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Face book - Tom Clendon Lecturer

ACCA P2

Secret tips 20/11/14

FTMS college

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Q Jet, Fly & Quay On 1 January 20x0 Jet acquired 100% of the equity shares in Fly for $8m. On the 1 July 20X1 Jet acquired 90% of the equity shares of Quay, whose functional currency is the Dinar (DNs). The statement of financial position of both companies at 30 June 20X2 are as follows: Jet Fly Quay $m $m DNm Non-current assets Investment in Fly FVTP&L 11 Investment in Quay 10 Investment in Service 2 Property Plant & Equipment 6 10 40 29 10 40 Current assets Inventory 4 Nil 20 Receivables 4 16 10 Cash at bank 3 8 4 40 34 74 Equity capital 24 5 30 Other components of equity (OCE) 5 Nil 10 Retained earnings (RE) 6 (1) 15 35 4 55 Non-current liabilities 3 24 5 Current Liabilities 2 6 14 40 34 74

The following information is applicable.

1. Jet purchased the shares in Fly on 1 January 20x0 for $8m and the investment has since been accounted for as a FVTP&L investment. At the date of acquisition the retained earnings of Fly were $2m and the fair value of the net assets were not materially different from the carrying value. An earlier impairment review resulted in all the goodwill being written off. At the reporting date Jet sold a 30% interest in for $2m. The proceeds received from the sale of these shares have been credited against the investment in Fly.

2. Jet purchased the shares in Quay on 1 July 20x1. At the date of acquisition the retained earnings of Quay were DN6m and the other components of equity DN1m. The provisional fair value of the net assets at acquisition were DN60m, the excess over the carrying value being attributable to a fair value adjustment on land. Three months after the year-end it transpired that the value of the land at acquisition is DN2m more than originally estimated and that deferred tax at 20% should be provided on the whole of the fair value adjustment. Goodwill is to be measured in full and the fair value of the non-controlling interest at the date of acquisition is DN4m. The fair value of the non-

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controlling interest at acquisition does not require revision due to the updating of the fair value adjustment on the land or the deferred tax adjustment. Goodwill is not impaired.

3. Jet purchased a 30% investment in Service on 1 January 20x2 for $2m. Since that date Jet has been able to exercise significant influence over the financial and operating activities of Service. In the financial year-end 30 June 20x2 Service reported a total comprehensive income of $3m which included a $1m gain on FVTOCI Investments. Service has not paid any dividends in the accounting period. At the reporting date the recoverable amount of Jet’s investment in Service has been assessed at $2.1m.

4. Included in the non-current liabilities of Jet is a zero coupon loan of $2m that was issued at par on 1 July 20x1 and will be redeemed in ten years at a substantial premium. The effective rate of interest on this loan is 10%. Jet has not recorded the finance cost.

5. During the year Jet has entered into a derivative at no cost which has been correctly designated as cash flow hedge as it relates to a planned import of a non-current asset eight months after the reporting date. At the reporting date the derivative is an asset with a fair value of $1m and the hedge has been assessed as 100% effective.

6. On 1 July 20x0 Jet granted share options to ten staff with a total fair value of $4m. These options are due to vest in four years and all staff were expected to meet the qualifying conditions at the vesting period. The fair value of these options were $10m at the start of the reporting period and are $5m at the reporting date. No expense has been charged in respect of the current reporting period but they were correctly accounted for in the previous period. On 1 August 20x2, after the reporting date but before the accounts are signed off, two staff tendered their resignations which were accepted.

The presentational currency of the group is to be the $. Exchange rates to $1

DN 1 July 20X1 8 Average rate 9 30 June 20X2 10

a) Required

Prepare the group statement of financial position at 30 June 20X2, showing the exchange difference arising on the translation of Quay’s net assets. 35 marks

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There are four directors of Quay, three of whom were newly appointed by Jet one year ago. The other director is Ms Lim, the managing director of Quay. Ms Lim and her husband were previously the majority shareholders of Quay. In the due diligence that was conducted by Jet on the financial statements of Quay prior to the business combination it transpired that Quay had guaranteed the bank borrowings of another company, Port up to a maximum of DN40 million. This guarantee is valid until December 20X3. The husband of Ms Lim is the sole director and majority shareholder of Port. At the date of acquisition the fair value of this guarantee was correctly assessed as nil. At the current reporting period it is judged it is not probable that Port will default on its bank borrowings and so no liability has been recognised. Ms Lim has proposed that it will be not be necessary to make any disclosure of this guarantee in the group financial statements on the grounds that it is neither a liability nor a transaction.

b) Required Discuss the accounting and ethical implications relating to the guarantee and the proposal not to make any disclosures in the group accounts in this regard. 5 marks.

The International Integrated Reporting Council (IIRC) is 'a global coalition of regulators, investors, companies, standard setters, the accounting profession and NGOs”. The IIRC argues that there is an overwhelming support for Integrated Reporting (<IR>) and so has issued a voluntary framework to assist in the development of Integrated Reporting.

c) Required Advise the directors of Jet as to the nature of integrated reporting and what advantages there would be to Jet adopting this approach. 10 marks Total 50 marks.

