DM ete ne ncit ats | Ft eet tetaig iTS) Topic list Sor “LIAS 36 impairment of Assets 2 cash-peneatng units ‘3 Gooduill and the impalment of aseels “Accounting treatment of an impairment ss a/alala Introduction IAS 96 san important standar. Impairment rules aply to both tangible ana intangible assets,Study guide B3 | Impairment of assets Identify circumstances which indicat that an impairment of an asset may have occurred Describe what is meant by a cash-generating unit Define and calculate the recoverable amount ofan asset and any associated impairment losses Sate the basis on which impairment losses shouldbe allocated, and allocate a given impaitment loss tothe assets ofa cash-generating unt ‘Account forthe reversal ofan impairment loss that was recognised in a previous period | Bs | Intangible assets and goodwill Explain the principe of impairment tess in relation to purchased goodwill 1 IAS 36 Impairment of Assets MESEEIID | innpairmentis determined by comparing the carrying amount of the asset with its recoverable amount. ‘hiss the higher ofits fair valueless costs of disposal and its value in use ‘There is an established principe that assets should not be carried above their recoverable amount, An entity should write down the carrying amount of an asset to its recoverable amount if the carrying amount of an asset is not recoverable in fll IAS 36 puts in place a detaled methodology for carrying out impairment reviews and related accounting treatments and disclosures. 1.1 Scope AS 36 applies to al tngible, intangible and financial assets except + inventories under IAS 2 Inventories, ‘© comtract assets and assets arising from costs to obtain o fulfil a contact under IFRS 15 Revenue ‘trom Contracts with Customers, © deferred tax assets under IAS 12 income Taxes, © assets arising under IAS 19 Employee Benefits, ‘+ financial assets within the scope of IFRS 9 Financial instruments, ‘© investment property under IAS 40 Investment Property This is because those standards already have rules for recognising and measuring Impairment. Note also that IAS 36 does not apply to non-current assets held forsale, which are dealt with under IFRS 5 Non- ‘current Assets Held for Sale and Discontinued Operations, Key terms | An impairment loss is the amount by which the carrying amount of an asset or a cash-generating unit exceeds its recoverable ammount Carrying amount is the amount at which an asset recognised after deducting any accumulated deprecation (amortisation) and accumulated impairment losses thereon, (IAS 36: para 6) The basic principle underlying IAS 36 is relatively straightforward. If an asset's carrying amount inthe financial statements is higher than the value it can realistically generate, measured as Its ‘recoverable amount , the asset is judged to have suffered an impairment loss, It should therefore be reduced in value, by the amount of the impairment oss. The amount ofthe impairment loss should be writen off against profitimmediately. DIMI = twtr asts | pat 8 cent of rani tates PeKey term The main accounting issues to consider are therefore (2) How sit possible to identity when an impaitment loss may have occurred? (0) How should the recoverable amount of the asset be measured? (c) How should an ‘impairment loss’ be reported inthe financial statements? 1.2 Identifying a potentially impaired asset ‘An entity should assess atthe end of each reporting period whether there are any indications of impairment to any assets. The concept of materiality applies, and only material impairment needs to be identities, lt there are indications of possible impaitment, the entity is requted to make a formal estimate ofthe recoverable amount ofthe assets concerned. AS 36 suggests how indications ofa possible impairment of assets might be recognised. The suggestions are based largely on common sense. (2) External sources of information (i) Afallin the asset's market value that is more significant than would normally be expected from passage of time over normal use (i) Asigniticant change in the technological, market, egal or economic environment of the business in which the assets are employed (ii) An increase in market interest rates or market rates of return on investments likely to affect the discount rate used in calculating value in use (iv) The carrying amount ofthe entity's net assets being more than its market capitalisation (©) Internal sources of information: evidence of obsolescence or physical damage, adverse changes in the use to which the asset is put, or the asset's economic performance (IAS 36: para. 12) Even i there are no indications of impairment, he following assets must always be tested for impairment annualy (2) Anintangibie asset with an indefinite useful lite (b) Goodwill acquire in a business combination 1.3 Measuring the recoverable amount of the asset What isan asset's recoverable amount? ‘The recoverable amount of an asset should be measured as the higher value ot: (2) the asset's fair valueless costs of disposal (0) its value in use (IAS 36: para. 6) ‘An asset's far valueless costs of disposal the price that would be recelved to sell the asset in an orderly transaction between market participants at the measurement dat, less direct disposal costs, such as legal expenses, (2) there isan active market in the asset, the fair value should be based on the marke pri the price of recent transactions in similar assets, (b) there is no active market in the asset it might be possible to estimate far value using best estimates of what market participants might pay in an orderly transaction. Fair value less costs of disposal eannot be reduced, however, by including within costs of disposal any restructuring or reorganisation expenses, or any costs that have already been recognised in the financial statements as labile, The concept of ‘value in use’ is very Important. ore pathname | 5 apm teKey term The value in use isthe present value ofthe future cashflows expected to be deve from an assets or cash-generating unit (IAS 36: para. 6). 1.4 Recognition and measurement of an impairment loss The rule for assets at historical cost I: lt the recoverable amount ofan assets lower than the carrying amount, the carrying amount should be reduced by the difference (ie the impairment loss) which should be charged as an expense in proft or loss, ‘The rule for assets held at arevalued amount (such as property revalued under IAS 16) is ‘The impairment loss isto be treated as a revaluation decrease under the relevant IFRS Standard In practice this means: ‘+ Tothe extent that there isa revaluation surplus held in respect ofthe asset, the impaltment loss should be charged to other comprehensive income (and shown in the revaluation surplus) © Any excess should be charged to profit or loss. (IAS 96: paras. 60-61) 1.5 Example: Calculating an impairment loss ‘Ao holds an item of machinery which it believes is impaired. The following information is relevant = The machine is held at historical cost ©The carrying amount ofthe machinery is $10,500 ‘= The fair value of the machinery is $10,000, the cost of selling is $500, © The present value ofthe value in use ofthe machinery is estimated to be $9,000 Required Determine whether the machinery is Impaired and i so, calulate the impairment loss. Solution The carrying amount ofthe machinery must be compared to its recoverable amount. The recoverable amounts the higher o: (2) The machinery's tar value less costs of disposal: 10,000 ~ 50¢ (b) Its value in use: $9,000 ‘Therefore the recoverable amount is $9,500, The carrying amount ofthe machinery is therefore greater than its recoverable amount, so the machi 's impaired. The impaitment loss is: $10,500 ~ $9,500 = $1,000. 39,500 DI eet ees | ree nt cet BPR2 Cash-generating units 7 MESES wren tis notpossibe to calculate the recoverable amount of single asst ten tat fs cash-generating unit shouldbe measured instead, 2.1 Use of cash-generating ut AS 36 goes ito detall about the important concept of cash-generatng units. Asa basic rule, the recoverable amount of an asset should be calculated for the asset individually. However, there will be ‘occasions when it is not possible to estimate such a value for an individual asset, particularly in the calculation of value in use. This is because cash inflows and outflows cannot be attributed tothe individual asset It itis not possible to calculate the recoverable amount for an individual asset, the recoverable amount of the asset's cash-generating unit should be measured instead, Koy term A cash-gonerating units the smalstidentitabe group of assets that generates cash inflows tat are largely independent of the cash inflows trom other assets or groups of assets (IAS 36: para. 6). (Can you think of some examples of how a cash-generating unit would be identified? Here are two possibilities. (2) Amining company owns a private rallway tat it uses to transport output from one of its mines. The railway now has no market value other than as scrap, and its impossible to identify any separate cash inflows with the use of the railway itself. Consequently, ifthe mining company suspects an impaltment inthe value ofthe ralway, it should teat the mine as a whole as a cash- generating unit, and measure the recoverable amount ofthe mine as a whole. (b) Abus company has an arrangement with @ town's authorites to run @bus service on four route in the town, Separately identifiable assets are allocated to each ofthe bus routes, and cash inflows ‘and outflows can be attributed to each individual route. Three routes are running ata profit and one is running ata loss. The bus company suspects that there isan impairment of assets on the loss- ‘making route. However, the company willbe unable to close the loss-making route, because itis under an obligation to operate all four routes, as pat of its contract withthe local authority Consequently, the company should treat all four bus routes together as a cash-generating Unit, and calculate the recoverable amount forthe unit asa whole. Minimart Co belongs toa retail store chain Maximart Co, Minimart Co makes all its retal purchases through Maximart Co's purchasing centre. Pricing, marketing, advertising and human resources policies (except for hiring Minimart Co's cashiers and salesmen) are decided by Maximart Co. Maximart Co also ‘owns five other stores in the same city as Minimart Co (although in different neighbourhoods) and 20, other stores in other cities. Al stores are managed in the same way as Minimart Co. Minimart Co and four other stores were purchased five years ago and goodwill was recognised, og Pett Grist soos | time etsRequired What factors will Maximart Co consider when determining if Minimart Co meets the definition of a cash- generating unit? In identifying Minimart Co's cash-generating unit, an ently considers whether, for example: (2) Internal management reporting is organised to measure performance on a store-by-store basis (b) The business is run on a store-by-store profit basis or ona regioncity basis, ‘All Maximart Co's stores are in diferent neighbourhoods and probably have diferent customer bases. So, although Minimart Co is managed at a corporate level, Minimart Co generates cash inflows that are largely independent from those of Maximart Co's other stores. Therefore, itis likely that Minimart Co is a cash-generating unit tan active market exists for the output produced by the asset or a group of assets, this asset or group, should be identified as acash-generating unit, even if some or all of the output is used internal. Cash-generating units should be Identiti consistently from period to period forthe same type of asset Unless a change is justitieg The group of net assets less liabilities that are considered for impairment shouldbe the same as those considered in the calculation ofthe recoverable amount. (For the treatment of goodwill and corporate assets see below) 2.2 Example: Recoverable amount and carrying amount Fourways Co is made up of four cash-generating units ll four units are being tested for impairment Assets and lables will be allocated to them as follows. (2) Property, plant and equipment and separate intangibles will be allocated to the cash-generating units as far as possible. (b) Current assets such as inventaries,recsvables and prepayments wil be allocated to the relevant cash-generating units (9) Liabities (eg payables) will be deducted fram the net assets ofthe relevant cash-generating units (provided thatthe recoverable amount ofthe cash generating unt cannot be calculated without consideration of those lables (IAS 36: para. 76) (4) There figure for cach cash-generting unit resulting trom this exer relevant recoverable amount, computed onthe same bass, Will be compared tothe 3 Impairment of goodwill ACCA's website contains many useful articles, chapter: including the following relating to topics covered inthis = Impairment of goodwit This is available inthe DiplFR study support resources section of the ACCA website, Do BPR3.1 Goodwill Purchased goodwill arses in a business combination and Is caloulted as the excess of the amount pald to acquire a business over the far value ofthat business's identifiable net assets, It therefore represents @ payment made by an acquirer in anticipation of future economic benefits or synergies that will result from ‘the acquisition (see Chapter 7 Section 3 for a detalled discussion of goodwill). Purchased goodwls recorded as an intangible asset inthe consolidated financial statements ofthe acquirer and lke other assets, it should be tested for impairment. Due tothe nature of goodwill, IAS 96 requires goodwill to be tested for impairment at least annually. 