consideration
of Rs. 25 million when Saqib had retained earnings of Rs. 10,200,000.
The draft statements of financial position of the two companies at 31 December are:
H (Rs. 000 ) S (Rs. 000)

Non-current assets:
Current assets
Inventory 7,450 4,310
Accounts receivable 12,960 4,330
Cash and bank - 920
Total assets 123,950 36,740
Equity
114,060 25,200
Bank loan 6,000
Current liabilities
Accounts payable and accruals 5,920 4,160
Bank overdraft 2,100 -
Taxation 1,870 1,380
9,890 5,540
Total equity and liabilities 123,950 36,740
The following information is relevant
(i) The fair value of Saqib Ltd’s land at the date of acquisition was Rs. 4 million in excess of its
carrying value. The fair value of Saqib Ltd’s other net assets approximated to their carrying
values.
(ii) During the year Haidar plc sold inventory to Saqib Ltd for Rs. 2.4 million. The inventory had
originally cost Haidar plc Rs. 2.0 million. Saqib Ltd held 25% of these goods at the year-end.
(iii) The two companies agreed their current account balances as Rs. 500,000 payable by Saqib
Ltd to Haidar plc at the year-end. Inter-company current accounts are included in accounts
receivable or payable as appropriate.
(iv) An impairment test at 31 December on the consolidated goodwill concluded that it should
be written down by Rs. 625,000.
Prepare a consolidated statement of financial position as at 31 December.


Solutions 1
H Group: Consolidated statement of financial position at 31 December 20X1
Rs.
Assets
Goodwill (W3) 6,225
Property, plant and equipment (78,450 + 27,180 – 4,000) 109,720
115,945
Current assets
Inventory (7,450 + 4,310 – 100) 11,660
Accounts receivable (12,960 + 4,330 – 500) 16,790
Cash and bank 920
29,370
Equity
Share capital 30,000
Share premium 20,000
Retained earnings (W4) 67,085
117,085
Non-controlling interest (W2) 7,300
124,385
Non-current liabilities 6,000
Current liabilities
Accounts payable and accruals (5,920 + 4,160 – 500) 9,580
Bank overdraft 2,100
Taxation (1,870 + 1,380) 3,250
14,930

Solution: Workings 1
W1: Net assets summary of S
At date of
Fair value adjustment 4,000 4,000
Net assets 29,200 24,200
W2: Non-controlling interest Rs.000

(25%  24,200) 6,050
NCI’s share of the post-acquisition retained earnings of S (25% of
5,000 (see above)) 1,250
W3: Goodwill Rs. 000

31,050
6,850
Write down of goodwill (given) (625)
Recoverable amount of goodwill 6,225
W4: Consolidated retained profits: Rs.

All of H’s retained earnings 64,060
Unrealised profit (100)
H’s share of the post-acquisition retained earnings of S
(75% of 5,000 (see above)) 3,750
Write down of goodwill (given) (625)
67,085


5
CHAPTER
Statements of Comprehensive Income
Contents
1 Consolidated statement of comprehensive income
2 Complications

1 CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

Section overview
 Consolidated income statement: the basic rules

 Pre-acquisition and post-acquisition profits
1.1 Consolidated income statement: the basic rules

The main problems with preparing a consolidated statement of comprehensive income relate to
reporting profit or loss for the period, and this section therefore focuses on profit or loss items.
A consolidated statement of comprehensive income brings together the sales revenue, income
and expenses of the parent and its subsidiaries.
All items of income and expense in the consolidated statement of comprehensive income are
straight cross cast of equivalent items in the individual financial statements of the members of the
group.
Non-controlling interest
Consolidated financial statements must also disclose the profit or loss for the period and the total
comprehensive income for the period attributable to:
 owners of the parent company; and
 non-controlling interests.
The figure for NCI is simply their share of the subsidiary’s profit for the year that has been
included in the consolidated statement of comprehensive income.
The amounts attributable to the owners of the parent and the non-controlling interest are shown
as a metric (small table) immediately below the statement of comprehensive income.
Illustration:
Total comprehensive income attributable to: Rs.
Owners of the parent (balancing figure) X
Non-controlling interests (x% of y) X
Where: x% is the NCI ownership interest

y is the subsidiary’s profit for the year that has been included in the
consolidated statement of comprehensive income

Chapter 5: Consolidated accounts: Statements of comprehensive income
Example:
Entity P bought 80% of S several years ago.
The income statements for the year to 31 December 20X1 are as follows.
P S
Rs. Rs.
Revenue 500,000 250,000
Cost of sales (200,000) (80,000)
Gross profit 300,000 170,000
Other income 25,000 6,000
Distribution costs (70,000) (60,000)
Administrative expenses (90,000) (50,000)
Other expenses (30,000) (18,000)
Finance costs (15,000) (8,000)
Profit before tax 120,000 40,000
Income tax expense (45,000) (16,000)
Profit after tax 75,000 24,000
A consolidated statement of comprehensive income can be prepared as follows:
Working
P S Consolidated
Rs. Rs. Rs.
Revenue 500,000 250,000 750,000
Cost of sales (200,000) (80,000) (280,000)
Gross profit 300,000 170,000 470,000
Other income 25,000 6,000 31,000
Distribution costs (70,000) (60,000) (130,000)
Administrative
expenses (90,000) (50,000) (140,000)
Other expenses (30,000) (18,000) (48,000)
Finance costs (15,000) (8,000) (23,000)
Profit before tax 120,000 40,000 160,000
Income tax expense (45,000) (16,000) (61,000)
Profit after tax 75,000 24,000 99,000
Total comprehensive income attributable to:

Owners of the parent (balancing figure) 94,200
Non-controlling interests (20% of 24,000) 4,800
99,000

1.2 Pre-acquisition and post-acquisition profits

Only post acquisition profits are consolidated. When a parent acquires a subsidiary during a
financial year, the profits of the subsidiary have to be divided into pre-acquisition and post-
acquisition profits.
Example:
Entity P acquired 80% of S on 1 October 20X1.
The acquisition date was 1 October. This means that only 3/12 of the subsidiary’s profit for the year
is post-acquisition profit.
P S
Rs. Rs.
Revenue 400,000 260,000
Cost of sales (200,000) (60,000)
Gross profit 200,000 200,000
Other income 20,000 -
Income tax expense (30,000) (15,000)
Profit after tax 50,000 60,000
A consolidated statement of comprehensive income can be prepared as follows:
Working
P S (3/12) Consolidated
Rs. Rs. Rs.
Revenue 400,000 65,000 465,000
Cost of sales (200,000) (15,000) (215,000)
Gross profit 200,000 50,000 250,000
Other income 20,000 – 20,000
Distribution costs (50,000) (7,500) (57,500)
Administrative expenses (90,000) (23,750) (113,750)
Income tax expense (30,000) (3,750) (33,750)
Profit after tax 50,000 15,000 65,000
Total comprehensive income attributable to:

Owners of the parent (balancing figure) 62,000
Non-controlling interests (20% of 15,000) 3,000
65,000

2 COMPLICATIONS
Section overview
 Inter-company items
 Fair value adjustments
 Impairment of goodwill and consolidated profit
2.1 Inter-company items

Consolidated income statements are prepared by combining the information given in the income
statements of the individual companies.
It is usually necessary to make adjustments to eliminate the results of inter-company trading.
This includes adjustments to cancel out inter-company trading balances and unrealised profit.
Inter-company trading
Inter-company trading will be included in revenue of one group company and purchases of
another. These are cancelled on consolidation.
Illustration:
Debit Credit
Revenue X
Cost of sales (actually purchases within cost of sales) X
Example:
P acquired 80% of S 3 years ago.
During the year P sold goods to S for Rs. 50,000.
By the year-end S had sold all of the goods bought from P to customers.
Extracts of the income statements for the year to 31 December 20X1 are as follows.
P S
Rs. Rs.
Revenue 800,000 420,000
Cost of sales (300,000) (220,000
Gross profit 500,000 200,000
The adjustment in respect of inter-company trading can be shown as follows:
Workings
P S Dr Cr Consol.
Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000)
Revenue 800 420 (50) 1,170
Cost of sales (300) (220) 50 (470)
Gross profit 500 200 (50) 50 700
The adjustment has no effect on gross profit.
Unrealised profits on trading

If any items sold by one group company to another are included in inventory (i.e. have not been
sold on outside the group by the year end), their value must be adjusted to lower of cost and net
realisable value from the group viewpoint (as for the consolidated statement of financial position).

This is an inventory valuation adjustment made in the consolidated financial statements.

Illustration:
Debit Credit
Closing inventory – Statement of comprehensive income X
The adjustment in the statement of comprehensive income reduces gross profit and hence profit
for the year. The NCI share in this reduced figure and the balance is added to retained earnings.
Thus, the adjustment is shared between both ownership interests.
Example:
During the year P sold goods to S for Rs. 50,000 at a mark-up of 25%. This means that the cost of
the goods to P was Rs. 40,000 (100/125  Rs. 50,000) and P made a profit of Rs. 10,000 ( 25/125 
Rs. 50,000) on the sale to S.
At the year-end S still had a third of the goods in inventory.
This means that S still held goods which it had purchased from P for Rs. 15,000 at a profit to P
of Rs. 3,000.
Rs. 3,000 are unrealised by the group as at the year-end.
P (Rs.) S (Rs.)
Revenue 800,000 420,000
Cost of sales (300,000) (220,000
Gross profit 500,000 200,000
The adjustments in respect of inter-company trading1 and unrealised profit2 can be shown
as follows:
Workings
P S Dr Cr Consol.
Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000)
Revenue 800 420 (50)1 1,170
Cost of sales (300) (220) (3)2 501 (473)
Gross profit 500 200 (53) 50 697
The adjustment in respect of inter-company trading1 has no effect on gross profit.

The adjustment in respect of an unrealised profit 2 reduces gross profit.
If the sale is from S to P the unrealised profit adjustment must be shared with the NCI.
Example:
During the year S sold goods to P for Rs. 50,000 at a mark-up of 25% on cost. This means that the
cost of the goods to S was Rs. 40,000 ( 100/125  Rs. 50,000) and S made a profit of Rs. 10,000
(25/125  Rs. 50,000) on the sale to P.
At the year-end P still had a third of the goods in inventory.
This means that P still held goods which it had purchased from S for Rs. 15,000 at a profit to S of
Rs. 3,000. The Rs. 3,000 is unrealised by the group as at the year-end. The NCI’s share of the
unrealised profit adjustment is Rs. 600 (20%  Rs. 3,000)

P (Rs.) S (Rs.)
Revenue 800,000 420,000
Cost of sales (300,000) (220,000
Gross profit 500,000 200,000
Expenses (173,000) (123,000)
The adjustments in respect of inter-company trading1 and unrealised profit2 can be shown
as follows:
Workings
P S Dr Cr Consol.
Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000)
Revenue 800 420 (50) 1 1,170
Cost of sales (300) (220) (3)2 501 (473)
Gross profit 500 200 (53) 50 697
Expenses (173) (123) (296)
Profit before tax 427 77 (53) 50 401
The adjustment in respect of and unrealised profit 2 reduces gross profit and is shared with
the NCI.
Total comprehensive income attributable to: Rs.(000)
Owners of the parent (balancing figure) 386.2
Non-controlling interests [(20%  77,000)  600)] 14.8
401.0
Inter-company management fees and interest

All other inter-company amounts must also be eliminated.
Where a group company charges another group company, management fees/interest, there is no
external group income or external group expense and they are cancelled one against the other
like inter-company sales and cost of sales.
Illustration: Debit Credit
Income (management fees) X
Expense (management charges) X
Example:
Other income in P’s statement of comprehensive income includes an inter-company management
charge of Rs. 5,000 to S. S has recognised this in administrative expenses.
P S
Rs. Rs.
Revenue 800,000 420,000
Cost of sales (300,000) (220,000)
Gross profit 500,000 200,000
Other income 12,000 2,000

The adjustments in respect of inter-company management charge can be shown as

follows:
Workings
P S Dr Cr Consol.
Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000)
Revenue 800 420 1,220
Cost of sales (300) (220) (520)
Gross profit 500 200 700
Administrative expenses (100) (90) 5 (185)
Distribution costs (85) (75) (160)
Other income 12 2 (5) 9
Profit before tax 327 37 364
The adjustment in respect of inter-company management charge has no effect on gross profit.
Inter-company dividends
The parent may have accounted for dividend income from a subsidiary. This is eliminated on
consolidation.
Dividends received from a subsidiary are ignored in the consolidation of the statement of
comprehensive income because the profit out of which they are paid has already been
consolidated.
2.2 Fair value adjustments

Depreciation is charged on the carrying amount of assets.
If a depreciable asset is revalued on consolidation the depreciation stream that relates to that
asset will also need to be revalued.
This adjustment is carried out in the financial statements of the subsidiary. It will affect the
subsidiary’s profit after tax figure and therefore will affect the NCI.
Example:
At the date of acquisition S had a depreciable asset with a fair value of Rs. 120,000 in excess of
its book value. This asset had a useful life of 10 years at the date of acquisition.
This means that the group has to recognise extra depreciation of Rs. 36,000 (Rs. 120,000/10 years  3
years) by the end of this period. One year’s worth of this (Rs. 12,000) is recognised in S’s statement
of comprehensive income prior to consolidation this year.
P S
Rs. Rs.
Revenue 800,000 420,000
Cost of sales (300,000) (220,000)
Gross profit 500,000 200,000
Expenses (173,000) (163,000)

The adjustments in respect of extra depreciation can be shown as follows:

Workings
P S Dr Cr Consol.
Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000)
Revenue 800 420 1,220
Cost of sales (300) (220) (520)
Expenses (173) (163)
(348)
Adjustment (12)
The adjustment in respect of the extra depreciation reduces the profit of S that is
consolidated.
2.3 Impairment of goodwill and consolidated profit

When purchased goodwill is impaired, the impairment does not affect the individual financial
statements of the parent company or the subsidiary. The effect of the impairment applies
exclusively to the consolidated statement of financial position and the consolidated income
statement.
If goodwill is impaired:
 it is written down in value in the consolidated statement of financial position, and
 the amount of the write-down is charged as an expense in the consolidated income
statement (normally in administrative expenses).
Example:
Goodwill on acquisition was Rs. 200,000.
The annual impairment test on goodwill has shown it to have a recoverable amount of only Rs.
175,000. Thus a write down of Rs. 25,000 is required.
P S
Rs. Rs.
Revenue 800,000 420,000
Cost of sales (300,000) (220,000)
Gross profit 500,000 200,000
Expenses (173,000) (163,000)
The adjustment in respect of inter-company trading1 and unrealised profit2 can be shown as
follows:
Workings
P S Dr Cr Consol.
Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000)
Revenue 800 420 1,220
Cost of sales (300) (220) (520)
Expenses (173) (163) (25) (361)
Profit before tax 327 37 (25) 339
The adjustment in respect of the goodwill reduces the consolidated profit. (There is no impact
on NCI).

Practice question 1
P acquired 80% of S 3 years ago. Goodwill on acquisition was Rs. 80,000. The recoverable amount
of goodwill at the year-end was estimated to be Rs. 65,000. This was the first time that the
recoverable amount of goodwill had fallen below the amount at initial recognition.
S sells goods to P. The total sales in the year were Rs. 100,000. At the year-end P retains inventory
from S which had cost Rs. 30,000 but was in P’s books at Rs. 35,000.
The distribution costs of S include depreciation of an asset which had been subject to a fair value
increase of Rs. 100,000 on acquisition. This asset is being written off on a straight line basis over
Rs. 10 years.
P S
Rs.(000) Rs.(000)
Revenue 1,000 800
Cost of sales (400) (250)
Gross profit 600 550
Distribution costs (120) (75)
Administrative expenses (80) (20)
400 455
Dividend from S 80 -
Finance cost (25) (15)
Profit before tax 455 440
Tax (45) (40)
Profit after tax 410 400
Prepare the consolidated income statement for the year ended 31 December.


Solutions 1
Consolidated statement of comprehensive income for the year ended 31 December.
Workings
P S Dr Cr Consol.
Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000)
Revenue 1,000 800 (100) 1,700
Cost of sales (400) (250) 3(5) 100 (555)
Gross profit 600 550 (105) 100 1,145
Distribution costs (120) (75)
Fair value adjustment 1(10)
(120) (85) (205)

Administrative expenses (80) (20) 2(15) (115)
400 445
Dividend from S 80 - (80)
Finance cost (25) (15) (40)
Tax (45) (40) (85)
Profit after tax 410 390 (200) 100 700
Total comprehensive income attributable to: Rs.(000)

Owners of the parent (balancing figure) 633
Non-controlling interests (20% of 390,000)  (20% of 35,000) 77
700
Notes:
1: Extra depreciation on fair value adjustment (100/10 years)
2: Goodwill impairment
3: Unrealised profit


6
CHAPTER
IAS 28: Investment in Associates
and Joint Ventures
Contents
1 IAS 28: Investments in associates and joint ventures

1 IAS 28: INVESTMENTS IN ASSOCIATES AND JOINT VENTURES

Section overview
 Associates and joint ventures

 Accounting for associates
 Trading with an associate
1.1 Associates and joint ventures
Definition
An associate is an entity over which the investor has significant influence.
Joint ventures have been defined in IFRS 11 Joint Arrangements. IFRS 11 is not part of the
syllabus at CAF level. Only associate is examinable at this level.
Significant influence
Significant influence is the power to participate in the financial and operating policy decisions of
the investee but is not control or joint control of those policies.
 IAS 28 states that if an entity holds 20% or more of the voting power (equity) of another
entity, it is presumed that significant influence exists, and the investment should be treated
as an associate.
 If an entity owns less than 20% of the equity of another entity, the normal presumption is
that significant influence does not exist.
Holding 20% to 50% of the equity of another entity therefore means as a general rule that
significant influence exists, but not control; therefore the investment is treated as an associate,
provided that it is not a joint venture.
The ‘20% or more’ rule is a general guideline, however, and IAS 28 states more specifically how
significant influence arises. The existence of significant influence is usually evidenced in one or
more of the following ways:
 Representation on the board of directors;
 Participation in policy-making processes, including participation in decisions about
distributions (dividends);
 Material transactions between the two entities;
 An interchange of management personnel between the two entities; or
 The provision of essential technical information by one entity to the other.
2.2 Accounting for associates
IAS 28 states that associates must be accounted for using the equity method.
The equity method is defined as a method of accounting whereby the investment is initially
recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share
of the investee’s net assets.
The investor’s profit or loss includes its share of the investee’s profit or loss and the investor’s
other comprehensive income includes its share of the investee’s other comprehensive income.

Chapter 6: IAS 28: Investment in associates and joint ventures
Statement of financial position: investment in the associate

In the statement of financial position of the reporting entity (the investor), an investment in an
associate is measured at:
Illustration: Equity method
Rs.
Cost of investment X
Plus/(Minus): Parent’s share of profits (losses) of the associate since acquisition X
Plus/(Minus): Parent’s share of OCI of the associate since acquisition X
Minus any impairment of the investment recognised (X)
There is no goodwill-recognised for an investment in an associate.

The accumulated profits of the reporting entity (or the consolidated accumulated reserves when
consolidated accounts are prepared) should include the investor’s share of the post-acquisition
retained profits of the associate, (minus any impairment in the value of the investment since
acquisition). This completes the other side of the entry when the investment is remeasured.
Similarly any other reserve of the reporting entity (or any other consolidated reserves when
consolidated accounts are prepared) should include the investor’s share of the post-acquisition
movement in the reserve of the associate.
Statement of profit or loss and other comprehensive income
In the statement of profit or loss and other comprehensive income, there should be separate lines
for:
 ‘Share of profits of associate’ in the profit and loss section of the statement
 ‘Share of other comprehensive income of associate’ in the ‘other comprehensive income’
section of the statement.
Example: Equity method

Entity P acquired 30% of the equity shares in Entity A during Year 1 at a cost of Rs. 147,000
when the fair value of the net assets of Entity A was Rs. 350,000.
Entity P is able to exercise significant influence over Entity A.
At 31 December Year 5, the net assets of Entity A were Rs. 600,000.
In the year to 31 December Year 5, the profits of Entity A after tax were Rs. 80,000.
The figures that must be included to account for the associate in the financial statements of
Entity P for the year to 31 December Year 5 are as follows:
Statement of financial position:

The investment in the associate is as follows: Rs.
Investment at cost 147,000
Investor’s share of post-acquisition profits of A (W1) 75,000
Investment in the associate 222,000

Example: Equity method (continued)
W1 Retained post-acquisition profits of Entity A Rs.

Net assets of the associate at 31 December Year 5 600,000
Net assets of Entity A at date of acquisition of shares (350,000)
Retained post-acquisition profits of Entity A 250,000
Entity P’s share of A 30%
Entity P’s share of A’s profits since the date of acquisition Rs.75,000
Note: Rs.75,000 will be included in the accumulated profits of Entity P

The journal to achieve the re-measurement is
Dr Cost Rs.75,000 and Cr Accumulated profits Rs.75,000
Statement of profit or loss

The share of the associate’s after-tax profit for the year is shown on a separate line as:
Share of profits of associate (30% × Rs. 80,000): Rs. 24,000.
Practice question 1
Entity P acquired 40% of the equity shares in Entity A during Year 1 at a cost of Rs.
128,000 when the fair value of the net assets of Entity A was Rs. 250,000.
Since that time, the investment in the associate has been impaired by Rs. 8,000.
Since acquisition of the investment, there has been no change in the issued share capital
of Entity A, nor in its share premium reserve or revaluation reserve.
On 31 December Year 5, the net assets of Entity A were Rs. 400,000.
In the year to 31 December Year 5, the profits of Entity A after tax were Rs. 50,000.
What figures would be included for the associate in the financial statements of Entity P
for the year to 31 December Year 5?
When an investment in an associate is held by, or is held indirectly through, an entity that is;
 a venture capital organisation, or
 a mutual fund, unit trust and similar entities including investment-linked insurance funds,
the entity may elect to measure that investment at fair value through profit or loss in accordance
with IFRS 9. An entity shall make this election separately for each associate, at initial recognition
of the associate.
When an entity has an investment in an associate, a portion of which is held indirectly through;
 a venture capital organisation, or
 a mutual fund, unit trust and similar entities including investment-linked insurance funds,
the entity may elect to measure that portion of the investment in the associate at fair value
through profit or loss in accordance with IFRS 9 regardless of whether it has significant influence
over that portion of the investment.
If the entity makes that election, the entity shall apply the equity method to any remaining portion
of its investment in an associate that is not held through a venture capital organisation, or a
mutual fund, unit trust and similar entities including investment-linked insurance funds.

2.3 Trading with an associate

There might be trading between a parent and an associate. If in addition to the associate the
parent holds investments in subsidiaries there might also be trading between other members of
the group and the associate.
In such cases there might be:
 Inter-company balances (amounts owed between the parent (or group) and the associate
in either direction); and
 Unrealised profit on inter-company transactions.
The accounting rules for dealing with these items for associate are different from the rules for
subsidiaries.
Inter-company balances
Inter-company balances between the members of a group (parent and subsidiaries) are
cancelled out on consolidation.
Inter-company balances between the members of a group (parent and subsidiaries) and
associates are not cancelled out on consolidation. An associate is not a member of the group
but is rather an investment made by the group. This means that it is entirely appropriate that
consolidated financial statements show amounts owed by the external party as an asset and
amount owed to the external party as a liability.
This is also the case if a parent has an associate and no subsidiaries. The parent must account
for the investment under equity method. Once again, it is entirely appropriate that consolidated
financial statements show amounts owed by the external party as an asset and amount owed to
the external party as a liability.
Unrealised inter-group profit
Unrealised inter-company (intra-group) profit between a parent and a member of a group must be
eliminated in full on consolidation.
For unrealised profit arising on trade between a parent and associate only the parent’s share of
the unrealised profit is eliminated.
IAS 28 does not specify the double entry to achieve this.
The following are often used in practice
Parent sells to associate:
 The unrealised profit is held in inventory of the associate. The investment in the associate
should be reduced by the parent’s share of the unrealised profit.
 The other side of the entry increases cost of sales
Illustration: Unrealised profit double entry when parent sells to associate Debit Credit
Cost of sales X
Investment in associate X
Associate sells to parent:

 The unrealised profit is held in inventory of the parent and this should be reduced in value
by the parent’s share of the unrealised profit.
 The other side of the entry reduces the parent’s share of the profit of the associate.
Illustration: Unrealised profit double entry when associate sells to parent Debit Credit
Share of profit of associate X
Inventory X
In both cases, there will also be a reduction in the post-acquisition profits of the associate, and
the investor entity’s share of those profits (as reported in profit or loss). This will reduce the
accumulated profits in the statement of financial position.

Example: Unrealised profit

Entity P acquired 40% of the equity shares of Entity A several years ago. The cost of the
investment was Rs. 205,000.
As at 31 December Year 6 Entity A had made profits of Rs. 275,000 since the date of acquisition.
In the year to 31 December Year 6, Entity P sold goods to Entity A at a sales price of Rs. 200,000
at a mark-up of 100% on cost.
Goods which had cost Entity A Rs. 30,000 were still held as inventory by Entity A at the year-end.
The necessary adjustments for unrealised profit, and the double entries are as follows:
Unrealised profit adjustment Rs.
Inventory sold by P to A 200,000
Profit on the sale (200,000  100%/200%) 100,000
Unrealised profit (100,000  Rs.30,000/Rs.200,000) 15,000
Entity P’s share (40%) 6,000
Double entries: Dr (Rs.) Cr (Rs.)

Investment in associate 110,000
Accumulated profits 110,000
Being: Share of post-acquisition profits (40% of Rs.275,000)
Dr (Rs.) Cr (Rs.)
Cost of sales (hence accumulated profit) 6,000
Being: Elimination of share of unrealised profit (see above)
Investment in associate (see above for adjustments) Rs.

Cost of the investment 205,000
Entity P’s share of post-acquisition profits of Entity A 110,000
Minus: Entity P’s share of unrealised profit in inventory (6,000)
309,000
Practice question 2
Entity P acquired 30% of the equity shares of Entity A several years ago at a cost of Rs.
275,000.
As at 31 December Year 6 Entity A had made profits of Rs. 380,000 since the date of
acquisition.
In the year to 31 December Year 6, the reported profits after tax of Entity A were Rs.
100,000.
In the year to 31 December Year 6, Entity P sold goods to Entity A for Rs. 180,000 at a
mark-up of 20% on cost.
Goods which had cost Entity A Rs. 60,000 were still held as inventory by Entity A at the
year-end.
a) Calculate the unrealised profit adjustment and state the double entry.
b) Calculate the investment in associate balance that would be included in Entity
P’s statement of fiancial position as at 31 December Year 6.
c) Calculate the amount that would appear as a share of profit of associate in
Entity P’s statement of profit or loss for the year ending 31 December Year 6.


Solution 1
The figures that must be included to account for the associate in the financial statements of Entity P for
the year to 31 December Year 5 are as follows:
Statement of financial position:
The investment in the associate is as follows:
Rs.
Investment at cost 128,000
Investor’s share of post-acquisition profits of A (W1) 60,000
Minus: Accumulated impairment in the investment (8,000)
Investment in the associate 180,000

W1 Retained post-acquisition profits of Entity A
Net assets of the associate at 31 December Year 5 400,000
Net assets of Entity A at date of acquisition of shares (250,000)
Retained post-acquisition profits of Entity A 150,000

Entity P’s share of A 40%
Entity P’s share of A’s profits since the date of acquisition Rs.60,000
Statement of profit or loss
The share of the associate’s after-tax profit for the year is shown on a separate line as:
Share of profits of associate (40% × Rs. 50,000): Rs. 20,000.
Solution 2
a) Unrealised profit adjustment Rs.
Inventory sold by P to A 180,000
Profit on the sale (180,000  20%/120%) 30,000
Unrealised profit (30,000  Rs.60,000/Rs.180,000) 10,000
Entity P’s share (30%) 3,000
Double entry Dr(Rs.) Cr(Rs.)

Cost of sales (hence accumulated profit) 3,000
Being: Elimination of share of unrealised profit (see above)
b) Investment in associate (see above for adjustments) Rs.

Cost of the investment 275,000
Entity P’s share of post-acquisition profits of Entity A (30% of
Rs.380,000) 114,000
Minus: Entity P’s share of unrealised profit in inventory (3,000)
386,000
c) Statement of profit or loss
The share of the associate’s after-tax profit for the year is shown on a separate line
as:
Share of profits of associate (30% × Rs. 100,000): Rs.30,000.


7
CHAPTER
IAS 8: Accounting Policies, Changes in
Accounting Estimates and Errors
Contents
1 Accounting policies
2 Accounting estimates
3 Errors

1 ACCOUNTING POLICIES
Section overview
 Introduction to IAS 8
 Accounting policies
 Selection of accounting policies
 Changes in accounting policies
 Retrospective application of a change in accounting policy
 Limitation on retrospective application
 Disclosure of a change in accounting policy
1.1 Introduction to IAS 8

The aim of IAS 8: Accounting policies, changes in accounting estimates and errors is to enhance
comparability of the entity’s financial statements to previous periods and to the financial
statements of other entities.
It does this by establishing:
 the criteria for selecting accounting policies; and,
 the accounting treatment and disclosure of:
 changes in accounting policies;
 changes in accounting estimates; and
 errors.
Much of IAS 8 is concerned with how changes or corrections should be reported in the financial
statements.
1.2 Accounting policies
Definition: Accounting policies

Accounting policies are the specific principles, bases, conventions, rules and practices applied by
an entity in preparing and presenting financial statements.
IFRSs set out accounting policies that result in financial statements containing relevant and
reliable information about the transactions, other events and conditions to which they apply.
Those policies need not be applied when the effect of applying them is immaterial.
Definition: Material
Omissions or misstatements of items are material if they could, individually or collectively,
influence the economic decisions that users make on the basis of the financial statements.
Materiality depends on the size and nature of the omission or misstatement judged in the
surrounding circumstances. The size or nature of the item, or a combination of both, could be the
determining factor.
1.3 Selection of accounting policies

Selection of accounting policies – Areas covered by IFRS
If an IFRS (or an Interpretation) applies to an item in the financial statements, the accounting
policy or policies applied to that item must be determined by applying the Standard or
Interpretation and any relevant implementation guidance issued.

Chapter 7: IAS 8: Accounting policies, changes in accounting estimates and errors
Selection of accounting policies – Area not covered by IFRS

If there is no rule in IFRS that specifically applies to an item in the financial statements,
management must use its judgement to develop and apply an accounting policy that results in
information that is:
 relevant to the decision-making needs of users; and
 reliable in that the financial statements:
- represent faithfully the results and financial position of the entity;
- reflect the economic substance of transactions and other events, and not merely the
legal form;
- are neutral, ie free from bias;
- are prudent; and
- are complete in all material respects.
In making the judgement management must consider the following sources in descending order:
 the requirements and guidance in IFRS dealing with similar and related issues;
 the definitions, recognition criteria and measurement concepts for assets, liabilities,
income and expenses set out in the “Framework”.
Management may also consider the most recent pronouncements of other standard-setting
bodies that use a similar conceptual framework to the extent that these do not conflict with the
above sources.
Consistency of accounting policies
An entity must apply consistent accounting policies in a period to deal with similar transactions,
and other events and circumstances, unless IFRS specifically requires or permits categorisation
of items for which different policies may be appropriate.
Illustration: Consistency
IAS 16: Property, plant and equipment allows the use of the cost model or the revaluation model
for measurement after recognition.
This is an example of where IFRS permits categorisation of items for which different policies may
be appropriate.
If chosen, each model must be applied to an entire class of assets. Each model must be applied
consistently within each class that has been identified.
1.4 Changes in accounting policies

Users of financial statements need to be able to compare financial statements of an entity over
time, so that they can identify trends in its financial performance or financial position. Frequent
changes in accounting policies are therefore undesirable because they make comparisons with
previous periods more difficult.
The same accounting policies must be applied within each period and from one period to the next
unless a change in accounting policy meets one of the following criteria. A change in accounting
policy is permitted only if the change is:
 required by IFRS; or
 results in the financial statements providing reliable and more relevant financial
information.
A new or revised standard usually include specific transitional provisions’ to explain how the
change required by the new rules should be introduced.
In the absence of specific transitional provisions, a change in policy should be applied
retrospectively. This is explained shortly.

Example:
 Valuation of inventory using FIFO or weighted average cost method
 Measurement of financial assets and liabilities
 Method used to measure non-current assets such as historical cost or revaluation model
 Accruals basis of preparation of financial statements
 Presentation (e.g. an entity changes from presenting a classified statement of financial
position (current and non-current assets and current and non-current liabilities shown as
separate classifications) to a liquidity presentation (items presented in order of liquidity
without current/non-current classification)
If at least one of these criteria is changed, then there is a change in accounting policy.
Illustration:
IAS 23 requires the capitalisation of borrowing costs directly attributable to the acquisition,
construction or production of a qualifying asset.
Previously, IAS 23 allowed companies to expense or capitalise borrowing costs.
The revision to IAS 23 led to a change in accounting policy for some companies as it affected:
 recognition – the interest cost previously recognised as an expense had to be recognised
as an asset; and
 presentation – the interest cost previously presented in the statement of profit or loss had
to be presented in the statement of financial position.
IAS 8 specifies that the application of a new accounting policy to transactions or events that did
not occur previously or differ in substance from those that occurred previously, is not a change of
accounting policy. It is simply the application of a suitable accounting policy to a new type of
transaction.
The initial application of a policy to revalue assets in accordance with IAS 16 Property, Plant and
Equipment or IAS 38 Intangible Assets is a change in an accounting policy. However, it is
accounted for in accordance guidance in those standards rather than in accordance with IAS 8.
1.5 Retrospective application of a change in accounting policy

When a change in accounting policy is required, and there are no transitional provisions relating
to the introduction of a new accounting standard, the change in policy should be applied
retrospectively.
Definition: Retrospective application

Retrospective application is applying a new accounting policy to transactions, other events and
conditions as if that policy had always been applied.
The entity should adjust the opening balance for each item of equity affected by the change, for
the earliest prior period presented, and the other comparative amounts for each prior period
presented, as if the new accounting policy had always been applied.
IAS 1: Presentation of Financial Statements requires a statement of financial position at the
beginning of the earliest comparative period when a new accounting policy is applied
retrospectively.

Illustration:
A company presents comparatives for the previous year only.
During the year ended 31 December 2016 it changes an accounting policy and this change must
be applied retrospectively.
If there were no change in accounting policy the company would present statements of financial
position as at December 2016 and December 2015 only.
However, because there is a change in policy the company must also present a statement of
financial position as at 1 January 2015 (the beginning of the earliest comparative period).
The change in accounting policy is applied retrospectively. This means that the change should be
applied to the balances at as at 1 January 2015 as if the new policy had always been applied.
Similarly, any other comparative amounts in previous periods should be adjusted as if the new
accounting policy had always been applied.
If this is impracticable, retrospective application should be applied from the earliest date that is
practicable.
1.6 Limitation on retrospective application

It might be impracticable to retrospectively apply an accounting policy. This could be because the
information necessary for the application of the policy to earlier periods is not available because it
had not been collected then.
Definition: Impracticable
Applying a requirement is impracticable when the entity cannot apply it after making every
reasonable effort to do so. For a particular prior period, it is impracticable to apply a change in an
accounting policy retrospectively or to make a retrospective restatement to correct an error if:
(a) the effects of the retrospective application or retrospective restatement are not
determinable;
(b) the retrospective application or retrospective restatement requires assumptions about what
management's intent would have been in that period; or
(c) the retrospective application or retrospective restatement requires significant estimates of
amounts and it is impossible to distinguish objectively information about those estimates
that:
(i) provides evidence of circumstances that existed on the date(s) as at which those
amounts are to be recognised, measured or disclosed; and
(ii) would have been available when the financial statements for that prior period were
authorised for issue from other information.
There are different degrees of impracticability.