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December 2013 ACCA P2 Examiners comments

If a client requests advice from an ACCA member, it is unlikely that they would want

the member to quote an IFRS word for word without any application to their

particular circumstances. Most of the real issues in corporate reporting revolve

around the application of existing standards and the weaknesses therein. The

Examiners guidance to P2 sets out the nature of what is considered to be a current

issue, and criticisms of extant standards are prominent in that cast. A candidate is

required to understand real issues affecting the profession. These issues will not

always be EDs or DPs simply because they will not be currently applied in practice

until they become an IFRS. It is difficult for the writers of the ACCA text books to

keep up with current issues. Therefore it is incumbent upon students to read articles

for themselves. A cursory glance at key websites on a monthly basis will keep a

student’s knowledge up to date. For example, recently there has been a DP on

the conceptual framework, recommendations on key areas for European

regulators to review, and a framework for integrated reporting published.

These are current issues, which may or may not appear in the examination but

candidates should ask themselves whether they could answer a question on such

topics.

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Concepts of profit or loss and other comprehensive income By Tom Clendon September 2014 This article explains the current rules and the conceptual debate as to where in the statement of comprehensive income, profits and losses should be recognised, i.e. when should they be recognised in profit or loss and when in the other comprehensive income. Further it explores the debate as to whether it is appropriate to recognise profits or losses twice! The performance of a company is reported in the statement of comprehensive income which comprises the statement of profit or loss and the statement of other comprehensive income. IAS 1 Presentation of Financial Statements defines profit or loss as "the total of income less expenses, excluding the components of other comprehensive income". Other comprehensive income (OCI) is defined as comprising "items of income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or permitted by other IFRSs". Total comprehensive income is defined as "the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners". It is a myth, and simply incorrect, to state that only realised gains are included in profit or loss (P&L) and that only unrealised gains and losses are included in the OCI. For example gains on the revaluation of land and buildings accounted for in accordance with IAS 16 Property Plant and Equipment (IAS 16 PPE) are recognised in OCI and accumulate in equity in Other Components of Equity (OCE) On the other hand gains on the revaluation of land and buildings accounted for in accordance with IAS 40 Investment Properties are recognised in P&L and are part of the Retained Earnings (RE). Both such gains are unrealised. The same point could be made with regard to the gains and losses on the financial asset of equity investments. If such financial assets are designated in accordance with IFRS 9 Financial Instruments (IFRS 9) at inception as Fair Value Through Other Comprehensive Income (FVTOCI) then the gains and losses are recognised in OCI and accumulated in equity in OCE. Whereas if management decides not to make this election, then the investment will by default be designated and accounted as Fair Value Through Profit or Loss (FVTP&L) and the gains and losses are recognised in P&L and become part of RE. There is at present no overarching accounting theory that justifies or explains in which part of the statement of comprehensive income gains and losses should be reported. The IASB’s Conceptual Framework for Financial Reporting is silent on the matter. So rather than have a clear principles based approach what we currently have is a rules based approach to this issue. It is down to individual accounting standards to direct when gains and losses are to be reported in OCI. This is clearly an unsatisfactory approach. It is confusing for users. In July 2013 the International Accounting Standards Board (IASB) published a discussion paper on its Conceptual Framework for Financial Reporting. This addressed the issue of where to recognise gains and losses. It suggests that the P&L should provide the primary source of information about the return an entity has made on its economic resources in a period. Accordingly the P&L should recognise the results of transactions, consumption and impairments of assets and fulfilment of

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liabilities in the period in which they occur. In addition the P&L would also recognise changes in the cost of assets and liabilities as well as any gains or losses resulting from their initial recognition. The role of the OCI would then be to support the P&L. Gains and losses would only be recognised in OCI if it made the P&L more relevant. In my view whilst this may be an improvement on the current absence of any guidance it does not provide the clarity and certainty users crave. Recycling (the reclassification from equity to P&L) Now let us consider the issue of recycling. This is where gains or losses are reclassified from equity to P&L as a reclassification adjustment. In other words gains or losses are first recognised in the OCI and then in a later accounting period also recognised in the P&L. In this way the gain or loss is reported in the total comprehensive income of two accounting periods and in colloquial terms is said to be recycled as it is recognised twice. At present it is down to individual accounting standards to direct when gains and losses are to be reclassified from equity to P&L as a reclassification adjustment. So rather than have a clear principles based approach on recycling what we currently have is a rules based approach to this issue. This is clearly, again an unsatisfactory approach, but again as we shall see one addressed by the July 2013 IASB discussion paper on its Conceptual Framework for Financial Reporting IAS 21The Effects of Changes in Foreign Exchange Rates (IAS 21) is one example of a standard that requires gains and losses to be reclassified from equity to P&L as a reclassification adjustment. When a group has an overseas subsidiary a group exchange difference will arise on the re-translation of the subsidiary’s goodwill and net assets. In accordance with IAS 21 such exchange differences are recognised in OCI and so accumulate in OCE. On the disposal of the subsidiary, IAS 21 requires that the net cumulative balance of group exchange differences be reclassified from equity to P&L as a reclassification adjustment, i.e. the balance of the group exchange differences in OCE is transferred to P&L to form part of the profit on disposal. IAS 16 PPE is one example of a standard that prohibits gains and losses to be reclassified from equity to P&L as a reclassification adjustment. If we consider land that cost $10m and is accounted in accordance with IAS 16 PPE. If the land is subsequently revalued to $12m, then the gain of $2m is recognised in OCI and will be taken to OCE. When in a later period the asset is sold for $13m, IAS 16 PPE specifically requires that the profit on disposal recognised in the P&L is $1m i.e. the difference between the sale proceeds of $13m and the carrying value of $12m. The previously recognised gain of $2m is not recycled / reclassified back to P&L as part of the gain on disposal. However the $2m balance in the OCE reserve is now redundant as the asset has been sold and the profit is realised. Accordingly there will be a transfer in the Statement of Changes in Equity, from the OCE of $2m into RE. Double entry For those who love the double entry let me show you the purchase, the revaluation, the disposal and the transfer to RE in this way.