3.2 Allocating goodwill to cash-generating units Testing goodwill for impairment is dificult because gooduill does not generate cash flows independently of other assets. Therefore, we cannot calculate the recoverable amount of goodwill as an asset on its ‘own, Instead, IAS 36 requires thatthe goodwill must be allocated to each of the acquirer's cash- generating units (or groups of cash-generating unit) that are expected to benefit from the synergies of the business combination, Each unit to which the goodwill isso allocated should (2) ‘Represent the lowest level within the entity at which the goodwil is monitored for internal ‘management purposes’ and (b) ‘Not be larger than an operating segment determined in accordance with IFRS & Operating Segments! (IAS 36: para. 80) It may be impracticable to complet the allocation of goodwill before the firs reporting date after a business combination, particularly i the acquirer is accounting for the combination forthe first time using provisional values. The intial allocation of goodwill must be completed before the end ofthe first reporting Period after the acquisition date. 3.3 Testing cash-generating units with goodwill for impairment ‘A cash-generating unt to wiich gooduil has been allocated is tested for impaltment annually. The carrying amount ofthe unt, including goodwill, is compared with the recoverable amount. I the carrying amount ofthe unit exceeds the recoverable amount, the entity must recognise an impaltment loss. ‘The annual impairment test may be performed at any time during an accounting period, but must be performed at the same time every year As explained in more detall in Section 4 below, when an impairment oss arses, gooduil is alvays written off first with any excess impairment allocated tothe other assets pro-rata, 3.4 Example: Allocation of impairment loss A cash- generating unit comprises the following $m Building 30 Plant and equipment 8 Goodwill, 10 Current assets 20 68 Following 2 recession, an impairment review has estimated the recoverable amount ofthe cash-generating Unit to be $50 milion, How do we allocate the impairment loss? ore rats eometltancd sine |S opiates EERSolution [As stated in section 3.2 above, the order or write of Is that the loss willbe aplie frst against the {goodwill and then against the tangible non-current assets on a pro-rata basis, The current assets are considered to be stated at fair value and hence no impairment loss is allocated to them (this is covered further inthe next section). Ater writing off the goodwill, the balance tobe allocated is $m. This is pro- rated over the total of $36m forthe remaining non-current assets at a rate of $1m per $m. Carrying amount ‘Carrying amount impairment loss post-impairment $m $ $ Building 30 6) 5 Plant and equipment 6 ay 5 Goodwill 10 (10) - Current assets = 20 ae (16) ey 4 Accounting treatment of an impairment loss |, and only if, the recoverable amount ofan asset i less than its carying amount in the statement of financlal position, an impaitment loss has occurred. Ths loss should be recognised immediately. (2) The asset's canying amount should be reduced tits recoverable amount inthe statement of financial postion (b) The impairment loss should be recognised immediately in profit or loss (unless the asset has been revalued upwards in which case the loss i treated as a revaluation decrease). After reducing an asset to its recoverable amount, the depreciation charge on the asset should then be based on its new carrying amount, its estimated residual value (if any) and its estimated remaining useful lite. ‘An impairment loss should be recognised for a eash-generating unit (and only it) the recoverable amount for the cash-generating units less than the carying amount in the statement of financial postion {oral the assets in the unit, As we mentioned in section 3.2 above, when an impairment oss is recognised for a cast-generating unt, the loss should be allocated between the assets in the uni in the following order. (2) First to the carying amount of any goodwill allocated tothe cash generating unit (0) Then to all other assets in the cash-generating unit, on a pro rata basis (IAS 36: para, 104) It any individual assets within a cash generating unit can be specifically identified as being impaired, for example, because they are damaged or have become obsolete, then the catrying amount of those assets, should be reduced frst. In allocating an impairment loss, the carrying amount ofan asset should not be reduced below the highest of: (2) ts alr value less costs of disposal (b) its value inuse (tf determinable) (9 210 (IAS 36: para. 105) Any remaining amount ofan impairment loss should be recognised asa ibility if required by other IFRS Standards ‘Allocating an impairment loss to goodwill is further complicated by the choice in IFRS 3 Business Combinations to value the non-controlin intrest at fair value or at the proportionate share of net assets, This is covered in Chapter 21 De BPR4.1 Example 1: Impairment loss ‘A company that extracts natural gas and oll has a dling platform in the Caspian Sea, It's requled by legislation ofthe country concerned to remove and dismantle the platform atthe end ofits useful fe, Accordingly, the company has included an amount in ts financial statements for removal and dismanting costs, and is depreciating this amount over the platforms expected ite The company is carrying out an exercise to establish whether there has been an Impairment of the platform. (@) Its arying amount in the statement of financial position is $3m. (b) The company has received an offer of $2.8m forthe platform from another oil company. The bidder would take over the responsibility (and costs) for dismantling and removing the platform at the end ofits ite, (c) The present value ofthe estimated cash flows from the platform's continued use is $3.8m (before adjusting for dismantling costs), (4) The carrying amount in te statement of financial postion forthe provision for dismantling and removal is currently $0.6m. What should be the value of te driling platform in the statement of financial position, and what, if anything, isthe impairment loss? Solution Fair value less costs of disposal = $28m Valu in use = PV of cash flows from use les the carrying amount ofthe provisioniabilty = $3.3m -$0.6m = $2.7m Recoverable amount Higher ofthese two amounts, ie $2.8m Carrying amount = $3m Impairment loss s0.2m ‘The catrying amount should be reduced to $2.8m 4.2 Example 2: Impairment loss ‘A company has acquired another business for $4.5m: tangible assets are valued at $4.0m and goodwill at $05m. ‘An asset with a carrying amount of $1m is destroyed in a terrorist attack. The asset was not insured. The loss ofthe asset, without insurance, has prompted the company to assess whether there has been an impairment of assets inthe acquired business and what the amount of any such loss is. The recoverable amount of the business (a single cash generating unit) is measured as $3.1m. Solution There has been an impairment loss of $1.4m (4.5m -$3.1m), The impaitment loss wll be recognised in profit or loss. The loss willbe allocated between the assets in the cash generating unit as follows. (2) loss of $1m can be attributed directly to the uninsured asset that has been destroyed. (b) The remaining loss of $0.4m should be allocated to goodwill ‘The carrying amount ofthe assets will now be $3m for tangible assets and $0.1m for gooduil. 4.3 Reversal of an impairment loss The annual assessment to determine whether there may have been some impairment should be applied to all assets, including assets that have already been impaired inthe past og Paid creistiac sees | «ime ets ESIn some cases, the recoverable amount of an asset that has previously been impaired might turn out to be higher than the assets current carrying amount. In ether words, there might have been a reversal of some of the previous impairment loss, In which case, the carrying amount ofthe asset should be increased to its new recoverable amount, and (2) Ifthe assets cartied at revalued amount (for example under 1AS 16), the reversal ofthe Impairment loss should be accounted for a a revaluation increase (so applying IAS 16: recognised in other comprehensive income and accumulated as a revaluation surplus in equity) (b) the assets not carried at revalued amount, the reversal ofthe impairment loss should be recognised immediately as income in profit or loss. (IAS 36: para. 119) The asset cannot be revalued toa carrying amount tha is higher than its value would have been ifthe asset had not been impaired originally, ie its depreciated carrying amount had the impairment not taken place. Depreciation of the asset should now be based on its new revalued amount, its estimated residual value (it any) and its estimated remaining useful ite ‘An exception to this rue is for goodwill. An impairment loss for goodwill should not be reversed in a ‘subsequent period (IAS 36: para. 124), 4 Reversal of implement loss ‘cash generating unit comprising @ factory, plant and equipment etc and assoclated purchased goodwill becomes impaired because the product it makes Is avertaken by a technolagicaly more advanced model produced by a competitor. The recoverable amount of the cash generating unit fas to $60m, resulting in an impairment loss of $80m, allocated as follows, Carrying amounts Carving amounts bere impairment after impairment $m $m Good 40 - Patent (with no market value) 20 - Tangible non-curent assets (market vlue 650m) 20 60 Total 0 60 After three years, the entity makes a technological breakthrough of its own, andthe recoverable amount of ‘the cash generating unit increases to $90m. The carrying amount ofthe tangible non-current assets had ‘the impairment not occurred would have been $70m. Required Calculate the reversal ofthe impalement loss. ‘The reversal of the impairment loss is recognised tothe extent that it increases the carying amount ofthe tangible non-current assets to what t would have been had the impairment not taken place, ie a reversal of the impairment loss of $10m is recognised and the tangible non-current assets written back to $70m. Reversal ofthe impaliments not recognised in relation to the patent because the effect ofthe extemal ‘event that caused the original impairment has not reversed ~ the original product is stil overtaken by @ ‘more advanced model. Reversal of an impairment to gooduil is not permitted under IAS 36. La focus | An exam question may ask you to calculate and allocate an impairment loss. Make sure you know the — ‘order in which to allocate the loss. Ds BPRPHC ‘© Impairment is determined by comparing the carrying amount ofthe asset with its recoverable amount This is the higher ofits far value less costs of disposal and its value In use. ‘© When it is not possible to calculate the recoverable amount ofa single asset, then that of its cash- ing unit should be measured instead. 1 Define recoverable amount ofan asset How is an impaitment loss on a revalued asset treated? How is an impairment loss allocated tothe asses ina cash-generating unit? Deserve the circumstances under which impairment losses may be reversed Non-depreciable assets with a carrying amount of $300,000 were found to have a recoverable amount of $280,000 at 31 December 20X5. On 31 December 20X6 the recoverable amount had increased to $310,000. How much of this reversal may be recognised”?Answers to Quick Quiz 1 Higher of fair value less costs of disposal and value In use 2 Asa revaluation decrease 3 Inthe following order: (2) against any damaged or destroyed assets; then (b) against goodwill then (c) against al other non-current assets on a pro rata basis. 