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Fac 3701- Consolidated Financial Reporting

General Financial Reporting (University of South Africa)

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FAC3701/501/3/2019

Tutorial Letter 501/3/2019

General Financial Reporting

FAC3701

Semesters 1 and 2

Department of Financial Accounting

IMPORTANT INFORMATION

This tutorial letter contains all the tutorial matter of all the learning units.

Please register on myUnisa, activate your myLife e-mail address and make
sure that you have regular access to the myUnisa module website, FAC3701-
2019-S1/S2, as well as your group website.

Note: This is an online module and therefore it is available on myUnisa.

However, in order to support you in your learning process, you will also
receive some study material in printed format.

BARCODE

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CONTENTS

1. INTRODUCTION ........................................................................................................... III

2. LECTURERS AND CONTACT DETAILS ...................................................................... III
3. LEARNING UNIT 1: Income taxes (IAS 12 and FRG1) .................................................. 1
4. LEARNING UNIT 2: Accounting policies, changes in accounting estimates and errors
(IAS 8) .......................................................................................................................... 58
5. LEARNING UNIT 3: The Conceptual Framework for Financial Reporting 2018 ........... 92
6. LEARNING UNIT 4: Preface to International Financial Reporting Standards ............... 94
7. LEARNING UNIT 5: Presentation of financial statements (IAS 1) .............................. 100
8. LEARNING UNIT 6: Events after the reporting period (IAS 10).................................. 141
9. LEARNING UNIT 7: Provisions, contingent liabilities and contingent assets (IAS 37) 152
10. LEARNING UNIT 8: Fair value measurement (IFRS 13) ............................................ 181
11. LEARNING UNIT 9: Revenue from contracts with customers (IFRS 15).................... 199

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INTRODUCTION

Dear Student,

This study guide includes the following learning units:

 Learning unit 1 – Income taxes (IAS 12 and FRG 1)
 Learning unit 2 – Accounting policies, changes in accounting estimates and
errors (IAS 8)
 Learning unit 3 – The Conceptual Framework for Financial Reporting 2018
 Learning unit 4 – Preface to International Financial Reporting Standards
 Learning unit 5 – Presentation of financial statements (IAS 1)
 Learning unit 6 – Events after the reporting period (IAS 10)
 Learning unit 7 – Provisions, contingent liabilities and contingent assets (IAS 37)
 Learning unit 8 – Fair value measurement (IFRS 13)
 Learning unit 9 – Revenue from contracts with customers (IFRS 15)

LECTURERS AND CONTACT DETAILS

Please use only the following e-mail address for all communication with the lecturers:

SEMESTER 1:
[email protected]

SEMESTER 2:
[email protected]

You can contact the lecturers of FAC3701 telephonically, by making use of the telephone
contact numbers provided below:

Telephone
Lecturers Office number
Mr Y Mohamed AJH van der Walt Building, 2-51 (012) 429 4414
Ms L Labuschagne AJH van der Walt Building, 2-49 (012) 429 4694
Ms R Horn AJH van der Walt Building, 2-53 (012) 429 3287
Mr J Riekert AJH van der Walt Building, 2-42 (012) 429 2135

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FAC3701 FAC3701/501

LEARNING UNIT 1
INCOME TAXES
(IAS 12 AND FRG 1)

General Financial Reporting

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LEARNING OUTCOMES

Learners should be able to calculate deferred tax and to disclose deferred and current tax
of companies in the annual financial statements in compliance with International Financial
Reporting Standards.

OVERVIEW

This learning unit is divided into the following:

1.1 Definitions
1.2 Objectives
1.3 Exempt differences
1.4 Examples of taxable temporary differences and treatment thereof according to the
statement of financial position approach
1.4.1 Capital allowances
1.4.2 Prepayments
1.5 Recognition of deferred tax assets
1.6 Unused (assessed) tax losses
1.7 Measurement
1.8 Presentation and disclosure
1.8.1 Statement of profit or loss and other comprehensive income
1.8.2 Statement of financial position
1.8.3 Summary of disclosure requirements
1.9 Provisional tax
1.10 The formal tax assessment and the resulting over/underprovision of current tax
1.11 Capital gains tax on companies
1.12 Dividends tax (withholding tax on dividends)
1.12.1 Tax liability
1.12.2 Accounting treatment
1.12.3 Dividends tax - exemptions
1.13 FRG 1 – Substantively enacted tax rates and tax laws

STUDY

PRESCRIBED
Descriptive Accounting
The chapter relevant to IAS 12 – Income taxes

RECOMMENDED
IFRS Standards – The Annotated IFRS Standards
IAS 12 – Income Taxes

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OVERVIEW OF LEARNING UNIT

The objective of this learning unit is to prescribe the accounting treatment for the current
and future tax consequences of the following:

 the future recovery/(settlement) of the carrying amount of assets/(liabilities) that are

recognised in an enterprise's statement of financial position; and
 transactions and other events of the current period that are recognised in an entity's
financial statements.

IAS 12 – Income taxes prescribes the accounting treatment of both current and deferred
tax. The income tax expense in the statement of profit or loss and other comprehensive
income comprises of both current and deferred tax.