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On purchase $m $m Dr Land PPE 10 Cr Cash 10 On revaluation Dr Land PPE 2 Cr OCE and recognised in OCI 2 On disposal Dr Cash 13 Cr Land PPE 12 Cr P&L 1 On transfer Dr OCE 2 Cr Retained earnings 2

If IAS 16 PPE allowed the reclassification from equity to P&L as a reclassification adjustment, the profit on disposal recognised in P&L would be $3m including the $2m reclassified from equity to P&L and the last two double entries above replaced with the following. On reclassification from equity to P&L $m $m Dr Cash 13 Cr Land PPE 12 Cr P&L 3 Dr OCE 2

IFRS 9 also prohibits the recycling of the gains and losse on FVTOCI investments to P&L on disposal. The no reclassification rule in both IAS 16 PPE and IFRS 9 means that such gains on those assets are only ever reported once in the statement of comprehensive income i.e. are only included once in the total comprehensive income. However many users, it appears, rather ignore the total comprehensive income and the OCI and just base their evaluation of a company’s performance on the P&L. These users then find it strange that gains that have become realised from transactions in the accounting period are not fully reported in the P&L of the accounting period. As such we can see the argument in favour of reclassification. With no reclassification the earnings per share will never fully include the gains on the sale of PPE and FVTOCI investments. The following extract from the statement of comprehensive income summarises the current accounting treatment for which gains and losses are required to be included in OCI and as required discloses which gains and losses can and cannot be reclassified back to profit and loss.

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Extract from the statement of comprehensive income $ Profit for the year XX Other comprehensive income Gains and losses that cannot be reclassified back to profit or loss Changes in revaluation surplus where the revaluation method is used in accordance with IAS 16

XX / (XX)

Remeasurements of a net defined benefit liability or asset recognised in accordance with IAS 19

XX / (XX)

Gains and losses on remeasuring FVTOCI financial assets in accordance with IFRS 9

XX / (XX)

Gains and losses that can be reclassified back to profit or loss Group exchange differences from translating functional currencies into presentation currency in accordance with IAS 21

XX / (XX)

The effective portion of gains and losses on hedging instruments in a cash flow hedge under IFRS 9

XX / (XX)

---------- Total comprehensive income XX / (XX) ----------

The future of reclassification In the July 2013 discussion paper on the Conceptual Framework for Financial Reporting the role of the OCI and the reclassification from equity to P&L is debated. No OCI and no reclassification It can be argued that reclassification should simply be prohibited. This would free the statement of comprehensive income from the need to formally to classify gains and losses between P&L and OCI. This would reduce complexity and gains and losses could only ever be recognised once. There would still remain the issue of how to define the earnings in earnings per share, a ratio loved by investors, as clearly total comprehensive income would contain too many gains and losses that were non-operational, unrealised, outside the control of management and not relating to the accounting period. Narrow approach to the OCI Another suggestion is that the OCI should be restricted, should adopt a narrow approach. On this basis only bridging and mismatch gains and losses should be included in OCI and be reclassified from equity to P&L. A revaluation surplus on a financial asset classified as FVTOCI is a good example of a bridging gain. The asset is accounted for at fair value on the statement of financial position but effectively at cost in P&L. As such by recognising the revaluation surplus

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in OCI, the OCI is acting as a bridge between the statement of financial position and the P&L. On disposal reclassification ensures that the amount recognised in P&L will be consistent with the amounts that would be recognised in P&L if the financial asset had been measured at amortised cost.

The effective gain or loss on a cash flow hedge of a future transaction is an example of a mismatch gain or loss as it relates to a transaction in a future accounting period so needs to be carried forward so that it can be matched in the P&L of a future accounting period. Only by recognising the effective gain or loss in OCI and allowing it to be reclassified from equity to P&L can users to see the results of the hedging relationship.

Broad approach to the OCI

A third proposition is for the OCI to adopt a broad approach, by also including transitory gains and losses. The IASB would decide in each IFRS whether a transitory remeasurement should be subsequently recycled. Examples of transitory gains and losses are those that arise on the remeasurement of defined benefit pension funds and revaluation surpluses on PPE. Conclusion Whilst the IASB has not yet determined which approach will be adopted, its chairman Hans Hoogervorst has gone on the record as saying “It is absolutely vital that the P&L contains all information that can be relevant to investors and that nothing of importance gets left out…. and….the IASB should be very disciplined in its use of OCI as resorting to OCI too easily would undermine the credibility of net income so the OCI should only be used as an instrument of last resort”. Now that sounds like a personal endorsement of the narrow approach to me! Tom Clendon is a lecturer at FTMS based in Singapore.

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Profit, Loss and OCI and the discussion paper on the Conceptual Framework

Graham Holt explains what differentiates profit or loss from other comprehensive income and where items should be presented

The purpose of the statement of profit or loss and other comprehensive income (OCI) is to show an entity's financial performance in a way that is useful to a wide range of users so they may attempt to assess the future net cash inflows of an entity. The statement should be classified and aggregated in a manner that makes it understandable and comparable.

International Financial Reporting Standards (IFRS) currently require that the statement be presented as either one statement, being a combined statement of profit or loss and other comprehensive income, or two statements, being the statement of profit or loss and the statement of other comprehensive income. An entity has to show separately in OCI, those items which would be reclassified (recycled) to profit or loss and those items which would never be reclassified (recycled) to profit or loss. The related tax effects have to be allocated to these sections.