4 An impaitment loss recognised in prior periods for an asset other than goodwill shal be reversed if, and only if, there has been change inthe estimates used to determine the asset's recoverable amount since the last impaiment loss was recognised. An impairment loss recognised for goodwill shall not be reversed ina subsequent period 5 $20,000 of the impairment reversal may be recognise, that isthe carying amount may be increased to the amount recorded prior to the impairmentPUTT me ey FAS 16 2 Lessee accountng 4 3 Sale and leaseback cy “Lessor aecounting # Introduction Leasing transactions are extremely common so this i an important practical subject. IFRS 16s the relevant IFAS Standard fr lease accounting,Study guide BA | Leases ‘Account for right-of-use assets and lease lables inthe records of the lesse. Explain the exemption from the recognition criteria for leases inthe records of the lessee ‘Account for sale and leaseback transactions inthe financial statements of lessees. Explain the distinction between operating and finance leases from a lessor perspective. ‘Account for operating leases and finance leases in the financial statements of lessor. Exam focus point IFRS 16 was tested asa full 20-mark question in the December 2017 exam. The examining team stated ‘that ‘performance on this question was disappointing overal. [The question] tested various aspects of, IFRS 16 - the new leasing standard, Whilst some candidates produced pleasing answers to question 3 it was evident that many candidates were not aware of the new standard at all I ls essential to keep up to date to ensure success in tis examination’ (Examiner's Report, December 2017: p. 1). In the June 2018 exam, correcting the treatment fa lease in ine with IFRS 16 was included as part ofa longer question, Most candidates performed wel on this area (Examiner's Report, June 2018: p. 2). n the September 2020 exam, leases were tested as part of question 4. The question required candidates to explain to a rnon-accountant why @ lease had resulted in aright-of-use asset inthe financial statements, as well as the ‘measurement ofthis asset and the other impacts on the financial statements of the new lease, The examiner reported that this question was generally well answered (Examiner's Report, September 2020, P.7), 1 IFRS 16 HESIOD ras 16 was orought into ensue that all assets are shown onthe statement of nancial positon, including leased assets. Under the previous standard (IAS 17) the assets acquired under operating leases ‘were not recognised as assets of the reporting entity, and as such, didnot reflect the substance of the ‘transactions or meet the Conceptual Frameworks characteristic of faithful representation. 1.1 Objective |FRS 16 sets out the principles forthe recognition, measurement, presentation and disclosure of leases. The objective is to ensure that lessees and lessors provide relevant information in a manner that faithfully represents those transactions (IFAS 16: para. IN1). 1.2 Main features IFRS 16 requires a lessee to recognise assets and labilte for al lases with a ttm of more than 12 months, unless the underlying assets of low value. Fr short-term leases or low value assets, the lease payments ate simply charged to profi or loss as an expense (see below). Noe that IFRS 16 does not dene a Tow value’ asset For all other leases, the lessee recognises a right-of-use asset, representing its right to use the Lnderiyin asset and a lease liability representing its obligation to make lease payments (IFRS 16: para, INO). Lessors are required to classify leases into finance and operating leases. 1.3 Ident Key terms | Lease. Acontract, 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 DIED) «sects torteaes | Prt 2 cents ct ani statements Peasset. An ascot that isthe subject ofa lease, for which the right to use that asset has been provided by @ lessor toa lessee, (IFRS 16: Appendix A) ‘An entity must identity whether a contract contains a lease, which isthe case if the contract conveys the right fo control the use of an identified asset fora petiod of time in exchange for consideration (IFRS 16 para. 9) ‘The rght to control the use ofan identited asset depends onthe lessee having (2) "The right to obtain substantially all of the economic benefits from use of the identified asset, and (0) Theright to direct the use ofthe identified asset’ (IFRS 16: para. 89) ‘The rght to direct the use ofthe asset wll arise when ether (IFRS 16: par. B24): () The customer has the right to direct how and for what purpose the asset is used during the whole term of usage; or (ll) Relevant decisions about use ofthe asset are pre-determined and the customer can operate the ‘asset without the supplier having the right to change thase operating instructions, or the customer designed the asset in a way that predetermines how and for what purpose the asset willbe used ‘throughout the period of use, for example, a piece of factory equipment designed tothe specifications ofthe customer. Even ifan asset is specified, a customer does not have the right to direct the use ofan identified asset i the supplier has the substantive right to substitute the asset throughout the period of use (IFRS 16: para. B14). Some contracts may contain elements that are not leases, such as service contract. These fia ‘must be separated out from the lease and accounted for separately (IFRS 16: para. 13). The following flowchart, from IFRS 16 Appendix B (para. B31), may help you in determining whether a contract contains a leas. Customer Is there an identified asset? No Consider paragraphs 813-820. ve Does the customer have the right to obtain substantial allof the economic | No benefits from use of the asset throughout he period of use? Consider paragraphs 821-823. Tvs ves Does the customer, the supple or nether party have the right to direct | supplier how and for what purpose the asses used tcoUghout the period of use? Consider paragraphs 825-830 ‘Nether; how and for what purpose the asset willbe ‘sed is predetermined Does the customer have the ight o operate the asset throughout he period of use, without the supplier having the ight to change those operating instructions? Consice paragraph 824(0)), Te ‘id the customer design the asset n away thal predetermines how and for | No what purpose the aset wil be used treughout the period of use? Consider paragraph B24(0(i. retseomneoltnncdseeewts | & coma tvewee EERE1.4 Identifying a lease: Examples 1.4.1 Example CCoketown Council has entered into a five-year contract with Caretloet Co, under which Careflest Co supplies the council with ten vehicles for the purposes of community transport. Carefleet Co owns the relevant vehicles, allen of which are specified in the contract. Coketown Council determines the routes taken for community transport and the charges and eligibility for discounts. The council can choose to use ‘the vehicles for purposes other than community transport. When the vehicles are nt being used, they are kept atthe councils offices and cannot be retrieved by Careflet Co unless Coketown Council defaults on payment. If vehicle neds to be serviced or repaired, Caretlet Co is obliged to provide a temporary replacement vehicle ofthe same typ. Conclusion: this is @ lease. There isan identifiable asset, the ten vehicles specified inthe contract. The council has @ right to use the vehicles for the period of the contract. Carefieet Co does not have the right to substitute any ofthe vehicles unless they are being serviced or repaired. Therefore Coketown Council would need to recognise a right-f-use asset and a lease lability in its statement o financial position. Is ita lease? 1.4.2 Example 2: Is it a lease? Broketown Council has recently made substantial cuts to its community transport service. twill now provide such services only in cases of great need, assessed on a case by case basis. Ithas entered into a two-year contract with Fleetcar Co fr the use of one ofits minibuses for this purpose, The minibus must seat ten people, but Fleetcar Co can use any of its ten-seater minibuses when required. The minibuses are held on Fleetcar Co's premises and are only made available to Broketown Council on request Conclusion: this is nota lease. There is no identifiable asset. Fleetcar Co can exchange one minibus for another. Therefore, Broketown Council should account fr the rental payments as an expense in profit or loss, 1.4.3 Example 3: Is it a lease? ‘This example is based on IFRS 16 ilustrative example 3. Kabal enters into a ten-year contract with a utlities company (Telenew) for the right to use three specified, Physically dstint dark fibres within a larger fibre-optic cable connecting North Town to South Town. Kabal makes the decisions about the use ofthe fibres by connecting each end ofthe fibres to its electronic. ‘equipment (je Kabal lights’ the fibres and decides what data, and how much data, those fibres wil transport) Ifthe fibres are damaged, Telenew is responsible for the repairs and maintenance. Telenew ‘owns extra fibres, but can substitute those for Kabal’s fibres only for reasons of repairs, maintenance or ‘malfunction (and is obliged to substitute the fibres in these cases) Conclusion: ths i a lease. The contract contains a lease of dark fibres. Kaba has the right to use the thee dak fibres for ten years. ‘There are thre identified fibres. The fibres ae explicitly spectid in the contact and are physically distinct ‘rom other fibres within the cable, Telenew cannot substitute the fbres other than for reasons of repairs, ‘maintenance or malfunction (IFRS 16: para. B18) Kabal has the right to control the use ofthe fibres throughout the ten-year period of use because: (2) Kabal has the right to obtain substantially al ofthe economic benefits from use ofthe fibres over the ten-year period of use and Kabal nas exclusive use ofthe fibres throughout the period of use (©) Kabal has the right to direct the use of the fibres because IFRS 16: para, B24 apples: () The customer has the right to direct how and for what purpose the asset is used during the hole ofits period of use, oF (i) The relevant decisions about use are pre-determined and the customer can operate the ‘asset without the supplier having the right to change those operating instructions. DIT « sects torteaes | Pr 2 eens ot ani tates PeKabal makes the relevant decisions about how and for what purpose the fibres are used by deciding (i) when and whether to light the fibres and (i) when and how much output the fibres wll produce (ie what data, and how much data, those fibres will transport) Kabal has the right to change these decisions during the ten-year period of use Although Telenew’s decisions about repairing and maintaining the fibres are essential to their efficent use, those decisions do not give Telenew the right to direct how and for what purpose the fibres are used, Consequently, Telenew does not control the use ofthe fibres during the period of use 1.5 Recognition exemptions IFRS 16 provides an optional exemption from te full requirements ofthe standard for (2) Short-term leases. These are leases witha lease term of 12 months or less. Ths election is made by class of undertying asset, A lease that contains a purchase option cannot be a short-term lease (b) Low value leases. These are leases where the underlying asset has alow value when new. This ‘lection can be made ona lease-by-lase basis IFRS 16 does not give an amount which is considered to be ‘low value’. However, it does give examples of items that would be considered to be low vale, including tablet and personal computers, small items of office furniture and telephones (IFRS 16: para, B8) Additionally, the assessment of whether an underlying asset is of low value Is not dependent on the size or circumstances of the lessee. So diferent lessees are expected to reach the same conclusion as to whether a particular underlying assets of low value (IFRS 16: para. B4). ‘An underlying asset qualifies as low value onl if two conditions apply ())_ "The lessee can benefit from using the underlying asset, (i) The underlying asset is not highly dependent on, or highly interrelated with, other assets (IFRS 16: para. 85). It the entity elects to take the exemption, lease payments are recognised as an expense on a straight- line basis over the lease term or another systematic bass, if more representative ofthe pattern of the lessee's benefits’ (IFRS 16: para. 6). 2 Lessee accounting MESEEIEWD | commencement ofthe ease, the esse recognise rght-ot-ate asset an eae liability 2.1 Recognition Atthe commencement date, which isthe date the lessor makes the underying asset available for use by the lessee, the lessee recognises: © Alease liability © Aright-of-use asset, Key terms + Right-ot-use asset, An asset that represents a lessees right to use an underlying asset forthe lease term. © Lease term. The non-cancellable period for which a lessee has the right to use an underlying asset, together with both (2) periods covered by an option to extend the lease if the lessee is reasonably certain to ‘exercise that option; and (6) periods covered by an option to terminate the lease ifthe lessee is reasonably certain not to exercise the option (\FRS 16: Appendix A) ore rats comneoltnncdseeewts | & ecutive EERE2.2 Lease liability The lease lability is initially measured at the present value of lease payments not paid at the commencement date, discounted atthe interest rate implicit in the lease ((FRS 18: para. 26). If that rate cannot be readily determined, the lessee's incremental borrowing rate should be used (IFRS 16: para 26), Key terms. + Inlerest rate implicit inthe lease, ‘The discount rate that, atthe inception of the lease, causes the aggregate present value of (2) Thelease payments, and (b) The unguaranteed residual value to be equal to the sum of (2) The fair value of the underlying asset, and (0) Any inital direct costs, ‘© Lessee's incremental borrowing rale, The rate of interest that a lessee would have to pay to borrow over a similar term, and witha similar security, the funds necessary to obtain an asset of similar value to the right of use asset ina similar economic environment ‘© _Unguaranteed residual value, That portion ofthe residual value ofthe underlying asset, the realisation of which by the lessor isnot assured, (IFRS 16: Appendix A) ‘The lease liability includes: = Fixed payments, less any lease incentives ‘Variable payments that depend on an index (eg the consumer price index) or rate (eg market rent) © Amounts expected to be payable under residual value guarantees ‘© Purchase options (if reasonably certain to be exercised) (FRS 16: Appendix A) Key term Lease incentives. Payments made by the lessor tothe lessee, or the relmbursement or assumption by the lessor of costs ofthe lessee (JFRS 16: Appendix A) ther variable payments (eg that arise due to level of use of the asset) are accounted for as period costs in profit or loss as incurred Ate the commencement date the carrying amount ofthe lease labily is increased by interest charges cn the outstanding iablity and reduced by lease payments made (IFRS 16: para. 36) 2.3 Right-of-use asset ‘The right-o-use assets initially measured at cost, which includes: (2) The amount ofthe initial measurement of the ease liability (he present value of lease payments not pa atthe commencement date) (b) Any lease payments made al/before the commencement date less any lease incentives received (©) Any intial direct costs (eg legal costs) incurred by the lessee (4) Any costs which the lessee will incur for dismantling and removing the underlying asset or restoring the site atthe end ofthe lease term Subsequently, the righ-of-use asset is normally measured at cost less accumulated depreciation and impairment losses in accordance with the cost model of IAS 16 Property, Plant and Equipment (IFRS 16: para, 29). PII) «sects torteaes | Pr 2 eens ct ani statements PeUnder this model, the right-of-use asset is depreciated from the commencement date to the earlier ofthe {end ofits useful lite or the end ofthe lease term. However, if ownership of the underlying asset is expected to be transferred tothe lessee atthe end ofthe leace the rght-of-use asset should be depreciated over the useful life of the underlying asset (|FRS 16: paras. 