Current tax is calculated on the taxable income of an entity according to the rules of the
Income Tax Act. Therefore, the amount of current tax payable by an entity is often not
proportionate to the entity’s profit for the period in the statement of profit or loss and other
comprehensive income. Examples of these differences are:

 The carrying amount of assets/liabilities in the entity’s statement of financial position is

different from the tax base thereof.
 Income and expenses that are recognised in different periods for accounting and tax
purposes. These differences are temporary differences and used as a basis to
calculate deferred tax and are discussed in detail later in this learning unit.
 Income and expenses that are not taxable or deductible for tax purposes. These
differences are known as exempt differences and discussed in detail in section 1.3.

1.1 DEFINITIONS

(a) Accounting profit is the net profit or loss for a period before deducting tax expense.

(b) Taxable profit/(tax loss) is the profit or loss for a period upon which income tax is
payable to the SA Revenue Service. This figure is calculated by adjusting the
accounting profit according to the rules established by the tax authorities.

(c) Tax expense/tax income is the aggregate amount disclosed in the statement of profit
or loss and other comprehensive income (P/L) as income tax expense/income. This
includes both current tax and deferred tax.

(d) Current tax is the amount of income taxes payable/(recoverable) in respect of the
taxable profit/(tax loss) for the year. This is the tax calculated according to the rules
and regulations of the SA Revenue Service

(e) Deferred tax liabilities are the taxes provided in the statement of financial position
(SFP) for the amount of income taxes payable in future periods in respect of taxable
temporary differences.

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(f) Deferred tax assets are the amounts of income taxes recoverable in future periods in
respect of
 deductible temporary differences;
 the carry forward of unused tax losses; and
 the carry forward of unused tax credits.

(g) The following definitions must be applied when determining the tax base of an item:
The tax base (TB) of an asset or liability is the amount attributable to that asset or
liability for tax purposes.
The tax base of an asset is the amount that will be deductible for tax purposes in
future against any taxable economic benefits that will flow to the entity when it
recovers/settles the carrying amount of the asset.

LECTURER’S COMMENT
Work through the relevant examples in Descriptive Accounting to calculate
the tax base of assets.

The tax base of a liability is the carrying amount of the liability, less any amount
that will be deductible for tax purposes in respect of that liability in future.

The tax base of the liability – revenue received in advance – is its carrying
amount less any amount of revenue that will not be taxable in future.

LECTURER’S COMMENT
Work through relevant examples in Descriptive Accounting to calculate the
tax base of liabilities.

(h) Temporary differences are differences between the tax base of an asset or liability
and the carrying amount of the asset or liability in the statement of financial position.
The tax base represents the amount at which the asset and liability would be included
in the statement of financial position for tax purposes (calculated based on the
application of tax rules) and the carrying amount is the amount for accounting
purposes at which the asset and liability is accounted for (using accounting rules) in
the statement of financial position.

(i) Temporary differences may be either of the following:

(a) Taxable temporary differences are temporary differences that will result in
taxable amounts in determining taxable profit/(tax loss) of future periods when the
carrying amount of the asset or liability is recovered or settled. This will happen
when:

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Rule 1: Carrying amount of the asset > tax base of the asset
= DEFERRED TAX LIABILITY (SFP)
OR
Rule 2: Carrying amount of the liability < tax base of the liability
= DEFERRED TAX LIABILITY (SFP)

If the carrying amount of the asset is greater than the tax base of the asset
(rule 1), it will result in taxable profit in the future, because the amount deductible
in the future for tax purposes is smaller than the amount deductible for accounting
purposes. In the future, the taxable profit will be greater than the accounting profit.

Therefore provision is made in the current year for the tax payable in future by
debiting deferred tax in the statement of profit or loss and other comprehensive
income and crediting a deferred tax liability in the statement of financial position.

Journal entry: Dr Cr
R R
Deferred tax expense (P/L) xxx
Deferred tax liability (SFP) xxx
Provision made for deferred tax expense.

If the carrying amount of the liability is less than the tax base of the liability
(rule 2), it will result in future taxable profit. The taxable profit will be greater than
the accounting profit in the future and we therefore provide deferred tax in the
current year for the tax payable in future.

Provision is made in the current year for the future tax payable by debiting the
deferred tax in the statement of profit or loss and other comprehensive income and
crediting a deferred tax liability in the statement of financial position.

Journal entry: Dr Cr
R R
Deferred tax expense (P/L) xxx
Deferred tax liability (SFP) xxx
Provision made for deferred tax expense.

(b) Deductible temporary differences are temporary differences that will result in
amounts that are deductible in determining taxable profit/(tax loss) of future
periods when the carrying amount of the asset or liability is recovered or settled.
This will happen when:

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Rule 3: Carrying amount of the asset < tax base of the asset
= DEFERRED TAX ASSET (SFP)
OR
Rule 4: Carrying amount of the liability > tax base of the liability
= DEFERRED TAX ASSET (SFP)

If the carrying amount of the asset is less than the tax base of the asset
(rule 3), then it will result in deductions in determining taxable profit of future
periods when the carrying amount of the asset is recovered. This will result in
taxable profit being less than the accounting profit in the future.