Period specific effect
It might be impracticable to determine the effect of changing an accounting policy on comparative
information for one or more prior periods presented. For example, it might be impracticable to
determine the impact on profit for the prior year.
In this case a company must apply the new accounting policy to the carrying amounts of assets
and liabilities (and therefore equity) as at the beginning of the earliest period for which
retrospective application is practicable. This may be the current period.
Cumulative effect
It might be impracticable to determine the cumulative effect, at the beginning of the current
period, of applying a new accounting policy to all prior periods,
In this case a company must adjust the comparative information to apply the new accounting
policy prospectively from the earliest date practicable.

When the cumulative effect of applying the policy to all prior periods cannot be determined, a
company must apply the new policy prospectively from the start of the earliest period practicable.
This means that it would disregard the portion of the cumulative adjustment to assets, liabilities
and equity arising before that date.
Definition: Prospective application

Prospective application of a change in accounting policy and of recognising the effect of a change
in an accounting estimate, respectively, are:
(a) applying the new accounting policy to transactions, other events and conditions occurring
after the date as at which the policy is changed; and
(b) recognising the effect of the change in the accounting estimate in the current and future
periods affected by the change.
1.7 Disclosure of a change in accounting policy

When a change in accounting policy has an effect on the current period or any prior period (or
would have an affected that period except that it is impracticable to determine the amount of the
adjustment) or might have an effect on future periods the following must be disclosed:
Disclosure: Change due Voluntary

to IFRS change
The title of the Standard or Interpretation 
The nature of the change in accounting policy  

A description of any transitional provisions 
The reason why the new accounting policy provides reliable

and more relevant information
For the current and previous period(s), to the extent
practicable, the amount of the adjustment to each item in the
 
financial statements and if IAS 33 Earnings per Share
applies to the entity, for basic and diluted earnings per share
To the extent practicable, the adjustment relating to
accounting periods before those presented in the financial  
statements
If retrospective application is impracticable, an explanation of
 
how the accounting policy change has been applied

2 ACCOUNTING ESTIMATES
Section overview
 Accounting estimates
 Changes in accounting estimates
 Disclosures
2.1 Accounting estimates

An accounting estimate is made for an item in the financial statements when the item cannot be
measured with precision, and there is some uncertainty about it.
An estimate is therefore based, to some extent, on management’s judgement. Management
estimates might be required, for example, for the following items:
 bad debts;
 inventory obsolescence;
 impairment of non-current assets;
 the fair value of financial assets or liabilities;
 the useful lives of non-current assets;
 the most appropriate depreciation pattern (depreciation method, for example straight line
or reducing balance) for a category of non-current assets;
 measurement of warranty provisions.
The use of reasonable estimates is an essential part of the preparation of financial statements
and does not undermine their reliability.
Accounting policy vs accounting estimate
It is important to distinguish between an accounting policy and an accounting estimate.
Sometimes it can be difficult to distinguish between changes in accounting policy from changes
in accounting estimate. In such cases any change is treated as a change in accounting estimate.
Illustration:
Accounting policy: Depreciating plant and equipment over its useful life.
Accounting estimate: How to apply the policy. For example whether to use the straight line method
of depreciation or the reducing balance method is a choice of accounting estimate.
A change in the measurement basis applied is a change in an accounting policy and is not a
change in an accounting estimate.
Illustration:
IAS 16: Property, plant and equipment allows the use of the cost model or the revaluation model
for measurement after recognition.
This is a choice of accounting policy.
2.2 Changes in accounting estimates

Definition: Change in accounting estimate
A change in accounting estimate is an adjustment of the carrying amount of an asset or a liability,
or the amount of the periodic consumption of an asset, that results from the assessment of the
present status of, and expected future benefits and obligations associated with, assets and
liabilities. Changes in accounting estimates result from new information or new developments and,
accordingly, are not corrections of errors.

A change in accounting estimate may be needed if changes occur in the circumstances on which
the estimate was based, or if new information becomes available. A change in estimate is not the
result of discovering an error in the way an item has been accounted for in the past and it is not a
correction of an error.
IAS 8 requires a change in an accounting policy to be accounted for retrospectively whereas a
change in an accounting estimate is normally recognised from the current period.
The effect of a change in accounting estimate should be recognised prospectively, by including it:
 in profit or loss for the period in which the change is made, if the change affects that period
only, or
 in profit or loss for the period of change and future periods, if the change affects both.
To the extent that a change in estimate results in a change in assets and liabilities, it should be
recognised by adjusting the carrying amount of the affected assets or liabilities in the period of
change.
Example:
A non-current asset was purchased for Rs. 200,000 two years ago, when its expected economic
life was ten years and its expected residual value was nil. The asset is being depreciated by the
straight-line method.
A review of the non-current assets at the end of year 2 revealed that due to technological change,
the useful life of the asset is only six years in total, and the asset therefore has a remaining useful
life of four years.
The original depreciation charge was Rs. 20,000 per year (Rs. 200,000/10 years) and at the beginning of
Year 2, its carrying value was Rs. 180,000 (Rs. 200,000 - Rs. 20,000).
The change in the estimate occurs in Year 2. The change in estimate should be applied
prospectively, for years 2 onwards (years 2 – 6). From the beginning of year 2, the asset has a
revised useful remaining life of five years.
The annual charge for depreciation for year 2 (the current year) and for the future years 3 – 6 will
be changed from Rs. 20,000 to Rs. 36,000 ( Rs. 180,000/5 years).
2.3 Disclosures
The following information must be disclosed:
 The nature and amount of a change in an accounting estimate that has an effect in the
current period or is expected to have an effect in future periods, except for the effect on
future periods when it is impracticable to estimate that effect.
 The fact that the effect in future periods is not disclosed because estimating it is
impracticable (if this is the case).

3 ERRORS
Section overview
 Errors
 Correction of prior period errors
 Limitation on retrospective restatement
 Disclosure of prior period errors
3.1 Errors
Errors can arise in respect of the recognition, measurement, presentation or disclosure of
elements of financial statements. Financial statements do not comply with IFRSs if they contain
either material errors or immaterial errors made intentionally to achieve a particular presentation
of an entity’s financial position, financial performance or cash flows. . If they are discovered
quickly, they are corrected before the financial statements are published. When this happens, the
correction of the error is of no significance for the purpose of financial reporting.
A problem arises, when an error is discovered that relates to a prior accounting period. For
example, in preparing the financial statements for Year 3, an error may be discovered affecting
the financial statements for Year 2, or even Year 1.
Definition: Prior period errors

Prior period errors are omissions from, and misstatements in, the entity's financial statements for
one or more prior periods arising from a failure to use, or misuse of, reliable information that:
(a) was available when financial statements for those periods were authorised for issue; and
(b) could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of those financial statements.
Such errors include the effects of mathematical mistakes, mistakes in applying accounting
policies, oversights or misinterpretations of facts, and fraud.
3.2 Correction of prior period errors

All material prior period errors should be corrected retrospectively in the first set of financial
statements following the discovery of the error.
Comparative amounts for the previous period should be re-stated at their corrected amount.
If the error occurred before the previous year, the opening balances of assets, liabilities and
equity for the previous period should be re-stated at their corrected amount unless that is
impracticable.
The correction of a prior period error is excluded from profit or loss in the period when the error
was discovered.
Illustration:
In preparing its financial statements for 31 December 2017 Company A discovers an error
affecting the 31 December 2016 financial statements.
The error should be corrected in the 31 December 2017 financial statements by restating the
comparative figures for 31 December 2016 at their correct amount.
If the error had occurred in 31 December 2015, the comparative opening balances for the
beginning of 31 December 2016 should be restated at their correct amount.
The reported profit for 31 December 2017 is not affected.

Example:
DEF is preparing its financial statements for 2017.
The draft statement of changes in equity is as follows:
Share Share Retained Total
capital premium earnings
Rs.000 Rs.000 Rs.000 Rs.000
Balance at 31/12/15 500 50 90 640
Profit for the year - - 150 150
Balance at 31/12/16 500 50 240 790
2017
Dividends - - (100) (100)
Balance at 31/12/17 500 50 525 1,075
DEF has now discovered an error in its inventory valuation. Inventory was overstated by Rs. 70,000
at 31 December 2017 and by Rs. 60,000 at 31 December 2016. The rate of tax on profits was
30% in both 2015 and 2016.
The error in 2017 is corrected against the current year profit.
The error in 2016 is corrected against the prior year profit. (Note that the 2016 closing inventory is
the opening inventory in 2017 so the 2016 adjustment will impact both periods statements
comprehensive income.
Profit adjustments: 2017 2016
Rs.000 Rs.000
Profit (2017 draft and 2016 actual) 385 150
Deduct error in closing inventory (70) (60)
Add error in opening inventory 60
(10) (60)
Tax at 30% 3 18
(7) (42)
Adjusted profit 378 108
The statement of changes in equity as published in 2017 becomes:
Share Share Retained Total
capital premium earnings
Rs.000 Rs.000 Rs.000 Rs.000
Balance at 31/12/15 500 50 90 640
Profit for the year (restated) - - 108 108
Balance at 31/12/16 500 50 198 748
2017
Dividends - - (100) (100)
Balance at 31/12/17 500 50 476 1,026

3.3 Limitation on retrospective restatement

A prior period error must be corrected by retrospective restatement except to the extent that it is
impracticable to determine either the period-specific effects or the cumulative effect of the error.
Period specific effect
It might be impracticable to determine the effect of correcting an error in comparative information
for one or more prior periods presented. For example, it might be impracticable to determine the
impact on profit for the prior year.
In this case a company must restate the carrying amounts of assets and liabilities (and therefore
equity) as at the beginning of the earliest period for which retrospective restatement is
practicable. This may be the current period.
Cumulative effect
It might be impracticable to determine the cumulative effect, at the beginning of the current
period, of correcting an error in all prior periods.
In this case a company must correct the error prospectively from the earliest date practicable.
3.4 Disclosure of prior period errors

The following information must be disclosed:
 the nature of the prior period error;
 for each period presented in the financial statements, and to the extent practicable, the
amount of the correction for each financial statement item and the change to basic and
fully diluted earnings per share;
 the amount of the correction at the beginning of the earliest prior period in the statements
(typically, a the start of the previous year);
 if retrospective re-statement is not practicable for a prior period, an explanation of how and
when the error has been corrected.
IAS 8 therefore requires that a note to the financial statements should disclose details of the prior
year error, and the effect that the correction has had on ‘line items’ in the prior year.
Example:
Returning to the above example the following note would be needed to the financial statements
for the year to 31 December 2017 to explain the adjustments made to figures previously published
for the year to 31 December 2016.
Note about statement of profit or loss. Rs.000
(Increase) in cost of goods sold (60)
Decrease in tax 18
(Decrease) in profit (42)
Note about statement of financial position Rs.000
(Decrease) in closing inventory (60)
Decrease in tax payable 18
(Decrease) in equity (42)


8
CHAPTER
IAS 12: Income Taxes
Contents
1 Accounting for taxation
2 Deferred tax: Introduction
3 Recognition of deferred tax: basic approach
4 Recognition and measurement rules
5 Presentation and disclosure

1 ACCOUNTING FOR TAXATION

Section overview
 Taxation of profits
 Over-estimate or under-estimate of tax from the previous year
 Taxation in the statement of financial position
1.1 Taxation of profits

Companies pay tax on their profits. The tax charge is based on their accounting profit as adjusted
according to the tax law of Pakistan.
Definitions
Accounting profit is profit or loss for a period before deducting tax expense.
Taxable profit (tax loss) is the profit (loss) for a period, determined in accordance with the rules
established by the taxation authorities, upon which income taxes are payable (recoverable).
Current tax is the amount of income taxes payable (recoverable) in respect of the taxable profit (tax
loss) for a period.
Tax computation
A series of adjustments is made against a company’s accounting profit to arrive at its taxable
profit. These adjustments involve:
 Adding back inadmissible deductions (accounting expenses which are not allowed as a
deduction against taxable profit).
 Deducting admissible deductions which include:
 expenses that are allowable as a deduction against taxable profit but which have not
been recognised in the financial statements.
 Income recognised in the financial statements but which is not taxed.
The tax rate is applied to the taxable profit to calculate how much a company owes in tax for the
period. IFRS describes this as current tax.
An exam question might require you to perform a basic taxation computation from information
given in the question.
Illustration: Tax computation format
Rs.
Accounting profit before tax X
Add back: Inadmissible deductions X
Less: Admissible deductions (X)
Taxable profit X
Tax rate x%
Tax payable (current tax) X

Chapter 8: IAS 12: Income taxes
Example: Taxation computation

Jhelum Traders had an accounting profit of Rs. 789,000 for the year ended 31 December 2017.
The accounting profit was after depreciation of Rs. 70,000 and included a profit on disposal (capital
gain) of Rs. 97,000.
The company had incurred borrowing costs of Rs. 70,000 in the year of which Rs. 10,000 had been
capitalised in accordance with IAS 23. The Company had paid fines of Rs. 125,000 due to non-
compliances with the requirements of the Companies Act, 2017.
The company holds some assets under leases. During the year it had recognised finance charge in
respect of the leases was Rs. 15,000 and rentals paid were Rs. 80,000.
At 1 January 2017 the tax written down value of machinery was Rs. 120,000 and for buildings was
Rs. 600,000.
Tax regime
All borrowing costs are deductible for tax purposes.
Capital gains are not taxable.
Fines are not tax deductible.
Lease rentals are deductible in full for tax purposes.
Accounting depreciation is not allowable for tax purposes.
Tax depreciation is claimable at 10% per annum for buildings and 15% per annum for machinery
applied to tax written down value at the start of the year.
Tax is paid at 30%
The tax computation is as follows:
Rs.
Accounting profit 789,000
Add back inadmissible deductions:
Accounting depreciation 70,000
Fine paid 125,000
Finance charge on lease 15,000
210,000
Less: Admissible deductions
Tax depreciation (15%  120,000 + 10%  600,000) 78,000
Lease payments 80,000
Capital gain 97,000
Borrowing cost capitalised 10,000
(265,000)
Taxable profit 734,000
Tax rate 30%
Tax payable 220,200

Tax base
The above example referred to the tax written down value of the machinery and buildings. This is
the tax authority’s view of the carrying amount of the asset measured as cost less depreciation
calculated according to the tax legislation.
IFRS uses the term tax base to refer to an asset or liability measured according to the tax rules.
Definition
The tax base of an asset or liability is the amount attributed to that asset or liability for tax
purposes.
The tax base of an asset is the amount that the tax authorities will allow as a deduction in the
future.
Measurement
Current tax liabilities (assets) for the current and prior periods must be measured at the amount
expected to be paid to (recovered from) the taxation authorities, using the tax rates (and tax
laws) that have been enacted or substantively enacted by the end of the reporting period.
1.2 Over-estimate or under-estimate of tax from the previous year

Current tax for current and prior periods must be recognised as a liability until paid. If the amount
already paid exceeds the amount due the excess must be recognised as an asset.
When the financial statements are prepared, the tax charge on the profits for the year is likely to
be an estimate. The figure for tax on profits in the statement of profit or loss is therefore not the
amount of tax that will eventually be payable, because it is only an estimate. The actual tax
charge, agreed with the tax authorities some time later, is likely to be different.
In these circumstances, the tax charge for the year is adjusted for any under-estimate or over-
estimate of tax in the previous year.
 An under-estimate of tax on the previous year’s profits is added to the tax charge for the
current year.
 An over-estimate of tax on the previous year’s profits is deducted from the tax charge for
the current year.
Example:
Rs. Rs.
Profit from operations 460,000
Interest (60,000)
Profit before tax 400,000
Tax:
Adjustment for under-estimate of tax in the previous year 3,000
Tax on current year profits 100,000
Tax charge for the year (103,000)
Profit after tax 297,000
1.3 Taxation in the statement of financial position

The taxation charge for the year is the liability that the company expects to pay. The timing of tax
payments on profits varies from one country to another, depending on the tax rules in each
country. The actual amount of tax payable, and reported in the statement of financial position as
a current liability (taxation payable), is calculated as follows:

Illustration:
Rs.
Tax payable at the beginning of the year X
Tax charge for the year X
X
Tax payments made during the year (X)
Tax payable at the end of the year X
Example:
Fresh Company has a financial year ending on 31 December.
At 31 December 2016 it had a liability for income tax of Rs. 77,000.
The tax on profits for the year to 31 December 2017 was Rs. 114,000.
The tax charge for the year to 31 December 2016 was over-estimated by Rs. 6,000.
During the year to 31 December 2017, the company made payments of Rs. 123,000 in income
tax.
This would result in the following accounting treatment:
Tax charge in the statement of profit or loss Rs.
Tax on current year profits 114,000
Adjustment for over-estimate of tax in the previous year (6,000)
Taxation charge for the year 108,000
Tax liability in the statement of financial position Rs.

Tax payable at the beginning of the year 77,000
Tax charge for the year 108,000
185,000
Tax payments made during the year (123,000)
Tax payable at the end of the year 62,000

2 DEFERRED TAX: INTRODUCTION

Section overview
 Deferred taxation – Underlying problem

 Identifying deferred tax balances
 IAS 12 approach to the problem
2.1 Deferred taxation - Underlying problem

Deferred tax is neither deferred, nor tax rather it is an accounting measure, more specifically an
accrual for tax. It is a timing difference between the economic benefits and the taxation.
As explained in the last section, in most jurisdictions the rules for the recognition and
measurement of certain assets, liabilities, income and expenses for tax purposes differ from the
equivalent rules under IFRSs. This results in different figures in the financial statements and in
the tax computations/tax working papers.
It is convenient to envisage two separate sets of accounts:
 one set constructed following IFRS rules; and,
 a second set following the tax rules (tax computations).
This results in a breakdown in the tax rate percentage relationship between the profit before tax
figure and the taxation figure. In other words the tax charge is not the tax rate applied to the profit
before tax.
Example:
X Limited made accounting profit before tax of Rs. 50,000 in each of the years, 20X1, 20X2 and
20X3 and pays tax at 30%.
X Limited bought an item of plant on 1 January 20X1 for Rs. 9,000. This asset is to be
depreciated on a straight line basis over 3 years.
Accounting depreciation is not allowed as a taxable deduction in the jurisdiction in which the
company operates. Instead tax allowable depreciation is available as shown in the following tax
computations.
20X1 20X2 20X3

Rs. Rs. Rs.
Accounting profit (after depreciation) 50,000 50,000 50,000
Add back depreciation 3,000 3,000 3,000
Deduct capital allowances (4,500) (2,500) (2,000)
(1,500) 500 1,000
Taxable profit 48,500 50,500 51,000
Tax @ 30% 14,550 15,150 15,300
In the absence of the recognition of deferred tax this would be reported as follows:
X Limited: Statement of profit or loss for the years ending:
20X1 20X2 20X3 Total
Rs. Rs. Rs. Rs.
Profit before tax 50,000 50,000 50,000 150,000
Income tax @ 30% (as above) (14,550) (15,150) (15,300) (45,000)
Profit after tax 35,450 34,850 34,700 105,000

Looking at the total column, the profit before tax is linked to the taxation figure through the tax
rate (150,000  30% = 45,000).
This is not the case in each separate year.
This is because the tax rate is not applied to the accounting profit before tax but to find the
current tax charge to that figure after adjustments.
The item of plant is written off in the calculation of both accounting profit and taxable profit but
by different amounts in different periods. The differences are temporary in nature as over the
three year period, the same expense is recognised for the item of plant under both the
accounting rules and the tax rules.
Transactions recognised in the financial statements in one period may have their tax effect
deferred to (or more rarely, accelerated from) another. Thus the tax is not matched with the
underlying transaction that has given rise to it.
In the above example the tax consequences of an expense (depreciation in this case) are
recognised in different periods to when the expense is recognised.
Accounting for deferred tax is based on the principle that the tax consequence of an item should
be recognised in the same period as the item is recognised. It tries to match tax expenses and
credits to the period in which the underlying transactions to which they relate are recognised.
In order to do this, the taxation effect that arises due to the differences between the figures
recognised under IFRS and the tax rules is recognised in the financial statements.
The double entry to achieve this is between a deferred tax balance in the statement of financial
position (which might be an asset or a liability) and the tax charge in the statement of profit or
loss. (More complex double entry is possible but this is outside the scope of your syllabus).
The result of this is that the overall tax expense recognised in the statement of profit or loss is
made up of the current tax and deferred tax numbers.
Definition: Tax expense

Tax expense (tax income) is the aggregate amount included in the determination of profit or loss for
the period in respect of current tax and deferred tax.
2.2 Identifying deferred tax balances

The differences between the two sets of rules will result in different numbers in the financial
statements and in the tax computations.
Two perspectives
These differences can be viewed from:
 a statement of profit or loss (income and expenses) perspective:
 the differences arising in the period are identified by comparing income and
expenses recognised under IFRS to the equivalent figures that are taxable or
allowable under tax legislation;
 the approach identifies the deferred tax expense or credit recognised in the
statement of profit or loss for the period (with the other side of the entry recognised
as a liability or asset);or
 a statement of financial position (assets and liabilities) perspective:
 the differences are identified on a cumulative basis by comparing the carrying
amount of assets and liabilities under IFRS to the carrying amount of the same
assets and liabilities according to the tax rules;
 the approach identifies the deferred tax liability (or asset) that should be recognised
(with the movement on this amount recognised as a credit or expense in the
statement of profit or loss).

IAS 12 uses the statement of financial position perspective but both will be explained here for
greater understanding.
Example continued:
The following table identifies the differences between the accounting treatment and the taxation
treatment of the item of plant from both perspectives.
Assets
Carrying and Income and
amount Tax base liabilities expenses
Cost at 01/01/X1 9,000 9,000
Charge for the year (3,000) (4,500) (1,500)
Cost at 31/12/X1 6,000 4,500 1,500

Charge for the year (3,000) (2,500) 500
Cost at 31/12/X2 3,000 2,000 1,000

Charge for the year (3,000) (2,000) 1,000
Cost at 31/12/X3    
Statement of profit or loss perspective
Example continued: Statement of profit or loss perspective
20X1:
Rs. 3,000 is disallowed but Rs. 4,500 is allowed instead.
 taxable expense is Rs. 1,500 greater than the accounting expense.
taxable profit is Rs. 1,500 less than accounting profit.
 current tax is reduced by 30% of Rs. 1,500 (Rs. 450).
 deferred tax expense of Rs. 450 must be recognised to restore the balance (Dr: Tax
expense / Cr: Deferred taxation liability).
20X2:
 taxable expense is Rs. 500 less than the accounting expense.
taxable profit is Rs. 500 more than accounting profit.
 current tax is increased by 30% of Rs. 500 (Rs. 150).
 deferred tax credit of Rs. 150 must be recognised to restore the balance (Dr: Deferred
taxation liability / Cr: Tax expense).
20X3:
 taxable expense is Rs. 1,000 less than the accounting expense.
taxable profit is Rs. 1,000 more than accounting profit.
 current tax is increased by 30% of Rs. 1,000 (Rs. 300).
 deferred tax credit of Rs. 300 must be recognised to restore the balance (Dr: Deferred
taxation liability / Cr: Tax expense).

Example continued: Statement of profit or loss perspective (continued)

The statement of profit or loss would now be as follows:
20X1 20X2 20X3
Rs. Rs. Rs.
Income tax @ 30% W1 14,550 15,150 15,300
Deferred tax 450 (150) (300)
(15,000) (15,000) (15,000)
Profit after tax 35,000 35,000 35,000
Statement of financial position 20X1 20X2 20X3

Deferred tax liability: Rs. Rs. Rs.
Balance b/f nil 450 300
Movement in the year 450 (150) (300)
Balance b/f 450 300 nil
Statement of financial position perspective
Example continued: Statement of financial position perspective

This approach compares the carrying amount of assets and liabilities in the financial statements
to their tax base to identify the cumulative differences to that point in time.
These differences are called temporary differences.
An asset in the financial statements compared to the taxman’s view requires the recognition of a
deferred tax liability which is measured by applying the tax rate to the temporary difference.
Carrying Temporary Tax @
amount Tax base difference 30%
At 31/12/X1 6,000 4,500 1,500 450
At 31/12/X2 3,000 2,000 1,000 300
At 31/12/X3 Nil nil nil nil
By the end of 20X1

The asset in the financial statements is Rs. 1,500 more than the tax base.
A deferred tax liability of Rs. 450 must be recognised.
Debit Credit
Tax expense 450
Deferred tax liability 450
By the end of 20X2

The asset in the financial statements is Rs. 1,000 more than the tax base.
A deferred tax liability of Rs. 300 must be recognised but there was Rs. 450 at the
start of the year so the liability must be reduced.
Debit Credit
Tax expense 150

Example continued: Statement of financial position perspective (continued)
By the end of 20X3

The asset in the financial statements is the same as the tax base (nil).
A deferred tax liability of nil must be recognised but there was Rs. 300 at the start
of the year so the liability must be reduced.
Debit Credit
Tax expense 300
These amounts are the same as on the previous page and would have the same
impact on the financial statements.
The recognition of deferred taxation has restored the relationship between profit before tax and
the tax charge through the tax rate in each year (30% of Rs. 50,000 = Rs. 15,000).
Terminology
When a difference comes into existence or grows it is said to originate. When the difference
reduces in size it is said to reverse.
Thus, in the above example a difference of Rs. 1,500 originated in 20X1. This difference then
reversed in 20X2 and 20X3.
Warning
Do not think that an origination always leads to the recognition of a liability and an expense. The
direction of the double entry depends on the circumstances that gave rise to the temporary
difference. This is covered in section 3 of this chapter.
2.3 IAS 12 approach to the problem

IAS 12: Income taxes, advocates a statement of financial position approach.
Business must identify a deferred tax liability (or perhaps asset) at each reporting date.
It must do this by identifying the differences between the carrying amount of assets and liabilities
in the financial statements to the tax base (tax authority’s view of those same items). These
differences are known as temporary differences (this will be explained in more detail in the next
section).
Once the temporary differences have been identified the deferred tax balance is calculated by
applying the appropriate tax rate to the difference.

3 RECOGNITION OF DEFERRED TAX: BASIC APPROACH

Section overview
 Identifying the temporary difference

 Taxable and deductible temporary differences
 Accounting for deferred tax
 Sources of temporary differences
3.1 Identifying the temporary difference

Accounting for deferred tax is based on the identification of the temporary differences.
Definition: Temporary difference

Temporary differences are differences between the carrying amount of an asset or liability in the
statement of financial position and its tax base.
Temporary differences may be either:
(a) taxable temporary differences, which are temporary differences that will result in taxable
amounts in determining taxable profit (tax loss) of future periods when the carrying amount
of the asset or liability is recovered or settled; or
(b) deductible temporary differences, which are temporary differences that will result in amounts
that are deductible in determining taxable profit (tax loss) of future periods when the carrying
amount of the asset or liability is recovered or settled.
The tax base of an asset is the amount that will be deductible for tax purposes against any
taxable economic benefit that will flow to an entity when it recovers the carrying amount of the
asset.
Definition: Tax base

The tax base of an asset or liability is the amount attributed to that asset or liability for tax
purposes.
3.2 Taxable and deductible temporary differences

Temporary differences may be either taxable temporary differences or deductible temporary
differences.
Taxable temporary differences
A taxable temporary difference is caused by a debit in the carrying amount of an asset or liability
in the financial statements compared to the tax base of that item.
Taxable temporary differences lead to the recognition of deferred tax liabilities.
Example: Taxable temporary differences

Each of the following is a taxable temporary difference leading to the recognition of a deferred tax
liability.
Carrying Temporary Deferred tax
amount Tax base difference liability (30%)
Non-current asset 1,000 800 200 60
Inventory 650 600 50 15
Receivable 800 500 300 90
Receivable (note 1) 500 nil 500 150
Payable (note 2) (1,000) (1,200) 200 60

Example: Taxable temporary differences (continued)

Note 1:
This implies that an item accounted for using the accruals basis in the financial statements
is being taxed on a cash bases.
If an item is taxed on cash basis the tax base would be zero as no receivable would be
recognised under the tax rules.
Note 2:
The credit balance in the financial statements is Rs. 1,000 and the tax base is a credit of
Rs. 1,200. Therefore, the financial statements show a debit balance of 200 compared to
the tax base. This leads to a deferred tax liability.
IAS 12 rationalises the approach as follows (using the non-current assets figures to
illustrate)
Inherent in the recognition of an asset is that the carrying amount (Rs. 1,000) will be
recovered in the form of economic benefits that will flow to the entity in future periods.
When the carrying amount exceeds the tax base (as it does in this case at Rs. 800) the
amount of taxable economic benefit will exceed the amount that will be allowed as a
deduction for tax purposes.
This difference is a taxable temporary difference and the obligation to pay the resulting
income tax in the future periods is a liability that exists at the reporting date.
The company will only be able to expense Rs. 800 in the tax computations against the
recovery of Rs. 1,000.
The Rs. 200 that is not covered will be taxed and that tax should be recognised for now.
Definition: Deferred tax liability

Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of
taxable temporary differences.
Deductible temporary differences

A deductible temporary difference is caused by a credit in the carrying amount of an asset or
liability in the financial statements compared to the tax base of that item.
Deductible temporary differences lead to the recognition of deferred tax assets.
Example: Deductible temporary differences

Each of the following is a deductible temporary difference leading to the recognition of a deferred
tax asset.
Deferred
Carrying Temporary tax asset
amount Tax base difference (30%)
Non-current asset (note 1) 1,000 1,200 (200) 60
Receivable 800 900 (100) 30
Payable (1,200) (1,000) (200) 60
Note 1:
There is a debit balance for the non-current asset of Rs. 1,000 and its tax base is a debit
of Rs. 1,200. Therefore, the financial statements show a credit balance of 200 compared
to the tax base. This leads to a deferred tax asset.

Definition: Deferred tax asset

Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
(a) deductible temporary differences;
(b) the carry forward of unused tax losses; and
(c) the carry forward of unused tax credits.
(The deferred tax assets arising from the carry forward of unused tax losses and the carry forward
of unused tax credits are not in your syllabus).
3.3 Accounting for deferred tax

Accounting for deferred taxation involves the recognition of a liability (or an asset) in the
statement of financial position at each year end. The business must then account for the
movement on the liability.
The other side of the entry that changes the balance on the deferred taxation liability (asset) is
recognised in the statement of profit or loss. (Note, that some differences require double entry to
other comprehensive income or directly to equity but the deferred tax consequences of these is
outside your syllabus).
Approach
The calculation of the balance to be recognised in the statement of financial position is quite
straightforward.
 Step 1: Identify the temporary differences (this should always involve a columnar working
as in the example below);
 Step 2: Multiply the temporary differences by the appropriate tax rate.
 Step 3: Compare this figure to the opening figure and complete the double entry.
Example:
X Ltd. has non-current assets with a carrying value of Rs. 200,000 and a tax base of Rs. 140,000.
It has recognised a receivable of Rs. 10,000. This relates to income which is taxed on cash basis.
It has also accrued for an expense in the amount of Rs. 20,000. Tax relief is only given on this
expense when it is paid.
At the start of the year X Ltd. had a deferred tax liability of Rs. 12,000.
Required
Show the movement on the deferred tax account and construct the journal to record this movement
(assume the tax rate is 30%).
In order to answer a question like this you need to complete the following proforma:
Rs.
Deferred taxation balance at the start of the year 12,000
Transfer to the income statement (as a balancing figure) ?
Deferred taxation balance at the end of the year (working) ?
In order to complete this you need a working to identify the temporary differences.

Example continued:
The temporary differences are identified and the required deferred tax balance calculated as
follows:
Working:
Carrying Temporary DT balance at
amount Tax base differences 30%
Rs. Rs. Rs. Rs.
Non-current assets 200,000 140,000 60,000 18,000
(liability)
Accrued income 10,000  10,000 3,000
(liability)
Accrued expense (20,000)  (20,000) (6,000)
asset
50,000 15,000
The answer can then be completed by filling in the missing figures and constructing the journal
as follows:
Rs.
Statement of profit or loss (as a balancing figure) 3,000
Deferred taxation balance at the end of the year (working) 15,000
Journal: Debit Credit

Income statement (tax expense) 3,000
Deferred tax liability 3,000
3.4 Sources of temporary differences

Circumstances under which temporary differences arise include;
 Situations when income or expense is included in accounting profit in one period but
included in the taxable profit in a different period. Examples include:
 Items which are taxed on a cash basis but which will be accounted for on an
accruals basis.
 Situations where the accounting depreciation does not equal tax allowable
depreciation.
 Revaluation of assets where the tax authorities do not amend the tax base when the asset
is revalued.