31 and 22). ‘Alternatively, the right-of-use asset is accounted for in accordance with (2) The revaluation model of IAS 16. This is optional where the right-of-use asset relates toa cass of property, plant and equipment which is measured under the revaluation model, and where elated, ‘must apply to all ight-f-use assets relating to that class; or (b) The fair model of AS 40 investment Property. This is compulsory ifthe righ-of-use asset mests the definition of investment property and the lessee uses the fair value model for its investment property 2.4 Presentation Inthe statement of financial postion right-ofuse assets can be presented on a separate line under non-current assets or they can be included in the total of corresponding underiying assets and disclosed inthe nots, Lease liabilities should be either presented separately rom othe ables or disclosed inthe notes (UFRS 16: para. 47(). IFRS 16 does not specify that lease liabilities should be spit between non-current and current bites, but this should be done as best practice, 2.5 Allocating the finance charge As the company benefits from paying the lease over a period of time, the total amount paid il therefore Include capital and interest payments. The interest Is referred to as an interest charge or finance charge. IFRS 16 requires the finance charge tobe allocated to periods during the lease term so as to produce a constant periodic rate of interest on the remaining balance ofthe lability for esch period, ie applying the Interest rate Implicit inthe lease (the leases internal rate of return) to the amount of capital outstanding to calculate the finance charge forthe period, (The lessee's incremental borrowing rate may be used i the Interest rat implicit inthe lease cannot be determined.) CConsequenty, atthe start of the lease the finance charges will be large asthe outstanding lease ibility is large. Towards the end ofthe leases life, the finance charge will be smaller asthe outstanding lease lability is smaller This is commonly called the actuarial methot This example is based on IFRS 16 Ilustrative example 13. Alessee enters into a five-year lease ofa building which has a remaining useful ite often years. Lease payments are $50,000 per annum, payable at the beginning of each yer. “The lessee incur intial direct costs of $20,000 and receives lease incentives of $5,000. Tere is no transfer of the asset a the end ofthe lease and no purchase option. The interest rate implicit n the lease i nt immediately determinable but the lessees incremental borrowing rates 5% {At the commencement date the lessee pays the initial $50,000, incurs the direct costs and receives the lease incentives, rats eomeeoltancdseeewts | & ecutive EEREExam focus point The lease lability is measured atthe present value ofthe remaining four payments not made on the commencement dat: $50,000/1.05, $50,000/1.05" $50,000/1.05" $50,000/1.05* s 47619 45,351 43,192 41.195 77287 ‘This present value calculation has been included for completeness ofthe illustration Inthe exam, you wil Not be expected to calculate the present value inthis way. Instead the question wil specity a value forthe cumulative present value of $1 payable in x years'time ata certain discount rate so that you can calculate ‘the present value quickly and easily. In this illustration, the cumulative present value of $1 payable annually in advance for four years is $3.456, Therefore the lease lability would be calculated as $50,000 x 3.456 = $177,300 Assets and lables willintaly be recognised as folows: Debit Credit $ $ Right-of-use asset Initial payment 50,000 Initial measurement of lease liability 17.297 Initial direct costs 20,000 Incentives received 6,000) 242,297 Lease lability 177,297 Cash (60,000 + 20,000 ~ 5,000) 65,000 wnpe7 = 242.297 Atthe end of year {the iailty will be measured as: Opening balance Interest 5% Current iabity Non-current ably The right-of-use asset willbe depreciated over five years, being the shorter of the lease term and the useful feof the underlying asset. Now we will see how this would work out ifthe lease payments were made in arrears. [At the commencement date the lessee would incur the drect costs and receive the lease incentives. The lease would be measured atthe present value of all fi ‘made on the commencement date: lease payments as no payments have been s $60,000/1.05. 47619 $50,000/1.05" 45,351 $50,000/1.05" 43,192 $$50,000/1.05* 41,135 $50,000/1.05* 39,176 216473 Do BPRAssets and labilties would be recognised as follows: Debit Crealt $ 8 Rightof-use asset Initial measurement of lease lability 216473 Direct costs 20,000 Lease incentives (6.000) 231,473 Lease liability 216.473 (ash (20,000 6,000) 16,000 1a ‘At the end of year 1 the liability will be measured as: 8 Opening balance 216.473 Interest 5% 10,824 Lease payment year 1 Year-end balance In order to ascertain the splt between non-current and current liabilities, we work out the balance at the ond of year 2: $ ‘pening balance 177297 Interest 53% 8,865 Lease payment year 2 (60,000) Year-end balance 136,162 The statement of anil poston wilstow: Non-currentHabity 136,162 Current ability (177,297 ~ 138,182) 44,135, maar Note that when payments are made in arrears the next instalment due will contain interest, so this is effectively deducted to arve atthe capital repayment. 2.7 Calculation of the lease liability ‘The calculation of the lease lieilty to be included inthe financial statements can be summarised as {ollows. Here the lease commencement date is 1.1.X1 and the interest rate implicit inthe lease is x%6. It lease payments are made in arears: 8 4.4x1 Lease lability (present value of future lease payments) x AAX1-31.42X1 Interest at 3% x 31.21 Instalment in arrears oo 3N12.K1 Liability cartied down x AAX2=31.12X2 Interest at % x 31.12x2 Instalment in arrears oo 31.12.42 Liability due in more than 1 year ix ore rats eomeecltancd sooo | & comin tvemee EEEIt lease payments are made in advance: $ 14x Lease abit (present valve of future lease payments) x JAX1—3142X1 Interest at x2 x 31.12.X1 ability carried down x 1132 Instament in advance ability due in more than 1 year x z Lanes scating Company A makes up its accounts to 31 December each yea. It enters into @ lease (asa lessee) to lease an item of equipment withthe following terms: Inception of lease: 4 January 204 Term: Five years: $2,000 paid at commencement of lease, followed by four payments of $2,000 payable at the start of ‘each subsequent year Fair value $8,000 Present value of future lease payments: $8,075 Usetul ie: Eight years Interest rate implicit inthe lease: 10% Required ‘Show how shoul ths lease should be accounted for in Company A's statement of financial positon as at 31 December 20X1, ‘STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20Xt (EXTRACT) ‘Non-current assets Rightof-use asset (W1) 6.480 ‘Non-current liabilities Lease lability (W2) 4,804 ‘Current abies Lease liability (6,804 ~ 4,804) W2) 2,000 Workings 1 Rightof-use asset 8 Initial measurement of lease liability 6,075 Payments made before or at commencement of lease 2,000 Rightof-use asset 075 Depreciate over the shorter of the useful life or the lease term: Depreciation charge = $8,075 Carrying amount at 31.121 Ds BPR2 Lease lability 8 4.4x1 Liability bis 6,075 AAX1-31.12X1 Interest at 12% 728 SNA2K1 Liability e/d 6,804 442 Instalment 2 (in advance) (2,000) 1A.X2 Liability due in more than one year 4,804 3 Sale and leaseback MES cate ac easedack transaction invaie the sale ofan asset and the leasing bac ofthe same aset Exam focus Ea focus [th iF vlads ony consider the elects of sland lssbk inthe nancial xa fhe lessee Asal and leaseback transaction Involves the sale of an asset and the leasing back ofthe same asset. The key question in determining the accounting treatment is: does the transaction constitute a sale? Tis is mined by considering when the performance obligation is atistied in accordance with IFRS 15 ‘Revenue from Contracts with Customers (IFRS 16: para. 98). 3.1 Transfer is a sale It the transfer satisties the IFRS 15 requitements to be accounted for asa sale: (2) The selleviessee measures the right-of-use asset arising ftom the leaseback atthe proportion of the previous carrying amount ofthe asset that relates to the right of use retained by the selleflessee. Ths is calculated as: present value of lease payments Caryingamount » “ (b) The seller/lessee only recognises the amount of any gain or loss on the sale that relates to the rights transferred to the buyer (IFRS 16: para, 100) This can be calculated in three stages: Stage alr value ~ carrying amount Stage 2: Calulate the gain that relates tothe rights retalned |: Calculate the total gain Total gat present value of lease payments ‘alr value Gain « = Galn relating to rights retained Stage 3: The gain relating to rights transferred isthe balancing figure: total gain (Stage 1) ~ gain on rights retained (Stage 2) ‘The right-of-use asset continues to be depreciated as normal, although a revision ofits remaining useful lite may be necessary to restrict it tothe lease term, 3.1.1 Example: Sale and leaseback where the transfer is a sale (On 1 April 20X2, Wigton Co bought an injection moulding machine for $600,000, The carrying amount of the machine as at 31 March 20X3 was $500,000. On 1 April 20X3, Wigton Co sold it to Whitehaven Co for $740,000, its fair value. Wiaton Co immediately leased the machine back for five years, the remainder of its useful fe, at $160,000 per annum payable in arrears. The present value of the lease payments is. {$700,000 and the transaction satisfies the IFAS 15 citria to be recognised as a sale. Gain on rights transferred ore Putt ar | A 107Required What gain should Wigton Co recognise for the year ended $1 March 20XS asa result of thes leaseback? and Solution Stage 1: Total gan on the sale = fair value carrying amount = $740,000 ~ $500,000 = $240,000 resent value oflease payments Stage 2: Gain eating tothe rights retained = gain x PS REESE AYES = $(240,000 x 700,000/740,000) $227,007 {otal gan (Stage 1) ~ gain on rights retained (Stage 2) = $240,000 $227,027 =$12.973 Wigton Co should recognise a gain of $12,973 for the year ended 31 March 20X4 as a result of the sale and leaseback. ‘Stage 3: Gain relating tothe rights transferred 3.1.2 Transaction not on market terms It the fair value ofthe consideration for he sale doesnot equa the fai value ofthe ase, orf the lease payments are not at market rte, the following adjustments should be made: ‘+ Any below-market terms shouldbe accounted for asa prepayment of lease payments (the shortall in consideration received from te lessor is treated asa lease payment made by the lesse0) + Any above-market toms are accounted fr as aditional financing provided by the buyerlessor (the additional amount paid by the lessor is treated as addtional ability, not as gan onthe sale) (IFRS 16: para. 101(b)) 3.1.3 Example: Sale and leaseback not on market terms Adapted from IFRS 16 lNustrative example 24. Sellalot Co sels a building to Buyalot Co for $800,000 cash. The carrying amount of the building prior to the sale was $600,000, Sellaot Co arranges to lease the building back for five years at $120,000 per annum, payable in arrears. The remaining useful lf is 15 years ‘The transaction satisfies the IFRS 15 criteria to be recognised as a sal sale and leaseback [At the date of sale the fir value ofthe bulding was $750,000, so the excess $50,000 pald by Buyalot Co \s recognised as additonal financing provided by Buyalot