Profit or loss includes all items of income or expense (including reclassification adjustments) except those items of income or expense that are recognised in OCI as required or permitted by IFRS.

Reclassification adjustments are amounts recycled to profit or loss in the current period that were recognised in OCI in the current or previous periods. An example of items recognised in OCI that may be reclassified to profit or loss are foreign currency gains on the disposal of a foreign operation and realised gains or losses on cashflow hedges. Those items that may not be reclassified are changes in a revaluation surplus under IAS 16, Property, Plant and Equipment, and actuarial gains and losses on a defined benefit plan under IAS 19, Employee Benefits.

However, there is a general lack of agreement about which items should be presented in profit or loss and in OCI. The interaction between profit or loss and OCI is unclear, especially the notion of reclassification and when or which OCI items should be reclassified.

A common misunderstanding is that the distinction is based on realised versus unrealised gains. This lack of a consistent basis for determining how items should be presented has led to an inconsistent use of OCI in IFRS. It may be difficult to deal with OCI on a conceptual level since the International Accounting Standards Board (IASB) is finding it difficult to find a sound conceptual basis.

However, there is urgent need for some guidance around this issue.

Opinions vary, but there is a feeling that OCI has become a 'dumping ground' for anything controversial because of a lack of clear definition of what should be included in the statement. Many users are thought to ignore OCI as the changes reported are not caused by the operating flows used for predictive purposes.

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Financial performance is not defined in the Conceptual Framework, but could be viewed as reflecting the value the entity has generated in the period and this can be assessed from other elements of the financial statements and not just the statement of comprehensive income. Examples would be the statement of cashflows and disclosures relating to operating segments. The presentation in profit or loss and OCI should allow a user to depict financial performance, including the amount, timing and uncertainty of the entity's future net cash inflows and how efficiently and effectively the entity's management have discharged their duties regarding the resources of the entity.

There are several arguments for and against reclassification. If reclassification ceased, there would be no need to define profit or loss, or any other total or subtotal in profit or loss, and any presentation decisions can be left to specific IFRSs. It is argued that reclassification protects the integrity of profit or loss and provides users with relevant information about a transaction that occurred in the period. Additionally, it can improve comparability where IFRS permits similar items to be recognised in either profit or loss or OCI.

Those against reclassification argue that the recycled amounts add to the complexity of financial reporting, may lead to earnings management, and the reclassification adjustments may not meet the definitions of income or expense in the period as the change in the asset or liability may have occurred in a previous period.

The original logic for OCI was that it kept income-relevant items that possessed low reliability from contaminating the earnings number.

Markets rely on profit or loss and it is widely used. The OCI figure is crucial because it can distort common valuation techniques used by investors, such as the price/earnings ratio. Thus, profit or loss needs to contain all information relevant to investors. Misuse of OCI would undermine the credibility of net income. The use of OCI as a temporary holding for cashflow hedging instruments and foreign currency translation is non-controversial.

However, other treatments such as the policy of IFRS 9 to allow value changes in equity investments to go through OCI, are not accepted universally.

US GAAP will require value changes in all equity investments to go through profit or loss. Accounting for actuarial gains and losses on defined benefit schemes are presented through OCI and certain large US corporations have been hit hard with the losses incurred on these schemes. The presentation of these items in OCI would have made no difference to the ultimate settled liability, but if they had been presented in profit or loss the problem may have been dealt with earlier. An assumption that an unrealised loss has little effect on the business is an incorrect one.

The discussion paper on the Conceptual Framework considers three approaches to profit or loss and reclassification. The first approach prohibits reclassification. The other approaches, the narrow and broad approaches, require or permit reclassification. The narrow approach allows recognition in OCI for bridging items or mismatched remeasurements, while the broad approach has an additional category

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of 'transitory measurements' (for example, remeasurement of a defined benefit obligation), which would allow the IASB greater flexibility. The narrow approach significantly restricts the types of items that would be eligible to be presented in OCI and gives the IASB little discretion when developing or amending IFRSs.

A bridging item arises where the IASB determines that the statement of comprehensive income would communicate more relevant information about financial performance if profit or loss reflected a different measurement basis from that reflected in the statement of financial position. For example, if a debt instrument is measured at fair value in the statement of financial position, but is recognised in profit or loss using amortised cost, then amounts previously reported in OCI should be reclassified into profit or loss on impairment or disposal of the debt instrument.

The IASB argues that this is consistent with the amounts that would be recognised in profit or loss if the debt instrument were to be measured at amortised cost.

A mismatched remeasurement arises where an item of income or expense represents an economic phenomenon so incompletely that presenting that item in profit or loss would provide information that has little relevance in assessing the entity's financial performance. An example of this is when a derivative is used to hedge a forecast transaction; changes in the fair value of the derivative may arise before the income or expense resulting from the forecast transaction.

The argument is that before the results of the derivative and the hedged item can be matched together, any gains or losses resulting from the remeasurement of the derivative, to the extent that the hedge is effective and qualifies for hedge accounting, should be reported in OCI. Subsequently those gains or losses are reclassified into profit or loss when the forecast transaction affects profit or loss.

This allows users to see the results of the hedging relationship.

The IASB's preliminary view is that any requirement to present a profit or loss total or subtotal could also result in some items being reclassified. The commonly suggested attributes for differentiation between profit or loss and OCI (realised/unrealised, frequency of occurrence, operating/non-operating, measurement certainty/uncertainty, realisation in the short/long-term or outside management control) are difficult to distil into a set of principles.