To match the future lower tax expense with the accounting profit, we have to debit
a further tax expense in the statement of profit or loss and other comprehensive
income in the form of a deferred tax charge. To achieve this, a deferred tax asset
must be created in the current year by crediting the statement of profit or loss and
other comprehensive income and debiting the deferred tax asset in the statement
of financial position (provided that it is probable that taxable profit against which
the deductible temporary differences can be utilised will be available in future). In
future, the debit deferred tax asset in the statement of financial position will be
reversed as a debit to the statement of profit or loss and other comprehensive
income.
Journal entry: Dr Cr
R R
Deferred tax asset (SFP) xxx
Deferred tax (P/L) xxx
Provision made for deferred tax.
If the carrying amount of the liability is greater than the tax base of that
liability (rule 4), it will result in deductions in determining taxable profit of future
periods when the carrying amount of the liability is settled. The tax charge in future
will therefore not match; it will be too low, compared to the accounting profit. To
match the future tax expense with the accounting profit the tax expense in the
statement of profit or loss and other comprehensive income will have to be debited
in the form of a deferred tax charge.

In order to accomplish this in the future, a deferred tax asset has to be created in
the current year (provided that taxable profit will be available in future against
which the deductible temporary differences can be utilised) by crediting the
statement of profit or loss and other comprehensive income and debiting the
deferred tax asset in the statement of financial position. In the future, the debit
deferred tax asset in the statement of financial position will be reversed as a debit
to the statement of profit or loss and other comprehensive income.

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Journal entry: Dr Cr
R R
Deferred tax asset (SFP) xxx
Deferred tax (P/L) xxx
Provision made for deferred tax.

SCHEMATIC SUMMARY OF TEMPORARY DIFFERENCES

ASSETS/LIABILITIES

CARRYING AMOUNT (CA) TAX BASE (TB)

The amount in the statement of Assets
financial position Amount deductible for tax purposes against
future economic benefits (when it recovers
the carrying amount of the asset)
Liabilities
Carrying amount of the liability less the
amount deductible for tax purposes in future
periods

TEMPORARY DIFFERENCE

TAXABLE TEMPORARY DIFFERENCE DEDUCTIBLE TEMPORARY DIFFERENCE

Assets: CA > TB Assets: CA < TB
Liabilities: CA < TB Liabilities: CA > TB
A deferred tax liability should be A deferred tax asset should be recognised
recognised for all taxable differences for all deductible temporary differences to
unless the deferred tax liability arises the extent that it is probable that taxable
from the following: profit will be available against which
deductible temporary difference can be
EXEMPTION – IAS 12.15 utilised unless the deferred tax asset arises
 Initial recognition of goodwill where from the following:
amortisation is not tax deductible
 the initial recognition of an EXEMPTION – IAS 12.24 The initial recog-
asset/liability in a transaction which: nition of an asset/liability in a transaction
 is not a business combination; that:
and  is not a business combination; and
 at the time of the transaction,  at the time of the transaction, affects
affects neither accounting profit neither accounting profit nor taxable
nor taxable profit/loss profit/loss
Note:
A deferred tax asset is recognised only when
it is probable that taxable profits will be
available against which the deferred tax
asset can be utilised

* CA – Carrying amount
TB – Tax base
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You can also memorise the following for purposes of determining whether a temporary
difference on an item is taxable or deductible:
ASSET (for example Machinery):
Carrying amount > tax base → taxable temporary difference → deferred tax liability
Carrying amount < tax base → deductible temporary difference → deferred tax asset
LIABILITY (for example Revenue received in advance):
Carrying amount > tax base → deductible temporary difference → deferred tax asset
Carrying amount < tax base → taxable temporary difference → deferred tax liability
CALCULATING THE MOVEMENT IN TEMPORARY DIFFERENCES
You should understand the following in order to determine whether the total movement in
temporary differences (from one year to the next year) is taxable or deductible:
DEFERRED TAX LIABILITY:
An increase in the deferred tax liability is an increase in taxable temporary differences.
The movement in temporary differences is deducted in the current tax calculation and
increases the income tax expense (deferred tax) (P/L). The journal entry is as follows:
Dr Income tax expense (deferred tax) (P/L)
Cr Deferred tax liability (SFP)
A decrease in the deferred tax liability is a decrease in taxable temporary differences.
The movement in temporary differences is added in the current tax calculation and
decreases the income tax expense (deferred tax) (P/L). The journal entry is as follows:
Dr Deferred tax liability (SFP)
Cr Income tax expense (deferred tax) (P/L)
DEFERRED TAX ASSET:
An increase in the deferred tax asset is an increase in deductible temporary differences.
The movement in temporary differences is added in the current tax calculation and
decreases the income tax expense (deferred tax) (P/L). The journal entry is as follows:
Dr Deferred tax asset (SFP)
Cr Income tax expense (deferred tax) (P/L)
A decrease in the deferred tax asset is a decrease in deductible temporary differences.