Co. (2) The lease liability must be calculated. , $0 wl be accounted for as a ‘The interest rate implicit inthe lease is 4.5% and the present value ofthe annual payments is calculated as follows. Using a discount factor of 4.5% the cumulative present value of $1 payable annually in arrears for five years is $4,990. Therefore, the cumulative present value of the future lease payments is $120,000 x 4:39 $526,800 Of this, $476,800 relates tothe lease and $50,000 relates to the additional financing 0: BPR(b) The right-of-use asset must be measured ‘At the commencement date, Selalot Co measures the right-of-use asset arising from the leaseback o the building atthe proportion ofthe previous carrying amount ofthe building that relates tothe right of use retained. This is calculated as: present value of lease payments Right-of-use asset (arising from leaseback) 7 ereng fair value arrying amount % $600,000 « 476, 800/750,000 $381,440 ‘The right-of-use asset wil be depreciated over five years, being the shorter ofthe lease term and the useful life ofthe asset (c) The gain on the sale and leaseback must be calculated. Sellalot Co only recognises the amount of gain that relates tothe rights transferred, To calculate the gain: Stage 1: Total gan onthe sale = fair value ~ carrying amount += $750,000 ~ $600,000 = $150,000 Stage 2: Gln relating to the ight tained» grin PYS@nt ale of ase payments Tair value += $150,000 x (476,800/750,000) fia $95,360 Stage 3: Gain eating to the rights transferred = total gan (Stage 1) — gain on rights retained (Stage 2) += $150,000 - $95,360 = 954,640, (d) The transaction must be recorded in Sllalat Co's accounts. ‘At the commencement date the transaction will be recorded as follows: Debit Credit $ 8 cash 800,000 Right-of-use asset 381,440 Building 600,000 Financial ibility 526,800 Gain on rights transferred 54,640 1187440 Ti81.440 The gain wil be recognised in profit or loss and the financial ability will be increased each year by the interest charge and reduced by the lease payments. Sale and leaseback Capital Co entered into a sale and leaseback on 1 April 20X7. It sold a lathe witha cartying amount of $$200,00 for $400,000 (equivalent to fair value) and leased it back over a five-year period, equivalent to its emaining useful life, The transaction constitutes a sale in accordance with IFRS 15. ‘The lease provided for five annual payments in arears of $90,000. The rate of interest implicit the lease is 5%. Using a discount factor of 5% the cumulative present value of $1 payable annually in arteats for five years is $4.28, ae Q retseomeeoltancdseeewts | & ecutive EEERequired What ae the amounts to be recognised inthe financial statements at 31 March 20X8 in respect ofthis transaction? (2) Calculate the lease liability at commencement ofthe lease. $4.329 x $90,000 = $389,610 {b) Measure the right-of-use asset =carrying amount > eset oso ase ayes = 900,000 x (389,610/400,000) = $292,208 (©) Galeulat the gain on the sale and leaseback. Stage 1: Total gain onthe sale» far value ~ carying amount $400,000 - $300,000, = $100,000 Stage 2: Gain relating to the rights retained = gain x BESS value of lease payments ‘alr value += $100,000 x (389,610/400,000) = $97,402 ‘Stage 3: Gain relating tothe rights transferred = total gain (Stage 1) ~ gain on rights retained (Stage 2) 100,000 ~ $97,402 = $2,598 (d) Record the transaction in the accounts. Debit realt $ 8 Cash 400,000 Right-of-use asset 292,208 Underlying asset (Lathe) 300,000 Liability 389,610 Gain on transfer 692,208 692,208 The transaction willbe shown inthe financial statements as follows: 8 Statement of profit or loss Gain on transfer 2,598 Depreciation (292,208/5) (68,442) Interest (W) (19.481) Statement of financial position ‘Non-current asset Right-of-use asset 292,208 ‘Non-current liabilties Lease lability (W) 245,045 (Current liabilities Lease lability (319,091 ~ 245,045) (WN) 74,045 Co BPRExam focus point =m) Exam focus point Key terms ore Working ~ lease lability $ 14.x7 Lease lability (present value of future lease payments) 309,610 1.4.X7-31.3.X8 Interest at 5% 19481, 31.3.X8 Instalment paid in arrears: (90,000) 31.38 Liability carried down 319,091 1.4X8-31.3X9 Interest at 556 15,955 31.39 Instalment paid in arrears (90,000) 31.3.X9 Liability due in more than 1 year 245,045 Current abilities reflect the amount ofthe ease lability that wil become due within 12 months. The sale and leaseback ofa property was tested inthe June 2019 exam for 12 matks. 3.2 Transfer is not a sale It the transfer does not satisty the IFRS 15 requirements to be accounted fo asa sale, the seller continues. ‘to recognise the transfered asset, and the transfer proceeds are treated as a financial ability, accounted for in accordance with IFRS 9 Financial Instruments. The transaction is more inthe nature ofa secured loan, 4 Lessor accounting ‘= Forlessor accounting, IFRS 16 distinguishes between finance leases and operating leases. ‘= Finance leases: record the amount due from the lessor inthe statement of financial postion atthe net investment in te lease, recognise finance income to give a constant periodic rte of return. = Operating leases: record as long-term asset and depreciate over useul fe, record income on a straight-line basis over the lease term. ‘The June 2017 exam contained an &-mark question on accounting fora nance lease from the perspective ofa lessor. ‘Several definitions are relevant to lessor accounting in particular, Finance lease. A lease that transfers substantially al the risks and rewards incidental to ownership of an Underiyng asset. Operating lease. A lease that does not transfer substantially al the risks and rewards Incidental to ‘ownership ofan underlying asset Guaranteed residual value is: (2) Fora lessee, that pat ofthe residual value which is uaranteed by the lessee or by 2 party related tothe lessee (the amount of the guarantee being the maximum amount that could in any event, become payable) (b) Fora lessor, that part ofthe residual value which is quaranteed by the lessee or by a third party unrelated tothe lessor who is financially capable of discharging the obligations under the uarantee. Unguaranteed residual value is that portion ofthe residual value ofthe underlying asset, the realisation of which by the lessor isnot assured or is guaranteed solely by a party related tothe lessor. rats comets eee | & cunt tees EEEGross jostment in the lease isthe sum of (2) Thelease payments receivable bythe lessor under a finance lease, and (b) Any unguaranteed residual value accruing to the lessor. Nt investment in the lease isthe gross investment inthe lease discounted atthe interest rte implicit in the lease Unearned finance income is the diference between: (2) The gross investment inthe lease, and (b) The net investment in the lease. (IFRS 16: Appendix A) 4.1 Finance leases AAfinance lease isa lease that transfers substantial all the risks and rewards incidental to ownership of an underiying asset. It can be considered to be, lke hire purchase, a form of instalment credit. When we talk of risks here, we specifically mean the risks of owmership, not other types of risk. Risks of ‘ownership include the possibilty of losses from idle capacity or technological obsolescence, or variations, In return due to changing economic conditions. The rewards are represented by the expectation of profitable operation over the assets economic, and also any gain from appreciation in value or Fealisation of a residual value (IFRS 16: para. B53) For lessors, but not lesse ‘inance leases are distinguished from operating leases. 4.1.1 Accounting treatment IFRS 16 requires the amount due from the lessee under a finance lease to be recorded inthe statement of financial position ofa lessor asa receivable atthe amount ofthe net investment in the lease. ‘The recognition of finance income under a finance lease should normally be based ona pattern to give a constant periodic rate of return onthe lessor's net investment outstanding in respect ofthe finance lease In ‘each period. In arriving atthe constant periodic rat of return, a reasonable approximation may be made. The lease payments (excluding costs for services) relating to the accounting period should be applied against the gross investment in the lease, so as to reduce both the principal and the unearned finance Income, The estimated unguaranteed residual values used to calculate the lessor's gross investment ina lease should be reviewed regularly f there has been a reduction in the value, then the income allocation over ‘the lease term must be revised. Any reduction in respect of amounts already accrued should be recognised immediately. Initial direct costs incurred by lessors (eg commissions, legal fees and other costs that are directly attributable to negotiating and arranging lease) are included inthe intial measurement ofthe net investment in the lease, The interes rate implicit in te lease is defined in such a way that the initial direct. costs ae included automaticaly inthe net investment inthe lease; there is no need to add them separately (IFRS 16: para. 69). 4.1.2 Manufacturer/dealer lessors IFRS 16 looks atthe situation where manufacturers or dealers offer customers the choice of ether buying or leasing an asset. There willbe two types of income under such a lease (2) Profivioss equal to that from an outright sale (normal seling price less any discount) (b) Finance income over the lease term Co BPRIFRS 16 requires the following treatment (paras. 70-74): (2) Recognise the selling profivoss in income forthe period as if twas an outright sale (b) interest rates are artificially low, restrict the seling profit to that which would apply had a commercial rate been applied. (0) Recognise eostsincured in connection with negotiating and arranging a lease as an expense when the selling profit is recognised (atthe start of the lease term). 4.2 Operating leases 4.2.1 Definition ‘An operating lease isa lease that does not transfer substantially all the risks and rewards incidental to ‘ownership ofan underlying asset. its useful lif. The distinction between finance and operating leases = applies only to lessors, not lessees, 4.2.2 Accounting treatment ‘An asset held for use in operating leases by a lessor should be recorded as a long-term asset and ‘depreciated over its useful life, The basis for depreciation should be consistent with the lessor's policy on similar non-lease assets and follow the guidance in IAS 16. Income from an operating lease, excluding charges for services such a insurance and maintenance, should be recognised on a straight-line basis over the period ofthe lease (even i the recepts are not on such a basis), unless another systematic and rational basis is more representative of the time pattern in hich the benefit rom the leased asset is receivable, ee Initial direct costs incurred by lessors in negotiating and arranging an operating lease should be added to {the carrying amount of the leased asset and recognised as an expense over the lease term on the same basis 2 lease income, ie capitalised and amortised over the lease term, Lessors should refr to IAS 36 in order to determine whether a leased asset has become impaired, ‘Alessor who Is @ manufacturer or dealer should not recognise any selling proton entering into an petting lease because its not the equivalent ofa sale, 4.2.3 Example: Operating lease Alpha Co leased 2 machine witha remaining useful le often years to Beta Co. The lease commenced on 4 Januaty 20% and i for aterm of three years. Lease payments of $3,600 are due on 31 December each ‘yar. As an incentive, Beta Co was given a rent-free period of two months atthe commencement ofthe lease, Alpha Co is responsible for maintenance of the machine. Required Discuss the accounting treatment ofthe above lease inthe financial statements of Alpha Co forthe year ended 31 December 20X1, including relevant calculation. Solution ‘Alpha Co retains the rsks and rewards of ownership ofthe machine evidenced by the fact that the lease is only fora small portion ofthe useful if of the machine and the fact that Alpha is responsible for ‘maintenance of the machine during the ease term, As such, the lease is an operating lease inthe financial statements of Alpha Co. The benefit received from the asset is earned over the three years ofthe lease. However, inthe fist year, ‘pha only eveives $9,600 = 10/12 «$3,000. Lease rentals of $10,200 ($3,000 + ($3,600 x 2 years)) are received over the 3 year lease term, In accordance with IFRS 16, Alpha should recognise income of $3,400 ($10,200/3 years) inthe year to 31 December 20X1, and in each of the following two years. ore retseomecltancdseeewts | & ecuatntvemee EEERA receivable of $400 should be recognised at 31 December 20X1 ($3,400 ~ $3,000 cash received). 