Therefore, the IASB is suggesting two broad principles, namely:

1. Profit or loss provides the primary source of information about the return an entity has made on its economic resources in a period.

2. To support profit or loss, OCI should only be used if it makes profit or loss more relevant.

The IASB feels that changes in cost-based measures and gains or losses resulting from initial recognition should not be presented in OCI and that the results of transactions, consumption and impairments of assets and fulfilment of liabilities should be recognised in profit or loss in the period in which they occur. As a

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performance measure, profit or loss is more used, although there are a number of other performance measures derived from the statement of profit or loss and OCI.

Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School

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Assets & Liabilities and the discussion paper on the Conceptual Framework

Graham Holt examines the discussion paper on the conceptual framework for financial reporting issued by the IASB in July

In July 2013 the International Accounting Standards Board (IASB) issued a discussion paper on a new version of its conceptual framework, which provides the fundamental basis for development of International Financial Reporting Standards (IFRS).

The discussion paper gives users and preparers of financial statements an opportunity to offer input into the direction of financial reporting standards. The paper sets out the fundamental principles of accounting necessary to develop robust and consistent standards. While it lacks the immediacy of other IASB proposals, it will nevertheless be a significant long-term influence on the direction that accounting standards will take.

The paper introduces revised thinking on the reporting of financial performance, the measurement of assets and liabilities, and presentation and disclosure. The paper proposes that the primary purpose of the framework - which underpins the accounting standards - is to identify consistent principles that the IASB can use in developing and revising those standards. The framework may also help in understanding and interpreting the standards.

The IASB framework was originally published in the late 1980s. In 2010 two chapters of a new framework were issued: Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information. There are no plans for a fundamental reconsideration of these chapters. The concept of a reporting entity is not considered in the discussion paper because the exposure draft of 2010 is to be used, with related feedback, in developing guidance in this area.

The discussion paper proposes to redefine assets and liabilities as:

An asset is a present economic resource controlled by the entity because of past events.

A liability is a present obligation of the entity to transfer an economic resource because of past events.

An 'economic resource', it should be noted, is a right, or other source of value, that is capable of producing economic benefits.

Currently the definitions of assets and liabilities require a probable expectation of future economic benefits or resource outflow. The IASB's initial view is that the definitions of assets and liabilities should not require an expected or probable inflow or outflow as it should be sufficient that a resource or obligation can produce or result in a transfer of economic benefits. Thus, a guarantee could qualify as a liability even though the obligation to transfer resources is conditional. However, the measurement of an asset or liability will be affected by the potential outcome. The

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IASB still believes that a liability should not be defined as limited to obligations that are enforceable against the entity.

Under the discussion paper, constructive obligations would qualify as liabilities. Liabilities would not arise where there is an economic necessity to transfer an economic resource unless there is an obligation to do so. Thus a group reconstruction would not necessarily create a liability.

However, the IASB believes that certain avoidable obligations could qualify as a liability - for example, directors' bonuses depending on employment conditions. No decision has been made on whether the definition of a liability should be limited to obligations that the entity has no practical ability to avoid or should include conditional obligations resulting from past events.

The discussion paper sets out that the framework's definition of control should be in line with its definition of an asset. An entity controls an economic resource if it has the present ability to direct the resource's use so as to obtain economic benefits from it. The exposure draft on revenue recognition uses the phrase 'substantially all' when referring to benefits from the asset but the IASB feels this phrase in this context would be confusing as an entity would recognise only the rights which it controls. For example, if an entity has the right to use machinery on one working day per week, then it should recognise 20% of the economic benefits (assuming a five-day working week) as it does not have all or substantially all of the economic benefits of the machinery.

The discussion paper proposes that equity remain defined as being equal to assets less liabilities. However, the paper does propose that an entity be required to present a detailed statement of changes in equity that provides more information regarding different classes of equity, and the transfers between these different classes.

The distinction between equity and liabilities focuses on the definition of a liability. The current guidance on the difference between equity and liability is complicated. The paper identifies two types of approach: narrow equity and strict obligation.

The narrow equity approach treats equity as being only the residual class issued, with changes in the measurement of other equity claims recognised in profit or loss.

Under the strict obligation approach, all equity claims are classified as equity with obligations to deliver cash or assets being classified as liabilities. Any changes in the measurement of equity claims would be shown in the statement of changes in equity.

If the latter approach were adopted, certain transactions (eg the issuance of a variable number of equity shares worth a fixed monetary amount) currently classed as liabilities would not be so designated because they do not involve an obligation to transfer cash or assets.

The IASB has come to the view that the objective of measurement is to contribute to the faithful representation of relevant information about the resources of the entity, claims against the entity and changes in resources and claims, and about how efficiently and effectively the entity's management and governing board have

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discharged their responsibilities to use the entity's resources. The IASB believes that a single measurement basis may not provide the most relevant information for users.

When selecting the measurement basis, the information that measurement will produce in both the statement of financial position and the statement of profit or loss and other comprehensive income (OCI) should be considered. Further, the selection of a measurement of a particular asset or a particular liability should depend on how that asset contributes to the entity's future cashflows and how the entity will settle or fulfil that liability.

NARROW AND BROAD

The current framework does not contain principles to determine the items to be recognised in profit or loss, and in OCI and whether, and when, items can be recycled from OCI to profit or loss. In terms of what items would be included in OCI, the paper proposes two approaches: 'narrow' and 'broad'.