The movement in temporary differences is deducted in the current tax calculation and
increases the income tax expense (deferred tax) (P/L). The journal entry is as follows:

Dr Income tax expense (deferred tax) (P/L)

Cr Deferred tax asset (SFP)

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1.2 OBJECTIVES

IAS 12 requires an entity to account for the tax consequences of transactions and other
events in the same way that it accounts for the transactions and other events themselves.
Thus for transactions and other events recognised in the statement of profit or loss and
other comprehensive income, any related tax effects are also recognised in the statement
of profit or loss and other comprehensive income, except for transactions and other events
recognised directly in equity. The tax effect relating to those transactions must be
recognised directly in equity.

IAS 12 refers to the statement of financial position approach. This method requires that
deferred tax be measured on the difference between:

 the carrying amount of the entity's assets and liabilities; and

 the tax base of each of the entity’s assets and liabilities.

The income tax expense is calculated in the following manner:

R
Profit before tax (as per the P/L) XXX
Exempt differences (refer section 1.3) XXX
Profit after exempt differences XXX
Movement in temporary differences XXX
Taxable profit/tax loss XXX
Current tax expense (28% of taxable profit) XXX
(Current tax expense is Rnil if there is a tax loss for the year)
Deferred tax expense (28% of temporary differences) XXX
(Can be deferred tax credit or debit to the P/L)
SA Normal tax* XXX

* Assuming that the tax rate is 28%, the SA normal tax should be 28% of the profit after
exempt differences.

1.3 EXEMPT DIFFERENCES

A deferred tax liability should be recognised for all taxable temporary differences unless
the deferred tax liability arises from

(a) goodwill for which amortisation is not deductible for tax purposes; or
(b) the initial recognition of an asset or liability in a transaction which
(i) is not a business combination*; and
(ii) at the time of the transaction, affects neither the accounting profit nor the taxable
profit (tax loss)

* Business combinations do not form part of this module.

These differences are then treated as exempt differences and no deferred tax expense is
provided on them.

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The initial recognition of an asset or a liability will therefore be treated as an exempt

difference if that item does not affect the tax computation, meaning that specific asset or
liability is never taxable or deductible for tax purposes.

Exempt differences are items that are never taxable nor tax deductible and therefore no
tax is provided on them. The exempt differences are reconciling items if the total of the
current and deferred tax expenses in the statement of profit or loss and other
comprehensive income do not amount to 28% of the profit before tax.

Examples of exempt differences are

 exempt income (income that will never be taxed), namely:

– dividends received; and
– the portion of capital profits on the sale of assets that is not taxable;
 non tax deductible expenses (expenses that will never be allowed as a deduction),
namely
– fines; and
– donations.

EXAMPLE 1

The company has profit before tax of R10 000. Included in the profit are dividends
received of R1 000 and fines paid of R200. There are no temporary differences. The tax
rate is 28%.

REQUIRED

Calculate the current tax expense and deferred tax expense for the year.

SOLUTION 1

R
Profit before tax 10 000
Exempt differences
– Dividends received – not taxable (1 000)
– Fines paid – not deductible for tax 200
Profit after exempt differences 9 200
Temporary differences –
Taxable profit 9 200

Current tax expense – 28% of taxable profit 2 576

Deferred tax expense – 28% of movement in temporary differences –
SA normal tax 2 576

The income tax expense in the statement of profit or loss and other comprehensive
income should have been R2 800 (R10 000 x 28%). The income tax expense is currently
shown as R2 576.

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The reason for the difference is that no tax is provided for on the exempt differences.
IAS 12 requires a reconciliation of the relationship between the tax expense and the profit
before tax (accounting profit). The reconciliation can be done in percentages or rand, as
follows:

Rand OR %
Standard tax (applicable tax rate)1 2 800 28,0
(10 000 x 28%)
Exempt differences
– Dividends received 2 (280) (2,8)
(1 000 x 28%); (1 000 / 10 000 x 28% x 100)
– Fines paid3 (200 x 28%); (200 / 10 000 x 28% x 100) 56 0,56
Effective tax4 (2 576 / 10 000 x 100) 2 576 25,76

1 Tax on profit before tax of 28% (tax rate).

2 Not taxable, therefore deduct from profit before tax.
3 Not deductible for tax purposes, therefore add back to profit before tax.
4 This is the total tax expenses that is being shown in the statement of profit or loss and

other comprehensive income.

1.4 EXAMPLES OF TAXABLE TEMPORARY DIFFERENCES AND THE

TREATMENT THEREOF ACCORDING TO THE STATEMENT OF
FINANCIAL POSITION APPROACH

Rule 1: Carrying amount of asset > tax base of asset

= DEFERRED TAX LIABILITY (SFP)

Where the carrying amount of the asset is greater than the tax base of the asset as a
result of taxable temporary differences, taxable profit arises in future periods. In the
current year, deferred tax expense in the statement of profit or loss and other
comprehensive income will be debited and a deferred tax liability in the statement of
financial position will be credited to provide for the tax payable in future.

1.4.1 Capital allowances

IAS 16 governs property, plant and equipment, and requires assets to be depreciated at a
rate based on the expected useful life. However, tax legislation requires assets to be
depreciated based on the standard rates of depreciation set out in the legislation,
irrespective of the actual expected rate of usage by the entity. The depreciation calculated
by the tax authorities is often referred to as a capital allowance or tax allowance.