4.3 Subleases Alesse, L, may sublease an asset which tin turn leases from another lessor, H. In this situation, His the head lessor’ wo ultimately owns the asset from a legal perspective. Lthen becomes an ‘intermediate lessor. An intermediate lessor must assess whether the sublease is a finance or operating lease inthe context ofthe rght-of-use asset being leased, not the actual undriying asset (IFRS 16: para. B 57) 4.3.1 Examp! (This example is adapted from Ilustrative Example 18 of IFRS 16.) Interis, enters into a ten-year lease for 6,000 square metres of office space (the head lease) with Headliss, (the head lessor). At the beginning of year 5, Inteliss subleases the 6,000 square metres of office space for the remaining six years ofthe head lease to @ Subliss Solution In this situation, Headliss isthe head lessor, Interlss isthe intermediate lessor, and Sublis i the sublessee. From the perspective ofthe intermediate lessor, atthe time the sub-lease is entered into, the right-of-use asset hasa six-year remaining life, and itis being sub-leased forthe entirety ofthat remaining period of time, As such, the sub-lease is fora major pat of the useful ite ofthe right-of-use asset and the lease is classified asa finance lease. ACCA's website contains many useful article Exam focus including the following on leases: point IFRS 16, Leases ‘This is available in the DipIFR exam resources section ofthe ACCA website: at www.accaglobal.com Co BPRPHC ‘© IFRS 16 was brought in to ensure that all assets are shown on the statement of financial postion, imcluding leased assets. Under the previous standard (IAS 17) the assets acquired under operating leases. Were not recognised as assets ofthe reporting entity, and as such, did not reflect the substance ofthe ‘transactions of meet the Conceptual Framework’ characteristic of falthul representation. 30 liability ‘+ Asale and leaseback transaction involves the sale ofan asset and the leasing back ofthe same asset and operating ‘+ Finance leases: record the amount due from the lessor inthe statement of financial position atthe net Investment in the lease, recognise finance income to gle a constant peodic rate of return ‘© Operating leases: record as long-term asset and depreciate over useful life, record income on a straight- line basis over the lease term, 1 Acontractis, or contains, a lease ifthe contract conveys the right to ..an identified asset for a period of time in exchange for ‘© _Atcommencement of the lease, the lessee recognises a ight-of-use asset and 2 ‘© For lessor accounting IFAS 16 distinguishes between finance | 2 business acquires an asset under a high-value, five-year lease. What is the double entry? 3 Alorty has an expected useful ie of six years. It is acquired under a four year lease with no purchase options. Over which period should It be depreciated? 4 Acompany leases a tablet computer. What how should this lease be treated in its financial statements? 5 Ina sale and leaseback transaction, the sale price is above fair value. How should this excess be treated Under IFRS 167Answers to Quick Quiz 1 A contract is, or contain, a lease ifthe contract conveys the right to control the use ofan identified asset for a period of time in exchange for consideration (IFAS 16: para. 9). DEBIT ——_—Right-of-use asset CREDIT Lease lability ‘The four-year tem, being the shorter ofthe legse term and the usefl te This isa lease ofan asset of low-value, so the company should recognise the lease rentals as an expense cover the lease term. Any above-market terms are accounted for as addtional financing provided by the buyer/lessor. The additional amount pad by the lessor is treated as addtional lability, not as gan on the sale (IFRS 16: para, 101(b)) 07 Examination 10 20 mins 08 Examination 6 29 mins Accounting | Jements of financial statements weer 8 PantIntangible assets UCM TL oo “LIAS 38 intangible Assets 2 Research and development costs ‘3 Goodwill (IFRS 3 Business Combinations) Introduction ‘We begin our examination of intanablenon-curtent assets witha discussion of IAs 38, ‘Goodwill and its treatment is @ controversial area, as isthe accounting for items simiar to goodwil, suchas brands, Goodwl is ery important in group ‘accounts and we wil ook at it again in Pat.Study guide B5 _| Intangible assets and goodwill Discuss the nature and possible accounting treatments of both internally generated and purchased goodwill Distinguish between goodwill and other intangible assets Define the criteria forthe inital recognition and measurement of intangible assets Identify the circumstances in which again on a bargain purchase (negative goodwil) arises, and its subsequent accounting treatment Describe and apply the requirements of IFRS to internally generated assets other than goodwill (eg research and development) 1 IAS 38 Intangible Assets ESI | riangiic assets are dened by IAS 38 as non-monetary assets without physical substance. 1.1 The objectives of the standard (2) Toestablish the criteria for when an intangible asset may or should be recognised (0) Tospecty how intangible assets should be measured (6) Tospecty the disclosure requirements for intangible assets 1.2 Definition of an intangible asset The definition ofan intangible asset is @ key aspect of the standard, because the rules for deciding whether or not an intangible asset may be recognised in the financial statements of an entity are based on the definition of what an intangible asset is Key term ‘An intangible asset isan identifiable non-monetary asset without physical substance, The asset must be: (2) Controlled by the entity as a result of events inthe past (b) Something from which the entity expects future economic benefits to flow (WAS 38: para 8) Examples of items that might be considered as intangible assets include computer software, patents, copyrights, motion picture films, customer list, franchises and fishing rights. An item should not be recognised as an intangible asset, however, unless it fully meets the definition in the standard. The {uidelines go into great detail on this matter. 1.3 Intangible asset: Must be identifiable ‘An intangible asset must be identifiable in order to distinguish it from goodwill, With non-physical items, ‘there may be a problem with ‘identifiability: (2) Han intangible assets acquired separately through purchase, there may be a transfer of a legal Tight that would help to make an asset identifiable (b) An intangible asset may be identifiable it itis separable, iif it could be rented or sold separately However, ‘separability’ is not an essential feature ofan intangible asset 1 re1.4 Intangible asset: Control by the entity Another element ofthe definition of an intangible assets that it must be under the control ofthe ently as, a result ofa past event. The entity must therefore be able to enjoy the future economic benefits from the asset, and prevent the access of others to those benefits. A legally enforceable rights evidence of such control, but isnot always a necessary condition. (2) Control over technical knowledge or know-how only exists i itis protected by a legal right (AS 38: para. 14), (b) The skil of employees, arising out ofthe benefits of training costs, are most unlikely to be recognisable as an Intangible asset, because an entity does not contol the future actions ofits staff (WAS 38: para. 15). (©) Simiarty, market share and customer loyalty cannot normally be intangible assets, since an entity cannot contral the actions ofits customers (IAS 38: para. 16) 1.5 Intangible asset: Expected future economic benefits ‘An iter can only be recognised as an intangible asset if economic benefits are expected to flow inthe future from ownership ofthe asset. Economic benefits may come from the sale of products or services, or from a reduction in expenditures (cost savings). ‘An intangible asset, when recognised intialy, must be measured at eost. It should be recognised it, and nly if both the following occur (2) ‘itis probable thatthe tuture economic benefits that are attributable tothe asset wil flow to the entity (b) The cost of the asset can be measured reliably’ (IAS 38: para. 21) Management has to exercise its judgement in assessing the degree of certainty attached tothe flow of economic benefits to the entity. External evidence is best (2) Manintangible asset is acquired separately its cost can usually be measured reliably as its purchase price including incidental costs of purchase such as legal fees, and any costs incurred in Getting the asset ready for use), (b) When an intangible asset is acquired as part ofa business combination (lean acquisition or takeover), the cost ofthe intangible asset sits far value atthe date ofthe acquisition, IFRS 3 Business Combinations explains thatthe fair value of intangible assets acquired in business combinations can normally be measured with sufficient reliability to be recognised separately from goodwil In accordance with IAS 20 Accounting for Government Grants and Disclosure of Government Assistance, intangible assets acquired by way of government grant andthe grant itself may be recorded intially either at cost (which may be zero) or fair valu. {IAS 38: para. 44) 1.6 Exchanges of assets tone intangible asset is exchanged for another, the cost ofthe intangible asset is measured at far value unless (IAS 38: para. 45) (2) ‘The exchange transaction lacks commercial substance, or (0) The flr value of nether the asset received nor the asset given up can be measured reliably Otherwise, ts cost is measured at the carrying amount ofthe asset given up. 1.7 Internally generated goodwill Internally generated goodwill may not be recognised as an aset. ore fut cennscttae snes | 7: wits at ETEIAS 38 deliberately precludes recognition of internally generated goodwill because It requites that, for intial recognition, the cost of the asset rather than its fair value should be capable of being measured reliably and that it should be identifiable and controlled. Thus you do nat recognise an asset which is subjective and cannot be measured reliably 2 Research and development costs MESES) | pevetopment costs are recognised as an asset they mest etn teria © Anintangible asset is intially recognised at cost and subsequently caried either at cost or revalued amount. ‘= Costs that do not meet the recognition criteria should be expensed as incurred. © An Intangible asset wit a finite useful Ife should be amortised over Its useful life. An Intangible ‘asset with an indefinite usefl life should not be amortised 2.1 Research Research activities by definition do not meet the criteria for recognition under IAS 98, This is because, at the research stage of a project, it cannot be certain that future economic benefits will probably flow tothe entity from the project. There is too much uncertainty about the likely success or otherwise ofthe projct. Rosearch costs should therefore be written off as an expense as they are incurred. IAS 38 (para. 56) gives the following examples of research costs: (2) ‘Activites aimed at obtaining new knowledge (0) The search for, evaluation and final selection of, applications of research findings or other knowledge (©) The search for alternatives for materials, devies, products, processes, systems or services (4) The formulation, design evaluation and final selection of possible alternatives for new or improved materials, devices, products, systems or services’ 2.2 Development Development costs may quay for recognition as intangible asets provided that the following strict criteria can be demonstrated (IAS 98: para. 57) (2) Thetechnical feasibility of completing te intangible asset so that wl be avalible for use o sale (b) The entity's intention to complete the intangible asset and use or sell it (©) Theentity's ability to use or sel the intangible asset (4) How the intangble asset will generate probable future economic benefits. Among other things, the entity should demonstrate the existence of a marke forthe output of the intangible asset or the Intangible asset itself o, iit isto be used internally the usefulness ofthe intangible asset. (©) The avaliabilty of adequate technical, financial and other resources to complete the development ‘and to use or sel the intangible asset () Theentity's ability to measure the expenditure attributable tothe intangible asset during its development reliably. (Once these citera are met, IAS 38 requires development expenditure tobe capitalised (ether is no option of not capitalising It) In contrast wit research costs development costs are incurred at alter stage ina projet, and the probabilty of success should be more apparent. [AS 38 (para 68) gives the following examples of development costs: (2) "The design, construction and testing of pre-production or pre-use prototypes and models (b) The design of tools, igs, moulds and dies involing new technology DIMI iets ete | poste tts BPRExam focus point (©) The design, construction and operation ofa pilot plant that isnot of a scale economically feasible for commercial production (4) The design, construction and testing ofa chosen alternative for new or improved material, devices, products, processes, systems or services| 2.3 Other internally generated intangible assets ‘The standard prohibits the recognition of internally generated brands, mastheads, publishing titles and customer lists and similar tems as intangible assets. These al fall to meet one of more (in some cases al) ‘the definition and recognition criteria and in some cases are probably distinguishable from internally generated goodwill 2.4 Cost of an internally generated intangible asset The costs allocated to an internally generated intangible asset should be only costs that can be directly attributed or allocated on a reasonable and consistent basis to creating, producing or preparing the asset for its intended use. The principles underying the costs which may or may not be included are simiar to those for other non-current assets and inventory. The cost ofan internally generated intangible asset isthe sum ofthe expenditure incurred from the date wen the intangible asset first meets the recognition criteia If, as often happens, considerable costs have already been recognised as expenses before management could demonstrate that the criteria have been met, this earlier expenditure should not be retrospectively recognised at a later date as part ofthe cost of an intangible asset ‘The treatment of development cost is examined frequently. The December 2013 exam, for instance, ‘tested It as part ofthe consolidation question In te form of an internally generated asset. The December 2018 exam asked students to explain the difference in treatment between internally generated and purchased brands, including demonstrating knowledge of the recognition criteria in each case. Treatment Doug Co is developing a new production process. During 20X3, expenditure incurred was $100,000, of which $90,000 was incurred before 1 December 20X3 and $10,000 between 1 December 20X3 and 31 December 20X3. Doug Co can demonstrat that, at 1 December 20X3, the production process met the criteria for recognition as an intangible asset. The recoverable amount ofthe know-how embodied in the process is estimated to be $50,000. Required Ee How should the expenditure be treated” Atthe end of 20XS, the production process is recognised as an intangible asset ata cost of $10,000, This Is the expenditure incurred since the date when the recognition criteria were met, that is 1 December 0X3. The $90,000 expenditure incurred before 1 Decemiver 20X3 is expensed, because the recognition citeria were not met. it will never form part of the cost of the production process recognised in the statement of nancial position. 