Examples leading to the recognition of deferred tax liabilities

Interest may be received in arrears, leading to a receivable in the statement of financial position.
However, this interest may not be taxable until the cash is received.
Example:
A Ltd. recognises interest receivable of Rs. 600,000 in its financial statements.
No cash has yet been received and interest is taxed on a cash basis. The interest receivable has a
tax base of nil.
Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Interest receivable 600,000  600,000
Deferred tax liability @ 30% 180,000
Development costs may be capitalised and amortised (in accordance with IAS 38) but tax relief
may be given for the development costs as they are paid.
Example:
In the year ended 30 June 2016, B Ltd. incurred development costs of Rs. 320,000.
These were capitalised in accordance with IAS 38, with an amortisation charge of Rs. 15,000 in
2016.
Development costs are an allowable expense for tax purposes in the period in which they are
paid. The relevant tax rate is 30%.
Carrying Temporary
Rs. Rs. Rs.
Development costs 305,000  305,000
Accounting depreciation is not deductible for tax purposes in most tax regimes. Instead the
governments allow a deduction on statutory grounds.
Example:
C Ltd. has non-current assets at 31 December 2016 with a cost of Rs. 5,000,000.
Accumulated depreciation for accounting purposes is Rs. 2,250,000 to give a carrying amount of
Rs. 2,750,000
Tax deductible depreciation of Rs. 3,000,000 has been deducted to date.
The fixed assets have a tax base of Rs. 2,000,000.
Carrying Temporary
Rs. Rs. Rs.
Non-current asset 2,750,000 2,000,000 750,000

Examples leading to the recognition of deferred tax assets

Warranty costs may be recognised as a liability (in accordance with IAS 37) but tax relief may be
given only when the cash is spent in the future.
Example:
D Ltd. recognises a liability of Rs. 100,000 for accrued product warranty costs.
For tax purposes, the product warranty costs will not be deductible until the entity pays any warranty
claims. (Therefore the tax base is nil).
The company is very profitable and does not expect this to change. (This means that they expect to
pay tax in the future so should be able to recover the deferred tax asset).
Carrying Temporary
Rs. Rs. Rs.
Warranty provision 100,000  100,000
Deferred tax asset @ 30% 30,000

This time the financial statements contain a liability when compared to the tax
authority’s view of the situation. Therefore deferred tax is an asset.
It is possible to have a temporary difference even if there is no asset or liability. In such cases
there is a zero value for the asset (or liability). For example, research costs may be expensed as
incurred (in accordance with IAS 38) but tax relief may be given for the costs at a later date.
Example:
In the year ended 31 December 2016, E Ltd. incurred research costs of Rs. 500,000.
These were expensed accordance with IAS 38.
Research costs are not permitted as a taxable deduction until a later period.
The relevant tax rate is 30%.
Carrying Temporary
Rs. Rs. Rs.
Research costs Nil 500,000 500,000
Deferred tax asset @ 30% 150,000

4 RECOGNITION AND MEASUREMENT RULES

Section overview
 Recognition of deferred tax liabilities
 Recognition of deferred tax assets
 A recognition issue – non-taxable items
 Measurement of deferred tax balances
 Items recognised outside profit or loss
 Carry forward of un-used tax losses and tax credits
 Reassessment of unrecognised deferred tax assets
4.1 Recognition of deferred tax liabilities

A deferred tax liability must be recognised for all taxable temporary differences, except to the
extent that the deferred tax liability arises from:
 the initial recognition of goodwill; or
 the initial recognition of an asset or liability in a transaction which:
 is not a business combination; and
 at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).
There is further guidance on the recognition of deferred tax liabilities in respect of taxable
temporary differences arising in a business combination but that is outside the scope of your
syllabus.
Comment on the exceptions: Goodwill
Goodwill usually exists only in group accounts. Groups are not taxed as such: it is the members
of a group that are the taxable entities, i.e. the parent and each subsidiary are taxed separately.
Goodwill in group accounts is not an asset recognised by the tax authorities so has a tax base of
nil. This means that goodwill is a temporary difference but does not lead to the recognition of a
deferred tax liability because of the exception.
Example:
In the year ended 31 December 2016, A Ltd. acquired 80% of another company and recognised
goodwill of Rs. 100,000 in respect of this acquisition.
Carrying amount Tax base Temporary difference
Rs. Rs. Rs.
Goodwill 100,000 nil 100,000
Deferred tax (due to the exception) nil
The exception refers to the initial recognition of goodwill. However, there is no deferred tax in
respect of this difference at any time in the future even if the carrying amount (and hence the
temporary difference) changes.
In some jurisdictions goodwill can arise in individual company financial statements. Furthermore,
the goodwill might be tax deductible in those jurisdictions. In such cases goodwill is just the same
as any other asset and its tax consequences would be recognised in the same way.
Example:
In the year ended 31 December 2016, B Ltd. acquired a partnership and recognised good will of
Rs. 100,000 in respect of this acquisition.
Rs. Rs. Rs.
Goodwill 100,000 100,000 Nil
Deferred tax on initial recognition Nil
In the future, both the carrying amount and the tax base of the goodwill might change leading
to deferred tax consequences.

Comment on the exceptions: Initial recognition of other items

A temporary difference may arise on initial recognition of an asset or liability, for example if part
or all of the cost of an asset will not be deductible for tax purposes. This exception relates to the
initial recognition of an asset or liability in a transaction that is not a business combination. In
other words, the exception does not apply if the initial recognition is due to a business
combination. There is guidance on deferred tax arising in business combinations but this is not
examinable at this level.
If the transaction is not a business combination and effects either accounting profit or taxable
profit the exception does not apply and deferred tax is recognised on initial recognition.
Example:
In the year ended 31 December 2016, C Ltd. lent Rs. 100,000 to another company and incurred
costs of Rs. 5,000 in arranging the loan. The loan is recognised at Rs. 105,000 in the accounts.
Under the tax rules in C Plc’s jurisdiction the cost of arranging the loan is deductible in the period
in which the loan is made.
Rs. Rs. Rs.
Loans and advances 105,000 100,000 5,000
Deferred tax on initial recognition 1,500
The exception does not apply as the transaction affects the taxable profits on initial
recognition.
If the transaction is not a business combination, and affects neither accounting profit nor taxable
profit, deferred tax would normally be recognised but the exception prohibits it.
Example:
In the year ended 31 December 2016, D Ltd. acquired a non-current asset at a cost of Rs.
100,000. The asset is to be depreciated on a straight line basis over its useful life of 5 years.
The asset falls outside the tax system. Depreciation is not allowable for tax purposes and there is
no tax deductible equivalent. Any gain or loss on disposal is not taxable.
Initial recognition:
Rs. Rs. Rs.
Non-current asset 100,000 Nil 100,000
Deferred tax on initial recognition (due to the exception) nil
Subsequent measurement (1 year later)
Rs. Rs. Rs.
Non-current asset 80,000 Nil 80,000
Deferred tax on initial recognition (due to the exception – this
still results from the initial recognition) nil
4.2 Recognition of deferred tax assets

A deferred tax asset must 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:
 is not a business combination; and
 at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).

There is further guidance on the recognition of deferred tax asset in respect of deductible
temporary differences arising in a business combination but that is outside the scope of your
syllabus.
A deferred tax asset must only be recognised to the extent that it is probable that taxable profit
will be available against which the deductible temporary difference can be used.
This means that IAS 12 brings a different standard to the recognition of deferred tax assets than
it does to deferred tax liabilities:
 liabilities are always be recognised in full (subject to certain exemptions); but
 assets may not be recognised in full (or in some cases at all).
IAS 12 also requires that the carrying amount of a deferred tax asset must be reviewed at the
end of each reporting period to check if it is still probable that sufficient taxable profit is expected
to be available to allow the benefit of its use.
If this is not the case the carrying amount of the deferred tax asset must be reduced to the
amount that it is expected will be used in the future. Any such reduction might be reversed in the
future if circumstances change again.
4.3 A recognition issue – non-taxable items

The definition of temporary difference is repeated here for convenience:
Definition: Temporary difference

Temporary differences are differences between the carrying amount of an asset or liability in the
statement of financial position and its tax base.
Deferred tax should be recognised only in respect of those items where expense or income is
recognised in both accounting profit and taxable profit but in different periods.
Unfortunately, applying the definition of temporary difference given above would result in the
inclusion of items where the difference might not be temporary but permanent in nature.
Example: Permanent difference.
E Ltd. has recognised Rs. 100,000 income as a receivable in its accounting profit for the year.
This income is not taxable. This means that it falls outside of the tax rules and in the absence of
other guidance it would have a tax base of nil.
Applying the definition of temporary difference would lead to the following:
Carrying Temporary
Rs. Rs. Rs.
Receivable 100,000 Nil 100,000
However, this is not a temporary difference. It is not a transaction recognised in accounting

profits in one period and taxable profits in another.
It is never recognised in taxable profits.
IAS 12 contains rules to stop this happening (see in bold below).
Items not taxable or tax allowable should not result in the recognition of deferred tax balances. In
order to achieve this effect, IAS 12 includes the following rules:
 The tax base of an asset is the amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to an entity when it recovers the carrying amount of
the asset. If those economic benefits will not be taxable, the tax base of the asset is
equal to its carrying amount (permanent difference).
 The tax base of a liability is its carrying amount, less any amount that will be deductible for
tax purposes in respect of that liability in future periods. In the case of revenue which is
received in advance, the tax base of the resulting liability is its carrying amount, less any
amount of the revenue that will not be taxable in future periods.

Returning to the earlier example:

Example: Permanent difference.
E Ltd. has recognised Rs. 100,000 income as a receivable in its accounting profit for the year.
This income is not taxable.
Applying the rule shown in bold above would lead to the following:
Carrying
amount Tax base Temporary difference
Rs. Rs. Rs.
Receivable 100,000 100,000 nil
The item is not taxable so its tax base is set to be the same as its carrying amount.
This results in a nil temporary difference and prevents the recognition of deferred tax on this
asset.
This is a mechanism to exclude non-taxable items from the consideration of deferred tax (even
though the definition might have included them).
Remember this: there is no deferred tax to recognise on items that are not taxed or for
which no tax relief is given.
Closing comment
Accounting for deferred taxation restores the relationship that should exist between the profit
before tax in the financial statements, the tax rate and the tax charge. In earlier examples we saw
that after accounting for deferred tax the tax expense (current and deferred tax) was equal to the
tax rate  the accounting profit before tax.
This will not be the case if there are permanent differences.
4.4 Measurement of deferred tax balances

Deferred tax assets and liabilities must not be discounted.
Deferred tax assets and liabilities must be measured at the tax rates that are expected to apply to
the period when the asset is realised or the liability is settled, based on tax rates (and tax laws)
that have been enacted or substantively enacted by the end of the reporting period.
4.5 Items recognised outside profit or loss

A change in the carrying amount of an asset or liability might be due to a transaction recognised
outside the statement of profit or loss (i-e. in other comprehensive income directly as per IFRS).
For example, IAS 16: Property, plant and equipment, allows for the revaluation of assets. The
revaluation of an asset without a corresponding change to its tax base (which is usually the case)
will change the temporary difference in respect of that asset. An increase in the carrying amount
of an asset due to an upward revaluation is recognised outside profit or loss. In Pakistan it is
credited directly to an account “outside equity” called revaluation surplus in accordance with the
Companies Act, 2017. (Elsewhere is credited to other comprehensive income in accordance
with IAS 16).
IFRS requires or permits various items to be recognised in other comprehensive income.
Examples of such items include:
 a change in carrying amount arising from the revaluation of property, plant and equipment
(IAS 16) though this is not the case in Pakistan;
 a change in carrying amount arising from the revaluation of intangible assets (IAS 38:
Intangible assets) though this is not the case in Pakistan;
 remeasurements of defined benefit plans (IAS 19: Employee benefits);
 movements on hedging relationships

 exchange differences arising on the translation of the financial statements of a foreign

operation (IAS 21: The effects of changes in foreign exchange rates);
IFRS requires or permits various items to be recognised directly in equity. Examples of such
items include:
 adjustment to the opening balance of retained earnings resulting from either a change in
accounting policy that is applied retrospectively or the correction of an error (see IAS 8:
Accounting policies, changes in accounting estimates and errors); and
 amounts arising on initial recognition of the equity component of a compound financial
instrument (IAS 32: Financial Instruments: Presentation).
In these cases, the other side of the entry that changes the balance on the deferred taxation
liability (asset) is also recognised outside the statement of profit or loss and in the same location
as the transaction that gave rise to the change in the temporary difference.
Example: Accounting for deferred tax

The following information relates to the movement on the carrying amount of an item of plant
together with temporary differences in a reporting period:
Carrying Temporary DT balance at
Assumed amount Tax base differences 30%
Rs. Rs. Rs. Rs.
At 1 January 100,000 80,000 20,000 6,000
Depreciation (10,000) (15,000) 5,000 1,500
90,000 65,000
Revaluation 35,000  35,000 10,500
125,000 65,000 60,000 18,000
The movement on the deferred tax liability is as follows:
Rs.
Statement of profit or loss (usually as a balancing figure) 1,500
Revaluation surplus 10,500
Deferred taxation balance at the end of the year (working above) 18,000
Statement of profit or loss (tax expense) 1,500
Revaluation surplus 10,500
Note: The balance on the revaluation surplus account is a credit balance stated net of
taxation at Rs. 24,500 (Rs. 35,000 – Rs. 10,500).
4.6 Carry forward of un-used tax losses and tax credits

A deferred tax asset shall be recognised for the carry forward of un-used tax losses and un-used
tax credits to the extent that it is probable that future taxable profit will be available against which
they can be utilised. However, the existence of unused tax losses is strong evidence that future
taxable profit may not be available. Hence, it should recognise deferred tax asset on these items,
only when there is convincing other evidence that sufficient taxable profit will be available. Carry
forward of un-used tax losses or tax credits create future tax relief for companies and are
therefore very valuable

An entity considers the following criteria in assessing the probability that taxable profit will be
available against which the unused tax losses or unused tax credits can be utilised:
a) whether the entity has sufficient taxable temporary differences relating to the same
taxation authority and the same taxable entity, which will result in taxable amounts against
which the unused tax losses or unused tax credits can be utilised before they expire;
b) whether it is probable that the entity will have taxable profits before the unused tax losses
or unused tax credits expire;
c) whether the unused tax losses result from identifiable causes which are unlikely to recur;
and
d) whether tax planning opportunities are available to the entity that will create taxable profit
in the period in which the unused tax losses or unused tax credits can be utilised.
4.7 Reassessment of unrecognised deferred tax assets

At the end of each reporting period, an entity reassesses unrecognised deferred tax assets. The
entity recognises a previously unrecognised deferred tax asset to the extent that it has become
probable that future taxable profit will allow the deferred tax asset to be recovered. For example,
an improvement in trading conditions may make it more probable that the entity will be able to
generate sufficient taxable profit in the future for the deferred tax asset to meet the recognition
criteria.
Example: Reassessment of unrecognised deferred tax assets

Fatima Limited disclosed in its financial statements for the year ended December 31, 2018, that
it has available tax losses of Rs.60 million. The company losses are available for only 5 years. The
company expects that it is unlikely to utilize all the losses and, therefore, does not recognize a
deferred tax asset. Tax rate is 35% for the year and will remain same for future periods.
In 2019, the company restructures its business and expects that this restructuring will result in
future taxable profits upto Rs.50 million in next 5 years. The company, therefore, shall recognize at
December 31, 2019 a deferred tax asset for the available tax losses to the extent future taxable
profits will be available i.e., Rs.17.5 (Rs.50 million x 35%).

5 PRESENTATION AND DISCLOSURE

Section overview
 Presentation
 Disclosure
5.1 Presentation
IAS 12: Income taxes contains rules on when current tax liabilities may be offset against current
tax assets
Offset of current tax liabilities and assets
A company must offset current tax assets and current tax liabilities if, and only if, it:
 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.
These are the same rules as apply to assets and liabilities in general as described in IAS 1.
In the context of taxation balances whether a current tax liability and asset may be offset is
usually specified in tax law, thus satisfying the first criterion.
In most cases, where offset is legally available the asset would then be settled on a net basis (i.e.
the company would pay the net amount).
Offset of deferred tax liabilities and assets
A company must offset deferred tax assets and deferred tax liabilities if, and only if:
 the entity has a legally enforceable right to set off current tax assets against current tax
liabilities; and
 the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the
same taxation authority on either:
 the same taxable entity; or
 different taxable entities which intend either to settle current tax liabilities and assets
on a net basis, or to realise the assets and settle the liabilities simultaneously, in
each future period in which significant amounts of deferred tax liabilities or assets
are expected to be settled or recovered.
The existence of deferred tax liability is strong evidence that a deferred tax asset from the same
tax authority will be recoverable.
Example:
The following deferred tax positions relate to the same entity:
Situation 1 Situation 2
Deferred tax liability 12,000 5,000
Deferred tax asset (8,000) (8,000)
4,000 (3,000)
In situation 1, the financial statements will report the net position as a liability of 4,000. The
existence of the liability indicates that the company will be able to recover the asset, so the asset
can be set off against the liability.
In situation 2, setting off the asset against the liability leaves a deferred tax asset of 3,000. This
asset may only be recognised if the entity believes it is probable that it will be recovered in the
foreseeable future.
5.2 Disclosure
This section does not include the IAS 12 disclosure requirements in respect of those aspects of
deferred taxation which are not examinable at this level.
Components of tax expense (income)
The major components of tax expense (income) must be disclosed separately.
Components of tax expense (income) may include:

 current tax expense (income);

 any adjustments recognised in the period for current tax of prior periods;
 the amount of deferred tax expense (income) relating to the origination and reversal of
temporary differences;
 the amount of deferred tax expense (income) relating to changes in tax rates or the
imposition of new taxes;
 the amount of the benefit arising from a previously unrecognised tax loss, tax credit or
temporary difference of a prior period that is used to reduce current tax expense;
 deferred tax expense arising from the write-down, or reversal of a previous write-down, of
a deferred tax asset;
 the amount of tax expense (income) relating to those changes in accounting policies and
errors that are included in profit or loss in accordance with IAS 8, because they cannot be
accounted for retrospectively.
Illustration: Note to the statement of profit or loss
Taxation expense Rs.
Current tax 129,000
Adjustment for over estimate of tax in prior year (5,000)
Deferred taxation
Arising during the period 20,000
Due to change in tax rate (5,000)
15,000
139,000
Example: Change in rate

31 December 2016
Profits were taxed at 30%.
A Ltd. recognised a deferred tax liability of Rs. 30,000 (it had temporary differences of Rs.
100,000).
31 December 2016
The tax rate changed to 25% during the year.
At the year end A Ltd. carried out the following deferred tax calculation:
Rs. Rs. Rs.
Non-current assets 1,000,000 820,000 180,000
Deferred tax at 25% 45,000
The movement on the deferred tax liability would be shown as follows: Rs.
Deferred taxation b/f 30,000
Statement of profit or loss: Rate change (5/30  30,000) (5,000)
Deferred taxation b/f restated 25,000
Statement of profit or loss (balancing figure – due to the origination of
temporary differences in the period) 20,000
Deferred taxation balance at the end of the year 45,000

Tax reconciliation
The following must also be disclosed:
 an explanation of the relationship between tax expense (income) and accounting profit in
either or both of the following forms:
 a numerical reconciliation between tax expense (income) and the product of
accounting profit multiplied by the applicable tax rate(s), disclosing also the basis on
which the applicable tax rate(s) is (are) computed; or
 a numerical reconciliation between the average effective tax rate and the applicable
tax rate, disclosing also the basis on which the applicable tax rate is computed;
 an explanation of changes in the applicable tax rate(s) compared to the previous
accounting period;
A major theme in this chapter is that the different rules followed to calculate accounting profit and
taxable profit lead to distortion of the relationship that exists between profit before tax in the
financial statements, the tax rate and the current tax expense for the period. Accounting for
deferred tax corrects this distortion so that after accounting for deferred tax the tax expense
(current and deferred tax) was equal to the tax rate  the accounting profit before tax.
This is not the case if there are permanent differences. The above reconciliations show the effect
of permanent differences.
Example: Tax reconciliations
B Ltd. had an accounting profit before tax of Rs. 500,000.
This contained income of Rs. 20,000 which is not taxable.
Accounting depreciation in the year was Rs. 100,000 and tax allowable depreciation was Rs.
150,000. This means that a temporary difference of Rs. 50,000 originated in the year.
BLtd.’s taxation computation is as follows: Rs.
Add back inadmissible deductions
Depreciation 100,000
Deduct admissible deduction
Tax allowable depreciation 150,000
Income not taxed 20,000
(170,000)
Taxable profit 430,000
Tax at 30% 129,000
Tax expense Rs.

Current tax 129,000
Deferred taxation (30%  Rs. 50,000) 15,000
Tax expense 144,000
Tax reconciliation (in absolute numbers) Rs.

Applicable tax rate 30%
Accounting profit  the applicable tax rate 150,000
Tax effect of untaxed income (30% of Rs. 20,000) (6,000)
Tax expense 144,000
Tax reconciliation (in percentages)

Applicable tax rate 30.0%
Tax effect of untaxed income (6,000/500,000) (1.2%)
Effective tax rate (144,000/500,000) 28.8%

Other disclosures
An entity must disclose the amount of income tax consequences of dividends to shareholders of
the entity that were proposed or declared before the financial statements were authorised for
issue, but are not recognised as a liability in the financial statements;
An entity must disclose the amount of a deferred tax asset and the nature of the evidence
supporting its recognition, when:
 the utilisation of the deferred tax asset is dependent on future taxable profits in excess of
the profits arising from the reversal of existing taxable temporary differences; and
 the entity has suffered a loss in either the current or preceding period in the tax jurisdiction
to which the deferred tax asset relates.
Practice questions 1
XYZ Limited had an accounting profit before tax of Rs. 90,000 for the year ended 31st
December 2016. The tax rate is 30%.
The following balances and information are relevant as at 31st December 2016.
Non-current assets Rs. Rs.
Property 63,000 1
Plant and machinery 100,000 90,000 2
Assets held under lease 80,000 3
Receivables:
Trade receivables 73,000 4
Interest receivable 1,000 5
Payables
Fine 10,000
Lease obligation 85,867 3
Interest payable 3,300 5
Note 1: The property cost the company Rs.70,000 at the start of the year. It is being
depreciated on a 10% straight line basis for accounting purposes.
The company’s tax advisers have said that the company can claim Rs.42,000
accelerated depreciation as a taxable expense in this year’s tax computation.
Note 2: The balances in respect of plant and machinery are after providing for
accounting depreciation of Rs. 12,000 and tax allowable depreciation of Rs.10,000
respectively.
Note 3: The asset held under the lease was acquired during the period.
Rental expense for leases is tax deductible. The annual rental for the asset is Rs.28,800
and was paid on 31st December 2016.
Note 4: The receivables figure is shown net of an allowance for doubtful balances of Rs.
7,000. This is the first year that such an allowance has been recognised. A deduction for
debts is only allowed for tax purposes when the debtor enters liquidation.
Note 5: Interest income is taxed and interest expense is allowable on a cash basis. There
were no opening balances on interest receivable and interest payable.
a. Prepare a tax computation and calculate the current tax expense.

b. Calculate the deferred tax liability required as at 31 December 2016.
c. Show the movement on the deferred tax account for the year ended 31 December
2016 given that the opening balance was Rs. 3,600 Cr.
d. Prepare a note showing the components of the tax expense for the period.
e. Prepare a reconciliation between the tax expense and the product of the accounting
profit multiplied by the applicable rate.


Solution: Tax computation for the year ended 31 December 2016 1a
Rs. Rs.
Add back inadmissible expenses
Depreciation on property 7,000
Depreciation of plant and machinery 12,000
Depreciation of asset held under finance lease 20,000
Finance charge of lease 14,667
Increase in provision for doubtful debts 7,000
Interest payable accrual 3,300
Fine 10,000 73,967
Less admissible deductions
Interest income 1,000
Tax allowable depreciation on property 42,000
Tax allowable depreciation on plant and machinery 10,000
Lease rentals 28,800 (81,800)
82,167
Tax 30% 24,650
Solution: Deferred tax liability as 31 December 2016 1b

Carrying Temporary
value Tax base difference
Rs. Rs. Rs.
Property 63,000 28,000 35,000
Plant and machinery 100,000 90,000 10,000
Assets held under finance lease 80,000 nil 80,000
Lease obligation (85,867) nil (85,867)
(5,867) nil (5,867)
Trade receivables 73,000 80,000 (7,000)
Interest receivable 1,000 nil 1,000
Fine (10,000) (10,000) 
Interest payable (3,300) nil (3,300)
29,833
Deferred tax @ 30% 8,950
Temporary Deferred tax
differences @ 30%
Deferred tax liabilities 46,000 13,800
Deferred tax assets (16,167) (4,850)
8,950

Solution: Movement on the deferred tax account for the year ended 31 December 2016. 1c
Rs.
Deferred tax as at 1st January 2016 3,600
Statement of profit or loss (balancing figure) 5,350
Deferred tax as at 31st December 2016 8,950
Solution: Components of tax expense for the year ended 31 December 2016. 1d
Rs.
Current tax expense (see part a) 24,650
Deferred tax (see part c) 5,350
Tax expense 30,000
Solutions: Tax reconciliation for the year ended 31 December 2016. 1e

Rs.
Tax at the applicable rate (30%) 27,000
Tax effects of expenses that are not deductible in determining taxable
profit
Fines 3,000
Tax expense 30,000

9
CHAPTER
IAS 21: Foreign Currency Transactions
Contents
1 IAS 21 The effects of changes in foreign exchange rates
2 The individual entity: accounting requirements

1 IAS 21: THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
Section overview
 The scope of IAS 21

 The two main accounting issues
 Terms and definitions used in IAS 21: currency definitions
 Terms and definitions used in IAS 21: other definitions
1.1 The scope of IAS 21

Many businesses have transactions and investments that are denominated in a foreign currency.
Individual companies often enter into transactions in a foreign currency. These transactions need
to be translated into the company’s own currency in order to record them in its ledger accounts.
For example:
 a Pakistani company may take out a loan from a French bank in Euros but will record the
loan in its ledger accounts in Rupees; or
 a Pakistani company may sell goods to a Japanese company invoiced in Yen but will
record the sale and the trade receivable in Rupees in its ledger accounts.
The rules on accounting for foreign currency items are concerned with translating or converting
items from one currency into another currency, at an appropriate rate of exchange between the
currencies.
IAS 21 deals with the translation of these transactions when they occur and at subsequent
reporting dates when re-translation at a different exchange rate may be necessary.
1.2 The two main accounting issues

Transactions, assets and liabilities in foreign currencies are translated or converted from the
foreign currency into the currency of the reporting entity. The process of translation would be
quite simple if exchange rates between currencies remained fixed. However, exchange rates are
continually changing. The translated valuation of foreign currency assets or liabilities in the
statement of financial position might therefore change if they are translated at different times.
The two main accounting issues when accounting for foreign currency items are:
What exchange rate(s) should be used for translation?
How to account for the gains or losses that arise when exchange rates change?
Before looking at these accounting rules in detail, it is important to understand the precise
meaning of some key terms used in IAS 21.
1.3 Terms and definitions used in IAS 21: currency definitions

IAS 21 identifies three types of currency: the presentation currency, the functional currency and
foreign currency.
Definitions
Presentation currency: The currency in which the financial statements of an entity are presented
Functional currency: The currency of the primary economic environment in which an entity
operates.
Foreign currency: A currency other than the functional currency of the entity

Chapter 9: IAS 21: Foreign currency transactions
Presentation currency
An entity is permitted to present its financial statements in any currency. This reporting currency
is often the same as the functional currency, but does not have to be.
Functional currency
When a reporting entity records transactions in its financial records, it must identify its functional
currency and make entries in that currency. It will also, typically, prepare its financial statements
in its functional currency. When financial statements prepared in a functional currency are
translated into a different presentation currency, the translation of assets and liabilities must
comply with the rules in IAS 21.
IAS 21 describes the functional currency as:
The currency that mainly influences:
 sales prices for goods and services
 labour, material and other costs of providing goods or services.
The currency in which funds are generated by issuing debt and equity
The currency in which receipts from operating activities are usually retained.
The functional currency is not necessarily the currency of the country in which the entity operates
or is based, as the next example shows.
Example: Presentation and functional currencies

P is a UK-registered mining company whose shares are traded on the London Stock Exchange. Its
operating activities take place in the gold and diamond mines of South Africa.
(a) What is the presentation currency of P?
(b) What is its functional currency?
(c) P bought specialised mining equipment from the US, invoiced in US dollars. What type of
currency is the US dollar, using the IAS 21 definitions?
Answer
(a) The presentation currency (reporting currency) is sterling (UK pounds). This is a
requirement of the UK financial markets regulator for UK listed companies.
(b) The functional currency is likely to be South African Rand, even though the company is
based in the UK. This is because its operating activities take place in South Africa and so
the company will be economically dependent on the Rand if the salaries of most of its
employees, and most operating expenses and sales are in Rand.
(c) The US dollars are ‘foreign currency’ for the purpose of preparing P’s accounts.
IAS 21 requires P to prepare its financial statements in its functional currency (Rand).
However, P is permitted to use Pound Sterling as its presentation currency. If it does use Sterling
as its presentation currency (which it will do, given the UK rules), the translation of assets and
liabilities from Rand to Sterling must comply with the rules in IAS 21.

1.4 Terms and definitions used in IAS 21: other definitions

Exchange rate definitions
IAS 21 uses the following terms to describe which exchange rate should be used in the
translation.
Definitions
Exchange rate: The rate of exchange between two currencies
Spot rate: The exchange rate at the date of the transaction
Closing rate: The spot exchange rate at the end of the reporting period
For example, suppose that on 16 November a German company buys goods from a US supplier,
and the goods are priced in US dollars. The financial year of the company ends on 31 December,
and at this date the goods have not yet been paid for.
The spot rate is the euro/dollar exchange rate on 16 November, when the transaction occurred.
The closing rate is the exchange rate at 31 December.
Other definitions
IAS 21 also includes some other terms and definitions.
Definitions
Exchange difference: A difference resulting from translating a given number of units of one
currency into another currency at different exchange rates.
Monetary items: Units of currency held and assets and liabilities to be received or paid (in cash),
in a fixed number of currency units. Examples of monetary items include cash itself, loans, trade
payables, trade receivables and interest payable.
Non-monetary items are not defined by IAS 21, but they are items that are not monetary items.
They include tangible non-current assets, investments in other companies, investment properties
and deferred taxation (which is a notional amount of tax rather than an actual amount of tax
payable.)

2 THE INDIVIDUAL ENTITY: ACCOUNTING REQUIREMENTS
Section overview
 Introduction
 Initial recognition: translation of transactions
 Reporting at the end of each reporting period and gain or loss arising on translation
 Reporting at the settlement of a transaction
2.1 Introduction
An individual company may have transactions that are denominated in a foreign currency. These
must be translated into the company’s functional currency for the purpose of recording the
transactions in its ledger accounts and preparing its financial statements.
These transactions may have to be translated on several occasions. When a transaction or asset
or liability is translated on more than one occasion, it is:
translated at the time that it is originally recognised;, and
re-translated at each subsequent occasion.
Re-translation may be required, after the transaction has been recognised initially:
 at the end of a financial year (end of a reporting period);
 when the transaction is settled (which may be either before, or after the end of the financial
year).
On each subsequent re-translation, an exchange difference will occur. This gives rise to a gain or
loss on translation from the exchange difference.
2.2 Initial recognition: translation of transactions

On initial recognition, a transaction in a foreign currency must be translated at the spot rate on
the date of the transaction.
If the company purchases goods on most days in the foreign currency, it might be
administratively difficult to record every transaction at the actual spot rate. For practical reasons,
IAS 21 therefore allows entities to use an average rate for a time period, provided that the
exchange rate does not fluctuate significantly over the period.
For example, an entity might use an average exchange rate for a week or a month for translating
all the foreign currency-denominated transactions in that time period.
These rules apply when an entity:
 buys or sells goods or services that will be paid for in a foreign currency;
 borrows or lends money when the interest payments and repayments of principal are in a
foreign currency;
 purchases or disposes of non-current assets in another currency; or
 receives dividends and other payments in another currency.

Example: Initial recognition

A Pakistani company (with the rupee as its functional currency) has a financial year ending on 31
December.
It buys goods from an Australian supplier (with the Australian dollar as its functional currency) on
1 December 20X6 invoiced in A$10,000.
The Australian supplier is eventually paid in March 20X7.
Exchange rates over the period were as follows:
1 December 20X6 Rs.75/A$1
The purchase/inventory and the trade payable should be recorded initially by translating the
transaction at the spot rate of Rs.75/A$1.
This gives a translated value of Rs. 750,000 for recording in the ledger accounts (Rs.75 
A$10,000).
On 1 December 20X6
Debit Credit
Purchases Rs. 750,000
Payables (Rs. 75  A$10,000) Rs. 750,000
Being the initial recognition of a purchase of inventory in a foreign currency
Note that for practical purposes, if the entity buys items in A$ frequently, it may be able to use an
average spot rate for a period, for all transactions during that period.
For example, if the Pakistani company bought items from Australia on an ongoing basis it might
adopt a policy of translating all purchases in a month at the average rate for that month.
2.3 Reporting at the end of each reporting period and gain or loss arising on translation
Transactions in a foreign currency are recognised initially at the spot rate on the date of the
transaction.
Balances resulting from such transactions may still ‘exist’ in the statement of financial position at
the end of the financial period.
Exchange rates change over time and the exchange rate at the end of the reporting period will
not be the same as the spot rate on the date of the transaction.
Retranslation of items at a later date will lead to gains or losses if the rates have moved.
The gain or loss is the difference between the original and re-translated value of the item.
There is an exchange gain when an asset increases in value on re-translation, or when a liability
falls in value.
There is an exchange loss when an asset falls in value on re-translation, or when a liability
increases in value.
The rules in IAS 21 for reporting assets and liabilities at the end of a subsequent reporting period
make a distinction between:
 monetary items, such as trade payables and trade receivables, and
 non-monetary items, such as non-current assets and inventory.

The rules are as follows, for entities preparing their individual financial statements:
Asset or liability Accounting treatment Treatment of exchange difference

Monetary items Re-translate at the closing Recognised in P&L
rate.
Non-monetary items No re-translation. The Not applicable
carried at cost transaction is left at the
original spot rate.
Non-monetary items Re-translate at the exchange Recognised in the same location
carried at fair value rate ruling at the date of the as the revaluation gain or loss
fair value adjustment.
Example: Subsequent measurement of monetary amount

December.
It buys inventory from an Australian supplier (with the Australian dollar as its functional currency)
on 1 December 20X6 invoiced in A$10,000.
The Australian supplier is eventually paid in March 20X7.
The transaction would be recorded as follows:
On 1 December 20X6
Debit Credit
Purchases Rs. 750,000
Payables (Rs. 75  A$10,000) Rs. 750,000
Being the initial recognition of a purchase of inventory in a foreign currency
On 31 December 20X6
Debit Credit
Statement of profit or loss Rs. 30,000
Payables Rs. 30,000
Being the recognition of the exchange loss arising on the retranslation of a

payable denominated a foreign currency.
Working
Rs.
Liability on initial recognition 750,000
Exchange loss (balancing figure) 30,000
Liability on retranslation at the year-end
(Rs. 78  A$10,000) 780,000

In the above example the Pakistani company had purchased inventory. Even if this were still held
at the year-end it would not be retranslated as it is a non-monetary asset.
Sometimes there might be a movement on the carrying amount of a balance denominated in a
foreign currency during a period. The exchange difference could be calculated by applying the
above approach. However, this can be time consuming where there is a lot of movements. An
easier approach is to find the exchange difference as a balancing figure.
Example: Retranslation of monetary item with movement on the account

A Pakistani company whose functional currency is the rupee paid $90,000 into a dollar account
on 30 June.
The company paid an additional $10,000 into the account on 30 September.
There were no other movements on this account.
30 June: Rs.100/$.
30 September Rs.99/$.
31 December (year-end): Rs.95/$.
The exchange difference arising at 31 December can be calculated as follows:
Exchange difference: gain or (loss)
a On re-translating June amount Rs. Rs.
$90,000 at rate of 100 9,000,000
$90,000 at closing rate of 95 8,550,000
Exchange loss 450,000
b On re-translating September amount:
$10,000 at average rate of 99 990,000
$10,000 at closing rate of 95 950,000
There is an exchange loss because the company has a dollar asset but the dollar has weakened
against the rupee over the period.
This approach might be cumbersome if there are more than a few movements on an account.
The following approach simply records all items at the appropriate rates and identifies the
exchange difference as a balancing figure.
$ Rate Rs.
Balance at start (30 June) 90,000 100 9,000,000
Amount paid in (30 Sept.) 10,000 99 990,000
Exchange loss (490,000)
Balance at end (31 Dec.) 100,000 95 9,500,000

Example: Retranslation of monetary item with movement on the account

A Pakistani company whose functional currency is the rupee borrowed $90,000 on 30 June.
The company recognised an interest accrual of $10,000 at its year-end (31 December).
There were no other movements on this account.
30 June: Rs.100/$.
Average for the period Rs.99/$.
31 December (year-end): Rs.95/$.
There is no rule in IAS 21 as to what rate should be used for the accrual of interest. The accrual
could be deemed to arise over the period in which case the average rate would be used or it
could be treated as a year-end transaction in which case the closing rate would be used. The
profit for the period is not affected by the choice of rate as there would be a compensating
adjustment in the amount of the exchange difference.
This is demonstrated below.
Exchange difference (interest at closing rate)
$ Rate Rs.
Interest 10,000 95 950,000
Exchange gain (450,000)
Exchange difference (interest at average rate)

$ Rate Rs.
Interest 10,000 99 990,000
Exchange gain (490,000)

There is an exchange gain because the company has a dollar liability but the dollar has
weakened against the rupee over the period.
The balancing figure approach can be used in any situation where there are movements on an
amount denominated in a foreign currency.
For example, when consolidating foreign subsidiaries the parent consolidated the subsidiary’s net
assets at the start of the period (in last year’s consolidated statement of financial position) and its
profit for the period (in this year’s consolidated statement of profit or loss. These two figures will
sum to the subsidiary’s net assets at the end of the period in the foreign currency but not when
translated into rupees. The difference is an exchange gain or loss.
This will be covered in a later section.
Revaluations of non-current assets
A non-current asset in a foreign currency might be re-valued during a financial period.
For example, a Pakistani company might own an office property in Thailand. The cost of the
office would have been translated at the spot rate when the property was originally purchased.
However, it might subsequently have been revalued. The revaluation will almost certainly be in
Thai baht. This revalued amount must be translated into the functional currency of the entity (in
this example, rupees).