If the depreciation rate and the tax allowance rate (capital allowances) on the same asset
differ, it will result in a different carrying amount and tax base for that asset. The difference
between the carrying amount and the tax base of the asset leads to taxable or deductible
temporary differences.

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This in turn may result in the profit or loss on sale of the asset in the statement of profit or
loss and other comprehensive income differing from that calculated in accordance with the
tax legislation. A profit on sale is generally referred to in the tax legislation as a
recoupment whereas a loss on sale is often referred to as a scrapping allowance
(generally granted as a deduction if certain criteria are met).

Accounting purposes
The carrying amount of a non-current asset is calculated as follows: R
Original cost xxx
Less accumulated depreciation (xxx)
Carrying amount xxx

The profit or loss on sale of a non-current asset (capital and non-capital

portions) is as follows: R
Proceeds on sale xxx
Less carrying amount (xxx)
Profit/(loss) on sale xxx

The non-capital profit included in the profit on sale of a non-current asset is as

follows: R

Proceeds on sale, limited to original cost xxx

Less carrying amount (xxx)
Non-capital profit/(loss) xxx

Tax purposes

The tax base is calculated as follows: R

Original cost xxx
Less accumulated capital allowances (tax allowance) (xxx)
Tax base xxx

The taxable recoupment (or scrapping allowance) is calculated as follows: R

Proceeds on sale, limited to original cost xxx

Less tax base (xxx)
Recoupment/(scrapping allowance) xxx

EXAMPLE 2
A manufacturing plant was purchased on 1 January 20.12 at a cost of R120 000. The
depreciation for the year amounted to R24 000 and the tax allowance to R40 000. The
company has been incorporated in the current year and has profit before tax of R100 000
for the year ended 31 December 20.12. The tax rate is 28%.
Deferred tax is provided on all temporary differences using the statement of financial
position approach.

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REQUIRED

Calculate the deferred tax expense for the year ended

31 December 20.12.

SOLUTION 2
Deferred tax on plant:
Carrying Tax Temporary
Amount base difference
R R R
Cost 120 000 120 000 -
Depreciation/tax allowance (24 000) (40 000) 16 000
Carrying amount/tax base 96 000 80 000 16 000

The carrying amount of the asset is greater than the tax base thereof and therefore the
recovery of the carrying amount will result in taxable profit in the future. The taxable
temporary difference is R16 000 and the deferred tax liability at 28% is R4 480
(R16 000 x 28%).
Journal entry: Dr Cr
R R
Deferred tax expense (P/L) 4 480
Deferred tax liability (SFP) 4 480
Provision made for deferred tax expense.

LECTURER’S COMMENT
IAS 12 adopts the statement of financial position approach for
calculating deferred tax. This approach entails the following:
 Calculate the carrying amounts of all assets and liabilities evident
from the information.
 For each asset and liability identified, determine the relevant tax
base.
 Thereafter calculate the temporary differences and take into
account the carrying amount and tax base of each asset and
liability.
 For each temporary difference, determine whether it results in a
deferred tax asset or liability.
 Each temporary difference must then be multiplied with the tax
rate.
 The net deferred tax liability or asset for the current year should
then be determined.
 As soon as the deferred tax liability or asset has been
determined for the current year, the deferred tax movement
(movement in temporary differences) in the statement of profit or
loss and other comprehensive income can be calculated as the
difference between the opening and closing balance of the
deferred tax liability or asset.
 Using the movement in temporary differences calculated in
above, calculate the current tax expense.
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EXAMPLE 3

On 1 January 20.12, A Ltd was incorporated and acquired a manufacturing building at a

cost of R2 000 000, an administration building at cost of R500 000 and land at a cost of
R300 000 for its own use. Land is not depreciated and no tax allowance is claimable. The
manufacturing building is depreciated at 4% per year using the straight-line method and
the SA Revenue Service allows a 5% annual allowance on the manufacturing building.
The administration building is depreciated over 20 years, but no tax allowance is
claimable.

The company's year-end is 31 December 20.12.

Assume that the profit before tax is R200 000 for the year ended 31 December 20.12 and
the tax rate is 28%.

Deferred tax is provided on all temporary differences according to the statement of

financial position approach.

REQUIRED
Calculate the deferred tax expense for the year ended
31 December 20.12.

SOLUTION 3

According to the statement of financial position approach, the following are the balances
for accounting and tax purposes:

Carrying Temporary
amount Tax base difference
R R R
Manufacturing building
Cost 2 000 000 2 000 000 -
Depreciation/annual allowance (80 000) (100 000) 20 000
(2 000 000 x 4%); (2 000 000 x 5%)
Carrying amount/tax base 1 920 000 1 900 000 20 000

The carrying amount is greater than the tax base and therefore the recovery of the
carrying amount will result in taxable profit in the future. The taxable temporary difference
resulted in a deferred tax liability of R5 600 (R20 000 x 28%).

Journal entry:
Dr Cr
R R
Deferred tax expense (P/L) 5 600
Deferred tax liability (SFP) 5 600
Provision made for deferred tax expense.