2.5 Recognition of an expense ‘All expenditure related to an intangible which does not meet the criteria for recognition elther as an dentiiable intangible asset or as goodwill rising on an acquisition should be expensed as incurred. IAS 36 (para. 69) gives examples of such expenditure: + Startup costs © Advertising costs = Training costs = Business relocation costs ore futher as |p aPrepaid costs for services, for example advetising or marketing costs for campaigns that have been prepared but not launched, can sil be recognised as a prepayment. 2.6 Measurement of intangible assets subsequent to initial recognition Th standard lows two mthodsof auton for itangil assets ater they have buen et recognised Applying the cost model, an intangible asset should be carried at its cost, less any accumulated amortisation andes any accumulated impaient losses The revaluation model allows an intangible asel oe cared ata evaled amount, which ss ae ‘alle a the date efrevauaon, los ny subsequent accuratd amoration an ary subsequent accumulated impairment osses (@) Theta vaue must be ble tobe measured reliably wih reference oan aeive mathe in that type ot asset (0) Thott cass of intangible assets of that ype must be sslectve ever). (©) Wanintanile asst ina ls of revalued intangible sets cannot be evalua becuse ther is no active maa rhs ace, th asset should be aed atts coat les any accomulated trvrtisation and impairment losses. (d) _ Revaluations should be made with such regularity that the carrying amount does not differ from that wich would be detrine ving fair vai a the endo th reporting paid valued atthe same time (to prevent Point to nate | This treatment is not availabe forthe initial recognition of Intangible asses, This is because the cost of the asset must be relably measured, The guidelines state that there will not usually be an active market in an intangible asset; therefore the revaluation model will usualy not be avaliable, For example, although copyrights, publishing rights and film rights can be sold, each has a unique sale value, In such cases, revaluation to fair value would be Inappropriate. A far value might be obtainable however for assets such as fishing rights or quotas or tax cab licences, Where an intangible asset is revalued upwards to afar value, the amount of the revaluation gain should be credited directy to equity under the heading of a revaluation surplus. However, if revaluation gain is a reversal ofa revaluation decrease that was previously charged to profit or los, the gain can be recognised in profit or loss. Where the carying amount ofan intangible asset is revalued downwards, the amount of the downws revaluation should be charged to profit or loss, unless the asset has previously been revalued upwards. A revaluation decrease should be fist charged against any previous revaluation surplus in respect of tht asset. yA Downward revaluation ‘An intangible asset is measured by @ company at far value. The asset was revalued by $400 in 20K3, and ‘there isa revaluation surplus of $400 inthe statement of financial position. At the end of 20K4, the asset is valued again, and a downward valuation of $500 is required Required State the accounting treatment forthe downward revaluation In this example, the downward valuation of $500 can frst be set against te revaluation surplus of $400, The revaluation surplus will be reduced to Snil and a charge of $100 made as an expense in 20X4 DEE) = ese asets and gent | Past 2 Eres ot nc states PeWhen the revaluation model is used, and an intangible asset is revalued upwards, the cumulative revaluation surplus may be transferred to retained earnings when the surplus Is eventually realised. The surplus would be realised when the assets disposed of. However, the surplus may also be realised over time as the asset is used by the entity. The amount ofthe surplus realised each year isthe difference between the amortisation charge forthe asset based onthe revalued amount ofthe asset, andthe amortisation that would be charged on the basis ofthe asset's historical cost. The realised surplus in such cases should be transferred trom revaluation surplus directly to retained earnings, and should not be taken through profit or loss, 2.7 Useful life ‘An entity should assess the useful fe of an intangible asset, which may be finite or indefinite. An intangible asset has an indefinite useful life when there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity. Many factors are considered in determining the useful fe ofan intangible asset, including (IAS 38: para. 90} Expected usage ‘Typical producti cycles ‘Technical, technological, commercial or other types of obsolescence ‘The stabilty ofthe industry; expected actions by competitors The love of maintenance expenditure required Legal or similar limits on the use ofthe asset, such as the expiry dates of related leases Computer software and many other intangible assets normally have short lives because they are susceptible to technological obsolescence, However, uncertainty does not justify choosing a ie that is unrealistically short, The useful fe ofan intangible asset that arises from contractual or other legal rights should not exceed the period ofthe rights, but may be shorter depending onthe period over which the entity expects to use the asset 2.8 Amortisation period and amortisation method ‘An intangible asset with finite usetu ite should be amartised over its expected useful Ite (2) Amotisation should start when the assets (b) Amortisation should cease atthe earler ofthe date that the asset is classified as held forsale in ‘accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations and the date thatthe asset is derecognised, (©) The amortisation method used should reflect the pattern in which the asset's future economic benefits are consumed. If such a pattern cannot be predicted reliably, the straight-ine method should be used. lable for use. (4) The amortisation charge foreach period should normally be recognised in profit or loss. (IAS 38: para. 97) The residual value ofan intangible asset wit a finite useful fis assumed to be zero unless a third party is committed to buying the intangible asset atthe end ofits useful ite or unless there isan active market for that type of asset (so tha its expected residual value can be measured) and itis probable that there will bea market forthe asset a the end of its useful Ife ‘The amortisation period and the amortisation method used for an intangible asset with a finite useful it should be reviewed at each financial year ond fut cennscttae snes | 7: wits tt EEE2.9 Intangible assets with indefinite useful lives ‘An intangible asset with an indefinite usetul fe should not asset is tested for impairment atleast annually. The useful fe ofan intangible asset that isnot being amortised should be reviewed each year to determine whether itis stil appropriate to assess its useful life as Indefinite, Reassessing the useful life of an intangible asset as finite rather than indefinite isan indicator that the asset may be impaired and therefore it shouldbe tested for Impairment. amortis 3d, JAS 36 requires that such an Intangible asset lt may be dificult to establish the useful life ofan intangible asset, and judgement will be needed Required Consider how to determine the useful life ofa purchased brand name, Factors to consider would include the following (2) Legal protection of the brand name and the contral ofthe entity over te (legal) use by others of the brand name (le control over pirating) (0) Age ofthe brand name (©) Status or position ofthe brand in its particular market (4) Ability ofthe management of the entity to manage the brand name and to measure activities that support the brand name (eg advertising and PR activites) (©) Stability and geographical spread of the market in which the branded products are sold () Pattern of benefits thatthe brand name is expected to generate over time (q) Intention ofthe entity to use and promote the brand name overtime (as evidenced perhaps by @ business plan in which there will be substantial expenditure to promote the brand name) 2.10 Disposals/retirements of intangible assets {An intangible asset should be eliminated from the statement of financial postion when itis disposed of or when there is no further expected economic benefit from its future use. On disposal the gain or loss arising trom the difference between the net disposal proceeds and the carrying amount of the asset should be taken to profit or lass as @ gain or loss on disposal (ie treated as income or expense), Zz no Asan aid to your revision, list the examples given In IAS 38 of activities that might be included in either research or development. IAS 38 gives these examples. a BPRResearch © Activities aimed at obtaining new knowledge ‘= The search for, evaluation and final selection of, applications of research findings or other knowledge ‘©The search for alternatives for materials, devices, products, processes, systems or services ‘© The formulation, design, evaluation and final selection of possible altenatves for new or improved materials, devices, products, processes, systems or services (IAS 38: para. 56) Development © The design, construction and testing of pre-production prototypes and models © The design of tols, igs, moulds and dies involving new technology ‘© The design, construction and operation ofa pilot plant that isnot of a scale economically feasible for commercial production ‘+ The design, construction and testing ofa chosen alternative for new or improved materials, devices, products, processes, systems or services (IAS 38: para, 59) 3 Goodwill (IFRS 3 Business Combinations) Purchased goodwill arising on consolidation is retained inthe statement of financial position as an intangible asset under IFRS. It must then be reviewed annually for impairment. 