Any gain or loss arising on retranslation of this property is recognised in the same place as the
gain or loss arising on the revaluation that led to the retranslation.
If a revaluation gain had been recognised in other comprehensive income in accordance with IAS
16, the exchange difference would also be recognised in other comprehensive income.
If a revaluation gain had been recognised in profit or loss in accordance with IAS 40, the
exchange difference would also be recognised in profit or loss.
Example: Subsequent measurement of monetary amount

December.
It bought a building in Bahrain on 1 December 20X6 for 100,000 Bahraini dinar (BD).
The building was revalued to BD 120,000 on 31 December 20X6 as permitted by IAS 16.
Exchange rates:
1 December 20X6 Rs.275/BD1
31 December 20X6 Rs.290/BD1
The transaction would be recorded as follows:
On 1 December 20X6
Debit Credit
Property, plant and equipment 27,500,000
Payables (Rs. 275  BD100,000) 27,500,000
Being the initial recognition of building bought in a foreign currency

On 31 December 20X6
Debit Credit
Property, plant and equipment
(5,800,000 + 1,500,000) 7,300,000
Other comprehensive income 7,300,000
Being the recognition of revaluation gain and exchange gain on retranslation of
carrying amount of a building denominated a foreign currency.
Working
BD Rate Rs.
Building on initial recognition 100,000 275 27,500,000
Revaluation (year-end) 20,000 290 5,800,000
Exchange gain 1,500,000
Building at year end 120,000 290 34,800,000
If the building was an investment property, revalued following the rules in IAS 40 the credit of
Rs.7,300,000 would be to the statement of profit or loss.

Practice question 1
A Pakistani company bought a machine from a German supplier for €200,000 on 1
March when the exchange rate was Rs. 120/€.
By 31 December, the end of the company’s accounting year, the exchange rate was Rs.
110/€.
At 31 December, the Pakistani company had not yet paid the German supplier any of
the money that it owed for the machine.
Required
Show the amounts that must be recognised to record this transaction.
2.4 Reporting at the settlement of a transaction

The settlement of a foreign currency transaction involves a receipt or payment in foreign
currency. The receipt or payment is a transaction in its own right and must be recorded at the
rate ruling at the date of the receipt or payment.
There will be exchange difference when the exchange rate at the date of settlement is different to
that at the date of initial recognition of the receivable or payable in question. This is recognised in
the statement of profit or loss.
Example: Settlement of a transaction

A Pakistani company sells goods to a customer in Saudi Arabia for SR 72,000 on 12 September,
when the exchange rate was Rs.28/SR (Saudi riyal).
It received payment on 19 November, when the exchange rate was Rs.30/SR.
The financial year-end is 31 December.
The sale will be initially translated at the spot rate giving rise to revenue and receivables of Rs.
2,016,000 (SR 72,000  Rs.28).
The receipt of the payment is recorded at Rs. 2,160,000 (SR 72,000  Rs.30).
The necessary double entries are as follows:
On 19 September
Debit Credit
Receivables 2,016,000
Revenue 2,016,000
On 19 November
Debit Credit
Cash 2,160,000
Receivables 2,016,000
Exchange gain (statement of profit or loss) 144,000


10
CHAPTER
IAS 38: Intangible Assets
Contents
1 IAS 38: Intangible assets – Introduction
2 Internally-generated intangible assets
3 Intangible assets acquired in a business combination
4 Measurement after initial recognition
5 Disclosure requirements

1 IAS 38: INTANGIBLE ASSETS - INTRODUCTION

Section overview
 Introduction
 Scope
 Definition of an intangible asset
 Recognition criteria for intangible assets
 Separate acquisition
 Exchange transactions
 Granted by government
 Subsequent expenditure on intangible assets
1.1 Introduction
An intangible asset is non-physical asset that has a useful life of greater than one year or
has an indefinite useful life. IAS 38: Intangible assets sets out rules on the recognition,
measurement and disclosure of intangible assets. It was developed from the viewpoint that there
should be no real difference in how tangible and intangible assets are accounted for. However,
there is an acknowledgement that it can be more difficult to identify the existence of an intangible
asset so IAS 38 gives broader guidance on how to do this when an intangible asset is acquired
through a variety of means.
IAS 38:
 requires intangible assets to be recognised in the financial statements if, and only if,
specified criteria are met and explains how these are applied however an intangible asset
is acquired.
 A key issue with expenditure on ‘intangible items’ is whether it should be treated as
an expense and included in full in profit or loss for the period in which incurred, or
whether it should be capitalised and treated as a long-term asset.
 IAS 38 sets out criteria to determine which of these treatments is appropriate in
given circumstances.
 explains how to measure the carrying amount of intangibles assets when they are first
recognised and how to measure them at subsequent reporting dates;
 Most types of long-term intangible asset are ‘amortised’ over their expected useful
life. (Amortisation of intangible assets is the equivalent of depreciation of tangible
non-current assets.)
 sets out disclosure requirements for intangible assets in the financial statements.
1.2 Scope
IAS 38 applies to all intangible assets, except those that are within the scope of another
standard. For example, IAS 38 does not apply to the following:
 intangible assets held by an entity for sale in the ordinary course of business (IAS 2:
Inventories);
 deferred tax assets (IAS 12: Income taxes);
 leases that are within the scope of IFRS 16: Leases;
 assets arising from employee benefits (IAS 19: Employee Benefits);
 financial assets (as defined in IAS 32: Financial assets: presentation);
 financial assets recognised and measured in accordance with IFRS 10: Consolidated
financial statements, IAS 27: Separate financial statements and IAS 28: Investments in
associates and joint ventures;

Chapter 10: IAS 38: Intangible assets
 goodwill acquired in a business combination (IFRS 3: Business combinations);

 contracts within the scope of IFRS 17 Insurance Contracts;
 non-current intangible assets classified as held for sale (or included in a disposal group
that is classified as held for sale) (IFRS 5: Non-current assets held for sale and
discontinued operations); and
 assets arising from contracts with customers that are recognised in accordance with IFRS
15: Revenue from contracts with customers.
In addition the following are also excluded specifically from the scope of IAS 38:
 the recognition and measurement of exploration and evaluation assets (see IFRS 6:
Exploration for and evaluation of mineral resources); and
 expenditure on the development and extraction of minerals, oil, natural gas and similar
non-regenerative resources.
1.3 Definition of an intangible asset
Definitions
An asset: A resource controlled by the company as a result of past events and from which future
economic benefits are expected to flow.
Intangible asset: An identifiable, non-monetary asset without physical substance’
Expenditure on an intangible item must satisfy both definitions before it can be considered to be
an asset.
Commentary on the definitions
Control
The existence of control is useful in deciding whether an intangible item meets the criteria for
treatment as an asset.
Control means that a company has the power to obtain the future economic benefits flowing from
the underlying resource and also can restrict the access of others to those benefits.
Control would usually arise where there are legal rights, for example legal rights over the use of
patents or copyrights. Ownership of legal rights would indicate control over them. However, legal
enforceability is not a necessary condition for control.
For tangible assets such as property, plant and equipment, the asset physically exists and the
company controls it. However, in the case of an intangible asset, control may be harder to
achieve or prove.
In the absence of legal rights to protect, an entity usually has insufficient control over the
expected future economic benefits, for example, a team of skilled staff, or customer relationships
and loyalty.
Some companies have tried to capitalise intangibles such as the costs of staff training or
customer lists on the basis that they provide access to future economic benefits. However, these
would not be assets as they are not controlled.
 Staff training: Staff training creates skills that could be seen as an asset for the employer.
However, staff could leave their employment at any time, taking with them the skills they
have acquired through training.
 Customer lists: Similarly, control is not achieved by the acquisition of a customer list, since
most customers have no obligation to make future purchases. They could take their
business elsewhere.

Illustration: Team of skilled staff

A company might have a team of skilled staff and may be able to identify incremental staff
skills leading to future economic benefits from training and expect that the staff will
continue to make their skills available to the company.
However, staff could leave their employment at any time, taking with them the skills they
have acquired through training. Therefore, a company usually has insufficient control over
the expected future economic benefits for these items to meet the definition of an
intangible asset.
Illustration: Customer lists

A company may have a portfolio of customers which it expects to continue to trade with the
company. In the absence of legal rights to protect the relationship, the company usually has
insufficient control over the expected economic benefits to meet the definition of an
intangible asset.
However, exchange transactions for the same or similar non-contractual customer
relationships provide evidence that the company is able to control those benefits in the
absence of such legal rights.
Such exchange transactions also provide evidence that the customer relationship is
separable so, thus meeting the intangible asset definition.
This means that a purchased customer list would usually be capitalised.
Future economic benefits

These may include revenues and/or cost savings.
Evidence of the probability that economic benefits will flow to the company may come from:
 market research;
 feasibility studies; and,
 a business plan showing the technical, financial and other resources needed and how the
company will obtain them.
Need to be identifiable
An intangible asset must also be ‘identifiable’. Intangibles, by their very nature, do not physically
exist. It is therefore important that this ‘identifiability test’ is satisfied.
IAS 38 states that to be identifiable an intangible asset:
 must be separable; or
 must arise from contractual or other legal rights.
To be separable, the intangible must be capable of being separated or divided from the
company, and sold, transferred, licensed, rented or exchanged.
Many typical intangibles such as patent rights, copyrights and purchased brands would meet this
test, (although they might fail other recognition criteria for an intangible asset).
Without physical substance
Non-physical form increases the difficulty of identifying the asset.
Certain intangible assets may be contained in or upon an article which has physical substance
(e.g. floppy disc). Whether such assets are treated as tangible or intangible requires. This
judgement is based on which element is the most significant.
 Computer software for a computer controlled machine tool that cannot operate without that
specific software is an integral part of the related hardware and it is treated as property,
plant and equipment. The same applies to the operating system of a computer.

 Computer software, other than the operating system, is an intangible asset. The same
applies to licences, patents or motion picture films acquired or internally generated by the
reporting company.
Identifiable assets that result from research and development activities are intangible assets
because any physical element of those assets (for example, a prototype) is secondary to the
knowledge that is the primary outcome of those activities.
Example:
Ateeq Ltd acquires new technology that will significantly reduce its energy costs for
manufacturing. Costs incurred include:
Amount in Rs.
Cost of new technology 1,500,000
Trade discount provided 200,000
Training course for staff in new technology 70,000
Initial testing of new technology 20,000
Losses incurred while other parts of plant shutdown
during testing and training. 30,000
The cost that can be capitalised is:

Cost of a new technology 1,500,000
Less discount (200,000)
Plus initial testing 20,000
1,320,000
The prominent types of intangibles are described below:

Patent
Patent rights entitle their owners, for limited period of time, the monopoly to manufacture or use a
certain product or process.
Trademark
Trademarks are the exclusive rights to proprietary symbols, names, and other unique properties
of a product, such as packaging, style, and even color in some instances.
Copyright
Copyrights represent the legal right on both published and unpublished work of an author to sell,
copy, or perform a piece of literary, musical, or art work. Copyrights protect the works
from reproduction or derivative use without the consent from the copyright owner (usually the
author or publisher).
License
Licenses are the contractual rights to use another's property, whether it be a patent, trademark,
copyright, lease or exploration for natural resources.
Franchise
Franchises provide their holders with the right to practice a certain kind of business in a certain
geographical location as sanctioned by the franchiser. Fast-food restaurants, for example, often
expand by selling franchise rights.
Goodwill
Goodwill refers to the price or value above the market value of the tangible assets of a company.
When a company is bought, the price paid will often be higher than the market value of its
facilities, equipment, inventory etc. A company develops this intangible asset by establishing a
strong business track record, credit rating, reputation and name.

1.4 Recognition criteria for intangible assets

Introduction
If an intangible item satisfies the definitions it is not necessarily recognised in the financial
statements. In order to be recognised it must satisfy the recognition criteria for intangible assets.
If an item meets the definitions of being an asset, and being intangible, certain recognition criteria
must be applied to decide whether the item should be recognised as an intangible asset.
Recognition
An intangible asset is recognised when it:
 complies with the definition of an intangible asset; and,
 meets the recognition criteria set out below.
Recognition criteria
An intangible asset must be recognised if (and only if):
 it is probable that future economic benefits specifically attributable to the asset will flow to
the company; and,
 the cost of the asset can be measured reliably.
The probability of future economic benefits must be assessed using reasonable and supportable
assumptions that represent management’s best estimate of the set of economic conditions that
will exist over the useful life of the asset.
These recognition criteria are broadly the same as those specified in IAS 16 for tangible non-
current assets.
Measurement
An intangible asset must be measure at cost when first recognised.
Means of acquiring intangible assets
A company might obtain control over an intangible resource in a number of ways. Intangible
assets might be:
 purchased separately;
 acquired in exchange for another asset;
 given to a company by way of a government grant.
 internally generated; or
 acquired in a business combination;
IAS 38 provides extra guidance on how the recognition criteria are to be applied and/or how the
asset is to be measured in each circumstance.
1.5 Separate acquisition

Recognition guidance
The probability recognition criterion is always satisfied for separately acquired intangible assets.
The price paid to acquire separately an intangible asset normally reflects expectations about the
probability that the future economic benefits embodied in the asset will flow to the company. The
effect of the probability is reflected in the cost of the asset.
Also the cost of a separately acquired intangible asset can usually be measured reliably
especially when the purchase consideration is in the form of cash or other monetary assets.

Cost guidance
Cost is determined according to the same principles applied in accounting for other assets.
The cost of a separately acquired intangible asset comprises:
 its purchase price, including any import duties and non-refundable purchase taxes, after
deducting any trade discounts and rebates; and
 any directly attributable expenditure on preparing the asset for its intended use. For
example:
 costs of employee benefits (as defined in IAS 19, Employee Benefits) arising directly
from bringing the asset to its working condition;
 professional fees for legal services; and
 costs of testing whether the asset is functioning properly.
The recognition of costs ceases when the intangible asset is in the condition necessary for it to
be capable of operating in the manner intended by management.
Deferred payments are included at the cash price equivalent and the difference between this
amount and the payments made are treated as interest.
1.6 Exchange transactions

An intangible asset may be acquired in exchange or part exchange for another intangible asset
or another asset.
The cost of such items is measured at fair value unless:
 the exchange transaction lacks commercial substance; or,
 the fair value of neither the asset received nor the asset given up is reliably measurable.
If the acquired item is not measured at fair value it is measured at the carrying amount of the
asset given up.
Note, that these rules are the same as those described for tangible assets in an earlier chapter.
1.7 Granted by government

A government transfers or allocates intangible assets such as airport landing rights, licences to
operate radio or television stations, import licences or quotas or rights to access other restricted
resources.
An intangible asset may be acquired free of charge, or for nominal consideration, by way of a
government grant.
IAS 20: Accounting for Government Grants and Disclosure of Government Assistance, allows the
intangible asset and the grant to be recorded at fair value initially or at a nominal amount plus
any expenditure that is directly attributable to preparing the asset for its intended use.
1.8 Subsequent expenditure on intangible assets

Subsequent expenditure is only capitalised if it can be measured and attributed to an asset and
enhances the value of the asset. This would rarely be the case:
 The nature of intangible assets is such that, in many cases, there are no additions to such
an asset or replacements of part of it.
 Most subsequent expenditure is likely to maintain the expected future economic benefits
embodied in an existing intangible asset rather than meet the definition of an intangible
asset and the recognition criteria.
 Also it is often difficult to attribute subsequent expenditure directly to a particular intangible
asset rather than to the business as a whole.
Maintenance expenditure is expensed out in profit or loss account.

2 INTERNALLY GENERATED INTANGIBLE ASSETS

Section overview
 Internally-generated intangible items

 Research and development
 Accounting treatment of development costs
 SIC 32: Intangible assets – Web site costs
2.1 Internally-generated intangible items

An internally-generated intangible asset is created by a company through its own efforts. (An
internally-generated asset differs from an acquired asset that has been purchased from an
external seller.) For example, a publishing company may build up legal copyrights by publishing
books.
It can sometimes be difficult for a company to assess whether an internally-generated asset
qualifies for recognition as an asset in the financial statements because:
 it is not identifiable: or
 its cost cannot be determined reliably.
Recognition prohibited
IAS 38 prohibits the recognition of the following internally-generated intangible items:
 goodwill
 brands
 mastheads (Note: a masthead is a recognisable title, usually in a distinctive typographical
form, appearing at the top of an item. An example is a newspaper masthead on the front
page of a daily newspaper)
 publishing titles
 customer lists.
Recognition of these items as intangible assets when they are generated internally is prohibited
because the internal costs of producing these items cannot be distinguished separately from the
costs of developing and operating the business as a whole.
Note that any of these items would be recognised if they were purchased separately.
Other internally generated intangibles
IAS 38 provides further guidance on how to assess whether other internally generated
intangibles assets meet the criteria for recognition.
2.2 Research and development

The term ‘research and development’ is commonly used to describe work on the innovation,
design, development and testing of new products, processes and systems.
Assessment of whether an internally generated intangible asset meets the criteria for recognition
requires a company to classify the generation of the asset into:
 a research phase; and
 a development phase.
If the research phase cannot be distinguished from the development phase the expenditure on
the project is all treated as that incurred on the research phase.
Research phase
Definition: Research
Research is original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge and understanding.

Examples of research activities include:

 Activities aimed at obtaining new knowledge.
 The search for and evaluation of applications of knowledge obtained from research.
 The search for alternative materials, products or processes.
 The formulation and testing of possible alternatives for new materials, products or
processes.
Research costs cannot be an intangible asset. Expenditure on research should be recognised as
an expense as it is incurred and included in profit or loss for the period.
Development phase
Definition: Development
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.
Examples of development activities include:

 The design, construction and testing of pre-production prototypes and models.
 The design of tolls involving new technology.
 The construction and operation of a pilot plant that is not large enough for economic
commercial production.
 The design, construction and testing of new materials, products or processes.
2.3 Accounting treatment of development costs

Development costs are capitalised when they meet certain further criteria. (These comprise more
detailed guidance on whether it is probable that future economic benefits from the asset will flow
to the entity and whether the cost can be measured reliably).
Development costs must be recognised as an intangible asset, but only if all the following
conditions can be demonstrated.
 It is technically feasible to complete the development project.
 The company intends to complete the development of the asset and then use or sell it.
 The asset that is being developed is capable of being used or sold.
 Future economic benefits can be generated. This might be proved by the existence of a
market for the asset’s output or the usefulness of the asset within the company itself.
 Resources are available to complete the development project.
 The development expenditure can be measured reliably (for example, via costing records).
If any one of these conditions is not met, the development expenditure must be treated in the
same way as research costs and recognised in full as an expense when it is incurred.
Only expenditure incurred after all the conditions have been met can be capitalised.
Once such expenditure has been written off as an expense, it cannot subsequently be reinstated
as an intangible asset.
Example:
Company Q has undertaken the development of a new product. Total costs to date have been Rs.
800,000. All of the conditions for recognising the development costs as an intangible asset have
now been met.
However, Rs. 200,000 of the Rs. 800,000 was spent before it became clear that the project was
technically feasible, could be resourced and the developed product would be saleable and profitable.

Development costs.
The Rs. 200,000 incurred before all of the conditions for recognising the development costs as an
intangible asset were met must be written off as an expense.
The remaining Rs. 600,000 should be capitalised and recognised as an intangible asset
(development costs).
Initial measurement
The cost of an internally generated intangible asset is the sum of expenditure incurred from the
date when the intangible asset first meets the recognition criteria for such assets.
Expenditure recognised as an expense in previous annual financial statements or interim
financial reports may not be capitalised.
The cost of an internally generated intangible asset comprises all expenditure that can be directly
attributed, and is necessary to creating, producing, and preparing the asset for it to be capable of
operating in the manner intended by management.
Where applicable cost includes:
 expenditure on materials and services used or consumed;
 the salaries, wages and other employment related costs of personnel directly engaged in
generating the asset; and
 any expenditure that is directly attributable to generating the asset.
In addition, IAS 23 specifies criteria for the recognition of interest as an element of the cost of an
internally generated intangible asset. The IAS 23 guidance was covered in the previous chapter.
Costs that are not components of cost of an internally generated intangible asset include:
 selling and administration overhead costs;
 initial operating losses incurred;
 costs that have previously been expensed, (e.g., during a research phase) must not be
reinstated; and, training expenditure.
2.4 SIC 32: Intangible assets – Web site costs

Issue
An entity may incur expenditure on the development and operation of its own web site for internal
or external access.
The issues are:
 whether the web site is an internally generated intangible asset that is subject to the
requirements of IAS 38; and
 the appropriate accounting treatment of such expenditure.
SIC 32 does not apply to expenditure on
 purchasing, developing, and operating hardware (e.g. web servers, staging servers,
production servers and internet connections). IAS 16 applies.
 an internet service provider hosting the entity’s web site. (This expenditure is recognised
as an expense as and when the services are received).
 the development or operation of a web site for sale to another entity.
SIC 32 must be applied by the:
 lessor of web site when it is leased under an operating lease, and
 lessee of the web site when it is leased under a finance lease.
The operating stage begins once development of a web site has been completed. During this
stage, an entity maintains and enhances the applications, infrastructure, graphical design and
content of the web site.

Consensus
An entity’s own web site is an internally generated intangible asset that is subject to the
requirements of IAS 38. It should be recognised as an intangible asset if it satisfies the IAS 38
recognition criteria.
If a web site is developed solely (or primarily) for promoting and advertising its own products and
services then an entity will not be able to demonstrate how it will generate probable future
economic benefits. All expenditure on developing such a web site should be recognised as an
expense when incurred.
The nature of each activity for which expenditure is incurred (e.g. training employees and
maintaining the web site) and the web site’s stage of development or post development should
be evaluated to determine the appropriate accounting treatment
The best estimate of a web site’s useful life should be short.
SIC 32 identifies several stages in the development of a web site and provides guidance on the
accounting treatment that is appropriate for each stage.
Stage Activities Accounting treatment
Planning Feasibility studies Expense when incurred
(This stage is Defining hardware and software specifications
similar in nature to
Evaluating alternative products and suppliers
the research
phase) Selecting preferences
Application and Obtaining a domain name Expense when incurred,

infrastructure Developing operating software (e.g. operating unless the expenditure
development* system and server software) meets the IAS 38
(This stage is recognition criteria.
Developing code for the application
similar in nature to
the development Installing developed applications on the web
phase) server
Stress testing
Graphical design Designing the appearance of web pages See above
development*
Content Creating, purchasing, preparing and See above
development* uploading information on the web site before
the completion of the web site’s development.
Operating Updating graphics and revising content Expense when incurred,
Adding new functions, features and content unless it meets the IAS
38 criteria for the
Registering the web site with search engines
capitalisation of
Backing up data subsequent expenditure
Reviewing security access (this will only occur in
Analysing usage of the web site rare circumstances).
Other Selling, administrative and other general Expense when incurred

overhead expenditure unless it can be directly
attributed to preparing the web site for use
Inefficiencies and initial operating losses
incurred
Training employees to operate the web site
* These will be capitalised only when the purpose of building a web site is solely promotion of the
business (marketing purpose).

3 INTANGIBLE ASSETS ACQUIRED IN A BUSINESS COMBINATION

Section overview
 Recognition guidance
 Cost guidance
 In-process research and development
This section relates to intangible assets acquired when a company (the acquirer) buys a
controlling interest in another company (the acquiree). The section largely relates to the
recognition of intangibles in the consolidated financial statements of the parent.
3.1 Recognition guidance

Any intangible asset identified in a business combination will be recognised as both recognition
criteria are deemed to be recognised.
The probability recognition criterion always considered to be satisfied for intangible assets
acquired in business combinations. This is because the fair value of an intangible asset reflects
expectations about the probability that the expected future economic benefits embodied in the
asset will flow to the company. In other words, the entity expects there to be an inflow of
economic benefits.
The reliable measurement criterion is always considered to be satisfied for intangible assets
acquired in business combinations. If an asset acquired in a business combination is separable
or arises from contractual or other legal rights, sufficient information exists to measure reliably
the fair value of the asset.
Commentary
This means that an intangible asset that was not recognised in the financial statements of the
new subsidiary might be recognised in the consolidated financial statements.
Illustration:
Company X buys 100% of Company Y.
Company Y owns a famous brand that it launched several years ago.
Analysis
The brand is not recognised in Company Y’s financial statements (IAS 38 prohibits the recognition
of internally generated brands).
From the Company X group viewpoint the brand is a purchased asset. Part of the consideration paid
by Company X to buy Company Y was to buy the brand and it should be recognised in the
consolidated financial statements.
Examples of intangible assets

The following are all items that would meet the definition of an intangible asset if acquired in a
business combination.
 Market related intangibles
 Trademarks, trade names, service marks, collective marks and certification marks;
 Internet domain names;
 Newspaper mastheads; and
 Non-competition agreements
 Customer related intangibles
 Customer lists;
 Order or production backlog;
 Customer contracts and the related customer relationships; and

 Artistic related intangibles

 Plays, operas and ballets;
 Books, magazines, newspapers and other literary works;
 Musical works (compositions, song lyrics and advertising jingles);
 Pictures and photographs; and
 Video and audio visual material:
 Music videos; and
 Television programmes
 Contract based intangibles
 Licensing and royalty agreements;
 Construction permits;
 Franchise agreements
 Operating and broadcasting rights;
 Use rights such as drilling, water, air, mineral, timber-cutting and route authorities;
 Technology based intangibles
 Patented and unpatented technology;
 Computer software and databases; and
 Trade secrets (secret formulas, processes, recipes)
3.2 Cost guidance

If an intangible asset is acquired in a business combination, its cost is the fair value at the
acquisition date.
If cost cannot be measured reliably then the asset will be subsumed within goodwill.
3.3 In-process research and development

Another similar example involves in-process research and development
The acquiree might have a research and development project in process. Furthermore, it might
not recognise an asset for the project because the recognition criteria for internally generated
intangible assets have not been met.
However, the acquirer would recognise the in-process research and development as an asset in
the consolidated financial statements as long as it:
 meets the definition of an asset; and
 is identifiable, i.e. is separable or arises from contractual or other legal rights.
Illustration:
Company X buys 100% of Company Y.
Company Y has spent Rs. 600,000 on a research and development project. This amount has all
been expensed as the IAS 38 criteria for capitalising costs incurred in the development phase of a
project have not been met. Company Y has knowhow as the result of the project.
Company X estimates the fair value of Company Y’s knowhow which has arisen as a result of this
project to be Rs. 500,000.

Analysis
The in-process research and development is not recognised in Company Y’s financial statements
(IAS 38 prohibits the recognition of internally generated brands).
From the Company X group viewpoint the in-process research and development is a purchased
asset. Part of the consideration paid by Company X to buy Company Y was to buy the knowhow
resulting from the project and it should be recognised in the consolidated financial statements at
its fair value of Rs. 500,000.
Subsequent expenditure on an acquired in-process research and development project

Expenditure incurred on an in-process research or development project acquired separately or in
a business combination and recognised as an intangible asset is accounted for in the usual way
by applying the IAS 38 recognition criteria.
This means that further expenditure on such a project would not be capitalised unless the criteria
for the recognition of internally generated intangible assets were met.
Illustration:
Continuing the previous example. Company X owns 100% of Company Y and has recognised an
intangible asset of Rs. 500,000 as a result of the acquisition of the company.
Company Y has spent a further Rs. 150,000 on the research and development project since the
date of acquisition. This amount has all been expensed as the IAS 38 criteria for capitalising costs
incurred in the development phase of a project have not been met.
Analysis
The Rs. 150,000 expenditure is not recognised in Company Y’s financial statements (IAS 38
prohibits the recognition of internally generated brands).
From the Company X group viewpoint, further work on the in-process research and development
project is research and the expenditure of Rs. 150,000 must be expensed.

4 MEASUREMENT AFTER INITIAL RECOGNITION

Section overview
 Choice of policy
 Revaluation model
 Amortisation of intangible assets
 Disposals of intangible assets
4.1 Choice of policy

Intangible assets are recognised at cost when first acquired.
IAS 38 allows a business to choose one of two measurement models as its accounting policy for
property, intangible assets after acquisition. The same model should be applied to all assets in
the same class.
The two measurement models for intangible assets after acquisition are:
 cost model (i.e. cost less accumulated amortisation); and
 revaluation model (i.e. revalued amount less accumulated amortisation since the most
recent revaluation).
Class of assets
The same model should be applied to all assets in the same class. A class of intangible assets is
a grouping of assets of a similar nature and use in an entity’s operations. Examples of separate
classes may include:
 brand names;
 mastheads and publishing titles;
 computer software;
 licences and franchises;
 copyrights, patents and other industrial property rights, service and operating rights;
 recipes, formulae, models, designs and prototypes; and
 intangible assets under development.
Cost model
An intangible asset is carried at its cost less any accumulated amortisation and any accumulated
impairment losses after initial recognition.
4.2 Revaluation model

Intangible assets can be revalued according to the same rules as those applied to the revaluation
of property, plant and equipment. These were explained in detail in IAS 16 at CAF – 05 so will be
covered in less detail here.
An intangible asset is carried at a revalued amount, (its fair value at the date of the revaluation
less any subsequent accumulated amortisation and any accumulated impairment losses).
This is only allowed if the fair value can be determined by reference to an active market in that
type of intangible asset.
Definition: Active market

An active market is a market in which all the following conditions exist:
(a) the items traded in the market are homogeneous;
(b) willing buyers and sellers can normally be found at any time; and
(c) prices are available to the public.

Active markets for intangible assets are rare. Very few companies revalue intangible assets in
practice.
The requirement that intangible assets can only be revalued with reference to an active market is
a key difference between the IAS 16 revaluation rules for property, plant and equipment and the
IAS 38 revaluation rules for intangible assets.
An active market for an intangible asset might disappear. If the fair value of a revalued intangible
asset can no longer be measured by reference to an active market the carrying amount of the
asset going forward is its revalued amount at the date of the last revaluation less any subsequent
accumulated amortisation and impairment losses.
Frequency of revaluations
Revaluations must be made with sufficient regularity so that the carrying amount does not differ
materially from its fair value at the reporting date.
The frequency of revaluations should depend on the volatility in the value of the assets
concerned. When the value of assets is subject to significant changes (high volatility), annual
revaluations may be necessary.
However, such frequent revaluations are unnecessary for items subject to only insignificant
changes in fair value. In such cases it may be necessary to revalue the item only every three or
five years.
Changing the carrying amount of the asset
When an intangible asset is revalued, any accumulated amortisation at the date of the
revaluation is treated in one of the following ways:
Method 1:
Restate accumulated amortisation proportionately with the change in the gross carrying amount
of the asset so that the carrying amount of the asset after revaluation equals its revalued amount.
Method 2:
 Step 1: Transfer the accumulated amortisation to the asset account. The result of this is
that the balance on the asset account is now the carrying amount of the asset and the
accumulated amortisation account in respect of this asset is zero.
 Step 2: Change the balance on the asset account to the revalued amount.
Accounting for the revaluation
The revaluation is carried out according to the same principles applied in accounting for other
assets.
Realisation of the revaluation surplus
Most intangible assets eventually disappear from the statement of financial position either by
becoming fully amortised or because the company sells them.
If nothing were done this would mean that there was a revaluation surplus on the face of the
statement of financial position that related to an asset that was no longer owned.
IAS 38 allows (but does not require) the transfer of a revaluation surplus to retained earnings
when the asset to which it relates is derecognised (realised).
This might happen over several years as the asset is depreciated or at a point in time when the
asset is sold.
Revaluation of an asset causes an increase in the annual amortisation charge. The difference is
known as excess amortisation (or incremental amortisation:

Excess amortisation is the difference between:

 the amortisation charge on the re-valued amount of the asset, and
 the amortisation that would have been charged on historical cost.
Each year a business might make a transfer from the revaluation surplus to the retained profits
equal to the amount of the excess amortisation.
4.3 Amortisation of intangible assets

A company must assess whether the useful life of an intangible asset is:
 finite or
 indefinite
If the useful life of an intangible asset is assessed as being finite the company must assess its
useful life.
An intangible asset is assessed as having an indefinite useful life when (based on an analysis of
all of the relevant factors) there is no foreseeable limit to the period over which the asset is
expected to generate net cash inflows.
Intangibles with a finite useful life
The depreciable amount of an intangible asset with a finite useful life is allocated on a systematic
basis over its useful life.
Amortisation begins when the asset is available for use, i.e. when it is in the location and
condition necessary for it to be capable of operating in the manner intended by management.
Amortisation ends at the earlier of the date that the asset is classified as held for sale in
accordance with IFRS 5 and the date that the asset is derecognised.
The amortisation method used must reflect the pattern in which the asset's future economic
benefits are expected to be consumed by the entity. If that pattern cannot be determined reliably,
the straight-line method must be used.
The residual value of an intangible asset must be assumed to be zero unless:
 there is a commitment by a third party to purchase the asset at the end of its useful life; or
 there is an active market for the asset and:
 residual value can be determined by reference to that market; and
 it is probable that such a market will exist at the end of the asset's useful life.
The amortisation period and the amortisation method must be reviewed at least at each financial
year-end.
 Where there is a change in the useful life, the carrying amount (cost minus accumulated
amortisation of the asset at the date of change is written off over the (revised) remaining
useful life of the asset.
 Where there is a change in the depreciation method used, this is a change in accounting
estimate. A change of accounting estimate is applied from the time of the change, and is
not applied retrospectively. The carrying amount (cost minus accumulated amortisation) of
the asset at the date of the change is written off over the remaining useful life of the asset.

Intangibles with an indefinite useful life
Where the useful life is assessed as indefinite:

 the intangible asset should not be amortised; but
 impairment reviews should be carried out annually (and even more frequently if there are
any indications of impairment).
The useful life of an intangible asset that is not being amortised must be reviewed each period to
determine whether events and circumstances continue to support an indefinite useful life
assessment for that asset.
If they do not, the change in the useful life assessment from indefinite to finite is accounted for as
a change in an accounting estimate in accordance with IAS 8. This means that the carrying
amount at the date of the change is amortised over the estimated useful life from that date.
4.4 Disposals of intangible assets

The rules for de-recognition of intangible assets (accounting for their ‘disposal’) are the same as
for property, plant and equipment under IAS 16. There is a gain or loss on disposal equal to the
difference between the net disposal proceeds and the carrying value of the asset at the time of
disposal.