Under the narrow approach, OCI would include bridging items and mismatched remeasurements. OCI would be used to bridge a measurement difference between the statement of financial position and the statement of profit or loss. This would include, for example, investments in financial instruments with profit or losses reported through OCI. Mismatched remeasurements occur when the item of income or expense represents the effects of part of a linked set of assets, liabilities or past or planned transactions. It represents their effect so incompletely that, in the opinion of the IASB, the item provides little relevant information about the return the entity has made on its economic resources in the period.

An example is a cashflow hedge where fair value gains and losses are deferred in OCI until the hedged transaction affects profit or loss. The paper suggests that under the narrow OCI approach, an entity should subsequently have to recycle amounts from OCI to profit or loss; and under the mismatched remeasurements approach the amount should be recycled when the item can be presented with the matched item.

The issue that arises here is that, under the narrow approach, the treatment of certain items would be inconsistent with current IFRS - eg revaluation gains and losses for property, plant and equipment.

The paper also sets out a third category - 'transitory remeasurements'. These are remeasurements of long-term assets and liabilities that are likely to reverse or significantly change over time. These items would be shown in OCI - for example, the remeasurement of a net defined pension benefit liability or asset. The IASB would decide in each IFRS whether a transitory remeasurement should be subsequently recycled. However, the IASB has not yet determined which approach it will use.

RECOGNITION

Recognition and derecognition deals with the principles and criteria for assets and liabilities to be included or removed from an entity's financial statements. The paper sets out to bring this into line with the principles used in IASB's current projects. It

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proposes that assets and liabilities should be recognised by an entity, unless that results in irrelevant information, the costs outweigh the benefits, or the measure of information does not represent the transaction faithfully enough.

Derecognition is not currently addressed in the framework and the paper proposes derecognition should occur when the recognition criteria are no longer met. The question for the IASB is whether to replace the current concept based on the loss of the economic risks and benefits of the asset with the concept based on the loss of control over the legal rights comprised in the asset. A concept based on control over the legal rights could result in several items going off balance sheet.

Proposed revisions to the disclosure framework include the objective of the primary financial statements, the objective of the notes to the financial statements, materiality and communication principles. The IASB has also identified both short-term and long-term steps for addressing disclosure requirements in existing IFRS.

These proposals are an attempt to make the conceptual framework a blueprint for developing consistent, high-quality, principles-based accounting standards. It is important that there is dialogue about the whole of IFRS and for the IASB to achieve buy-in to its core principles by enabling constituents to help shape the future of IFRS.

Graham Holt is associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School

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Graham Holt outlines the purpose of, and what's involved with, adopting the IIRC's new integrated reporting framework

The International Integrated Reporting Council (IIRC) has recently released a framework for integrated reporting. This follows a three-month global consultation and trials in 25 countries. The framework establishes principles and concepts that govern the overall content of an integrated report.

An integrated report sets out how the organisation's strategy, governance, performance and prospects lead to the creation of value. There is no benchmarking for the above matters and the report is aimed primarily at the private sector, but it could be adapted for public sector and not-for-profit organisations.

The primary purpose of an integrated report is to explain to providers of financial capital how an organisation creates value over time. An integrated report benefits all stakeholders interested in a company's ability to create value, including employees, customers, suppliers, business partners, local communities, legislators, regulators and policymakers, although it is not directly aimed at all stakeholders. Providers of financial capital can have a significant effect on the capital allocation and attempting to aim the report at all stakeholders would be an impossible task and would reduce the focus and increase the length of the report. This would be contrary to the objectives of the report, which is value creation.

Historical financial statements are essential in corporate reporting, particularly for compliance purposes, but do not provide meaningful information regarding business value. Users need a more forward-looking focus without the necessity of companies providing their own forecasts.

Companies have recognised the benefits of showing a fuller picture of company value and a more holistic view of the organisation. The International Integrated Reporting Framework will encourage the preparation of a report that shows their performance against strategy, explains the various capitals used and affected, and gives a longer-term view of the organisation. The integrated report is creating the next generation of the annual report as it enables stakeholders to make a more informed assessment of the organisation and its prospects.

Culture change

The IIRC has set out a principle-based framework rather than specifying a detailed disclosure and measurement standard. This enables each company to set out its own report rather than adopt a checklist approach. The culture change should enable companies to communicate their value creation better than the often boilerplate disclosures under International Financial Reporting Standards (IFRS).

The report acts as a platform to explain what creates the underlying value in a business and how management protects this value. This gives the report more business relevance than the compliance-led approach currently used. Integrated reporting will not replace other forms of reporting, but the vision is that preparers will pull together relevant information already produced to explain the key drivers of their business's value.

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Information will only be included in the report where it is material to the stakeholder's assessment of the business. There were concerns that the term 'materiality' had a certain legal connotation, with the result that some entities may feel they should include regulatory information in the integrated report. However, the IIRC concluded that the term should continue to be used in this context as it is well understood.

The integrated report aims to provide an insight into the company's resources and relationships which are known as the capitals and how the company interacts with the external environment and the capitals to create value. These capitals can be financial, manufactured, intellectual, human, social and relationship, and natural capital, but companies need not adopt these classifications. The purpose of this framework is to establish principles and content that governs the report, and to explain the fundamental concepts that underpin them. The report should be concise, reliable and complete, including all material matters, both positive and negative, and presented in a balanced way without material error.