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FAC3701/501

Carrying Temporary
Amount Tax base difference
R R R
Land
Cost 300 000 – 300 000
Depreciation/annual allowance – – –
Carrying amount/tax base 300 000 – 300 000

The temporary difference on the land is exempt in terms of paragraph .15 of IAS 12 as it
arises from the initial recognition of an asset in a transaction which, at the time of the
transaction, affects neither accounting nor taxable profit/loss. When the land is recognised
for the first time, a temporary difference arises immediately, as the carrying amount of the
land amounts to R300 000, while the tax base (future tax deductions) amounts to Rnil.
However, the acquisition of the land does not affect accounting profit (debit – Land, credit
– Bank) and there is no immediate tax deduction that will affect taxable income. Therefore
the exemption in terms of paragraph .15(b) of IAS 12 applies.

Carrying Tax base Temporary

Amount difference
R R R
Administration building
Cost 500 000 – 500 000
Depreciation/annual allowance (25 000) – (25 000)
Carrying amount/tax base 475 000 – 475 000

The temporary difference on the administration building is exempt in terms of

paragraph .15 of IAS 12 as it arises from the initial recognition of an asset in a transaction
which at the time of the transaction affects neither accounting nor taxable profit/loss.

LECTURER’S COMMENT
Work through the relevant example in Descriptive Accounting, which
illustrates the exemption from recognising a deferred tax liability.

1.4.2 Prepayments

Prepayments are amounts actually incurred in the current year and therefore tax
deductible in terms of section 11(a) of the Income Tax Act. For accounting purposes,
however, the amount is not taken to the statement of profit or loss and other
comprehensive income as a deduction, but is disclosed as a current asset in the statement
of financial position. The temporary difference occurs because the amount will be claimed
as a deduction for tax in the current year, but will only be taken to the statement of profit or
loss and other comprehensive income as an expense in the following year. The carrying
amount will be equal to the amount of the prepayment and the tax base is Rnil (no amount
in the statement of financial position for tax purposes since it has already been claimed).

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EXAMPLE 4

Assume that a company, incorporated in the current year, paid insurance in

advance amounting to R1 000. The profit before tax is R5 000 for the year ended
31 December 20.12. The tax rate is 28%.

Deferred tax is provided on all temporary differences according to the statement of

financial position approach.

REQUIRED

Calculate the deferred tax expense for the year ended

31 December 20.12.

SOLUTION 4
The following journal entry for insurance prepayments is prepared for accounting
purposes:
Dr Cr
R R
Insurance prepaid (SFP) 1 000
Bank (SFP) 1 000

According to the statement of financial position approach, the following are the balances
for accounting and tax purposes:

Carrying Tax Temporary

amount base difference
R R R
Prepayments – current assets 1 000 – 1 000

This temporary difference will result in future taxable amounts when the carrying amount of
the asset is recovered. (The prepayment has already been claimed for tax purposes in the
current year and will not be claimed when the expense is taken to the statement of profit or
loss and other comprehensive income in the future.) The carrying amount of the asset,
which is greater than the tax base, is a taxable temporary difference and therefore a
deferred tax liability is created.

The tax base of the asset is Rnil as there is no future deductible amount for tax purposes.
The carrying amount of the asset will be recovered in the future as a deduction against
profit before tax (credit the asset and debit the statement of profit or loss and other
comprehensive income), which will result in taxable profit being greater than the profit
before tax in the future. This resulting future liability requires a deferred tax provision in the
current year.

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Journal entry:
Dr Cr
R R
Deferred tax expense (P/L) 280
Deferred tax liability (SFP) 280
Provision made for deferred tax expense.

LECTURER’S COMMENT
Work through the relevant example in Descriptive Accounting, which
illustrates taxable temporary differences.

Rule 2: Carrying amount of liability < tax base of liability

= DEFERRED TAX LIABILITY (SFP)
Where, as a result of temporary differences, the carrying amount of the liability is less
than the tax base of the liability, this will result in taxable temporary differences leading to
taxable amounts in determining taxable profit of future periods. In the current year, we
have to debit deferred tax expense in the statement of profit or loss and other
comprehensive income, and credit a deferred tax liability in the statement of financial
position.

It is difficult to imagine circumstances where the carrying amount of a liability would be

smaller than the tax base of a liability.

In the case of the section 24C allowance, which is granted by the SA Revenue Service in
respect of construction contracts, the carrying amount for accounting purposes is Rnil, but
the tax base is the value of the section 24C allowance. A deferred tax liability is therefore
created.

1.5 RECOGNITION OF DEFERRED TAX ASSETS

IAS 12 states that a deferred tax asset should be recognised to the extent that it is
probable that taxable profit will be available in the future against which the deductible
temporary differences can be utilised, unless the deferred tax asset arises from the initial
recognition of an asset or liability in a transaction which
(a) is not a business combination*; and
(b) at the time of the transaction, affects neither accounting profit nor taxable profit/(loss).

* Business combinations do not form part of this module.

Rule 3: Carrying amount of asset < tax base of asset

= DEFERRED TAX ASSET (SFP)
Rule 4: Carrying amount of liability > tax base of liability
= DEFERRED TAX ASSET (SFP)

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This results in deductible temporary differences leading to amounts which are deductible
in determining taxable profit of future periods. In the current year, we have to credit
deferred tax income in the statement of profit or loss and other comprehensive income,
and debit a deferred tax asset in the statement of financial position.