5 DISCLOSURE REQUIREMENTS
Section overview
 Disclosure requirements
 Accounting policies
5.1 Disclosure requirements

In the financial statements, disclosures should be made separately for each class of intangible
asset. (Within each class, disclosures must also be made by internally-generated intangibles and
other intangibles, where both are recognised.)
Most of the disclosure requirements are the same as for tangible non-current assets in IAS 16.
The only additional disclosure requirements are set out below.
 Whether the useful lives of the assets are finite or indefinite.
 If the useful lives are finite, the useful lives or amortisation rates used.
 If the useful lives are indefinite, the carrying amount of the asset and the reasons
supporting the assessment that the asset has an indefinite useful life.
Example:
An example is shown below of a note to the financial statement with disclosures about intangible
assets
Internally- generated Software
Goodwill Total
developmen costs Licences
Rs. m Rs. m Rs. m Rs. m
Cost
At the start of the year 290 64 900 1,254
Additions 60 14 - 74
Additions through business - - 20 20
combinations
Disposals (30) (4) - (34)
––– ––– ––– –––––
At the end of the year 320 74 920 1,314
––– ––– ––– –––––
Accumulated amortisation
and impairment losses
At the start of the year 140 31 120 291
Amortisation expense 25 10 - 35
Impairment losses - - 15 15
Accumulated amortisation 10 2 - 12
on disposals
––– ––– –––– ––––
At the end of the year 175 43 135 353
––– ––– –––– ––––
Net carrying amount
At the start of the year 150 33 780 963
––– ––– –––– ––––
At the end of the year 145 31 785 961
––– ––– –––– ––––
 For any intangible asset that is individually material to the financial statements, the
following disclosure is required:
 a description
 its carrying amount
 the remaining amortisation period.
 The total amount of research and development expenditure written off (as an expense)
during the period must also be disclosed.

5.2 Accounting policies

IAS 1 requires the disclosure of accounting policies used that are relevant to an understanding of
the financial statements. Intangible assets might be among the largest numbers in the statement
of financial position and result in significant expense in the statement of profit or loss.
One of the learning outcomes in this area is that you be able to formulate accounting policies for
intangible assets.
There are several areas that are important to explain to users of financial statements.
Amortisation policy
The depreciable amount of an intangible asset must be written off over its useful life.
Formulating a policy in this area involves estimating the useful lives of different categories of
intangible assets.
Under the guidance in IAS 38 the estimated residual values of an asset would usually be zero
and the straight line method would usually be used.
Other explanations:
This is not so much about choosing a policy as explaining situations to users:
 Development expenditure: Does the company have any?
 Intangible assets acquired in business combinations in the period.
 Whether the company has intangible assets assessed as having an indefinite useful life.
Below is a typical note which covers many of the possible areas of accounting policy for
intangible assets.
Illustration: Accounting policy – Intangible assets
The intangible assets of the group comprise patents, licences and computer software.
The group accounts for all intangible assets at historical cost less accumulated amortisation and
accumulated impairment losses.
Computer software
Development costs that are directly attributable to the design and testing of identifiable and unique
software products controlled by the group are recognised as intangible assets when the following
criteria are met:
a. it is technically feasible to complete the software product so that it will be available for use;
b. management intends to complete the software product and use or sell it;
c. there is an ability to use or sell the software product;
d. it can be demonstrated how the software product will generate probable future economic
benefits;
e. adequate technical, financial and other resources to complete the development and to use or
sell the software product are available; and
f. the expenditure attributable to the software product during its development can be reliably
measured.
Directly attributable costs that are capitalised as part of the software product include the software
development employee costs and an appropriate portion of relevant overheads.
Development expenditures that do not meet these criteria are recognised as an expense as
incurred. Costs associated with maintaining computer software programmes are recognised as an
expense as incurred.
Useful lives
Amortisation is calculated using the straight-line method to allocate their cost or revalued amounts
to their residual values over their estimated useful lives, as follows:
Patents: 25 to 30 years
Licenses 5 to15 years
Computer software 3 years
All intangible assets are estimated as having a zero residual value.

11
CHAPTER
IAS 41: Agriculture
Contents
1 IAS 41: Agriculture

1 IAS 41: AGRICULTURE

Section overview
 Scope and definitions

 Accounting treatment
 Government grants
 Disclosure requirements
1.1 Scope and definitions

Scope
IAS 41 Agriculture covers the following agricultural activities:
 biological assets, except for bearer plants;
 agricultural produce at the point of harvest; and
 government grants for agriculture (in certain situations).
IAS 41 does not apply to:
 the harvested agricultural product (IAS 2 Inventory applies);
 land relating to the agricultural activity (IAS 16 or IAS 40 applies);
 bearer plants related to agricultural activity (however, IAS 41 does apply to the produce on
those bearer plants).
 intangible assets related to agricultural activity (IAS 38 Intangible assets applies).
Definitions
The following definitions are relevant to IAS 41:
Definitions
Agricultural activities – the management by an entity of the biological transformation and
harvest of biological assets:
a. for sale; or
b. into agricultural produce; or
c. into additional biological assets.
Biological asset – a living animal or plant, such as sheep, cows, plants, trees and so on.
Biological transformation means the processes of growth, production, degeneration and
procreation that cause changes in the quality or the quantity of a biological asset
Agricultural produce is the harvested product of the entity’s biological assets.
Harvest – the detachment of produce from a biological asset or the cessation of a biological
asset’s life.
Illustration: Definitions
A farmer has a field of lambs (‘biological assets’).
As the lambs grow they go through biological transformation.
As sheep they are able to procreate and lambs will be born (additional biological assets) and the
wool from the sheep provides a source of revenue for the farmer (‘agricultural produce’).
Once the wool has been sheared from the sheep (‘harvested’), IAS 2 requires that it be accounted
for as regular inventory.

Chapter 11: IAS 41: Agriculture
Definitions
A bearer plant is a living plant that:
a. is used in the production or supply of agricultural produce;
b. is expected to bear produce for more than one period; and
c. has a remote likelihood of being sold as agricultural produce, except for incidental scrap
sales.
Illustration: Definitions (further examples)

Products that result
from processiong after
Biological assets Agricultural produce harvest
sheep wool yarn, carpet etc.
trees in a timber plantation felled trees logs, lumber
dairy cattle milk cheese
cotton plants harvested cotton thread, clothing etc.
sugarcane harvested cane sugar
tobacco plants picked leaves cured tobacco
tea bushes picked leaves tea
fruit tress picked fruit processed fruit
oil palm picked fruit palm oil
rubber trees harvested latex rubber products
Plants such as tea bushes, grape vines, oil palms and rubber trees, usually meet the definition of
a bearer plant and are within the scope of IAS 16 Property, Plant and equipment. However, the
produce growing on bearer plants, for example, tea leaves, grapes, oil palm fruit and latex, is
within the scope of IAS 41.
Note that there is no “animal” equivalent of a bearer plant. Thus, cows kept for milk are within the
scope of IAS 41.
1.2 Accounting treatment
Recognition of a biological asset or agricultural produce
An entity should recognise a biological asset or agricultural produce when (and only when):
 the entity controls the asset as a result of past events
 it is probable that future benefits will flow from the asset to the entity, and
 the fair value or cost of the asset can be measured reliably.
Measurement
 A biological asset should be measured initially and subsequently at the end of each
reporting period at its fair value minus ultimate selling costs (unless the fair value
cannot be measured reliably). The gain or loss arising on initial recognition and
subsequent revaluation should be included in profit or loss for the period in which it arises.
 Agricultural produce harvested from an entity’s biological assets is measured at its fair
value minus estimated ultimate selling costs. The gain or loss on initial recognition is
included in the profit or loss for that period. Ultimate selling costs include commissions to
brokers and dealers, levies to regulators, transfer taxes and duties.
 Fair value is the quoted price in an active market. It is presumed that fair values can be
measured reliably for biological assets. If this is not so, the biological asset should be
measured at its cost minus any accumulated depreciation or impairment.

Example: Accounting treatment

Using the earlier example of a sheep farmer, lambs should initially be measured when they are
born at their fair value minus costs to sell.
As they grow and their value changes, this gain or loss should be reflected in the biological asset
value and also in profit and loss.
The sheep may be used for obtaining wool. Once the wool has been sheared from the sheep, as
an agricultural produce the wool should be valued at fair value minus costs to sell.
If the wool is then turned into yarn or carpet its value is then transferred to inventory and IAS 2
will provide any further accounting rules.
1.3 Government grants

Agricultural entities (for example, farms) often benefit from government grants in the form of cash
payments. An unconditional grant relating to a biological asset that is being measured at fair
value less costs to sell should be recognised as income when the grant becomes receivable.
A grant may be dependent on certain conditions being met. For example, the entity may be
asked not to engage in a specific agricultural activity. In such cases, the grant should be
recognised only when the conditions are met.
If the biological asset has been measured at cost because fair value could not be measured
reliably, then the requirements of IAS 20 Accounting for government grants should be applied.
1.4 Disclosure requirements

The IAS 41 disclosure requirements include the following:
 the aggregate gain or loss arising during the current period on initial recognition of
biological assets and agricultural produce and from the change in fair value less costs to
sell of biological assets.
 a description of each group of biological assets;
 information about biological assets whose title is restricted or that are pledged as security
 commitments for development or acquisition of biological assets
 financial risk management strategies
 reconciliation of changes in the carrying amount of biological assets, showing separately
changes in value, purchases, sales, harvesting, business combinations, and foreign
exchange differences;
If fair value cannot be measured reliably, additional required disclosures include:
 description of the assets
 an explanation of the circumstances
 if possible, a range within which fair value is highly likely to lie
 depreciation method
 useful lives or depreciation rates
 gross carrying amount and the accumulated depreciation, beginning and ending
If the fair value of biological assets previously measured at cost now becomes available, certain
additional disclosures are required.
Disclosures relating to government grants include the nature and extent of grants, unfulfilled
conditions, and significant decreases expected in the level of grants.

12
CHAPTER
Financial instruments:
Recognition and measurement
Contents
1 GAAP for financial instruments
2 IFRS 9: Recognition and measurement

Advanced accounting and financial reporting
1 GAAP FOR FINANCIAL INSTRUMENTS

Section overview
 Background
 Definitions
1.1 Background
The rules on financial instruments are set out in three accounting standards:
 IAS 32: Financial instruments: Presentation;
 IFRS 7: Financial instruments: Disclosure; and
 IFRS 9: Financial Instruments
1.2 Definitions
A financial instrument is a contract that gives rise to both:
 A financial asset in one entity, and
 A financial liability or equity instrument in 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 financial asset from another entity; or
 to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favorable to the entity
A financial liability is any liability that is a contractual obligation:
 To deliver cash or another financial asset to another entity; or
 To exchange financial assets or financial liabilities with another entity under conditions that
are potentially unfavourable to the entity.
Financial instruments include:
 Cash/Bank
 Investment in Shares
 Loans
 Debentures/Bonds
 Accounts receivable or accounts payable; and
 Derivatives .
Note: Derivatives are not part of the syllabus at CAF Level.
1.3 Equity instruments

Equity instrument is any contract that evidences a residual interest of an entity after deducting all
of its liabilities.
Investments in equity are measured at fair value through profit or loss only if held for trading.
For all equity instruments not held for trading, a company can make an irrevocable election at
initial recognition to measure an equity investment at fair value through other comprehensive
income.

Chapter 12: Financial instruments: Recognition and measurement
2 IFRS 9: RECOGNITION AND MEASUREMENT

Section overview
 Recognition of financial instruments

 Classification of financial assets
 Other measurement rules
 Classification of financial liabilities
2.1 Recognition of financial instruments

An entity shall recognize a financial asset or a financial liability in its statement of financial
position when, and only when, the entity becomes party to the contractual provisions of the
instrument.
A financial asset might be an investment in debt or in equity.
2.2 Classification of financial assets

Classification determines how financial assets are accounted for and in particular, how they are
measured on an ongoing basis.
A company must classify financial assets as subsequently measured at:
 amortised cost;
 fair value through other comprehensive income; or
 fair value through profit or loss
This classification is made on the basis of both:
 the business model for managing the financial assets and
 the contractual cash flow characteristics of the financial asset.
Financial assets at amortised cost

A financial asset must be measured at amortised cost if both of the following conditions are met:
 the asset is held within a business model whose objective is to hold assets in order to
collect contractual cash flows; and
 the contractual terms of the financial asset give rise on specified dates to cash flows that
are solely payments of principal and interest on the principal amount outstanding.
Financial assets at fair value through other comprehensive income

A financial asset must be measured at fair value through other comprehensive income if both of
the following conditions are met:
 the financial asset is held within a business model whose objective is achieved by both
collecting contractual cash flows and selling financial assets and
 the contractual terms of the financial asset give rise on specified dates to cash flows that
are solely payments of principal and interest on the principal amount outstanding.
Financial assets at fair value through profit or loss

A financial asset must be measured at fair value through profit or loss unless it is measured at
amortised cost or at fair value through other comprehensive income.

Example: Classification of financial assets

A company makes a large bond issue to the market.
Three companies (A Limited, B Limited and C Limited) each buy identical Rs. 10,000,000 bonds.
Company Business model Classification of bond
A Limited A Limited holds bonds for the purpose A Limited must measure the bond
of collecting contractual cash flows to at amortised cost
maturity
B Limited B Limited holds bonds for the purpose B Limited must measure the bond
of collecting contractual cash flows at fair value through OCI
but sells them on the market when
prices are favourable
C Limited C Limited buys bonds to trade in them C Limited must measure the bond
at fair value through P&L
2.3 Other measurement rules

Option to designate a financial asset at fair value through profit or loss
Despite the above, a company may, at initial recognition, irrevocably designate a financial asset
as measured at fair value through profit or loss if doing so eliminates or significantly reduces a
measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’)
that would otherwise arise from measuring assets or liabilities or recognising the gains and
losses on them on different bases.
Amortised cost criteria - commentary
The rules try to limit the use of amortised cost to those situations where it best reflects the
substance of the transactions. Therefore it can only be used by a company whose business
model is to make loans and collect future repayments.
A company might sell a loan before its maturity. This does not preclude classification of loans at
amortised cost as long as the company’s overall business model is to hold assets in order to
receive contractual cash flows.
On the other hand a company might hold a portfolio of loans in order to profit from the sale of
these assets when market conditions are favourable. In this case the company’s business model
is not to hold assets in order to receive contractual cash flows. The loans in this portfolio must be
measured at fair value.
Overview of classification of financial assets
Method Which instruments?

Amortised cost Loans and receivables that satisfy the amortised cost criteria
Fair value to OCI  Loans and receivables that satisfy the fair value through OCI
criteria
 Equity that has been subject to a declaration
Fair value through  Equity
profit or loss  Derivatives
(FVTPL)  Loans and receivables that fail the amortised cost criteria
 Loans and receivables that satisfy the amortised cost criteria but
are designated into this category on initial recognition
2.4 Classification of financial liabilities
At initial recognition, financial liabilities are classified as subsequently measured at amortised
cost with specific exceptions including:
 derivatives that are liabilities at the reporting date; and
 financial liabilities that might arise when a financial asset is transferred but this transfer
does not satisfy the derecognition criteria.

Chapter 12: Financial instruments: Recognition and measurement
Irrevocable designation
A company is allowed to designate a financial liability as measured at fair value through profit or
loss. This designation can only be made if:
 it eliminates or significantly reduces a measurement or recognition inconsistency; or
 this would allow the company to reflect a documented risk management strategy.
Any such designation is irrevocable.
If a financial liability is measured at fair value any change due to the company’s own credit risk is
recognised in OCI (not P&L)
Summary of accounting of items measured at fair value
Category Examples
Financial asset at fair Whole fair value movement to profit or loss
value through profit or loss
Financial asset at fair Whole fair value movement to OCI
value through OCI Subsequent sale of the asset
Gain or loss on disposal calculated based on the carrying amount
of the asset at the date of disposal.
No reclassification of the amounts previously recognised in OCI in
respect of equity for which an irrevocable election has been made.
Reclassification is still required for debt instruments measured at
fair value through OCI.
Financial liability at fair Change in fair value attributed to change in credit risk to OCI.
value through profit or loss Remaining change in fair value to profit or loss
Transaction costs
Transaction costs are incremental costs that are directly attributable to the acquisition, issue or
disposal of a financial instrument. Examples of transaction costs are:
 fees and commissions paid to agents, advisers, brokers and dealers;
 levies by regulatory agencies and securities exchanges;
 transfer taxes and duties;
 credit assessment fees;
 registration charges and similar costs.
An incremental cost is one that would not have been incurred if the entity had not acquired,
issued or disposed of financial instrument.
Examples of costs that do not qualify as transaction costs are financing costs, internal
administration costs and holding costs.
For all financial instruments that are not measured at FVTPL the treatment of transaction costs is
made on an instrument-by-instrument basis as follows:
 Fair value of financial asset plus transaction cost
 Fair value of financial liability minus transaction cost
However, trade receivable is an exception to this treatment. Trade receivable are measured in
accordance with IFRS 15.
The following costs expensed as and when they are incurred:
 Transaction cost for financial instruments carried at FVTPL; and

 all other costs related to transaction that do not qualify as transaction costs.

Example: Equity investment

An equity investment is purchased for Rs. 30,000 plus 1% transaction costs on 1 January 20X6. It
is classified as at fair value through OCI.
At the end of the financial year (31 December) the investment is revalued to its fair value of Rs.
40,000.
On 11 December 20X7 it is sold for Rs. 50,000.
Required
Explain the accounting treatment for this investment.
Answer
1 January 20X6 The investment is recorded at Rs. 30,300. This is the cost plus the capitalised
transaction costs.
31 December 20X6 The investment is revalued to its fair value of Rs. 40,000.
The gain of Rs. 9,700 is included in other comprehensive income for the year.
11 December 20X7 The journal entry to record the disposal is as follows:
Dr Cr
Cash 50,000
Investment 40,000
Statement of profit or loss 10,000

13
CHAPTER
IFRS 16: Leases
Contents
1 Introduction and definitions
2 Lease classification
3 Accounting for lease by Lessee
4 Accounting for a finance lease: Lessor accounting
5 Accounting for an operating lease

1 INTRODUCTION AND DEFINITIONS
Section overview
 Introduction
 Leases
 Types of lessor
 Inception and commencement
 Defined periods
 Residual values
 Lease payments
 Interest rate implicit in the lease
 Initial direct costs
 Lessee's incremental borrowing rate of interest
1.1 Introduction
IFRS 16 introduces a single lessee accounting model and requires a lessee to recognise assets
and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of
low value. A lessee is required to recognise a right-of-use asset representing its right to use the
underlying leased asset and a lease liability representing its obligation to make lease payments.
1.2 Leases
IFRS 16 prescribes the accounting treatment of leased assets in the financial statements of
lessees and lessors.
Definition: Lease
A contract or part of a contract, that conveys the right to use an asset (the underlying asset) for a
period of time in exchange for consideration.
A lease is a way of obtaining a use of an asset, such as a machine, without purchasing it outright.
The company that owns the asset (the lessor) allows another party (the lessee) to use the asset
for a specified period of time in return for a series of lease payments.
Types of lease
IFRS 16 identifies two types of lease.
Definitions
A lease that transfers substantially all the risks and rewards incidental to ownership of an
underlying asset is known as finance lease.
A lease that does not transfer substantially all the risks and rewards incidental to ownership of
an underlying asset is known as operating lease.
The identification of a lease as a finance lease or an operating lease is crucial as it determines

how a lease is accounted for by the lessor.
This is explained in more detail in later sections.

Chapter 13: IFRS 16: Leases
1.3 Types of lessor

Companies might be lessors as a result of a variety of business models.
Finance companies (often banks and their subsidiaries)
Finance companies provide finance for the purchase of assets. In addition they might finance the
use of assets through leases.
Finance companies are often associated with finance leases but they also fund large operating
leases. Many airlines have use of aircraft through operating leases through finance companies.
Hire companies
These companies own a stock of capital assets which they will lease out for varying periods.
They include:
 tool hire companies;
 plant hire companies; and
 car hire companies
Hire companies are usually involved in operating leases.
Manufacturer/dealer lessors
Some companies make or buy assets to sell. They may offer to lease the asset out as an
alternative to outright sale.
Many motor vehicle manufacturers and dealers do this. Such leases would usually be finance
leases (but not necessarily).
Property companies
Many companies own properties which they lease out to others. These companies might apply
IAS 40: Investment Properties to these assets.
1.4 Inception and commencement

Definitions: Inception date of the lease
The earlier of the date of a lease agreement and the date of commitment by the parties to the
principal terms and conditions of the lease.
The type of lease in a contract (finance or operating) is identified at the date of inception. This is
where the parties to the lease contract commit to the terms of the contract.
Definition: Commencement date of the lease

The date on which a lessor makes an underlying asset available for use by a lessee.
The accounting treatment required is applied to a lease at the date of commencement. This is the
date that a lessee starts to use the asset or at least, is entitled to start to use the asset.
A lease agreement may allow for an adjustment to the terms of the lease contract during the
period between the inception of the lease and the commencement of the lease term. Such
adjustments might be to take account of unexpected changes in costs (for example the lessor’s
costs of making the asset that is the subject of the lease).
In such cases, the effect of any such changes is deemed to have taken place at the inception of
the lease.

1.5 Defined periods

IFRS 16 refers to different periods when describing its rules.
Definition: Lease term

The non-cancellable period for which a lessee has the right to use an underlying asset, together
with both:
(a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise
that option; and
(b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to
exercise that option.
A lease may be split into a primary period followed by an option to extend the lease for a further
period (a secondary period).
In some cases, the lessee might be able to exercise such an option with a small rental or even
for no rental at all. If such an option exists and it is reasonably certain that the lessee will
exercise the option, the second period is part of the lease term.
Definitions: Economic and useful life

Economic life is either:
(a) the period over which an asset is expected to be economically usable by one or more users; or
(b) the number of production or similar units expected to be obtained from the asset by one or
more users.
Useful life is the period over which an asset is expected to be available for use by an entity; or the
number of production or similar units expected to be obtained from an asset by an entity.
Economic life relates to the life of the asset whereas useful life relates to the period that a party
will obtain benefits from that asset.
1.6 Residual values

When a company that owns an asset leases it to another party they have two interests in that
asset:
 It gives them a right to receive a series of rentals over the lease term; and
 They own the asset at the end of the lease.
The value of the asset at the end of the lease is called its residual value. This figure might be
guaranteed by the lessee. This means that if the asset is not worth the amount guaranteed, the
lessee must pay the lessor the shortfall.
On the other hand, the residual value might not be guaranteed.
Definition: Unguaranteed residual value and residual value guarantee

Unguaranteed residual value is that portion of the residual value of the underlying asset, the
realisation of which by the lessor is not assured or is guaranteed solely by a party related to the
lessor.
Residual value guarantee is a guarantee made to a lessor by a party unrelated to the lessor that
the value (or part of the value) of an underlying asset at the end of a lease will be at least a
specified amount.

1.7 Lease payments

In essence, the term lease payments refer to the payments that a lessee expects to make over
a lease term or to the receipts that a lessor expects over the economic life of the asset.
In a straight forward example the lease payments that a lessee expects to make and a lessor
expects to receive are same. However, this is not always the case. The definition of lease
payments takes that into account.
Definition: Lease payments

Payments made by a lessee to a lessor relating to the right to use an underlying asset during the
lease term, comprising the following:
(a) fixed payments (including in-substance fixed payments), less any lease incentives;
(b) variable lease payments that depend on an index or a rate;
(c) the exercise price of a purchase option if the lessee is reasonably certain to exercise that
option; and
(d) payments of penalties for terminating the lease, if the lease term reflects the lessee
exercising an option to terminate the lease.
1.8 Interest rate implicit in the lease
Definition: Interest rate implicit in the lease

The interest rate implicit in the lease is the interest rate that causes the present value of; (a) the
lease payments and (b) the unguaranteed residual value to be equal to the sum of: (i) the fair
value of the underlying asset and (ii) any initial direct costs of the lessor.
The interest rate implicit in the lease is the IRR of the cash flows from the lessor’s viewpoint. It is
the rate that equates the future cash inflows for the lessor to the amount that the lessor invested
in the asset.
Example: Interest rate implicit in the lease

A finance company has purchased an asset for Rs.50,000 and will lease it out in a series of
leases as follows:
The first lease is to Company A for a period of 5 years at an annual rental of Rs.10,000.
After the end of the lease to Company A the asset will be leased to Company B for 1 year at a
rental of Rs.10,000. Company B is a party related to Company A.
After the end of the lease to Company B the asset will be leased to Company C for 1 year at a
rental of Rs.10,000. Company C is not related to Companies A and B.
At the end of this lease the asset is expected to have an unguaranteed residual value of
Rs.2,573.
The interest rate implicit in the lease is 10%.
Proof
Time Narrative Lessor’s cash Discount factor Present
flows (10%) value
0 Fair value of the asset (50,000) 1 (50,000)
1 to 7 Lessor’s MLPs 10,000 4.868 48,680
Unguaranteed residual
7 value 2,573 0.513 1,320
50,000
nil

1.9 Initial direct costs

The definition of interest rate implicit in the lease makes reference to incremental initial direct
costs.
Definition: Initial direct costs

Initial direct costs are incremental costs for obtaining a lease that would not have been incurred
if the lease had not been obtained, except for such costs incurred by a manufacturer or dealer
lessor in connection with a finance lease.
The accounting treatment for initial direct costs will be explained later.
1.10 Lessee's incremental borrowing rate of interest
The interest rate implicit in the lease might be important in deciding whether a lease is a finance
lease or an operating lease.
It is calculated from the lessor’s viewpoint. Sometimes, the lessee might not be able to ascertain
the interest rate implicit in the lease. In that case, it would use the lessee’s incremental borrowing
cost instead.
Definition: Lessee's incremental borrowing rate of interest

The lessee's incremental borrowing rate of interest is 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 right-of-use asset in a similar
economic environment.
Further definitions important to finance lessor accounting will be provided in that section.

2 LEASE CLASSIFICATION
Section overview
 Finance leases and operating leases

 Identifying a finance lease
 Commentary on finance lease indicators
2.1 Finance leases and operating leases

IFRS 16 describes two types of lease (with each type being accounted for in a different way):
 finance leases and
 operating leases
A lessor shall classify each of its leases as either an operating lease or a finance lease.
A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incidental to ownership. A lease is classified as an operating lease if it does not transfer
substantially all the risks and rewards incidental to ownership.
Risks may be represented by the possibility of losses from:
 idle capacity;
 technological obsolescence;
 variations in return caused by changes in economic conditions.
Rewards may be represented by the expectation of;
 profitable use of the asset over its economic life;
 gains from increases in value or profits on disposal.
Substance over form
Whether a lease is a finance lease or an operating lease depends on the substance of the
transaction rather than the form of the contract.
The legal form of a finance lease is that the lessor is the legal owner of the underlying asset.
The economic substance of a finance lease is that the lessee has all the benefits and costs
associated with ownership of the asset. The finance lessee is in the same position as it would
have been if it had borrowed money to buy the asset itself. That is why such leases are called
finance leases; they provide finance for the use of an asset.
Example – Substantive substitution right

ABC Ltd enters into a 5 year contract with a freight carrier (XYZ Ltd.) to transport a specified
quantity of goods. XYZ Ltd. uses rail cars of a particular specification, and has a large pool of
similar rail cars that can be used to fulfil the requirements of the contract. The rail cars and
engines are stored at XYZ Ltd. premises when they are not being used to transport goods. Costs
associated with substituting the rail cars are minimal for XYZ Ltd.
In this case, because the rail cars are stored at XYZ Ltd. premises, it has a large pool of similar
rail cars and substitution costs are minimal, the benefits to XYZ Ltd. of substituting the rail cars
would exceed the costs of substituting the cars.
Therefore, XYZ Ltd. substitution rights are substantive and the arrangement does not contain a
lease.

2.2 Identifying a finance lease

At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. 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.
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.
Indicators of situations that individually or in combination could also lead to a lease being
classified as a finance lease are:
(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are
borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for
example, in the form of a rent rebate equaling most of the sales proceeds at the end of the
lease); and
(c) the lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent.
In all these situations, it can normally be concluded that substantially all the risks and rewards
incidental to ownership are transferred to the lessee.
These indicators are not always conclusive. Classification should always be based on the
substance of the agreement taking account of all information.
Leases are classified at the inception of the lease. Sometimes, a lessee and lessor agree to
change the provisions of a lease and the changes might be of a sort that would have changed
the lease classification if the new terms had been in effect at the inception of the lease. In these
cases, the revised agreement is regarded as a new agreement over its term.
However, changes in estimates (for example, changes in estimates of the economic life or of the
residual value of the leased property), or changes in circumstances (for example, default by the
lessee), do not give rise to a new classification of a lease for accounting purposes.

The following flowchart may assist entities in making the assessment of whether a contract is, or
contains, a lease.

2.3 Commentary on finance lease indicators

It is not always obvious why the above circumstances indicate that a lease is a finance lease.
This section provides an explanation on some of these.
To understand these, it is useful to think of the terms from the lessor’s viewpoint.
Purchase option
If a lease includes a term whereby the lessee can buy the underlying asset at a bargain price at
the end of the lease that lease is a finance lease.
If the lessor includes this term in the lease, the lessor would expect the lessee to take advantage
of it. Therefore, the lessor knows that it needs to make sure to recover the cost of the asset
together with any related interest during the lease term. The rentals and final sale price are set at
a level which allows it to do this.
If the lease transfers ownership of the underlying asset to the lessee by the end of the lease term
or if the cost of the right-of-use asset reflects that the lessee will exercise a purchase option, the
lessee shall depreciate the right-of-use asset from the commencement date to the end of the
useful life of the underlying asset.
Therefore, the lessee will pay the full cash price of the asset together with related finance
expense over the lease term.
 The lessee would only do this if it had access to the risks and benefits of ownership
 In substance, this is just like borrowing the cash and buying the asset
Therefore, the lease is a finance lease.
If there is a change in the assessment of an option to purchase the underlying asset, a lessee
shall determine the revised lease payments to reflect the change in amounts payable under the
purchase option.
Lease is for a major part of the expected economic life of the asset
If the lessor includes this term in the lease, the lessor knows that when the asset is given back to
it at the end of the lease, the asset will only have a small value.
Therefore, the lessor knows that it needs to make sure to recover the cost of the asset together
with any related interest during the lease term. The rentals are set at a level which allows it to do
this.
Therefore, the lessee will pay the full cash price of the asset together with related finance
expense over the lease term.
 The lessee would only do this if it had access to the risks and benefits of ownership
 In substance, this is just like borrowing the cash and buying the asset
Specialised nature of the asset
If the lessor includes this term in the lease, the lessor knows that when the lease comes to an
end, it will be unable to lease the asset on to another party.
Therefore, the lessor knows that it needs to make sure to recover the cost of the asset together
with any related interest during the lease term. The rentals are set at a level which allows it to do
this.
The lessee will pay the full cash price of the asset together with related finance expense over the
lease term.
 The lessee would only do this if it had access to the risks and rewards of ownership.
 In substance, this is just like borrowing the cash and buying the asset.

PV of future lease payments amounts to substantially all of the fair value of the underlying asset
A lease is a finance lease if at the inception of the lease, the present value of all the future lease
payments amounts to substantially all of the fair value of the underlying asset, or more. (The
discount rate to be used in calculating the present value of the lease payments is the interest rate
implicit in the lease). In this case, the lessee is paying the full cash price of the asset together
with related finance expense over the lease term.
Example: PV of future lease payments

A finance company has purchased an asset to lease out to a manufacturing company.
The asset cost for Rs.500,000 and has an economic life of 10 years.
The lease is for 9 years at an annual rental (in arrears) of Rs.87,000 per annum.
The interest rate implicit in the lease is 10%.
Analysis: Lessor’s view
Discount factor Present
Time Narrative Cash flows (10%) value
1 to 9 Lessor’s LPs 87,000 5.759 501,033
This is more than the fair value of the asset. This lease is a finance lease (also note that the
lease is for the major part of the expected economic life of the asset which is another
finance lease indicator).
Example: PV of future lease payments

A finance company has purchased an asset for Rs.50,000 and will lease it out in a series of
leases as follows:
The first lease is to Company A for a period of 4 years at an annual rental of Rs.10,000.
After the end of the lease to Company A the asset will be leased to Company B for 3 years at a
rental of Rs.10,000. Company B is not related to Company A.
At the end of this lease the asset is expected to have an unguaranteed residual value of
Rs.2,573.
The Interest rate implicit in the lease is 10%.
Analysis: Lessor’s view

1 to 7 Lessor’s MLPs 10,000 4.868 48,680
This is 97.4% (48,680/50,000  100) of the fair value of the asset.
Most would agree that this was substantially all of the fair value of the asset (though IFRS 16
does not give a numerical benchmark).
This lease is a finance lease.
1 to 4 Lessor’s MLPs 10,000 3.170 31,700
This is 63.4% (31,700/50,000  100) of the fair value of the asset.
Most would agree that this is not substantially all of the fair value of the asset (though IFRS
16 does not give a numerical benchmark).
This lease is an operating lease.

Practice question 1
Jhang Construction has leased a cement lorry. The cash price of the lorry would be
Rs.3,000,000. The lease is for 6 years at an annual rental (in arrears) of Rs.600,000. The
asset is believed to have an economic life of 7 years. The interest rate implicit in the lease
is 7%.
Jhang Construction is responsible for maintaining and insuring the asset.
Required
State with reasons the kind of lease Jhang has entered into.

3 ACCOUNTING FOR LEASE BY LESSEE
Section overview
 Lease accounting: Initial recognition

 Lease accounting: Subsequent measurement of the asset
 Lease accounting: Subsequent measurement of the liability
 Current and non-current elements of the lease liability
 Presentation
 Disclosure
3.1 Lease accounting: Initial recognition

A lease is capitalised at the commencement of the lease term. This involves the recognition of
the asset that is subject to the lease and a liability for the future lease payments.
At the commencement date, a lessee should recognise a right-of-use asset and a lease liability. It
is the date on which a lessor makes an underlying asset available for use by a lessee.
At the commencement date, a lessee should measure the right-of-use asset at cost.
The cost of the right-of-use asset should comprise:
(a) the amount of the initial measurement of the lease liability;
(b) any lease payments made at or before the commencement date less any lease
incentives received;
(c) any initial direct costs incurred by the lessee;
(d) an estimate of costs to be incurred by the lessee in dismantling and removing the
underlying asset, restoring the site on which it is located or restoring the underlying asset
to the condition required by the terms and conditions of the lease unless those costs are
incurred to produce inventories.
At the commencement date, a lessee shall measure the lease liability at the present value of the
lease payments that are not paid at that date. The lease payments shall be discounted using the
interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be
readily determined, the lessee shall use the lessee’s incremental borrowing rate.
Illustration:
Debit Credit
Right-of-use X
Lease liability (PV of lease payments) X
Examples of initial direct costs of a lessee include:

- Commissions
- Legal fees*
- Costs of negotiating lease terms and conditions*
- Costs of arranging collateral
- Payments made to existing tenants to obtain the lease
* If they are contingent on origination of the lease

Illustration:
ABC Limited paid Rs.30,000 to a legal advisor to review and advise on lease agreement of a
plant leased by SRT Limited. Procurement Manager of ABC remained involved for a month for
negotiating the lease whose monthly salary paid at Rs.150,000.
Debit Credit
Right-of-use 30,000
Bank 30,000
Salary paid to Procurement Manager is not incidental to this particular lease.
Recognition exemptions
A lessee may elect not to apply the requirements of recognition and measurement of the right-of-
use the leased asset and liability to:
(a) short-term leases; and
(b) leases for which the underlying asset is of low value
Short-term lease
A lease that at the commencement date, has a lease term of 12 months or less. A lease that
contains a purchase option is not a short-term lease.
Example - Applying the short term lease exemption

Lessee ABC enters into a 8-year lease of a machine to be used in manufacturing parts for a plane
that it expects to remain popular with consumers until it completes development and testing of
an improved model. The cost to install the machine in DEF manufacturing facility is not
significant. ABC and DEF each have the right to terminate the lease without a penalty on each
anniversary of the lease commencement date.
The lease term consists of a one-year non-cancellable period because both ABC and DEF have a
substantive termination right
ABC and DEF have a substantive termination right
– both can terminate the lease without penalty
– and the cost to install the machine in DEF manufacturing facility is not
significant.
As a result, the lease qualifies for the short-term lease exemption.
Example – Applying the leases of low value exemption

Lessee A is in the pharmaceutical manufacturing and distribution industry and has the following
leases:
– leases of real estate: both office building and warehouse;
– leases of office furniture;
– leases of company cars, both for sales personnel and for senior management
and of varying quality, specification and value;
– leases of trucks and vans used for delivery; and
– leases of IT equipment such as laptops.
A determines that the leases of office furniture and laptops qualify for the recognition exemption
on the basis that the underlying assets, when they are new, are individually of low value. B elects
to apply the exemption to these leases.
As a result, it applies the recognition and measurement requirements in IFRS 16 to its leases of
real estate, company cars, trucks and vans.