Key components

Integrated reporting is built around the following key components:

1. Organisational overview and the external environment under which it operates.

2. Governance structure and how this supports its ability to create value. 3. Business model. 4. Risks and opportunities and how they are dealing with them and how they

affect the company's ability to create value. 5. Strategy and resource allocation. 6. Performance and achievement of strategic objectives for the period and

outcomes. 7. Outlook and challenges facing the company and their implications. 8. The basis of presentation needs to be determined, including what matters are

to be included in the integrated report and how the elements are quantified or evaluated.

The framework does not require discrete sections to be compiled in the report, but there should be a high-level review to ensure that all relevant aspects are included. The linkage across the above content can create a key storyline and can determine the major elements of the report, such that the information relevant to each company would be different.

An integrated report should provide insight into the nature and quality of the organisation's relationships with its key stakeholders, including how and to what extent the organisation understands, takes into account and responds to their needs and interests. Furthermore, the report should be consistent over time to enable comparison with other entities.

An integrated report may be prepared in response to existing compliance requirements; for example, a management commentary. Where that report is also prepared according to the framework or even beyond the framework, it can be considered an integrated report. An integrated report may be either a standalone

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report or be included as a distinguishable part of another report or communication. For example, it can be included in the company's financial statements.

Nature of value

The IIRC considered the nature of value and value creation. These terms can include the total of all the capitals, the benefit captured by the company, the market value or cashflows of the organisation, and the successful achievement of the company's objectives. However, the conclusion reached was that the framework should not define value from any one particular perspective, because value depends upon the individual company's own perspective. It can be shown through movement of capital and can be defined as value created for the company or for others. An integrated report should not attempt to quantify value, as assessments of value are left to those using the report.

Many respondents felt that there should be a requirement for a statement from those 'charged with governance' acknowledging their responsibility for the integrated report in order to ensure the reliability and credibility of the integrated report. Additionally it would increase the accountability for the content of the report.

The IIRC feels that the inclusion of such a statement may result in additional liability concerns, such as inconsistency with regulatory requirements in certain jurisdictions and could lead to a higher level of legal liability. The IIRC also felt that the above issues might result in a slower take-up of the report and decided that those 'charged with governance' should, in time, be required to acknowledge their responsibility for the integrated report, while at the same time recognising that reports in which they were not involved would lack credibility.

There has been discussion about whether the framework constitutes suitable criteria for report preparation and for assurance. The questions asked concerned measurement standards to be used for the information reported and how a preparer can ascertain the completeness of the report.

Future disclosures

There were concerns over the ability to assess future disclosures, and recommendations were made that specific criteria should be used for measurement, the range of outcomes and the need for any confidence intervals to be disclosed. The preparation of an integrated report requires judgment, but there is a requirement for the report to describe its basis of preparation and presentation, including the significant frameworks and methods used to quantify or evaluate material matters. Also included is the disclosure of a summary of how the company determined the materiality limits and a description of the reporting boundaries.

The IIRC has stated that the prescription of specific key KPIs (key performance indicators) and measurement methods is beyond the scope of a principles-based framework. The framework contains information on the principle-based approach and indicates that there is a need to include quantitative indicators whenever practicable and possible. Additionally, consistency of measurement methods across

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different reports is of paramount importance. There is outline guidance on the selection of suitable quantitative indicators.

A company should consider how to describe the disclosures without causing a significant loss of competitive advantage. The entity will consider what advantage a competitor could actually gain from information in the integrated report, and will balance this against the need for disclosure.

Companies struggle to communicate value through traditional reporting. The framework can prove an effective tool for businesses looking to shift their reporting focus from annual financial performance to long-term shareholder value creation. The framework will be attractive to companies who wish to develop their narrative reporting around the business model to explain how the business has been developed.

Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School

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Following research by European Securities and Markets Authority (ESMA), the regulatory bodies are focusing on key aspects of IAS 36, says Graham Holt

IAS 36, Impairment of Assets, describes the procedures that an entity should follow to ensure that it carries its assets at no more than their recoverable amount, which is effectively the higher of the amount to be realised through using or selling the asset. When the carrying amount of asset exceeds the recoverable amount, the asset is considered to be impaired and the entity recognises an impairment loss. Goodwill acquired in a business combination or intangible assets with indefinite useful lives have to be tested for impairment at least on an annual basis. The standard details the circumstances when an impairment loss should be reversed, although this is not possible for goodwill.

For the purposes of impairment testing, goodwill should be allocated to the cash-generating units (CGU) or groups of CGUs benefiting from goodwill. Such group of units should not be larger than an operating segment before aggregation. For any asset, an impairment test has to be carried out at each reporting date if there is any indicator of impairment. IAS 36 gives a list of common indicators of impairment such as increases in market interest rates, market capitalisation falling below net asset carrying value or the economic performance of an asset being worse than projected in internal budgets.

Detailed disclosures, including the circumstances that have led to impairment are required in relation to each CGU with significant amounts of goodwill and other intangible assets. These include the key assumptions on which management has based cashflow projections, a description of management's approach to determining the values of each key assumption, terminal growth rates and discount rates as well as sensitivity analysis where a reasonable change in a key assumption would lead to impairment.

Additionally, the International Accounting Standards Board (IASB) has recently published Recoverable Amount Disclosures for Non-Financial Assets (Amendments to IAS 36). These narrow amendments to IAS 36 detail the disclosure of information about the recoverable amount of impaired assets if that amount is based on fair value less costs of disposal. When developing IFRS 13, Fair Value Measurement, the IASB decided to change IAS 36 to require disclosures about the recoverable amount of impaired assets. The recent amendment limits the scope of those disclosures to the recoverable amount of impaired assets that is based on fair value less costs of disposal. The amendments are to be applied retrospectively for annual periods beginning on or after 1 January 2014 with earlier application permitted.