It is inherent in the recognition of a liability that the carrying amount will be settled in future
periods through the outflow of resources from the company. When resources flow from the
enterprise, part or all of their amounts may be deductible in determining taxable profit in a
period later than the period in which the liability is recognised. In such cases, a temporary
difference exists between the carrying amount of the liability and its tax base. Accordingly,
a deferred tax asset arises in respect of the income taxes that will be recoverable in future
periods when that part of the liability is allowed as a deduction in determining taxable
profit.

EXAMPLE 5

Revenue received in advance is not accounted in the statement of profit or loss and other
comprehensive income in the current year, but disclosed as a liability in the statement of
financial position (debit – Bank; credit – Revenue received in advance). The amount is
taxable in the current year since all amounts received or accrued are taxed according to
the rules of the Income Tax Act.

A company has been incorporated in the current year and has received deposits in
advance to the amount of R20 000 from their customers to book holiday accommodation.
The accounting profit of the company amounted to R150 000 for the year ended
31 December 20.12 and the tax rate is 28%.

Deferred tax is provided on all temporary differences according to the statement of

financial position approach. There is assurance beyond reasonable doubt that there will be
sufficient taxable profit in the future to realise any tax benefits.

REQUIRED

Calculate the deferred tax expense for the year ended 31 December 20.12

SOLUTION 5

The following journal entry for deposits received in advance is prepared for accounting
purposes:
Dr Cr
R R
Bank (SFP) 20 000
Deposits received in advance (SFP) 20 000

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According to the statement of financial position approach, the following are the balances
for accounting and tax purposes:
Carrying Tax Temporary
amount base difference
R R R
Deposits received in advance 20 000 – 20 000

(The tax base is equal to the carrying amount less the amount of revenue that will not be
taxed in future (20 000 – 20 000)).

As a result of the deposits received in advance, the carrying amount of the liability is
greater than the tax base of the liability and this will result in amounts which are deductible
in determining future taxable profit.

Journal entry:
Dr Cr
R R
Deferred tax asset (SFP) 5 600
Deferred tax (P/L) 5 600
Provision made for deferred tax.

EXAMPLE 6

A company has been incorporated in the current year, and it sells vacuum cleaners with a
one-year warranty. The warranty is an assurance type warranty. The company provides for
the warranty costs and the total of the provision account at the end of the year is R150
000. Assume that the profit before tax is R500 000 for the year ended 31 December 20.12
and the tax rate is 28%. The SA Revenue Service will allow the warranty costs as a
deduction once they are actually incurred. The directors of the company are certain that
the amount provided is not excessive.

Deferred tax is provided on all temporary differences using the statement of financial
position approach. There is assurance beyond reasonable doubt that there will be
sufficient taxable profit in the future to realise any tax benefits.

REQUIRED

Calculate the deferred tax expense for the year ended

31 December 20.12.

SOLUTION 6

The following journal entry for warranty costs is prepared for accounting purposes:

Dr Cr
R R
Warranty costs (P/L) 150 000
Provision for warranty costs (SFP) 150 000

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According to the statement of financial position approach, the following are the balances
for accounting and tax purposes:
Carrying Tax Temporary
amount base difference
R R R
Provision for warranty costs 150 000 – 150 000

The tax base is equal to the carrying amount less the amount deductible for tax purposes
in future (150 000 – 150 000)).

The tax base represents two amounts, namely the liability for warranty costs of R150 000
and the tax allowance of R150 000 still due as a deduction from tax in the future. The
carrying amount of the liability is greater than the tax base of the liability, which means that
this will result in future deductions for tax purposes.

Journal entry Dr Cr
R R
Deferred tax asset (SFP) 42 000
Deferred tax (P/L) (150 000 x 28%) 42 000
Provision made for deferred tax.

EXAMPLE 7

On 1 January 20.12 a company was incorporated and it entered into an instalment sale
agreement, buying manufacturing machines. The company's year-end is 31 December.

Cost of machines R171 000

Instalment – payable annually in arrears R63 567
Finance term 4 years
Nominal interest rate 18%
Depreciation rate – straight-line 20%
Tax allowance (SA Revenue Service) – straight-line 33,33%

The interest paid in year 1 is R30 780 and the outstanding capital balance of the liability at
the end of year 1 is R138 213.

The tax rate is 28% and the profit before tax is R500 000.

Deferred tax is provided on all temporary differences using the statement of financial
position approach. There is assurance beyond reasonable doubt that there will be
sufficient taxable profit in the future to realise any tax benefits.

REQUIRED

Calculate the deferred tax expense for the year ended

31 December 20.12.

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SOLUTION 7

In the case of an instalment sale agreement, the tax authorities recognise the
capitalisation of the asset and allow a tax allowance to be claimed on the asset. A liability
also exists for tax purposes and the interest is claimable for tax purposes.

For accounting purposes, the asset is capitalised and the liability raised. The depreciation
and interest paid are expensed to the statement of profit or loss and other comprehensive
income.