3.2 Lease accounting: Subsequent measurement of the asset

After the commencement date, a lessee should measure the right-of-use asset applying a cost
model, unless it applies either of the measurement models described below
Cost model
To apply a cost model, a lessee should measure the right-of-use asset at cost:
(a) less any accumulated depreciation and any accumulated impairment losses; and
(b) adjusted for any re-measurement of the lease liability.
A lessee should apply the depreciation requirements in IAS 16 Property, Plant and Equipment in
depreciating the right-of-use asset
If the lease transfers ownership of the underlying asset to the lessee by the end of the lease term
or if the cost of the right-of-use asset reflects that the lessee will exercise a purchase option, the
lessee should depreciate the right-of-use asset from the commencement date to the end of the
useful life of the underlying asset.
Otherwise, the lessee should depreciate the right-of-use asset from the commencement date to
the earlier of the end of the useful life of the right-of-use asset or the end of the lease term.
Other measurement models

If a lessee applies the fair value model in IAS 40 Investment Property to its investment property,
the lessee shall also apply that fair value model to right-of use assets that meet the definition of
investment property in IAS 40. If right-of-use assets relate to a class of property, plant and
equipment to which the lessee applies the revaluation model in IAS 16, a lessee may elect to
apply that revaluation model to all of the right-of-use assets that relate to that class of property,
plant and equipment.
Example:
Jhang Construction enters into a 6 year lease of a machine on 1 January Year 1.
The fair value of the machine at the commencement of the lease was Rs.80,000 and Jhang
Construction incurred initial direct costs of Rs.2,000 when arranging the lease.
The estimated residual value of the asset at the end of the lease is Rs.8,000.
The estimated useful life of the asset is 5 years.
The accounting policy for similar owned machines is to depreciate them over their useful life on a
straight line basis.
Annual depreciation charge:

Initial cost: Rs.
Fair value of the machine 80,000
Initial direct costs 2,000
82,000
Residual value (8,000)
Depreciable amount 74,000
Useful life (shorter of the lease term and the useful life) 5 years
Annual depreciation charge 14,800
The underlying asset is included in the statement of financial position at its carrying amount (cost
less accumulated depreciation less any accumulated impairment loss (if any)) in the same way
as similar assets.

Example:
Year 1 Year 2 Year 3 Year 4 Year 5
Rs. Rs. Rs. Rs. Rs.
Cost 82,000 82,000 82,000 82,000 82,000
Accumulated depreciation:
Brought forward nil 14,800 29,600 44,400 59,200
Charge for the year 14,800 14,800 14,800 14,800 14,800
Carried forward 14,800 29,600 44,400 59,200 74,000
Carrying amount 67,200 52,400 37,600 22,800 8,000

The asset is depreciated down to a carrying amount at the end of the asset’s useful life
that is the estimated residual value
3.3 Lease accounting: Subsequent measurement of the liability

After the commencement date, a lessee should measure the lease liability by:
(a) increasing the carrying amount to reflect interest on the lease liability;
(b) reducing the carrying amount to reflect the lease payments made; and
(c) re-measuring the carrying amount to reflect any reassessment or lease modifications
After initial recognition, the lease liability is measured at amortised cost using the effective
interest method.
After the commencement date, a lessee should recognise in profit or loss, unless the costs are
included in the carrying amount of another asset applying other applicable Standards, both:
(a) interest on the lease liability; and
(b) variable lease payments not included in the measurement of the lease liability in the period
in which the event or condition that triggers those payments occurs.
Finance charge
The total rental payments over the life of the lease will be more than the amount initially
recognised as a liability. The difference is finance charge.
The total finance charge that arises over the life term is the difference between the amount
initially recognised as the lease liability and the sum of the lease payments from the standpoint of
the lessee.
Illustration: Total finance charge
Rs.
Lessee’s lease payments (sum of all payments made by the lessee to

the lessor) X
Amount on initial recognition (X)
Total finance charge X

Example: Total finance charge

Jhang Construction enters into a 6 year lease of a machine on 1 January Year 1.
The fair value of the machine at the commencement of the lease was Rs.80,000 and Jhang
Construction incurred initial direct costs of Rs.2,000 when arranging the lease.
The annual lease payments are Rs.18,000, payable at the end of each year.
The estimated residual value of the asset at the end of the lease is Rs.8,000 and Jhang
Construction has guaranteed this amount.
The interest rate implicit in the lease is 11.18%.
Total finance charge
Lessee’s lease payments: Rs.
Annual rentals (6  18,000) 108,000
Guaranteed residual value 8,000
116,000
Amount on initial recognition (80,000)*
Total finance charge (interest) 36,000
* This is the amount of the liability, The asset is recognised at Rs.82,000
The finance charge (interest) is recognised over the life of the lease by adding a periodic charge
to the liability for the lease obligation with the other side of the entry as an expense in profit or
loss for the year.
Illustration: Debit Credit
Interest expense X
Lease liability X
3.4 Current and non-current elements of the lease liability

The total liability must be divided between:
 the current liability (amount payable within the next 12 months), and
 the non-current liability.
The easy way to do it is to use the tables to identify the current liability or the non-current liability
and then find the other as a balancing figure.
Example: Split of current and non-current liability at the end of year 1
Opening Lease Capital Closing
Year balance payments Interest repayments balance
1 80,000 (18,000) 8,941 (9,059) 70,941
2 70,941 (18,000) 7,929 (10,071) 60,870
 
This is the This is the
current non-current
liability liability
Liability: Rs.
Current liability 10,071
Non-current liability 60,870
Total liability (for proof) 70,941

3.5 Presentation
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 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.
3.6 Disclosures
A lessee shall disclose information about its leases for which it is a lessee in a single note or
separate section in its financial statements. However, a lessee need not duplicate information
that is already presented elsewhere in the financial statements, provided that the information is
incorporated by cross-reference in the single note or separate section about leases.
A lessee shall disclose the following amounts for the reporting period:
(a) depreciation charge for right-of-use assets by class of underlying asset;
(b) interest expense on lease liabilities;
(c) the expense relating to short-term leases. This expense need not include the expense
relating to leases with a lease term of one month or less;
(d) the expense relating to leases of low-value assets. This expense shall not include the
expense relating to short-term leases of low-value assets;
(e) the expense relating to variable lease payments not included in the measurement of lease
liabilities;
(f) income from subleasing right-of-use assets;
(g) total cash outflow for leases;
(h) additions to right-of-use assets;
(i) gains or losses arising from sale and leaseback transactions; and
(j) the carrying amount of right-of-use assets at the end of the reporting period by class of
underlying asset.

A lessee shall provide the disclosures specified in a tabular format, unless another format is more
appropriate. The amounts disclosed shall include costs that a lessee has included in the carrying
amount of another asset during the reporting period.
A lessee shall disclose the amount of its lease commitments for short-term leases accounted if
the portfolio of short-term leases to which it is committed at the end of the reporting period is
dissimilar to the portfolio of short-term leases to which the short-term lease expense disclosed
(See disclosure (c) as discussed in the preceding paragraph).
If right-of-use assets meet the definition of investment property, a lessee shall apply the
disclosure requirements in IAS 40. In that case, a lessee is not required to provide the
disclosures in preceding paragraph (a), (f), (h) or (j) for those right-of-use assets.
If a lessee measures right-of-use assets at revalued amounts applying IAS 16, the lessee shall
disclose the information specified in relevant disclosure (paragraph 77 of IAS 16) for those right-
of-use assets.
Maturity Analysis
Under IFRS 16 the financial liability of lessee under lease arrangement requires a maturity analysis
that is dealt by IFRS 7. According to IFRS 7, the lessee is required to disclose maturity analysis of
lease liability for remaining contractual maturities. The contractual maturities are the future lease
payments (without discounting).
Moreover, application guidance (B11) of IFRS 7, Financial Instruments: Disclosures requires that in
preparing the maturity analysis, a lessee uses its judgment to determine an appropriate number of time
bands.
The maturity analysis is explained with the following examples:
Example:
On 1 Jan 2017, Pervez Limited (PL) leases a plant from a bank. PL is required to pay an annual
instalment of Rs.1 million at the end of each year for seven years. First payment was made on 23
December 2017
Solution - based on the judgment of Pervez Limited
As at 31 December 2017
Maturity analysis – contractual undiscounted lease payments 2017
Rs. in 000
Less than one year 1,000
Two to five years 4,000
More than five years 1,000
Total undiscounted lease payments 6,000
Solution - based on the judgment of Pervez Limited
Maturity analysis – contractual undiscounted lease payments 2017
Rs. in 000
Less than 1 year 1,000
One to two years 1,000
Two to three years 1,000
Three to four years 1,000
Four to five years 1,000
More than five years 1,000
Total undiscounted lease payments 6,000

4 ACCOUNTING FOR A FINANCE LEASE: LESS0R ACCOUNTING
Section overview
 Definitions
 Finance lease accounting
 Manufacturer/dealer lessors
 Disclosure requirements for lessor
4.1 Definitions
The lessor does not record the leased asset in his own financial statements because he has
transferred the risks and rewards of ownership of the leased asset to the lessee. Instead, he
records the amount due to him under the terms of the finance lease as a receivable.
The receivable is described as the net investment in the lease.
Definitions: Gross and net investment in the lease

Gross investment in the lease is the aggregate of:
(a) the lease payments receivable by the lessor under a finance lease, and
(b) any unguaranteed residual value accruing to the lessor.
Net investment in the lease is the gross investment in the lease discounted at the interest rate
implicit in the lease.
An earlier section explained that the interest rate implicit in the lease is the discount rate that, at
the inception of the lease, causes the present value of the lease payments and the
unguaranteed residual value to be equal to the sum of the fair value of the underlying asset and
any initial direct costs of the lessor.
Therefore the net investment in the lease is the sum of the fair value of the asset plus the initial
direct costs.
Definitions:
Unearned finance The difference between:

income (a) the gross investment in the lease; and
(b) the net investment in the lease.
4.2 Finance lease accounting

Many of the entries to be made in the ledger accounts of the lessor are a ‘mirror image’ of those
made by the lessee in respect of his lease liability.
Lessee Lessor
Initial recognition & Lease payments payable Finance lease receivable (net
measurement investment in the lease)
Subsequent Finance cost Finance income
measurement
Pattern of recognition So as to provide a So as to provide a constant periodic
constant periodic rate of rate of return on the net investment in
charge on the outstanding the lease.
obligation

Initial recognition
The lessor records a receivable for the capital amount owed by the lessee. This should be stated
at the amount of the ‘net investment in the lease’.
Illustration: Double entry on Initial recognition of a finance lease

Debit Credit
Net investment in the lease X

Cash/bank X
For finance leases other than those involving manufacturer or dealer lessors, initial direct costs
are included in the initial measurement of the finance lease receivable thus reducing the amount
of income recognised over the lease term to below what it would have been had the costs not
been treated in this way. The result of this is that the initial direct costs are recognised over the
lease term as part of the income recognition process.
Initial direct costs of manufacturer or dealer lessors in connection with negotiating and arranging
a lease are excluded from the definition of initial direct costs. As a result, they are excluded from
the net investment in the lease.
The treatment of similar costs incurred by manufacturers and dealers is explained later.
Subsequent measurement of the receivable
During each year, the lessor receives payments from the lessee. Each receipt is recorded in the
ledger account as follows.
Debit Credit
Illustration: Lessor receipts
Cash/bank X
A finance lease receivable (net investment in the lease) is measured in the same way as any
other financial asset. The balance at any point in time is as follows:
Illustration: Net investment in the lease Rs.
Amount of loan at the start of the lease (the amount recognised on X

initial recognition of the lease)
Plus: Interest accrued X
Minus: Repayments (lease payments or rentals) (X)
Repayment of loan principal (X)
Amount owed to the lessor now. X
In effect, each lease receipt consists of two elements:

 finance income on the receivable; and
 a partial repayment of the receivable (net investment in the lease).
The finance charge is recognised as income in profit or loss for the period. The partial repayment
of the lease receivable reduces the amount owed to the lessor.
Finance income
The total rental receipts over the life of the lease will be more than the amount initially recognised
as a receivable. The difference is finance income.

The total finance income that arises over the life of the lease is the difference between the
amount invested in the lease (the amount loaned plus the initial direct costs) and the sum of all
receipts.
Illustration: Total finance income

Rs.
Lessor’s lease payments X
Initial direct costs X
X
Amount on initial recognition (X)
Total finance income X
Example: Total finance income

Sialkot Finance agreed to lease a machine to Jhang Construction commencing on 1 January Year
1.
The lease was a 6 year finance lease of a machine on 1 January Year 1 with annual lease
payments of Rs.18,000, payable in arrears.
The fair value of the machine at the commencement of the lease was Rs.80,000 and Sialkot
Finance incurred initial direct costs of Rs.2,000 when arranging the lease.
The estimated residual value of the asset at the end of the lease is Rs.10,000. The lessee has
guaranteed an amount of Rs.8,000.
The interest rate implicit in the lease is 10.798%.
Total finance income
Lessor’s lease payments: Rs.
Annual rentals (6  18,000) 108,000
Guaranteed residual value 8,000
Unguaranteed residual value 2,000
118,000
Amount on initial recognition (80,000)
Initial direct costs (2,000)
(82,000)
Total finance income 36,000
The finance income is recognised over the life of the lease by adding a periodic return to the net
investment in the lease with the other side of the entry as income in profit or loss for the year.
Illustration:
Debit Credit
Statement of comprehensive income: finance income X

4.3 Manufacturer/dealer lessors

Manufacturers or dealers often offer to customers the choice of either buying or leasing an asset.
A finance lease of an asset by a manufacturer or dealer lessor gives rise to two types of income:
 profit or loss equivalent to the profit or loss resulting from an outright sale of the asset being
leased, at normal selling prices, reflecting any applicable volume or trade discounts; and
 finance income over the lease term.
Revenue
The sales revenue recognised at the commencement of the lease term is the lower of:
 the fair value of the underlying asset; and
 the present value of the lease payments accruing to the lessor discounted at market rate of
interest.
Cost of sale
The cost of sale recognised at the commencement of the lease term is the carrying amount of the
underlying asset less the present value of the unguaranteed residual value.
The deduction of the present value of the unguaranteed residual value recognises that this part
of the asset is not being sold. This amount is transferred to the lease receivable. The balance on
the lease receivable is then the present value of the amounts which the lessor will collect off the
lessee plus the present value of the unguaranteed residual value. This is the net investment in
the lease as defined in section 5.2.
Costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging a
lease must be recognised as an expense when the selling profit is recognised.
Profit or loss on the sale
The difference between the sales revenue and the cost of sale is the selling profit or loss. Profit
or loss on these transactions is recognised in accordance with the policy followed for recognising
profit on outright sales.
The manufacturer or dealer might offer artificially low rates of interest on the finance transaction.
In such cases the selling profit is restricted to that which would apply if a market rate of interest
were charged.
Example: Manufacturer or dealer leases

Multan Motors is a car dealer.
It sells cars and offers a certain model for sale by lease.
The following information is relevant:
Price of the car in a cash sale Rs.2,000,000
Cost of the car Rs.1,500,000
Finance option:
Annual rental Rs.804,230
Lease term 3 years
Interest rate 10%
Estimated residual value nil
Lessor’s cost of setting up the lease Rs.20,000

Example: Manufacturer or dealer leases (continued)
Discount factor
t1 to t3 @ 10% 2.486852 (written as 2.487)
Working: Revenue – lower of: Rs.
Fair value of the asset 2,000,000
Present value of the lease payments
804,230  2.487 2,000,000

Initial double entry:
Revenue Debit Credit
Lease receivable (Net investment in the lease) 2,000,000

Statement of comprehensive income 2,000,000
Cost of sale

Asset (Inventory) 1,500,000
Cost of setting up the lease
Statement of comprehensive income 20,000

Cash/bank 20,000
Net investment in the lease (over its life):
Opening net Lease Closing net
Year investment Interest (10%) receipts investment
1 2,000,000 200,000 (804,230) 1,395,770
2 1,395,770 139,577 (804,230) 731,117
3 731,117 73,113 (804,230) nil
The interest income is calculated by multiplying the opening receivable by 10% in each year
(so as to provide a constant rate of return on the net investment in the lease).
Summary of double entry in year 1:
Net investment
Bank Inventory in the lease Profit or loss
B/f 1,500,000Dr
Revenue 2,000,000Dr 2,000,000Cr
Cost of sales (1,500,000)Cr (1,500,000)Dr
Set up cost (20,000)Cr (20,000)Dr
Profit on sale 480,000Cr
Lease income 200,000Dr 200,000Cr
Lease rental 804,230Dr (804,230)Cr
1,395,770Dr 680,000Cr

Example: Manufacturer or dealer leases with unguaranteed residual value

The following information is relevant:
Price of the car in a cash sale Rs.2,000,000
Cost of the car Rs.1,500,000
Finance option:
Annual rental Rs.764,018
Lease term 3 years
Interest rate 10%
Estimated residual value Rs.133,100
Lessor’s cost of setting up the lease Rs.20,000
Discount factors:
t3 @ 10% 0.7513148 (written as 0.751)
t1 to t3 @ 10% 2.486852 (written as 2.487)
Workings
W1: Revenue – lower of: Rs.
Fair value of the asset 2,000,000
764,018 2.487 1,900,000
W2: Present value of the unguaranteed residual value Rs.

133,156  0.751 100,000
Initial double entry:

Revenue Debit Credit
Lease receivable (Net investment in the lease) 1,900,000
Cost of sale
Asset (Inventory) 1,400,000
Transfer
Lease receivable (Net investment in the lease) 100,000
Asset (Inventory) 100,000
Cost of setting up the lease
Statement of comprehensive income 20,000
Cash/bank 20,000

Example: Manufacturer or dealer leases with unguaranteed residual value (continued)

Opening net Lease Closing net
Year investment Interest (10%) receipts investment
1 1,900,000
100,000
2,000,000 200,000 (764,018) 1,435,982
2 1,435,982 143,598 (764,018) 815,562
3 815,562 81,556 (764,018) 133,100
The interest income is calculated by multiplying the opening receivable by 10% in each year
(so as to provide a constant rate of return on the net investment in the lease).
The balance on the account at the end of the lease term is the unguaranteed residual value.
Net investment in the lease (over its life):

Summary of double entry in year 1:
Net investment
Bank Inventory in the lease Profit or loss
B/f 1,500,000Dr
Revenue 1,900,000Dr 1,900,000Cr
Cost of sales (1,400,000)Cr (1,400,000)Dr
Set up cost (20,000)Cr (20,000)Dr
Profit on sale 480,000Cr
Transfer (100,000)Cr 100,000Dr
Lease income 200,000Dr 200,000Cr

Lease rental 764,018Dr (764,018)Cr
1,435,982Dr 680,000Cr
A motor dealer acquires vehicles of a particular model from the manufacturer for Rs.21,000, a
20% discount on the recommended retail price of Rs.26,250. It offers them for sale at the
recommended retail price with 0% finance over three years, provided three annual payments of
Rs.8,750 are made in advance. The market rate of interest is 8%.
A sale transaction made on 1 January 20X5 is recognised as a combination of an outright sale
and a finance lease. The present value of the minimum lease payments is treated as the
consideration for the outright sale and at 8% is calculated as follows:
Year Cash flow Discount factor at 8% Present value
Rs. Rs.
20X5 8,750 1.000 8,750
1
20X6 8,750 8,102
(1.08)= 0.926
1
20X7 8,750 7,499
(1.08)2=0.857
24,351

Requirement
How should the transaction be recognised by the dealer in the year ending 31 December 20X5?
Statement of comprehensive income
Revenue (lower of FV Rs.26,250 and PV of MLPs Rs.24,351) 24,351
Cost of sales (lower of cost and CV — PV of unguaranteed residual value) (21,000)
Profit 3,351
Finance income: (Working) 1,248
Statement of financial position
Receivable (Working) 16,849
WORKING
Bal b/f Installments c/f Interest Bal c/f 8%
in advance income at 31 Dec
Rs. Rs. Rs. Rs. Rs.
20X5 24,351 (8,750) 15,601 1,248 16,849
4.4 Disclosure requirements for lessor
Finance lease
 Selling profit or loss
 Finance income on the net investment in the lease
 Income relating to variable lease payments not included in the measurement of the net
investment in the lease
 Qualitative and quantitative explanation of the significant changes in the carrying amount
of the net investment in the lease
 Maturity analysis of undiscounted lease payment receivable for a minimum of each of the
first five years plus a total amount for the remaining years.
 A lessor shall reconcile the undiscounted lease payments to the net investment in the
lease. The reconciliation shall identify the unearned finance income relating to the lease
payments receivable and any discounted unguaranteed residual value.
Operating lease
 Lease income, separately disclosing income relating to variable lease payments that do
not depend on an index or a rate.
 Maturity analysis of undiscounted lease payments to be received for a minimum of each of
the first five years plus a total amount for the remaining years
 Disclosure requirements in IAS 36, IAS 38, IAS 40 and IAS 41 for assets subject to
operating leases
 Disclosure requirements in IAS 16 for items of property, plant and equipment subject to an
operating lease
Qualitative disclosures for all leases

 Nature of the lessor’s leasing activities
 Management of the risk associated with any rights that the lessor retains in underlying
assets.

Maturity Analysis and reconciliation

The maturity analysis is explained in the following example:
Example: Finance lease

On 1 Jan 2017, Oscar Bank Limited (OBL) gave a machine on finance lease to Pervez Limited (PL).
Instalment of Rs.5.714 million at the end of each year is receivable for seven years. First payment
was received on 23 December 2017. The interest rate implicit in the lease is 6%.
Maturity analysis – contractual undiscounted cash flows
Rs. in 000
Less than 1 Year 5,714
More than 5 years 5,714
Total undiscounted lease receivable 34,284
Reconciliation
Rs. in 000
Total lease receivable 34,284
Add: Un-guaranteed Residual Value _
Gross investment in lease 34,284
Less: Unearned finance income (6,255)
Net investment in lease 28,029
Example: Operating lease

On 1 Jan 2017, Genuine Properties Ltd. (GPL) leased a building to Faheem Limited (FL) at
Rs.5.714 per annum. Lease term is for seven years and economic life of the building is twenty five
years. First payment was received on 23 December 2017.
Maturity analysis – contractual undiscounted cash flows
Rs. in 000
Less than 1 Year 5,714
More than 5 years 5,714
Total undiscounted lease receivable 34,284

5 ACCOUNTING FOR AN OPERATING LEASE
Section overview
 Operating leases in the financial statements of the lessor

 Operating lessor disclosures
5.1 Operating leases in the financial statements of the lessor

Because the lessor has not transferred the risks and rewards of ownership of the physical asset
to the lessee, the lessor shows the leased asset as a non-current asset in its statement of
financial position.
It will be shown in an appropriate category of property, plant and equipment as an investment
property at its carrying value (cost/valuation minus accumulated depreciation).
In respect of the leased asset, the lessor’s annual statement of comprehensive income will
include in profit or loss:
 depreciation on the asset as an expense, and
 rental income (as for the lessee, this is usually calculated on a straight-line basis).
Lease income from operating leases is recognised in income on a straight-line basis over the
lease term, unless another systematic basis is more representative of the time pattern in which
use benefit derived from the leased asset is diminished.
Initial direct costs incurred by lessors in negotiating and arranging an operating lease are added
to the carrying amount of the leased asset and recognised as an expense over the lease term on
the same basis as the lease income.
The depreciation policy for depreciable leased assets must be consistent with the lessor's normal
depreciation policy for similar assets, and calculated in accordance with IAS 16 and IAS 38.
A lessor shall apply IAS 36 to determine whether an underlying asset subject to an operating
lease is impaired and to account for any impairment loss identified.
Manufacturer/dealer lessors
A manufacturer or dealer lessor must not recognise any selling profit on entering into an
operating lease. It is not the equivalent of a sale as the risks and benefits of ownership do not
pass.
5.2 Operating lessor disclosures

A lessor shall disclose the lease income, separately disclosing income relating to variable lease
payments that do not depend on an index or a rate. A lesser shall provide the specified
disclosures in a tabular format, unless another format is more appropriate.
In order to achieve the disclosure objective, a lessor shall disclose additional qualitative and
quantitative information about its leasing activities.
This additional information includes, but is not limited to, information that helps users of financial
statements to assess:
 the nature of the lessor’s leasing activities; and
 How the lessor manages the risk associated with any rights it retains in underlying assets.
In particular, a lessor shall disclose its risk management strategy for the rights it retains in
underlying assets, including any means by which the lessor reduces that risk. Such means
may include, for example, buy-back agreements, residual value guarantees or variable
lease payments for use in excess of specified limits.


Solution 1
The lease is a finance lease.
Reasons
The lease is for a major part of the life of the asset (6 out of 7 years).
Jhang Construction must ensure the asset. It is exposed to one of the major risks of ownership of the
asset (its loss).
The present value of the lease payments is 95.3%
(4.767  600,000/3,000,000) of the fair value of the asset at the inception of the lease.
Solution 2
Rs.
Total lease payments (3 × Rs.4,021) 12,063
Minus: Cash price of the asset (10,000)
––––––––
Total finance charge 2,063
––––––––
Actuarial method
Year ended 31 Opening Lease Capital Interest at Closing

December balance payment outstanding 22.25% balance
Rs. Rs. Rs. Rs. Rs.
Year 1 10,000 (4,021) 5,979 1,330 7,309
Year 2 7,309 (4,021) 3,288 733 4,021
Year 3 4,021 (4,021) – – –
The year-end liability at the end of Year 1 is Rs.7,309 in total.
 The non-current liability is the liability at the start of the next year after deducting the first payment
(Rs.3,288).
 The current liability is the payment in year 2 less any interest contained in it that has not yet accrued.
Rs.
Current liability, end of Year 1 4,021*
Non-current liability, end of Year 1 3,288
Total liability, end of Year 1 7,309
* Rs.4,021 can be divided into Rs.1,330 of interest payable and Rs.2,691 of principal payable

14
CHAPTER
Other areas of IFRSs
(IFRS 8, IAS 10, IAS 37)
Contents
1 IFRS 8: Operating segments
2 IAS 10: Events After the Reporting Period
3 IAS 37: Provisions: Recognition
4 IAS 37: Provisions: Measurement
5 IAS 37: Provisions: Double Entry and Disclosures
6 IAS 37: Guidance on Specific Provisions
7 IAS 37: Contingent liabilities and contingent assets

1 IFRS 8: OPERATING SEGMENTS

Section overview
 Introduction
 Operating segments
1.1 Introduction
Many companies operate in several different industries (or ‘product markets’) or diversify their
operations across several geographical locations. A consequence of diversification is that
companies are exposed to different rates of profitability, different growth prospects and different
amounts of risk for each separate ‘segment’ of their operations.
Objective of IFRS 8
IFRS 8 requires quoted companies to disclose information about their different operating
segments, in order to allow users of the financial statements to gain a better understanding of the
company’s financial position and performance.
Users are able to use the information about the main segments of the company’s operations to
carry out ratio analysis, identify trends and make predictions about the future. Without segment
information, good performance in some segments may ‘hide’ very poor performance in another
segment, and the user of the financial statements will not see the true position of the company.
Scope of IFRS 8
Segment reporting is required for any entity whose debt or equity is quoted on a public securities
market (stock market) and also entities that are in the process of becoming quoted. If an entity
includes some segment information in the annual report that doesn’t comply with IFRS 8, it
cannot call it ‘segmental information.’
1.2 Operating segments
IFRS 8 defines an operating segment as a component of an entity:
 that engages in business activities from which it earns revenues and incurs expenses
 whose operating results are regularly reviewed by the entity’s chief operating decision
maker to make decisions about resources to be allocated to the segment and assess its
performance, and
 for which discrete financial information is available.
Not every part of an entity is necessarily an operating segment. For example a corporate head
office may not earn revenue and would not be an operating segment.
The standard requires a segment to have its results reviewed by the chief operating decision
maker. The reason for this part of the definition of an operating segment is to ensure that an
entity reports segments that are used by management of the entity to monitor the business.
Aggregation of segments
Two or more operating segments may be aggregated into a single operating segment if they
have similar economic characteristics, and the segments are similar in each of the following
respects:
 The nature of the products and services
 The nature of the production process
 The type or class of customer for their products and services
 The methods used to distribute their products or provide their services, and
 If applicable, the nature of the regulatory environment, for example, banking insurance or
public utilities.

Chapter 14: IFRS 8, IAS 37 and IAS 10
Quantitative thresholds
An entity must report separately information about an operating segment that meets any of the
following quantitative thresholds:
 Its reported revenue, including external sales and intersegment sales is 10% or more of
the combined internal and external revenue of all operating segments
 Its reported profit is 10% or more of the greater of the combined profit of all segments that
did not report a loss and the combined reporting loss of all segments that reported a loss
 Its assets are 10% or more of the combined assets of all operating segments
Reportable segments
An entity must report separately information about each operating segment that:
 Has been identified in accordance with the definition of an operating segment shown
above;
 is aggregated with another segment; or
 exceeds the quantitative thresholds.
If the total external revenue reported by operating segments constitutes less than 75% of the
entity’s total revenue, then additional operating segments must be identified as reporting
segments, even if they do not meet the criteria, until 75% of revenue is included in reportable
segments.
Example:
The following information relates to a quoted company with five divisions of operation:
Profit Loss
Rs.m Rs.m
Division 1 10 -
Division 2 25 -
Division 3 - 40
Division 4 35 -
Division 5 40 -
110 40
Which of the divisions are reportable segments under IFRS 8 Operating segments?
Answer
Since Profit figure is higher, we will take 10% of that amount.
Reportable segment
Profit Loss (results > Rs. 11m
Rs.m Rs.m
Division 1 10 - No
Division 2 25 - Yes
Division 3 - 40 Yes
Division 4 35 - Yes
Division 5 40 - Yes
110 40
Greater of the two 110
Materiality threshold (10%) 11
Note: Division 3 is reportable as the loss of Rs. 40m is greater than Rs. 11m (ignoring the sign).

Example:
The following information relates to Oakwood, a quoted company with five divisions of operation:
Wood Furniture Veneer Waste Other Total
sales sales sales sales sales
Rs.m Rs.m Rs.m Rs.m Rs.m Rs.m
Revenue from external
customers 220 256 62 55 57 650
Inter segment revenue 38 2 - 5 3 48
Reported profit 54 45 12 9 10 130
Total assets 4,900 4,100 200 400 600 10,200
Which of the business divisions are reportable segments under IFRS 8 Operating segments?
Answer
IFRS 8 states that a segment is reportable if it meets any of the following criteria:
1. its internal and external revenue is more than 10% of the total entity internal and external
revenue.
2. its reported profit is 10% or more of the greater of the combined profit of all segments that
did not report a loss.
3. its assets are 10% or more of the combined assets of all operating segments.
From the table above, only the Wood and Furniture department sales have more than 10% of
revenue, assets and profit and meet the requirements for an operating segment. The other three
divisions do not meet the criteria: none of them pass the 10% test for assets, profit or revenue.
Additionally IFRS 8 states that if total external revenue reported by operating segments
constitutes less than 75% of the entity’s revenue then additional operating segments must be
identified as reporting segments, until 75% of revenue is included in reportable segments
The total external revenue of Wood and Furniture is Rs.476m and the total entity revenue is
Rs.650m, which means that the revenue covered by reporting these two segments is only 73%.
This does not meet the criteria so we must add another operating segment to be able to report on
75% of revenue. It doesn’t matter that any of the other entities do not meet the original segment
criteria.
In this case, we can add on any of the other segments to achieve the 75% target. If we add in
Veneer sales, this gives total sales of Rs.538m, which is 83% of the sales revenue of Rs.650m.
This is satisfactory for the segmental report.
Disclosure
IFRS 8 states that an entity must disclose information so that users of the financial statements
can evaluate the nature and financial effects of the business activities in which it engages and
the economic environments in which it operates.
The information that is to be disclosed is:
 A measure of profit or loss for each reportable segment
 A measure of total assets and liabilities for each reportable segment if such an amount is
reported regularly to the chief operating decision maker
 Information about the following items if they are specified and included in the measure of
segment profit that is reported to the chief operating decision maker:
 revenues from external customers
 revenues from transactions with other operating segments of the same entity
 interest revenue
 interest expense

 depreciation and amortisation

 material items of income and expense in accordance with IAS 1
 the entity’s interest in the profit or loss of associates and joint ventures accounted
for by the equity method
 income tax expense or income
 material non-cash items other than depreciation and amortisation.
 the amount of investment in associates and joint ventures accounted for by the equity
method and the amounts of additions to non-current assets (excluding financial
instruments, deferred tax assets, post-employment benefit assets and rights arising under
insurance contracts), provided that these amounts are included in segment assets.
Additionally, the following reconciliations are required:
 Reconciliation of the totals of segment revenues to the entity’s revenue;
 Reconciliation of the total of reported segment profits or losses to the entity’s profit before
tax and discontinued operations;
 Reconciliation of the total of the assets of the reportable segments to the entity’s assets;
 Reconciliation of the total of the liabilities of the reportable segments to the entity’s
liabilities (but only if segment liabilities are reported); and
 Reconciliation of the total of the assets of the other material items to the entity’s
corresponding items.
Also, the factors used to identify the entity’s reportable segments, including the basis of
organisation, (i.e. whether the entity is organised around different products and services or
geographical area), and the types of products and service from which the reportable segments
derive their income must all be disclosed.
Measurement
IFRS 8 requires that the amount of each segment item reported shall be the measure reported to
the chief operating decision maker for the purposes of making decisions about allocating
resources to the segment and assessing its performance. This is based on the internal structure
of how division of the entity report their results to the chief operating decision maker. Any
adjustments and eliminations made in preparing an entity’s financial statements shall be included
in determining segment results only if they are included in the measure of the segment’s results
used by the chief operating decision maker.
The minimum amount the entity must disclose is:
 The basis of accounting for any transactions between reportable segments
 The nature of any differences between the measurement of the reportable segments’ profit
or loss before tax and the entity’s profit or loss, for example, the allocation of centrally
incurred costs.
 The nature of any differences between the measurement of the reportable segments’
assets and the assets of the entity.
 The nature of any differences between the measurement of the reportable segments’
liabilities and the liabilities of the entity.
 The nature of any changes from prior periods in measurement methods used to determine
segment profit or loss and the effect on profit or loss from those changes.
 The nature of asymmetrical allocations to reportable segments. For example, a reportable
segment may be charged the depreciation expense for a particular asset but the related
depreciable asset might not have been allocated to the segment.