In January 2013,the European Securities and Markets Authority (ESMA) issued a report on the accounting practices relating to impairment testing of goodwill and other intangible assets. ESMA reviewed the nature of disclosures in the 2011 IFRS financial statements of a sample of 235 companies with material amounts of goodwill. Similarly, a recent research report by the Centre for Financial Analysis and Reporting Research (CeFARR) at the Cass Business School entitled Accounting for asset impairment: a test for IFRS compliance across Europe reviewed the compliance of European listed companies' as regards IAS 36. The authors, Hami Amiraslani, George E Iatridis and Peter F Pope, investigated the degree of

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compliance with IFRS by analysing impairment disclosures during 2010/11, relating to non-financial assets within a sample of over 4,000 listed companies from the European Union plus Norway and Switzerland.

The two reports make interesting reading and there is some consistency in their conclusions. The findings of the CeFARR research contextualise the ESMA report. CeFARR found that compliance with some impairment disclosure requirements varied quite considerably suggesting inconsistency in the application of IFRS. Compliance with impairment disclosure requirements that required greater managerial involvement was less rigorous than those requirements with low effort required. This leads to a tendency to use boilerplate description, which helps reduce the cost of compliance. There appears to be considerable variation across European countries in compliance with some impairment disclosure requirements.

CeFARR found that the quality of impairment reporting is better in companies whose jurisdiction has a strong regulatory and institutional infrastructure. They placed the UK and Ireland in this category. However, impairment disclosures seem to be of lower quality in jurisdictions where there is a weaker regulatory regime. They further conclude that companies operating in a strong regulatory and enforcement setting appear to recognise impairment losses on a timelier basis. These findings could have implications for future investment decisions in terms of lower risk in certain jurisdictions.

In the current economic and financial crisis, assets in many industries are likely to generate lower than expected cashflows with the result that their carrying amount is greater than their recoverable amount with the result that impairment losses are required. However, ESMA found that the material impairment losses of goodwill reported in 2011 were limited to a small number of companies, and these were mainly in the financial services and telecommunication industries. Overall impairment losses on goodwill in 2011 amounted to only 5% of goodwill recognised in the 2010 IFRS financial statements.

An indication of impairment could be a fall in market capitalisation below the carrying value of equity. An equity/market capitalisation ratio above 100% is one of the external sources of information indicating that assets may be impaired, and should be considered in assessing the realistic values of key assumptions used in impairment testing. ESMA reported that the average equity/market capitalisation ratio of its sample rose from 100 % at 2010 year-end to 145% at 2011 year-end and further, that as at 31 December 2011, 43 % of the sample showed a market capitalisation below equity compared to 30 % in 2010. Of these entities, 47% recognised impairment losses on goodwill in their 2011 IFRS financial statements.

ESMA feels that the increased equity/market capitalisation ratio and relatively limited impairment losses call into question whether the level of impairment in 2011 appropriately reflects the effects of the financial and economic crisis. As CeFARR found, in many cases the disclosures relating to impairment were of a boilerplate nature and not entity-specific due to a failure to comply with the requirements of the standard and possibly IAS 36 not providing specific enough detail, especially as regards the nature of the sensitivity analysis.

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As a result of the ESMA review, they have identified five problem areas: 1 Key assumptions of management

In the ESMA sample, only 60% of the entities discussed the key assumptions used for cashflow forecasts other than the discount rate and growth rate used in the impairment testing and half of these entities did not provide the relevant entity-specific information.

2 Sensitivity analysis

ESMA has identified different practices with regard to disclosures on sensitivity analysis. Only half of the entities presented a sensitivity analysis where the book value of their net assets exceeded their market capitalisation. This is a surprisingly low figure considering that this is an indication of impairment.

3 Determination of recoverable amount

'Value in use' is used by most entities for goodwill impairment testing purposes and 60% of entities used discounting to calculate 'fair value less costs to sell'. Thus a significant number of entities estimate the recoverable amount using discounted cashflows. IAS 36 requires different criteria for cashflows when using value in use or fair value less costs to sell to determine the recoverable amount. One would expect that third party information would prevail over entity based assumptions when determining 'fair value less costs to sell' in this way.

4 Determination of growth rates

IAS 36 states that for periods beyond those covered by the most recent budgets and forecasts, they should be based on extrapolations using a steady or declining growth rate unless an increasing rate can be justified. ESMA found that more than 15% of

issuers disclosed a long-term growth rate above 3% which, given the current

economic environment, is optimistic and probably unrealistic.

5 Disclosure of an average discount rate

ESMA found that 25% of issuers in the sample disclosed an average discount rate, rather than a specific discount rate on each material cash-generating unit. The applied discount rate has a major impact on the calculation of value in use. Therefore separate discount rates should be disclosed and used which fit the risk profile of each CGU. The disclosure of a single average discount rate for all CGUs obscures relevant information.

As a result of the above, ESMA and the national regulatory authorities are focusing on certain key aspects of IAS 36. The key areas include the application by entities of the rules re impairment testing of goodwill and other intangible assets, the reasonableness of cashflow forecasts, the key assumptions used in the impairment test and the relevance and appropriateness of the sensitivity analysis provided. ESMA expects issuers and their auditors to consider the findings of their review when preparing and auditing the IFRS financial statements. ESMA also expects

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national regulatory authorities to take appropriate enforcement actions where needed.

Graham Holt is associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School