3.4 What is goodwill? Goodwill is created by good relationships between a business and its customers. (2) By building up 2 reputation (by word of mouth perhaps) for high quality products or high standards of service (0) By responding promptly and helpfully to queries and complaints trom customers (6) Through he personality of the staff and their attitudes to customers The value of goodwlto a business might be considerable. However goodwill is not usualy valued inthe financial statements of a business tal, and we should not normaly expect to find an amount for goodwill inits statement of nancial poston. For example, te friendly welcome given by a clés sttf may contribute more to the café’s profits than the fact that anew electronic cash register has recently been acquired. Even so, whereas the cash register will be recorded inthe financial statements asa non-curent asst, the value of staff would be ignored for accounting purposes. On retetion, we might agree wit this omission of goodil from the financial statements ofa business. (2) The goodwilis inherent inthe business bu I has not been pld for, andi does nt have an ‘objective’ value. We can guess at what such goodwill s woth but such guesswork would be a matter of individual opinion, and not based on hard facts. (&) Goodwill changos from day to day. One act of bad custome relations might damage goodwill and one act of good relations might improve it. Statf witha favourable personaly might retire or eave to find another jb, tobe replaced by staf who need time to tind ther feet nthe jb, et. Since oodnilis continually changing in value, cannot realistically be recorded in the financial statements ofthe business. ore fut ennscttae snes | 7: wits tt EE3.2 Purchased goodwill That is one exception tothe general rule that goodwill has no objective valuation. This is when a business is sold, People wishing to set up in business have a choice of how to do it~ they can either buy ‘their own long-term assets and inventory and set up their business from scratch, or they can buy up an existing business from a proprietor wiling to sell it, When a buyer purchases an existing business, he wil have to purchase not ony its long-term assets and inventory (and perhaps take over its accounts payable and receivable too) but also the goodwill ofthe business. ESE) Purchased goodwill is shown in the statement of financial position because it has been paid for. It has no tangible substance, and so tis an intangible non-current asset 3.3 How is the value of purchased goodwill decided? When a business Is sold, thee is likely to be some purchased gooduil in the seling price. But how Is the amount ofthis purchased goodwill decided? This isnot really a problem for accountants, who must simply record the goodwill inthe financial statements ofthe new business. The value ofthe goodwill sa matte for the purchaser and seller to agroe upon in fixing the purchase/sale price, However, two methods of valuation are worth mentioning here: (2) The eller and buyer agree on a price for the business without specifically quantifying the goodwill, The purchased goodwill wil then be the difference between the price agreed and the value ofthe identifiable net assets in the books ofthe new business, (b) However, the calculation of goodwill often precedes the fixing ofthe purchase price and becomes a central element of negotiation. There are many ways of artving at value for goodwill and most of them are related to the profit record ofthe business in question, No matter how goodwill is calculated within the total agreed purchase pric, the goodwill shown by the purchaser in his accounts willbe the difference between the purchase consideration and his own Valuation ofthe net assets acquired. If A values his net assets at $40,000, goodwill s agreed at $21,000 and B agrees to pay $81,000 forthe business but values the net assets at only $36,000, then the goodwill in B's books will be $61,000 ~ $38,000 = $23,000. 3.4 IFRS 3 Business Combinations IFRS 3 covers the accounting treatment of gooduil acquired in a business combination. Key term Goodwill. An asset representing the future economic benefits arising from othe assets acquited in @ business combination that are not capable of being individually identified and separately recognised (IFRS 3: Appendix A) Goodwill acquired in a business combination is recognised as an asset and is intially measured at cost Cost is the excess of the cost of the combination over the acquirer’ interest in the net far value of the acquiree's identifiable assets, abilities and contingent liailtes. After inital recognition good acquired in a business combination is measured at cost less any ‘accumulated impairment losses. Its not amortised, Instead its tested for impairment a least annually, in accordance with IAS 36, Again on a bargain purchase (also known as ‘negative goodwil) arses when the acquirer's interest in ‘the net fir value ofthe acquire’s identifiable assets, liabiltis and contingent iabiities exceeds the cost of the business combination. Again on a bargain purchase can arise because the entity has genuinely obtained a bargain, perhaps for example because the seller has been forced to sell ta low price, However, it can also arise as the result of errors in measuring the fat value of either the cast ofthe combination or the acquire’s identifiable net assets, DIRE = aes asets and pent | Pat 2 Eres nc states eeBefore recognising a gain on a bargain purchase, an entity should frst reassess the amounts at which i has measured both the cost of the combination and the acquire's identitiable net assets (IFRS 3: para, 36). This exercise should identity any errors ‘Any gain on the bargain purchase remaining should be recognised immediately in profit or loss. Characteristics of goodwill What are the main characteristics of goodwill which distinguish it from other intangible non-current assets? To what extent do you consider that these characteristics should affect the accounting treatment of goodwill? State your reasons. Goodwill may be distinguished from other intangible non-current assets by reference tothe following characteristics. (2) tis incapable of realisation separately from the business as whole (b) Its value has no reliable or predictable relationship to any costs which may have been incurred. (¢) _Itsvalue arises from various intangible factors such as skilled employees, effective advertising or a strategic location. These indirect factors cannot be valued (4) The value of goodwill may fluctuate widely according to internal and external circumstances over relatively short periods of time (2) The assessment ofthe value of goodwill is highly subjective, It could be argued that, because goodwil is so diferent from other intangible non-current assets it does ‘not make sense to account for it inthe same way. Thus the capitalisation and amortisation treatment Would not be acceptable. Furthermore, because goodwill sso dificult to value, any valuation may be misleading, and itis best eliminated from the statement of financial position altogether. However, there are strong arguments for treating it ike any other intangible non-current asset. This issue remains controversial. Part 8 Ekmente of franc statements | 7: Intangible asete and goodwl eaPHC © Intangible assets are defined by IAS 98 as non-monetary assets without physical substance. ‘+ Development costs are recognised as an asset if they meet certain criteria, ‘= Anintangible asset is intialy recognised at cost and subsequently carried either at cost or revalued amount, © Costs that do not meet the recognition criteria should be expensed as incurred. ‘© Anintangible asset with a finite useful life should be amortised over its useful life, An Intangible asset with an indefinite useful ite should not be amortised, ‘© Purchased goodwill arising on consolidation is retained inthe statement of financial position as an Intangible asset under IFRS 3. It must then be reviewed annually for impaltment. © Purchased gooduil is shown in the statement of financial position because ithas been pad for. It has no tangible substance, and so itis an intangible non-current as 1 Intangible assets can only be recognised in a company’s financial statements if © Itis probable that will flow tothe entity © Thecost can be 2 What are the criteria which must be met before development expenditure can be deferred? 3 Startup costs must be expensed. True False 4 Pegay buys Phils business for $30,000. The business assets are a bar valued at $20,000, inventories at $3,000 and receivables of $3,000. How much is goodwill valued at? 5 What method of accounting for goodwill arising on consolidation is required by IFAS 3? 6 How should a gan on a bargain purchase be accounted for under IFRS 37 a assets and yootil | Put 8 Eamets of nancial statementsAnswers to Quick Quiz Future economic benefits; measured relably See Section 22 True $80,000 ~ $20,000 - $3,000 ~ $3,000 = $4,000 Cost les impairment losses Recognised in proftor loss immediately Now try the question bel 0 inveaoy | insDEMME estes ete | poste ttsSCCM Lg PEST Ca Fist 6) 1 Provisions ee 2 Provisions for restructuring ee ‘3 Contingent lailties and contingent assets cd Introduction You wit have come across provisions and contingencies in your eal studes or professional work, However, you may be asked in more étal about AS 37 inthis eam.Study guide BG __| Provisions, contingent assets and liabilities Explain why an accounting standard on provisions is necessary — give examples of previous buses inthis area Define provisions, legal and constructive obligations, past events and the transfer of economic benefits ‘State when provisions may and may not be made, and how they should be accounted for Explain how provisions should be measured Define contingent assets and lables give examples and describe ther accounting treatment Identify and account for = Onerous contracts = Environmental and similar provisions 1 Provisions WEEE) Under 4537 (ure 14) provision soul be recognised when: . An entity has a present obligation, legal or constructive, as a result of a past event. ‘+ Itis probable that a transfer of resources embodying economic benefits willbe required to settle it © Arellable estimate can be made of Its amount. 1.1 Objective IAS 37 Provisions, Contingent Liabilties and Contingent Assets aims to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the note tothe financial statements to ‘enable users to understand their nature, timing and amount. 1.2 Provisions Before IAS 37, there was no accounting standard dealing with provisions. Companies wanting to show ‘thelr results in the most favourable ight used to make large ‘one off provisions in years where a high level of underlying profits was generated. These provision, often known as ‘big bath’ provisions, were then available to shield expenditure in future years when perhaps the underlying profits were not as good. Inter words, provisions were used for prot smoothing. Prof smoothing ls misleading Important | The key am of AS 37 ito ensure tha provisions are made only where ter re valid grounds fr them IAS 37 views a provision as a lability Key terms | provision ica ability of uncetan timing or amount. A liability is a present obligation ofthe entity arising from past events , the setiement of whichis expected to result in an outflow from the entity of resources embodying economic benefits. (IAS 37: para. 10) ‘The IAS distinguishes provisions from other liabilities such as trade creditors and accruals, This ison the basis that fora provision there is uncertainty about the timing or amount of the future expenditure. Whilst ‘uncertainty is clearly present inthe case of certain accruals the uncertainty is generally much less than for provisions. a re1.3 Recognition AS 37 states that a provision should be recognised as a ibility inthe financial statements when: + Avent has a present obligation (legal or constructive) as a result ofa past event ‘+ Itis probable that an outflow of resources embodying economic benefits will be required to settle the obligation ‘© Areliable estimate can be made of the amount ofthe obligation (IAS 37: para. 14) 1.4 Meaning of obligation ‘tis tally clear what a legal obligation is. However, you may not know what @ constructive obligation is. Key term Constructive obligation ‘An obligation that derives from an entily's actions where * _ Byanestablished pattern of past practice, published polices ora sufficiently specific current statement the entity has indicated to other partis that it will accept certain responsibilities; and ‘© Asaresult, the entity has created 2 valid expectation on the pat of those other partes that twill discharge those responsibiltes. (IAS 37: para 10) For instance, an oil company may have an established practice of always making good any environmental ‘damage caused by diling, even though itis not legally obliged to doo. In this way, it has created a valid expectation that it will do this and it wil have to recognise the constructive obligation and make a corresponding provision each time it drills a new well 1.4.1P able transfer of resources For the purpose ofthe Standard, a transfer of resources embodying economic benefits is regarded as. ‘probable’ i the event is more likely than not to occur. This appears to indicate a probability of more than '50%. However, the standard makes it clear that where there is a numberof similar obligations the probability should be based on considering the population as a whole, rather than one single item. 1.4.2 Example: Transfer of resources Ia company has entered into a warranty obligation then the probably of transfer of resources ‘embodying econemic benefits may well be extremely small in respect of one specific tem, However, when, considering the population a a whole the probability of some transfer of resources is quite likly to be ‘much higher. If there isa greater than 50% probability of some transfer of economic benefit then @ provision should be made for the expected amount. 1.5 Measurement Important | The amount recognised asa provision shouldbe the best estimate ofthe expenditure require to sete the present obligation at the end of the reporting period (IAS 37: para. 36). The estimates willbe determined by the judgement of the entity's management supplemented by the experience of similar transactions. ‘Allowance is made for uncertainty. Where the provision being measured involves a large population of items, the obligation is estimated by weighting al possible outcomes by their associated probabilities, ie expected value. Where the provision involves a single item, such as the outcome of a legal case, provision is made in full for the most likely outcome. cate tats cutnet ts EE BPP 0 Part B Elements of financial statements |