Entity wide disclosures

The reporting entity must also make the following disclosures in the financial statements, even if
it only has one reportable segment:
 Revenue from external customers for each product and service or each group of similar
products and services.
 Revenue from external customers attributed to the entity’s country of domicile and
attributed to all foreign countries in total where revenue is made.
 Non-current assets located in the country of domicile and located in all foreign countries in
total where the entity holds assets
 If revenue from any customer is more than 10% of total revenue then it must be disclosed
along with the total of revenues from these customers and the identity of the segment
reporting the revenue.

2 EVENTS AFTER THE REPORTING PERIOD: IAS 10

Section overview
 Purpose of IAS 10
 Accounting for adjusting events after the reporting period
 Disclosures for non-adjusting events after the reporting period
 Dividends
 The going concern assumption
2.1 Purpose of IAS 10

IAS 10 Events after the reporting period has two main objectives:
 to specify when a company should adjust its financial statements for events that occur
after the end of the reporting period, but before the financial statements are authorised for
issue, and
 to specify the disclosures that should be given about events that have occurred after the
end of the reporting period but before the financial statements were authorised for issue.
IAS 10 also includes a requirement that the financial statements should disclose when the
statements were authorised for issue, and who gave the authorisation.
IAS 10 sets out the following key definitions.
Definitions
Events after the reporting period: Those events, favourable and unfavourable that occur between
the end of the reporting period and the date the financial statements are authorised for issue.
Adjusting events: Events that provide evidence of conditions that already existed as at the end of
the reporting period.
Non-adjusting events: Events that have occurred due to conditions arising after the end of the
reporting period.
2.2 Accounting for adjusting events after the reporting period

IAS 10 states that if a company obtains information about an adjusting event after the reporting
period, it should update the financial statements to allow for this new information.
‘A company shall adjust the amounts recognised in its financial statements to reflect adjusting
events after the reporting period.’
IAS 10 gives the following examples of adjusting events.
 The settlement of a court case after the end of the reporting period, confirming that the
company had a present obligation as at the end of the reporting period as a consequence
of the case.
 The receipt of information after the reporting period indicating that an asset was impaired
as at the end of the reporting period. For example, information may be obtained about the
bankruptcy of a customer, indicating the need to make a provision for a bad (irrecoverable)
debt against a trade receivable in the year-end statement of financial position. Similarly,
information might be obtained after the reporting period has ended indicating that as at the
end of the reporting period the net realisable value of some inventory was less than its
cost, and the inventory should therefore be written down in value.
 The determination after the end of the reporting period of the purchase cost of an asset,
where the asset had already been purchased before the end of the reporting period, but
the purchase price had not been finally agreed or decided. Similarly, the determination
after the reporting period of the sale price for a non-current asset, where the sale had been
made before the end of the reporting period but the sale price had not yet been finally
agreed.
 The discovery of fraud or errors showing that the financial statements are incorrect.

Example:
On 31 December Year 1, Company G is involved in a court case. It is being sued by a supplier.
On 15 April Year 2, the court decided that Company G should pay the supplier Rs.45,000 in
settlement of the dispute.
The financial statements for Company G for the year ended 31 December Year 1 were authorised
for issue on 17 May Year 2.
The settlement of the court case is an adjusting event after the reporting period:
 It is an event that occurred between the end of the reporting period and the date the
financial statements were authorised for issue.
 It provided evidence of a condition that existed at the end of the reporting period. In this
example, the court decision provides evidence that the company had an obligation to the
supplier as at the end of the reporting period.
Since it is an adjusting event after the reporting period, the financial statements for Year 1 must
be adjusted to include a provision for Rs.45,000. The alteration to the financial statements should
be made before they are approved and authorised for issue.
Other examples of adjusting events are;

 Sale of inventory after the end of the reporting period for less than its carrying value at the
year end.
 Amount received or paid in respect of legal or insurance claim which were in negotiation at
the year end.
 Evidence of a permanent dismantling in property value or value of a long-term investment
prior to the year end.
2.3 Disclosures for non-adjusting events after the reporting period

Non-adjusting events after the reporting period are treated differently. A non-adjusting event
relates to conditions that did not exist at the end of the reporting period, therefore the financial
statements must not be updated to include the effects of the event. IAS 10 states quite firmly: ‘A
company shall not adjust the amounts recognised in the financial statements to reflect non-
adjusting events after the reporting period’.
However, IAS 10 goes on to say that if a non-adjusting event is material, a failure by the
company to provide a disclosure about it could influence the economic decisions taken by users
of the financial statements. For material non-adjusting events IAS 10 therefore requires
disclosure of:
 the nature of the event; and
 an estimate of its financial effect, or a statement that such an estimate cannot be made.
This information should be disclosed in a note to the financial statements.
(Note: There are no disclosure requirements for adjusting events as they have already been
reflected in the financial statements.)
IAS 10 gives the following examples of non-adjusting events:
 A fall in value of an asset after the end of the reporting period, such as a large fall in the
market value of some investments owned by the company, between the end of the
reporting period and the date the financial statements are authorised for issue. A fall in
market value after the end of the reporting period will normally reflect conditions that arise
after the reporting period, not conditions already existing as at the end of the reporting
period.
 The acquisition or disposal of a major subsidiary after the year end.
 The formal announcement of a plan to discontinue a major operation.
 Announcing or commencing the implementation of a major restructuring.

 The destruction of a production plant by a fire after the end of the reporting period. The
‘condition’ is the fire, not the plant, and the fire didn’t exist at the end of the reporting
period. The plant should therefore be reported in the statement of financial position at its
carrying amount as at the end of the reporting period. The fire, and the financial
consequences of the fire, should be disclosed in a note to the financial statements.
 Litigation commenced after the end of the reporting period.
2.4 Dividends
IAS 10 also contains specific provisions about proposed dividends and the going concern
presumption on which financial statements are normally based.
If equity dividends are declared after the reporting period, they should not be recognised,
because they did not exist as an obligation at the end of the reporting period.
Dividends proposed after the reporting period (but before the financial statements are approved)
should be disclosed in a note to the financial statements, in accordance with IAS 1.
Pakistan
Typically, in Pakistan a company will pay a dividend once a year. Dividend payments in Pakistan
must be approved by the members in a general meeting and this usually takes place after the
year end. This means that the dividend expensed in any one year is the previous year’s dividend
(which could not be recognised last year as it had not yet been approved in the general meeting.
Listed companies often pay an interim dividend part way through a year and a final dividend after
the year end. The actual dividend payment recognised in any one year would then be that year’s
interim dividend and the previous year’s final dividend (which could not be recognised last year
as it had not yet been approved in the general meeting).
2.5 The going concern assumption

There is one important exception to the normal rule that the financial statements reflect
conditions as at the end of the reporting period.
A deterioration in operating results and financial position after the end of the reporting period may
indicate that the going concern presumption is no longer appropriate.
There are a large number of circumstances that could lead to going concern problems. For
example:
 The financial difficulty of a major customer leading to their inability to pay their debt to the
agreed schedule if at all.
 An event leading to the net realisable value of lines of inventory falling to less than cost.
 An event leading to a crucial non-current asset falling out of use. This might cause
difficulties in supplying customers and fulfilling contracts.
 A change in market conditions leading to a loss in value of major investments.
 Shortages of important supplies
 The emergence of a highly effective competitor.
If it becomes clear that the client cannot be considered to be a going concern, the financial
statements will need to disclose this and the basis for preparing them will change to the ‘break-
up’ basis.
This means that values will have to be adjusted to the amounts expected to be realised through
sale.

3 PROVISIONS: RECOGNITION
Section overview
 Introduction
 Recognition criteria for provisions
 Present obligation
 Obligation arising out of a past event
 Probable outflow of economic benefits
3.1 Introduction
The first five sections of this chapter explain rules set out in IAS 37: Provisions, contingent
liabilities and contingent assets.
The sixth section is another topic, IAS 10: Events after the reporting period.
Definition
Provisions are liabilities of uncertain timing or amount.
A liability is 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.
An obligating event is an event that creates a legal or constructive obligation that results in an
entity having no realistic alternative to settling that obligation.
Provisions differ from other liabilities because there is uncertainty about the timing or amount of
the future cash flows required to settle the liability.
Accruals are liabilities to pay for goods or services that have been received or supplied but not
yet invoiced. There is often a degree of estimation in the measurement of accruals but any
inherent uncertainty is much less than for provisions.
IAS 37 applies to all provisions and contingencies apart from those covered by the specific
requirements of other standards.
In some countries the term “provision” is also used to describe the reduction in the value of an
asset. For example accountants might talk of provision for depreciation, provision for doubtful
debts and so on. These “provisions” are not covered by this standard which is only about
provisions that are liabilities.
Major accounting issues
There are three issues to address in accounting for provisions::
 whether or not a provision should be recognised;
 how to measure a provision that is recognised; and
 what is the double entry on initial recognition of a provision and how is it remeasured on
subsequent reporting dates.
3.2 Recognition criteria for provisions

A provision should be recognised when:
 a company has a present obligation (legal or constructive) as a result of a past event;
 it is probable that an outflow of economic benefits will be required to settle the obligation;
and
 a reliable estimate can be made of the amount of the obligation.
If one of these conditions is not met then a provision cannot be recognised.

3.3 Present obligation

An obligation must exist in order for a provision to be recognised.
An obligation may be legal or constructive.
 A legal obligation is one arising from a contract, or some other aspect of the law.
 A constructive obligation is one arising from the company’s actions, whereby
 through established past practice, published policies, or a specific current statement,
the company has indicated to other parties that it will accept certain responsibilities;
and
 as a result, the company has created a valid expectation that it will discharge those
responsibilities.
Example: Constructive obligation

A clothing retailer has a policy of taking back items of clothing that customers have purchased,
and refunding the purchase price, simply because the purchaser has changed his or her mind about
the item.
The retailer does not have a legal obligation to do this under the consumer protection legislation
that applies in the jurisdiction in which it operates.
If this is the usual practice of a particular retailer, and the retailer’s policy is well-known or has been
made known to customers, then a constructive obligation exists whenever a sale is made.
A provision would be recognised for sales returns subject to the other two criteria being satisfied.
In most cases it will be clear that a past event has given rise to a present obligation. However, in
rare cases this may not be the case. In these cases, the past event is deemed to give rise to a
present obligation if it is more likely than not that a present obligation exists at the end of the
reporting period. This determination must be based on all available evidence,
3.4 Obligation arising out of a past event

A past event that leads to a present obligation is called an obligating event. For this to be the
case it is necessary that the company has no realistic alternative to settling the obligation created
by the event.
This is the case only:
 where the settlement of the obligation can be enforced by law; or
 in the case of a constructive obligation, where the event (which may be an action of the
company) creates valid expectations in other parties that the company will discharge the
obligation.
The event leading to the obligation must be past, and must have occurred before the end of the
reporting period when the provision is first recognised. No provision is made for costs that may
be incurred in the future but where no obligation yet exists.
Illustration:
A company is planning a reorganisation. These plans are in an early stage.
There is no obligation (legal or constructive) to undertake the reorganisation. The company cannot
create a provision for reorganisation costs.
Only obligations arising from past events that exist independently of a company's future actions
are recognised as provisions.

Example:
Shan Properties owns a series of high rise modern office blocks in several major cities in Pakistan.
The government introduces legislation that requires toughened safety glass to be fitted in all
windows on floors above the ground floor. The legislation only applies initially to new buildings but
all buildings will have to comply within 5 years.
Analysis:
There is no obligating event.
Even though Shan Properties will have to comply within 5 years it can avoid the future expenditure
by its future actions, for example by selling the buildings. There is no present obligation for that
future expenditure and no provision is recognised.
Example:
Jhang Energy Company operates in a country where there is no environmental legislation. Its
operations cause pollution in this country.
Jhang Energy Company has a widely published policy in which it undertakes to clean up all
contamination that it causes and it has a record of honouring this published policy.
Analysis:
There is an obligating event. Jhang Energy Company has a constructive obligation which will lead
to an outflow of resources embodying economic benefits regardless of the future actions of the
company. A provision would be recognised for the clean-up subject to the other two criteria being
satisfied.
An obligation always involves another party to whom the obligation is owed.

However, it is not necessary to know the identity of that party. It is perfectly possible to have an
obligation to the public at large or to a group of people.
Example:
Shekhupura Household Appliances Corporation gives warranties at the time of sale to purchasers
of its products. Under the terms of the sale contract the company undertakes to make good any
manufacturing defects that become apparent within three years from the date of sale.
In the period it has sold 250,000 appliances and estimates that about 2% will prove faulty.
Analysis:
There is an obligating event being the sale of an item with the promise to repair it as necessary.
The fact that Shekhupura Household Appliances Corporation does not know which of its customers
will seek repairs in the future is irrelevant to the existence of the obligation.
A provision would be recognised for the future repairs subject to the other two criteria being
satisfied.
Note that the estimate that only 2% will be faulty is irrelevant in terms of recognising a provision.
However, it would be important when it came to measuring the size of the provisions. This is covered
in the next section.
An obligation always involves a commitment to another party. Therefore, a management decision

does not give rise to a constructive obligation unless it has been communicated before the end of
the reporting period to those affected by it in a sufficiently specific manner to raise a valid
expectation in them that the company will discharge its responsibilities.

Example:
On 13 December Kasur Engineering decided to close a factory. The closure will lead to 100
redundancies at a significant cost to the company.
At 31 December no news of this plan had been communicated to the workforce.
Analysis:
There is no obligating event. This will only come into existence when communication of the decision
and its consequences are communicated to the workforce.
An event may not give rise to an obligation immediately but may do so at a later date due to a
change in circumstances. These include:
 changes in the law; or
 where an act of the company (for example, a sufficiently specific public statement) gives
rise to a constructive obligation.
If details of a proposed new law have yet to be finalised, an obligation arises only when the
legislation is virtually certain to be enacted as drafted.
3.5 Probable outflow of economic benefits

The outflow of benefits must be probable. ‘Probable’ is defined by IAS 37 as ‘more likely than not
to occur’.
Illustration:
A company may have given a guarantee but may not expect to have to honour it.
No provision arises because a payment under the guarantee is not probable.
More likely than not implies a greater than 50% chance but be careful to think about this in the
right way.
Example:
Shekhupura Household Appliances Corporation gives warranties at the time of sale to purchasers
of its products. Under the terms of the sale contract the company undertakes to make good any
manufacturing defects that become apparent within three years from the date of sale.
In the period it has sold 250,000 appliances and estimates that about 2% will prove faulty.
Analysis:
The outflow of benefits is probable. It is more likely than not that 2% will be faulty. (In other words
there is more than a 50% chance that 2% of items will prove to be faulty).

4 PROVISIONS: MEASUREMENT
Section overview
 Introduction
 Risk and uncertainties
 Time value
 Future events
 Expected disposal of assets
 Reimbursements
 Changes in provisions
4.1 Introduction
The amount recognised as a provision must be the best estimate, as at the end of the reporting
period, of the future expenditure required to settle the obligation. This is the amount that the
company would have to pay to settle the obligation at this date. It is the amount that the company
would have to pay a third party to take the obligation off its hands.
The estimates of the outcome and financial effect of an obligation are made by management
based on judgement and experience of similar transactions and perhaps reports from
independent experts.
Risks and uncertainties should be taken into account in reaching the best estimate. Events after
the reporting period will provide useful evidence. (Events after the reporting period are dealt with
in more detail later.)
4.2 Risk and uncertainties

Risk describes variability of outcome. A risk adjustment may increase the amount at which a
liability is measured.
Uncertainties about the amount to be recognised as a provision are dealt with by various means
according to the circumstances.
In measuring a single obligation, the best estimate of the liability may be the most likely outcome.
However, other possible outcomes should be considered. If there are other possibilities which are
mostly higher or mostly lower than the most likely outcome, then the best estimate will be a
higher or lower amount.
Example:
Gujrat Prefabricators Limited (GPL) has won a contract to provide temporary accommodation for
workers involved in building a new airport. The contract involves the erection of accommodation
blocks on a public park and two years later the removal of the blocks and the reinstatement of
the site.
The blocks have been built and it is now GPL’s year-end.
GPL estimates that the task of removing the blocks and reinstating the park to its present condition
might be complex, resulting in costs with a present value of Rs. 2,000,000, or straightforward,
resulting in costs with a present value of Rs. 1,300,000.
GPL estimates that there is a 60% chance of the job being straightforward.
Should a provision be recognised and if so at what value?

Analysis
Should a provision be recognised?
Is there a present obligation as a result Yes. A present obligation arises due to the
of a past event? existence of a contractual term and the building
of the block.
Is it probable that there will be an Yes. This is certain.
outflow of economic benefits to settle
the obligation
Can a reliable estimate be made of the Yes. Data is available.
amount of the obligation?
A provision should be recognised.
How should the provision be measured? (What is the best estimate of expenditure required to
settle the obligation?)
The most likely outcome is that the job will be straightforward. In this case the provision would
be recognised at Rs. 1,300,000.
However there is a significant chance that the job will be complex so perhaps GPL should
measure the liability at the higher amount. This may sound a little vague but in practice this
comes down to a matter of judgement.
When there is a large population of potential obligations (for example, a provision for multiple
claims under guarantees) the obligation should be estimated by calculating an expected value of
the cost of the future obligations. This is done by weighting all possible outcomes by their
associated probabilities.
Example:
Sahiwal Manufacturing has sold 10,000 units in the year. Sales accrued evenly over the year.
It estimates that for every 100 items sold, 20 will require small repairs at a cost of Rs. 100, 10 will
require substantial repairs at a cost of Rs. 400 each and 5 will require major repairs or replacement
at a cost of Rs. 800 each.
On average the need for a repair becomes apparent 6 months after a sale.
What is the closing provision?
A provision will be required for the sales in the second six months of the year as presumably the
repairs necessary in respect of the sales in the first six months have been completed by the year
end.
Sales accrue evenly, therefore, the sales in the second six months are 5,000 units (6/12  10,000).
Repair Number of units Cost per repair (Rs.) Total (Rs.)

Small 20%  5,000 = 1,000 100 100,000
Substantial 10%  5,000 = 500 400 200,000
Major 5%  5,000 = 250 800 200,000
Provision 500,000
Note that this would be reduced by the repairs already made by the year end

4.3 Time value

Where the effect of the time value of money is material, a provision is measured at the present
value of the expenditures expected to be required to settle the obligation.
The discount rate used should be a pre-tax rate (or rates) that reflect(s) current market
assessments of the time value of money and the risks specific to the liability.
The need to discount is often found when accounting for decommissioning liabilities.
Example:
Gujrat Prefabricators Limited (GPL) has won a contract to provide temporary accommodation for
workers involved in building a new airport. The contract involves the erection of accommodation
blocks on a public park and two years later the removal of the blocks and the reinstatement of the
site.
The blocks have been built and it is now 31 December 2017 (GPL’s year-end).
GPL estimates that in two years it will have to pay Rs. 2,000,000 to remove the blocks and reinstate
the site.
The pre-tax discount rate that reflects current market assessments of the time value of money and
the risks specific to the liability is 10%.
The provision that should be recognised at 31 December 2017 is as follows:
1
Rs. 2,000,000 = Rs. 1,652,893
(1.1)2
Unwinding of discount should be accounted for as follows:

Debit Credit
Finance cost XXX
Provision XXX
4.4 Future events

Expected future events may be important in measuring provisions. For example, a company may
believe that the cost of cleaning up a site at the end of its life will be reduced by future changes in
technology.
The measurement of an obligation must take expected future changes into account where there
is sufficient objective evidence that they will occur. In such cases the measurement of the
provision should be based on the reasonable expectations of technically qualified, objective
observers, taking account of all available evidence as to the technology that will be available at
the time of the clean-up.
This means that a company might include expected cost reductions associated with increased
experience in applying existing technology or the expected cost of applying existing technology to
a larger or more complex clean-up operation than has previously been carried out.
One future event might be the effect of possible new legislation.
The measurement process should take this into account when there is sufficient objective
evidence that the legislation is virtually certain to be enacted.
In practice, the proceeds of the sale of an asset in the future might be used to pay for an event
for which a provision is recognised today. However, gains from the expected disposal of assets
must not be taken into account in measuring a provision.
4.5 Expected disposal of assets

Gains from the expected disposal of assets should not be taken into account in measuring a
provision even if the expected disposal is closely linked to the event giving rise to the provision.

4.6 Reimbursements
In some cases, a part or all of a company’s provision may be recoverable from a third party. For
example, a company paying out to a customer under the terms of a guarantee may itself be able
to claim money back from one of its own suppliers.
IAS 37 requires that such a reimbursement:
 should only be recognised where receipt is virtually certain; and
 should be treated as a separate asset in the statement of financial position (i.e. not netted
off against the provision) at an amount no greater than that of the provision.
However, IAS 37 allows the expense relating to a provision to be presented net of the amount
recognised for a reimbursement in the statement of profit or loss.
A reimbursement right is recognized as a separate asset (no netting off with the provision itself),
but you can net off the expenses for provision with the income from reimbursement in the profit or
loss.
Reimbursements should be accounted for as follows:
Debit Credit
Asset XXX
Expense XXX
4.7 Changes in provisions

Provisions must be reviewed at the end of each reporting period and adjusted to reflect the current
best estimate. If it is no longer probable that an outflow of resources embodying economic benefits
will be required to settle the obligation, the provision should be reversed.

5 PROVISIONS: DOUBLE ENTRY AND DISCLOSURES

Section overview
 Introduction
 Measurement on initial recognition
 Use of provisions
 Subsequent measurement
 Disclosures about provisions
5.1 Introduction
IAS 37 is about the recognition and measurement of provisions which are of course a credit
balance. It gives little guidance on the recognition of the debit entry on initial recognition of a
provision saying that whether an expense or asset is recognised is left to guidance in other
standards.
5.2 Measurement on initial recognition

In most cases the debit entry that arises when a provision is recognised is an expense. There is
one important case where it is capitalised as an asset (on recognition of a decommissioning
liability) and this is discussed later.
Illustration: Usual double entry on initial recognition of a provision

Debit Credit
Profit or loss (expense) X
Provision X
5.3 Use of provisions

A provision is set up to recognise an expense (usually) that exists at the reporting date. When the
expense is paid the following double entry is used:
Illustration: Using a provision.

Debit Credit
Provision X
Cash X
If the provision is more than the amount needed to settle the liability the balance is released as a
credit back through the income statement.
If the provision is insufficient to settle the liability an extra expense is recognised.
IAS 37 also states that a provision may be used only for expenditures for which the provision was
originally recognised.
Example:
A company has created a provision of Rs.300,000 for the cost of warranties and guarantees.
The company now finds that it will probably has to pay Rs.250,000 to settle a legal dispute.
It cannot use the warranties provision for the costs of the legal dispute. An extra Rs. 250,000
expense must be recognised.

5.4 Subsequent measurement

Each provision must be reviewed at the end of each reporting period. This might result in
derecognition of a provision that no longer meets the recognition criteria or in the re-
measurement of a provision. An increase in a provision would result in the recognition of a further
expense or a reduction in expense as the previously recognised provision is reduced through a
credit to profit or loss.
Illustration: Subsequent re-measurement of provisions.
Debit Credit
Derecognition of a provision that is no longer needed.
Provision X
Income statement X
Increase in a provision:
Profit or loss (expense) X
Provision X
Decrease in a provision:
Provision X
Profit or loss X
Example:
31 December 2016
A company was sued by a customer in the year ended 31 December 2016.
Legal advice is that the customer is virtually certain to win the case as several similar cases have
already been decided in the favour of the injured parties.
At 31 December 2016, the company’s lawyer was of the opinion that, the cost of the settlement
would be Rs.1,000,000.
A provision is recognised in the amount of Rs.1,000,000 as follows (reducing profit for the year by
that amount) .
Debit (Rs.) Credit (Rs.)
Expenses 1,000,000
Provision 1,000,000
31 December 2017
The claim has still not been settled. The lawyer now advises that the claim will probably be settled
in the customer’s favour at Rs.1,200,000.
The provision is increased to Rs.1,200,000 as follows.
Expenses 200,000
Provision 200,000
31 December 2018
The claim has still not been settled. The lawyer now believes that the claim will be settled at
Rs.900,000.
The provision is reduced to Rs.900,000 as follows.
Provision 300,000
Expenses 300,000

The reduction in the provision increases profit in the year and the provision in the statement of
financial position is adjusted down to the revised estimate of Rs.900,000.
31 December 2019
The claim is settled for Rs.950,000. On settlement, the double entry in the ledger accounts will be:
Expenses 50,000
Provision 900,000
Cash 950,000
The charge against profit on settlement of the legal claim is Rs.50,000.
The provision no longer exists. The total amount charged against profit over the four years was the
final settlement figure of Rs.950,000.
When a provision is included in the statement of financial position at a discounted value (at
present value) the amount of the provision will increase over time, to reflect the passage of time.
In other words, as time passes the amount of the discount gets smaller, so the reported provision
increases. This increase in value is included in borrowing costs for the period.
5.5 Disclosures about provisions

IAS 37 requires the following disclosures about provisions in notes to the financial statements.
 For each class of provision, an entity shall disclose:
(a) the carrying amount at the beginning and end of the period;
(b) additional provisions made in the period, including increases to existing provisions;
(c) amounts used (i.e. incurred and charged against the provision) during the period;
(d) unused amounts reversed during the period; and
(e) the increase during the period in the discounted amount arising from the passage of
time and the effect of any change in the discount rate.
 a brief description of:
 the nature of the obligation;
 the expected timing of any settlement; and
 an indication of the uncertainties surrounding the amount and timing of any
settlement.

6 GUIDANCE ON SPECIFIC PROVISIONS

Section overview
 Warranty / guarantee
 Onerous contracts
 Future operating losses
 Restructuring
 Decommissioning liabilities and similar provisions
 IFRIC 1: Changes in existing decommissioning, restoration and similar liabilities
 Future repairs to assets
IAS 37 explains how its rules apply in given circumstances. Some of the guidance is in the body of the
standard and some in an appendix to the standard.
6.1 Warranty / guarantee

An entity provides guarantee to its customers to repair or replace certain types of damage to its
products within a certain specific period following the sale date. If the company can reasonably
estimate the amount of warranty claims likely to arise under the policy, it should accrue an
expense that reflects the cost of these anticipated claims.
The accrual should be recorded in the same reporting period in which the related product’s sales
are recorded so that the financial statements represent all costs associated with product sales
most accurately.
If the cost of warranty claims were to instead be recognized only when the company processes
actual claims from customers, the costs may not be recognized until several months after the
associated sales. The financial reporting under this approach would report high initial profits,
followed by depressed profits in later months, for as long as the warranty period lasts.
If there is no information from which to derive a warranty estimate for use in an accrual, industry
information about warranty claims should be gathered.
If a warranty claim period extends for longer than one year, it may be necessary to split the
accrued warranty expense into a short-term liability for those claims expected within one year,
and a long-term liability for those claims expected in more than one year.
Example of Warranty Accounting

Chino Ltd. produces trucks. It has experienced a warranty cost of 1% of revenues, and so records
a warranty expense based on that information. However, the company has just developed a new
model of truck that may be less durable than its more traditional truck. The truck could be subject
to more breakage under a heavy load, and so may have a higher warranty claim rate. No other
companies in the industry sell such version of trucks, The Truck controller elects to apply a high 3%
warranty claim rate as the basis for an accrual, based on the results of initial product testing. The
amount of the entry is for Rs.300,000, as shown in the following journal entry:
Debit Credit
Warranty expense 300,000
Accrued warranty liability 300,000
During the following month, Chino receives claims for damaged trucks from its distributors
amounting Rs.9,000, which are covered by the company's warranty policy. The journal entry used
to record this transaction is:
Debit Credit
Accrued warranty liability 9,000
Cash 9,000

6.2 Onerous contracts
Definition
An onerous contract is a contract where the unavoidable costs of fulfilling/completing the
contract now exceed the benefits to be received (the contract revenue).
A provision should be made for the additional unavoidable costs of an onerous contract. (The
‘additional unavoidable costs’ are the amount by which costs that cannot be avoided are
expected to exceed the benefits). You should make a provision in the amount lower of:
 Unavoidable costs of fulfilling the contract and
 Compensation/penalty for not meeting your obligations from the contract
Onerous contracts arise when unavoidable cost exceeds economic benefits. In relation to the
trading and sales of commodities, an onerous contract may occur if the market price of the
commodity being held falls below the cost that is needed in order to obtain, uncover or produce
the commodity.
Example:
Nawabsha Clothing has a contract to buy 300 metres of silk from a supplier each month for
Rs.3,000 per metre.
Nawabsha Clothing had a contract with a Dubai retailer to sell each dress for Rs. 5,000 but this
retailer has fallen into administration and the administrators have cancelled the contract as they
were entitled to do under one of its clauses.
Nawabsha Clothing cannot sell the dresses to any other customer.
The contract to buy the silk can be cancelled with three months’ notice.
Analysis
The company can cancel the contract but must pay for the next three months deliveries:
Cost (300m × Rs. 3,000 × 3 months) Rs. 2,700,000
A provision should be recognised for this amount.
6.3 Future operating losses

A company may forecast that it will make a substantial operating loss in the next year or several
years. If so, its directors might want to ‘take all the bad news’ immediately, and create a provision
for the future losses.
Provisions cannot be made for future operating losses. This is because they arise from future
events, not past events.
6.4 Restructuring
A company may plan to restructure a significant part of its operations. Examples of restructuring
are:
 the sale or termination of a line of business
 the closure of business operations in a country or geographical region, or relocation of
operations from one region or country to another
 major changes in management structure, such as the removal of an entire ‘layer’ of
management from the management hierarchy
 fundamental reorganisations changing the nature and focus of the company’s operations.
A provision is recognised for the future restructuring costs only if a present obligation exists.

A constructive obligation to restructure arises only when a company:

 has a detailed formal plan for the restructuring identifying at least:
 the business or part of a business concerned;
 the principal locations affected;
 the location, function, and approximate number of employees who will be
compensated for terminating their services;
 the expenditures that will be undertaken; and
 when the plan will be implemented; and
 has raised a valid expectation in those affected that it will carry out the restructuring by
starting to implement that plan or announcing its main features to those affected by it.
A restructuring decision made before the end of the reporting period does not give rise to a
constructive obligation unless the company has:
 started to implement the plan; or
 announced the main features of the plan to those affected by it in a sufficiently specific
manner to raise a valid expectation in them that the restructuring will occur.
A company might start to implement a restructuring plan, or announces its main features to those
affected, after the reporting period but before the financial statements are authorised for issue.
Disclosure is required under IAS 10 Events after the Reporting Period if the restructuring is
material (see section 6 of this chapter).
A restructuring provision must only include the direct expenditures arising from the restructuring.
These are those that are both:
 necessarily entailed by the restructuring; and
 not associated with the ongoing activities of the company.
A restructuring provision would not include costs that are associated with ongoing activities such
as:
 retraining or relocating continuing staff;
 marketing; or
 investment in new systems etc.
6.5 Decommissioning liabilities and similar provisions

A company may be required to ‘clean up’ a location where it has been working when production
ceases.
This is often the case in industries where companies are only granted licenses to operate on
condition that they undertake to perform future clean-up operations.
Such industries include, oil and gas, mining and nuclear power.
For example, a company that operates an oil rig may have to repair the damage it has caused to
the sea bed once the oil has all been extracted.
The normal rules apply for the recognition of a provision: a company recognises a provision only
where it has an obligation to rectify environmental damage as a result of a past event.
A company has an obligation to ‘clean-up’ a site if:
 it is required to do so by law (a legal obligation); or
 its actions have created a constructive obligation to do so.
A constructive obligation might exist if (for example) a company has actually promised to
decontaminate a site or if it has adopted environmentally friendly policies and has made the
public aware of this.

Accounting for a provision for a decommissioning liability

IAS 16 Property, plant and equipment identifies the initial estimate of the costs of dismantling and
removing an item and restoring the site upon which it is located as part of the cost of an asset.
Future clean-up costs often occur many years in the future so any provision recognised is usually
discounted to its present value.
Illustration: Initial recognition of a provision for a decommissioning liability

Debit Credit
Non-current asset X
Provision X
The asset is depreciated over its useful life in the same way as other non-current assets.
The provision is remeasured at each reporting date. If there has been no change in the estimates
(i.e. the future cash cost, the timing of the expenditure and the discount rate) the provision will
increase each year because the payment of the cash becomes one year closer. This increase is
described as being due to the unwinding of the discount.
The amount due to the unwinding of the discount must be expensed.
Example: Deferred consideration
A company has constructed an oil rig which became operational on 1 January 2017.
The company has contracted to remove the oil rig and all associated infrastructure and to restore
the site to repair any environmental damage to the site on completion of drilling activity. This is
estimated to be at a cost of Rs.8,000,000 in 10 years’ time.
The pre-tax rate that reflects current market assessments of the time value of money and the risks
specific to the liability is 10%.
1 January 2017 – Initial measurement
1
Rs. 8,000,000 × = Rs. 3,084,346
(1.1)10
Debit Credit
Asset 3,084,346
Provision 3,084,346
31 December 2017
The provision is remeasured as:
1
Rs. 8,000,000 × = Rs. 3,392,781
(1.1)9
Provision: Rs.
Balance b/f 3,084,346
Interest expense (the unwinding of the discount) 308,435
Balance c/f 3,392,781
The asset is depreciated (say on a straight line)
Asset: Rs.
Cost 8,000,000
Depreciation (Rs. 8,000,000/10 years) (800,000)
Carrying amount 7,200,000

Example: Deferred consideration (continued)

Double entry:
Debit Credit
Profit or loss (interest expense) 308,435
Provision 308,435
Profit or loss (depreciation expense) 800,000
Accumulated depreciation 800,000
A provision for making good environmental damage might be recognised both on when an asset
is installed and then increased as the asset is used.
Example:
A company is about to begin to operate a coal mine. At the end of the reporting period, the
mineshaft has been prepared and all the necessary equipment has been constructed and is in
place, but no coal has yet been extracted.
Under local law, the company is obliged to rectify all damage to the site once the mining operation
has been completed (this is expected to be several years from now).
Management estimates that 20% of the eventual costs of performing this work will relate to
plugging the mine and removing the equipment and various buildings and the remaining 80% will
relate to restoring the damage caused by the actual extraction of coal.
Analysis
The company has a legal obligation to rectify the environmental damage caused by the actual
digging of the mineshaft and construction of the site. An outflow of economic benefits is probable.
Therefore the company should recognise a provision for the best estimate of removing the
equipment and rectifying other damage which has occurred to date. This is expected to be about
20% of the total cost of restoring the site.
Because no coal has yet been extracted, the company has no obligation to rectify any damage
caused by mining. No provision can be recognised for this part of the expenditure (estimated at
about 80% of the total).
6.6 IFRIC 1: Changes in existing decommissioning, restoration and similar liabilities
At a glance
IFRIC 1 applies where an entity has previously included decommissioning or restoration costs
within the cost of an item of property, plant or equipment, and created a corresponding provision.
Such a provision should be discounted to present values using a current market-based discount
rate.
IFRIC 1 mainly addresses how an entity accounts for any subsequent changes to the amount of
the liability that may arise from;
a) a revision in the timing or amount of the estimated costs or
b) a change in the current market-based discount rate.
Background and issue

Many entities have obligations to dismantle, remove and restore items of property, plant and
equipment’. Under IAS 16, Property, Plant and Equipment, the cost of an item of property, plant
and equipment includes the initial estimate of the costs of dismantling and removing the item and
restoring the site on which it is located, the obligation for which an entity incurs either when the
item is acquired or as a consequence of having used the item during a particular period for
purposes other than to produce inventories during that period.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets contains requirements on how to
measure decommissioning, restoration and similar liabilities. This Interpretation provides
guidance on how to account for the effect of subsequent changes in the measurement of existing
decommissioning, restoration and similar liabilities.
Scope
IFRIC 1 applies to changes in the measurement of any existing decommissioning, restoration or

similar liability that is both:
i. Recognised as part of the cost of an item of property, plant and equipment in accordance
with IAS 16
ii. Recognised as a liability in accordance with IAS 37.
For example, a decommissioning, restoration or similar liability may exist for decommissioning a
plant or rehabilitating environmental damage, in extractive industries, or the removal of
equipment.
Consensus
Changes in the measurement of an existing decommissioning, restoration and similar liability that
result from changes in the estimated timing or amount of the outflow of resources embodying
economic benefits required to settle the obligation, or a change in the discount rate, are
accounted for as detailed below.
Asset measured using the Cost Model
 Changes in the liability are added to, or deducted from, the cost of the related asset in the
current period
 The amount deducted from the cost of the asset cannot exceed its carrying amount. If a
decrease in the liability exceeds the carrying amount of the asset, the excess is recognised
immediately in profit or loss
 If the adjustment results in an addition to the cost of an asset, the entity considers whether
this is an indication that the new carrying amount of the asset may not be fully recoverable.
If there is such an indication, the entity tests the asset for impairment by estimating its
recoverable amount, and accounts for any impairment loss, in accordance with IAS 36
Impairment of Assets.
Asset measured using the Revaluation Model
Changes in the liability alter the revaluation surplus or deficit previously recognised on that asset,
so that:
 A decrease in the liability is recognised in other comprehensive income and increases the
revaluation surplus within equity, except that it is recognised in profit or loss to the extent
that it reverses a revaluation deficit on the asset that was previously recognised in profit or
loss
 An increase in the liability is recognised in profit or loss, except that it is recognised in

other comprehensive income and reduces the revaluation surplus within equity to the
extent of any credit balance existing in the revaluation surplus in respect of that asset
 In the event that a decrease in the liability exceeds the carrying amount that would have
been recognised had the asset been carried under the cost model, the excess is
recognised immediately in profit or loss
 A change in the liability is an indication that the asset may have to be revalued in order to
ensure that the carrying amount does not differ materially from that which would be
determined using fair value at the end of the reporting period
 The change in the revaluation surplus arising from a change in the liability is separately
identified and disclosed as such.

Disclosure
 The periodic unwinding of discount is recognised in profit or loss as a finance cost as it

occurs
 Capitalisation under IAS 23 Borrowing Costs is not permitted.
6.7 Future repairs to assets

Some assets need to be repaired or to have parts replaced at intervals during their lives.
For example, suppose that a furnace has a lining that has to be replaced every five years. If the
lining is not replaced, the furnace will break down.
Before IAS 37 was issued, companies would often recognise provisions for the cost of future
repairs or replacement parts. These might be built up in instalments over the life of the asset or
the relevant part of the asset.
IAS 37 effectively prohibits this treatment. The reasoning behind this is that a company almost
always has an alternative to incurring the expenditure, even if it is required by law (for example,
for safety reasons). For example, the company which has to replace the lining of its furnace could
sell the furnace or stop using it, although this is unlikely in practice.
IAS 37 states that a provision cannot be recognised for the cost of future repairs or replacement
parts unless the company has an obligation to incur the expenditure, which is unlikely. The
obligating event is normally the actual repair or purchase of the replacement part.
Instead of recognising a provision, a company should capitalise expenditure incurred on
replacement of an asset and depreciate this cost over its useful life. This is the period until the
part needs to be replaced again. For example, the cost of replacing the furnace lining should be
capitalised, so that the furnace lining is a non-current asset; the cost should then be depreciated
over five years. (Note: IAS 16: Property, plant and equipment states that where an asset has two
or more parts with different useful lives, each part should be depreciated separately.)
Normal repair costs, however, are expenses that should be included in profit or loss as incurred.

7 CONTINGENT LIABILITIES AND CONTINGENT ASSETS

Section overview
 Definitions
 Recognising contingent liabilities or contingent assets
 Disclosures about contingent liabilities and contingent assets
 Summary: liabilities, provisions, contingent liabilities and contingent assets
7.1 Definitions
‘Contingent’ means ‘dependent on something else happening’.
Contingent liability
A contingent liability is one that does not exist at the reporting date but may do so in the future or
it is a liability that exists at the reporting date but cannot be recognised because it fails one of the
IAS 37 recognition criteria.
Definition: Contingent liability
A contingent liability is either of the following:
A contingent liability is a possible obligation that arises from past events and whose existence will
be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the entity.
OR
A contingent liability is a present obligation that arises from past events but is not recognised
because it is not probable that an outflow of economic benefits will be required to settle the
obligation or the amount of the obligation cannot be measured with sufficient reliability.
IAS 37 makes a distinction between:

 provisions – which are recognised as liabilities (assuming that a reliable estimate can be
made) because they are present obligations and it is probable that an outflow of resources
embodying economic benefits will be required to settle the obligations; and
 contingent liabilities – which are not recognised as liabilities because they are either:
 possible obligations;
 present obligations that do not meet the recognition criteria for provisions because
either:
 it is not probable that an outflow of resources embodying economic benefits

will be required to settle the obligation; or
 a sufficiently reliable estimate of the amount of the obligation cannot be

made).
Example:
Company G is involved in a legal dispute with a customer, who is making a claim against Company
G for losses it has suffered as a consequence of a breach of contract.
If Company G’s lawyers believe that the likelihood of the claim succeeding is possible rather than
probable, then the claim should be treated as a contingent liability and not as a provision.
Contingent asset
Definition: Contingent asset

A contingent asset is a possible asset that arises from past events whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the entity.

An example of a contingent asset might be a possible gain arising from an outstanding legal
action against a third party. The existence of the asset (the money receivable) will only be
confirmed by the outcome of the legal dispute.
7.2 Recognising contingent liabilities or contingent assets

Contingent liabilities and contingent assets are not recognised in the financial statements.
In some circumstances, information about the existence of a contingent asset or a contingent
liability should be disclosed in the notes to the financial statements.
 Contingent liabilities should be disclosed unless the possibility of any outflow in
settlement is remote (the meaning of ‘remote’ is not defined in IAS 37).
 Contingent assets should be disclosed only if an inflow in settlement is probable.
’Probable’ is defined by IAS 37 as ‘more likely than not’. (And if an inflow is certain, the
item is an actual asset that should be recognised in the statement of financial position.)
7.3 Disclosures about contingent liabilities and contingent assets

Where disclosure of a contingent liability or a contingent asset is appropriate, the following
disclosures are required:
 A brief description of the nature of the contingent liability/asset
 Where practicable:
 an estimate of its financial effect
 an indication of the uncertainties.
 For contingent liabilities, the possibility of any reimbursement.
7.4 Summary: liabilities, provisions, contingent liabilities and contingent assets

The following table provides a summary of the rules about whether items should be treated as
liabilities, provisions, contingent liabilities or contingent assets.
Criteria Provision Contingent liability Contingent asset
Present Yes Yes No (but may Only a possible

obligation/ asset come into asset
arising from past existance in
events? the future)
Will settlement Probable outflow Not probable Outflow to be Inflow to be

result in outflow/ – and a reliable outflow – or a confirmed by confirmed by
inflow of estimate can be reliable estimate uncertain uncertain future
economic made of the cannot be made future events events
benefits? obligation of the obligation
Treatment in the Recognise a Disclose as a Disclose as a Only disclose if

financial provision contingent contingent inflow is probable
statements liability (unless liability (unless
the possibility of the possibility
outflow is of outflow is
remote) remote)

Practice question
A manufacturing company has the following litigations at year end. The outcome is not yet known.
1. A company expects to probably receive the damages
2. The company thinks it may receive damages, but it is not probable..
3. It expects to have to pay a penalty of about Rs.250,000.
4. The company expects to have to pay damages but is unable to estimate the amount.
5. The company expects to receive damages of Rs.100,000 and this is virtually certain.
Discuss whether provision, contingent liability and contingent asset should be recognised in each
of the following situations?
Answer
1. A contingent asset is disclosed
2. No disclosure.
3. A provision for Rs.100,000 is recognised in current period.
4. A contingent liability is disclosed.
5. An asset is recognised
Decision tree
An Appendix to IAS 37 includes a decision tree, showing the rules for deciding whether an item
should be recognised as a provision, reported as a contingent liability, or not reported at all in the

Practice question 1
Sahiwal Transformers Ltd (STL) is organised into several divisions.
The following events relate to the year ended 31 December 2017.
1 A number of products are sold with a warranty. At the beginning of the year the
provision stood at Rs. 750,000.
A number of claims have been settled during the period for Rs. 400,000.
As at the year end there were unsettled claims from 150 customers. Experience is that
40% of the claims submitted do not fulfil warranty conditions and can be defended at
no cost.
The average cost of settling the other claims will be Rs. 7,000 each.
2 A transformer unit supplied to Rahim Yar Khan District Hospital exploded during the
year.
The hospital has initiated legal proceedings for damages of Rs. 10 million against STL.
STL’s legal advisors have warned that STL has only a 40% chance of defending the
claim successfully. The present value of this claim has been estimated at Rs. 9 million.
The explosion was due to faulty components supplied to STL for inclusion in the
transformer. Legal proceedings have been started against the supplier. STL’s legal
advisors say that STL have a very good chance of winning the case and should receive
40% of the amount that they have to pay to the hospital.
3 On 1 July 2017 STL entered into a two-year, fixed price contract to supply a customer
100 units per month.
The forecast profit per unit was Rs. 1,600 but, due to unforeseen cost increases and
production problems, each unit is anticipated to make a loss of Rs. 800.
4 On 1 July 2016 one of STL’s divisions has commenced the extraction of minerals in an
overseas country. The extraction process causes pollution progressively as the ore is
extracted.
There is no environmental clean-up law enacted in the country.
STL made public statements during the licence negotiations that as a responsible
company it would restore the environment at the end of the licence.
STL has a licence to operate for 5 years. At the end of five years the cost of cleaning (on
the basis of the planned extraction) will be Rs. 5,000,000.
Extraction commenced on 1 July 2017 and is currently at planned levels.
Required
Prepare the provisions and contingencies note for the financial statements for the year
ended 31 December 2017, including narrative commentary.

SOLUTION TO PRACTICE QUESTION

Solution: Provisions and contingencies 1
Legal Onerous Clean-up
Warranty claim contract costs Total
Rs. 000 Rs. 000 Rs. 000 Rs. 000 Rs. 000
At 1 January
2017 750 nil nil 500 1,250
Used in the year (400) (400)
Statement of
profit or loss
(balance) 280 9,000 1,440 1,000 11,720
At 31 December
2017 630 9,000 1,440 1,500 12,570
W1 W2 W3 W4
Warranty: The company grants warranties on certain categories of goods. The

measurement of the provision is on the company’s experience of the likelihood and cost of
paying out under the warranty.
Legal claim: The legal claim provision is in respect of a claim made by a customer for
damages as a result of faulty equipment supplied by the company. It represents the
present value of the amount at which the company's legal advisors believe the claim is
likely to be settled.
Onerous contract: The provision for the onerous contract is in respect of a two-year fixed-
price contract which the company entered into on 1 July 2017. Due to unforeseen cost
increases and production problems, a loss on this contract is now anticipated. The provision
is based on the amount of this loss up to the end of the contract.
Clean-up costs: The provision for clean-up costs is in respect of the company's overseas
mineral extraction operations.
The company is 18 months into a five year operating licence. The estimated cost of
cleaning up the site at the end of the five years is Rs. 5,000,000. A provision of Rs.
1,000,000 per annum is recognised.
Contingent asset: The company is making a claim against a supplier of components. These
components led in part to the legal claim against the company for which a provision has
been made above. Legal advice is that this claim is likely to succeed and should amount to
around 40% of the total damages (Rs. 3.6 million).
W1 Warranty provision: 150  Rs. 7,000  60% = Rs. 630,000.

W2 Onerous contract: 18 months  100 units  Rs. 800 = Rs. 1,440,000.
W3 Clean up costs: Rs. 1,000,000 per annum as it is the extraction that causes the cost.

15
CHAPTER
Ethical Issues in Financial Reporting
Contents
1 ICAP Code of Ethics
2 Preparation and reporting of information

1 ICAP CODE OF ETHICS

Section overview
 Introduction
 The fundamental principles
 Threats to the fundamental principles
1.1 Introduction
Ethics can be difficult to define but it is principally concerned with moral principles, character and
conduct. Ethical behaviour is more than obeying laws, rules and regulations. It is about doing ‘the
right thing’. The accountancy profession is committed to acting ethically and in the public interest.
Professional accountants may find themselves in situations where values are in conflict with one
another due to responsibilities to employers, clients and the public.
ICAP has a code of conduct which members and student members must follow. The code
provides guidance in situations where ethical issues arise.
Comment
Most people are honest and have integrity and will always try to behave in the right way in a
given set of circumstances. However, accountants might face situations where it is not easy to
see the most ethical course of action. One of the main roles of the ICAP code is to provide
guidance in these situations.
Impact on members in practice
All members and student members of ICAP are required to comply with the code of ethics and it
applies to both accountants in practice and in business.
This chapter explains ethical issues surrounding the preparation of financial statements and other
financial information.
1.2 The fundamental principles

ICAP’s Code of Ethics expresses its guidance in terms of five fundamental principles. . These
are:
 integrity;
 objectivity;
 professional competence and due care;
 confidentiality; and
 professional behaviour
Integrity
Members should be straightforward and honest in all professional and business relationships.
Integrity implies not just honesty but also fair dealing and truthfulness.
A chartered accountant should not be associated with reports, returns, communications or other
information where they believe that the information:
 Contains a materially false or misleading statement;
 Contains statements or information furnished recklessly; or
 Omits or obscures information required to be included where such omission or obscurity
would be misleading.

Chapter 15: Ethical issues in financial reporting
Objectivity
Members should not allow bias, conflicts of interest or undue influence of others to override their
professional or business judgements.
A chartered accountant may be exposed to situations that may impair objectivity. It is
impracticable to define and prescribe all such situations.
Relationships that bias or unduly influence the professional judgment of the chartered accountant
should be avoided.
Professional competence and due care
Practising as a chartered accountant involves a commitment to learning over one’s entire working
life.
Members have a duty to maintain their professional knowledge and skill at such a level that a
client or employer receives a competent service, based on current developments in practice,
legislation and techniques. Members should act diligently and in accordance with applicable
technical and professional standards.
Continuing professional development develops and maintains the capabilities that enable a
chartered accountant to perform competently within the professional environments.
Confidentiality
Members must respect the confidentiality of information acquired as a result of professional and
business relationships and should not disclose such information to third parties without authority
or unless there is a legal or professional right or duty to disclose.
Confidential information acquired as a result of professional and business relationships should
not be used for the personal advantage of members or third parties.
Professional behaviour
Members must comply with relevant laws and regulations and should avoid any action which
discredits the profession. They should behave with courtesy and consideration towards all with
whom they come into contact in a professional capacity.
1.3 Threats to the fundamental principles

Compliance with the fundamental principles may potentially be threatened by a broad range of
circumstances. Many threats fall into the following categories:
 Self-interest;
 Self-review;
 Advocacy;
 Familiarity; and
 Intimidation.
Members must identify, evaluate and respond to such threats. Unless any threat is clearly
insignificant, members must implement safeguards to eliminate the threats or reduce them to an
acceptable level so that compliance with the fundamental principles is not compromised.
Self- interest threats
Self-interest threats may occur as a result of the financial or other interests of members or their
immediate or close family members.
Such financial interests might cause members to be reluctant to take actions that would be
against their own interests.
Examples of circumstances that may create self-interest threats include, but are not limited to:
 Incentive compensation arrangements.
 Concern over employment security.
 Commercial pressure from outside the employing organization.

Example:
Ibrahim is member of ICAP working as a unit accountant.
He is a member of a bonus scheme under which, staff receive a bonus of 10% of their annual salary
if profit for the year exceeds a trigger level.
Ibrahim has been reviewing working papers prepared to support this year’s financial statements. He
has found a logic error in a spreadsheet used as a measurement tool for provisions.
Correction of this error would lead to an increase in provisions. This would decrease profit below the
trigger level for the bonus.
Analysis:
Ibrahim faces a self-interest threat which might distort his objectivity.
Self-review threats
Self-review threats occur when a previous judgement needs to be re-evaluated by members
responsible for that judgement. For example, where a member has been involved in maintaining
the accounting records of a client he may be unwilling to find fault with the financial statements
derived from those records. Again, this would threaten the fundamental principle of objectivity.
Circumstances that may create self-review threats include, but are not limited to, business
decisions or data being subject to review and justification by the same chartered accountant in
business responsible for making those decisions or preparing that data.
Advocacy threats
A chartered accountant in business may often need to promote the organisations position by
providing financial information. As long as information provided is neither false nor misleading
such actions would not create an advocacy threat.
Familiarity threats
Familiarity threats occur when, because of a close relationship, members become too
sympathetic to the interests of others. Examples of circumstances that may create familiarity
threats include:
 A chartered accountant in business in a position to influence financial or non-financial
reporting or business decisions having an immediate or close family member who is in a
position to benefit from that influence.
 Long association with business contacts influencing business decisions.
 Acceptance of a gift or preferential treatment, unless the value is clearly insignificant.
Intimidation threats
Intimidation threats occur when a member’s conduct is influenced by fear or threats (for example,
when he encounters an aggressive and dominating individual at a client or at his employer).
Examples of circumstances that may create intimidation threats include:
 Threat of dismissal or replacement over a disagreement about the application of an
accounting principle or the way in which financial information is to be reported.
 A dominant personality attempting to influence decisions of the chartered accountant.

2 PREPARATION AND REPORTING OF INFORMATION

Section overview
 Accountants in business
 Section 320 of the ICAP Code of Ethics
 Potential conflicts
2.1 Accountants in business

Accountants in business are often responsible for the preparation of accounting information.
Accountants in business need to ensure that they do not prepare financial information in a way
that is misleading or that does not show a true and fair view of the entity’s operations.
Accountants who are responsible for the preparation of financial information must ensure that the
information they prepare is technically correct, reports the substance of the transaction and is
adequately disclosed.
There is a danger of influence from senior managers to present figures that inflate profit or assets
or understate liabilities. This puts the accountant in a difficult position. On one hand, they wish to
prepare proper information and on the other hand, there is a possibility they might lose their job if
they do not comply with their managers wishes.
In this case, ethics starts with the individual preparing the information. They have a difficult
decision to make; whether to keep quiet or take the matter further. If they keep quiet, they will
certainly be aware that they are not complying with the ethics of the accounting body they belong
to. If they speak out, they may be bullied at work into changing the information or sacked.
2.2 Section 320 of the ICAP Code of Ethics

Chartered accountants in business are often involved in the preparation and reporting of
information that may either be made public or used by others inside or outside the employing
organisation. Such information may include financial or management information, for example:
 forecasts and budgets;
 financial statements;
 management discussion and analysis; and
 the management letter of representation provided to the auditors as part of an audit of
Information must be prepared and presented fairly, honestly and in accordance with relevant
professional standards. In particular financial statements must be prepared and presented in
accordance with the applicable financial reporting standards.
A chartered accountant in business must maintain information for which he is responsible in a
manner that:
 describes clearly the true nature of business transactions, assets or liabilities;
 classifies and records information in a timely and proper manner; and
 represents the facts accurately and completely in all material respects.
Threats to compliance with the fundamental principles, for example self-interest or intimidation
threats to objectivity or professional competence and due care, may be created where a
chartered accountant in business may be pressured (either externally or by the possibility of
personal gain) to become associated with misleading information or to become associated with
misleading information through the actions of others.
The significance of such threats will depend on factors such as the source of the pressure and
the degree to which the information is, or may be, misleading.

The significance of the threats should be evaluated and unless they are clearly insignificant,
safeguards should be considered and applied as necessary to eliminate them or reduce them to
an acceptable level. Such safeguards may include consultation with superiors within the
employing organization, for example, the audit committee or other body responsible for
governance, or with a relevant professional body.
Where it is not possible to reduce the threat to an acceptable level, a chartered accountant
should refuse to remain associated with information they consider is or may be misleading.
If the chartered accountant is aware that the issuance of misleading information is either
significant or persistent, he should consider informing appropriate authorities in line with the
guidance in this code. The chartered accountant in business may also wish to seek legal advice
or resign.
2.3 Potential conflicts

There may be times when the responsibilities of a chartered accountant to an employing
organisation come into conflict with their professional obligations to comply with the fundamental
principles in the Code. Where compliance with the fundamental principles is threatened, a
chartered accountant in business must consider a response to the circumstances.
Responsibilities to an employer may put a chartered accountant under pressure to act or behave
in ways that could directly or indirectly threaten compliance with the fundamental principles. Such
pressure may be explicit or implicit; it may come from a supervisor, manager, director or another
individual within the employing organization.
A chartered accountant in business may face pressure to:
 Act contrary to law or regulation.
 Act contrary to technical or professional standards.
 Lie to, or otherwise intentionally mislead (including misleading by remaining silent) others,
in particular:
 The auditors of the employing organization; or
 Regulators.
 Issue, or otherwise be associated with, a financial or non-financial report that materially
misrepresents the facts, including statements in connection with, for example:
 The financial statements;
 Tax compliance;
 Legal compliance; or
 Reports required by securities regulators.
The significance of threats must be evaluated and unless they are clearly insignificant,
safeguards should be considered and applied to eliminate them or reduce them to an acceptable
level.
Such safeguards may include:
 Obtaining advice where appropriate from within the employing organisation, or an
independent professional advisor or a relevant professional body.
 The existence of a formal dispute resolution process within the employing organization.
 Seeking legal advice.

Example:
Ibrahim is member of ICAP working as a unit accountant.
He is a member of a bonus scheme under which, staff receive a bonus of 10% of their annual salary
if profit for the year exceeds a trigger level.
Ibrahim has been reviewing working papers prepared to support this year’s financial statements.
He has found a logic error in a spreadsheet used as a measurement tool for provisions.
Correction of this error would lead to an increase in provisions. This would decrease profit below
the trigger level for the bonus.
Analysis:
Ibrahim faces a self-interest threat which might distort his objectivity.
Ibrahim has a professional responsibility to ensure that financial information is prepared and
presented fairly, honestly and in accordance with relevant professional standards. He has further
obligations to ensure that financial information is prepared in accordance with applicable
accounting standards and that records maintained represent the facts accurately and completely
in all material respects.
Ibrahim must make the necessary adjustment even though it would lead to a loss to himself.
Ali is a chartered accountant recruited on a short-term contract to assist the finance director, Bashir
(who is not a chartered accountant) in finalising the draft financial statements.
The decision on whether to employ Ali on a permanent basis rests with Bashir.
Ali has been instructed to prepare information on leases to be included in the financial statements.
He has identified a number of large leases which are being accounted for as operating leases even
though the terms of the contract contain clear indicators that the risks and benefits have passed
to the company. Changing the accounting treatment for the leases would have a material impact
on asset and liability figures.
Ali has explained this to Bashir. Bashir responded that Ali should ignore this information as the
company need to maintain a certain ratio between the assets and liabilities in the statement of
financial position.
Analysis
Ali faces a self-interest threat which might distort his objectivity.
The current accounting treatment is incorrect.
Ali has a professional responsibility to ensure that financial information is prepared and presented
fairly, honestly and in accordance with relevant professional standards. He has further obligations
to ensure that financial information is prepared in accordance with applicable accounting
standards and that records maintained represent the facts accurately and completely in all
material respects.
Possible course of action
Ali must explain his professional obligations to Bashir in particular that he cannot be party to the
preparation and presentation of knowingly misleading information.
Ali should refuse to remain associated with information that is misleading.
If Bashir refuses to allow the necessary changes to the information Ali should report the matter to
the audit committee or the other directors.
As a last resort if the company refuses to change the information Ali should resign from his post.
Ali may need to consider informing the appropriate authorities in line with the ICAP guidance on
confidentiality.

Example:
Etishad is a chartered accountant who works as in a team that reports to Fahad, the finance
director of Kohat Holdings.
Fahad Is also a chartered accountant. He has a domineering personality.
Kohat Holdings revalues commercial properties as allowed by IAS 16. Valuation information
received last year showed that the fair value of the property portfolio was 2% less than the carrying
amount of the properties (with no single property being more than 4% different). A downward
revaluation was not recognised on the grounds that the carrying amount was not materially
different from the fair value.
This year’s valuation shows a continued decline in the fair value of the property portfolio. It is now
5% less than the carrying amount of the properties with some properties now being 15% below the
carrying amount.
Etishad submitted workings to Fahad in which he had recognised the downward revaluations in
accordance with IAS 16.
Fahad has sent him an email in response in which he wrote “Stop bothering me with this rubbish.
There is no need to write the properties down. The fair value of the portfolio is only 5% different
from its carrying amount. Restate the numbers immediately”.
Analysis
Etishad faces an intimidation threat which might distort his objectivity.
The current accounting treatment might be incorrect. The value of the properties as a group is
irrelevant in applying IAS 16’s revalution model. IAS 16 allows the use of a revalution model but
requires that the carrying amount of a property should not be materially different from its fair value.
This applies to individual properties not the whole class taken together.
(It could be that Fahad is correct because there is insufficient information to judge materiality in
this circumstance. However, a 15% discrepancy does sound significant).
Etishad has a professional responsibility to ensure that financial information is prepared and
presented fairly, honestly and in accordance with relevant professional standards. He has further
obligations to ensure that financial information is prepared in accordance with applicable
accounting standards and that records maintained represent the facts accurately and completely
in all material respects.
Possible course of action
Etishad should arrange a meeting with Fahad to try to explain Fahad’s misapplication of the IAS
16 guidance and to try to persuade Fahad that a change might be necessary.
Fahad should be reminded that he too is bound by the same guidance that applies to Etishad.
Indeed he has a greater responsibility as the more senior person to show leadership in this area.
Etishad cannot be party to the preparation and presentation of knowingly misleading information.
He should explain that he cannot remain associated with information that is misleading. If Fahad
refuses to allow the necessary changes to the information Etishad should report the matter to the
audit committee or the other directors.
As a last resort if the company refuses to change the information Etishad should resign from his
post.
Etishad may need to consider informing the appropriate authorities in line with the ICAP guidance
on confidentiality.

I
Index
a c
Accounting estimates 125 Changes in
Accounting for accounting estimates 125
Taxation 132 accounting policies 121
Goodwill 92 Cash from
Revaluation 186 new shares issue 41
associates 112 Code of ethics 267
share issues 41 Commencement date of the lease 203
lease by lessee 213 Common reporting date 50
finance lease by lessor 220 Companies Act, 2017:
operating lease 229 Third schedule 2
deferred tax 143 Fifth schedule 2, 11
Acquired intangible assets 76 Fourth schedule 2, 7
Adjusting events after the reporting period 237 Components of
Analysis of expenses 34 Statement of changes inequity 36
Accounting regulation 2 of tax expense 153
Acquisition related costs 76 of financial statements 16
Allowance for doubtful debts 24 Consolidated
financial statements 51
income statement 100
b retained earnings
Consolidated Statements of comprehensive
70
income 100
Bargain purchases 94 Constructive obligation 241
Borrowing costs 250 Contingent
Business combinations 46 asset 258
Bonus issues 41 liability 258
Control 46
Correction of prior period errors 127

Current
assets
liabilities
8,12,26
9,13,27
g
Gain or loss on disposal 188
d Going concern assumption

Gross investment in the lease
239
220
Guaranteed residual value 204, 222
Development costs 179 Gross or net investment in the lease 220
Dividends 239 Group as single Economic entity 46
Disclosure of Accounting policies 38 Goodwill 56,57,59,69,92,107
Disclosure requirement of
About provisions 250
IAS 41
IAS 38
194
189
h
lessor 227
Holding company 46
non-adjusting events 238
Deferred tax 136
Liability
Assets
142,147
143,148 i
IAS 1: Presentation of Financial Statements 15
e IAS 8: Accounting policies, changes in
accounting estimates and errors 119
IAS 10: Events after the reporting
Equity 20 period 231, 237
shares 41 IAS 12: Income taxes 131
Errors 127 IAS 37: Provisions, Contingent
Estimates 125 Liabilities and assets 239
Events after the reporting period: IAS 38: Intangible assets 171
IAS 10 237 Identifying a finance lease 208
Exchange transactions 177 Impairment
Expenses 20 of goodwill 107
Extra depreciation 82 IFRS 10: Consolidated Financial
Statements 5, 46
f IFRS 3: Business Combinations

IFRS 16: Leases
4, 46, 55
5, 201
Impracticable 123
Fair presentation and compliance with IFRSs 21 Inception and commencement 203
Finance Income 20
income 221 Initial direct costs of a lease 206
lease accounting 220 Integrity 264
Fundamental principles 264 Interest rate implicit in the lease 205
Finance and Operating Leases 207 Internally-generated intangibles 178
Fair value Issued shares 41
Exercise at acquisition 79 Intragroup transactions 85
Adjustments 106 Intangible assets 172
Acquired in Business Combinations 182

Index
l p
Lease payments 205 Parent entity 46
Lease term 204 Part-exchange of an old asset 177
Lease 202 Pre-acquisition and post-
acquisition profits 53, 102
Classification 207
Proposed dividends 238
Leaseback 218
Purchase option 205, 210
Legal obligation 241
Property, Plant &
Lessor accounting 220 Equipment (P, P& E) 27, 28
Lessee's incremental borrowing Provisions
rate of interest 206 Recognition 239
Measurement 242
Double entry and disclosure 248
m
Manufacturer/dealer lessors 223-226
q
Material items 35
Material non-adjusting events 238 Qualifying asset 122
Measurement after initial
Recognition 185
Mid-year acquisition 83 r
Materiality 23
Reclassification adjustments 34
Recognition criteria
n for intangible assets
Regulatory framework
176
2
Residual value 204
Negative goodwill 94
Reducing Balance Method 125
Net investment in the lease 220 Realisation of revaluation surplus 186
Non-controlling interest 52, 59, 62, 93, 100 Research and Development 178, 183
Reporting period 18
Reserves 8, 12
o Restructuring 252
Restructuring costs 66
Retrospective
Objectivity 265
adjustments 36
Operating leases 207, 229
application 122
Other comprehensive income 31
limitations 123, 129
Over-estimate or under-estimate Revaluation model 185
of tax 134
Revaluation
Offsetting 21, 24
frequency 186
Ordinary share 41

Tax
s deferred
reconciliation
68
154
Taxation
Section 320 267
of profits 132
Securities and Exchange Commission of
Pakistan (The) 2 statement of financial position 134
Self-review threats 266 Transaction costs of issuing new equity
shares 41
Statement of
Transitional provisions 121
changes in equity (SOCIE) 36
Types of lessors 203
comprehensive income 31, 42, 100
Time value 246
Statement of
Threats to fundamental principles 265
financial position 43, 51
of cash flows 17
Subsequent expenditure
Subsidiary
177, 184
46
u
Substance over form 207
Share capital & reserves 8,12,30 Unguaranteed residual value 204
Separate Acquisition 176 Uniform accounting policies 50
Unrealised profit
Inter-group 115
t Inventory
Non-current assets
86
89
From trading 103
Tax
base 134
computation 132

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© Emile Woolf International, February 2019

© Emile Woolf International ii The Institute of Chartered Accountants of Pakistan

1 Legal background to the preparation of financial statements 1

2 IAS 1: Presentation of financial statements 15

Consolidated accounts: Statements of financial position –

Consolidated accounts: Statements of financial position –

5 Consolidated accounts: Statements of comprehensive income 99

6 IAS 28: Investment in Associates and Joint Ventures 111

IAS 8: Accounting policies, changes in accounting estimates and

8 IAS 12: Income taxes 131

9 IAS 21: Foreign Currency Transactions 159

10 IAS 38: Intangible assets 171

11 IAS 41: Agriculture 191

12 IFRS 9: Financial instruments-Recognition and measurement 195

13 IFRS 16: Leases 201

© Emile Woolf International iii The Institute of Chartered Accountants of Pakistan

14 Other areas of IFRSs (IFRS 8, IAS 10, IAS 37) 231

15 Ethical issues in financial reporting 263

© Emile Woolf International iv The Institute of Chartered Accountants of Pakistan

© Emile Woolf International 1 The Institute of Chartered Accountants of Pakistan

1 REGULATORY FRAMEWORK FOR ACCOUNTING IN PAKISTAN

 Accounting regulation in Pakistan

1.1 Accounting regulation in Pakistan

© Emile Woolf International 2 The Institute of Chartered Accountants of Pakistan

1.3 International Financial Reporting Standards

Published by the IASC (up Published by the IASB

Accounting standards IASs IFRSs

Interpretations SICs IFRICs

© Emile Woolf International 3 The Institute of Chartered Accountants of Pakistan

© Emile Woolf International 4 The Institute of Chartered Accountants of Pakistan

1.4 Classification of Companies

© Emile Woolf International 5 The Institute of Chartered Accountants of Pakistan

© Emile Woolf International 6 The Institute of Chartered Accountants of Pakistan

2 COMPANIES ACT, 2017: FOURTH SCHEDULE

The following requirements must be followed in addition to those in IFRS.

2.1 Fixed assets

2.2 Long term investments

© Emile Woolf International 7 The Institute of Chartered Accountants of Pakistan

2.3 Long term loans and advances

2.4 Current assets

2.5 Share capital and reserves

© Emile Woolf International 8 The Institute of Chartered Accountants of Pakistan

In respect of issued share capital of a company following shall be disclosed separately:

2.6 Non-current liabilities

2.7 Current liabilities

2.8 Contingencies and commitments

© Emile Woolf International 9 The Institute of Chartered Accountants of Pakistan

2.9 Profit and loss account

© Emile Woolf International 10 The Institute of Chartered Accountants of Pakistan

3 COMPANIES’ ACT, 2017: FIFTH SCHEDULE

3.1 Sundry requirements

3.2 Fixed assets

3.3 Long term investments

© Emile Woolf International 11 The Institute of Chartered Accountants of Pakistan

3.4 Long term loans and advances

3.5 Current assets

3.6 Share capital and reserves

© Emile Woolf International 12 The Institute of Chartered Accountants of Pakistan