According to the statement of financial position approach, the following are the balances
for accounting and tax purposes:
Carrying Tax Temporary
amount base difference
R R R
Property, plant and equipment¹ 136 800 114 000 22 800

1 (171 000 x 80%); (171 000 x 66,67%)

(The tax base of the asset is the amount that will be deductible for tax purposes in future
years.)

The carrying amount of the asset is greater than the tax base of the asset and it will result
in a deferred tax liability. The carrying amount of the asset will be recovered in the future
as a deduction against profit before tax (credit the asset in the statement of financial
position and debit the statement of profit or loss and other comprehensive income), which
will result in taxable profit in future periods. We have to provide for deferred tax in the
current year to account for the effect of the lower tax base being recoverable in the future.

Deferred tax in the statement of profit or loss and other comprehensive income will be
debited with R6 384 (R22 800 x 28%) and the deferred tax liability in the statement of
financial position will be credited with R6 384.

Carrying Tax Temporary

amount base difference
R R R
Liability² 138 213 138 213 –
2 171 000 – (63 567 – 30 780)

(The tax base is equal to the carrying amount less amount still deductible in future for tax
purposes (138 213 – 0).)

The carrying amount of the liability and the tax base of the liability are equal and therefore
there is no temporary difference. Please note that the interest paid is deductible for both
accounting and tax purposes.

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Temporary differences according to the statement of financial position approach are:

R
Property, plant and equipment 22 800
Liability –
Net temporary differences 22 800
Deferred tax liability @ 28% 6 384

Journal entry: Dr Cr
R R
Deferred tax expense(P/L) 6 384
Deferred tax liability (SFP) 6 384
Provision made for deferred tax expense.

1.6 UNUSED (ASSESSED) TAX LOSSES

A deferred tax asset should be recognised for the carry forward of unused (assessed) tax
losses to the extent that it is probable that future taxable profit will be available against
which the unused tax losses can be utilised.

The unused tax losses result when the company has calculated a tax loss and therefore
no tax is payable. However, the SA Revenue Service will not refund the tax loss to the
company, but allows the company to carry forward the tax loss to future periods to net off
against the taxable profit of those periods, thereby reducing the tax payable in future
periods.

EXAMPLE 8

A company have been incorporated in the current year and the company's profit before tax
for the year ended 31 December 20.12 is R20 000. Included in the profit before tax is
R10 000 depreciation. The tax allowance for the year is R40 000. The tax rate is 28%.
Deferred tax is provided on all temporary differences using the statement of financial
position approach. There is assurance beyond reasonable doubt that there will be
sufficient taxable profit in the future to realise any tax benefits.
R
Profit before tax 20 000
Exempt differences –
Profit after exempt differences 20 000
Temporary differences (30 000)
Depreciation 10 000
Tax allowance (40 000)
Tax loss (10 000)
Current tax expense Nil

REQUIRED

Calculate the deferred tax expense for the year ended

31 December 20.12.

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SOLUTION 8

No current tax is payable due to the tax loss in the current year. The SA Revenue Service
does not refund tax losses. The tax loss is treated as a temporary difference in the year
that the tax loss arises. Deferred tax in the statement of profit or loss and other
comprehensive income will be credited and a deferred tax asset will be debited in the
statement of financial position.

In terms of the statement of financial position approach, the tax loss is treated as follows:
Carrying Temporary
amount Tax base difference
R R R
Tax loss – 10 000 (10 000)

The tax base of the asset is the amount that will be deductible for tax purposes in future
years that is R10 000. The carrying amount of the tax loss is Rnil. The tax loss is not
recorded in the accounting records.

The carrying amount of the asset is lower than the tax base of the asset (tax loss) and it
will result in a deferred tax asset.

Deferred tax in the statement of profit or loss and other comprehensive income is credited
with R2 800 (10 000 x 28%) and the deferred tax asset in the statement of financial
position is debited with R2 800.

The tax loss will be utilised in the following year.

Assume in the following year the company made a profit before tax of R50 000 after
depreciation of R10 000. The tax allowance is R10 000. The tax rate is 28%.
The tax computation and the deferred tax entries for the following year are as follows:
R
Profit before tax 50 000
Exempt differences –
Profit after exempt differences 50 000
Temporary differences –
Depreciation 10 000
Tax allowance (10 000)
Taxable profit 50 000
Assessed tax loss carried forward from previous year (10 000)
Taxable profit for the year 40 000
Current tax at 28% 11 200

The assessed tax loss was utilised against the current year's taxable profit. It was treated
as a temporary difference in the previous year, resulting in a deferred tax asset.

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The deferred tax asset is reversed in the current year, the journal entry being:

Dr Cr
R R
Deferred tax expense (P/L) (10 000 x 28%) 2 800
Deferred tax asset (SFP) 2 800
Utilisation of the tax loss from the previous year in the current year.

Carrying Temporary
amount Tax base difference
R R R
Tax loss Nil Nil Nil

The tax base of the asset is Rnil because there is no amount left that will be deductible for
tax purposes in future years. The tax loss was utilised in the current year.

The utilisation of the tax loss is therefore a debit entry to the deferred tax in the statement
of profit or loss and other comprehensive income to increase the tax charge in the current
year.

The criteria for recognising deferred tax assets arising from the carry forward of unused
assessed tax losses are the same as the criteria for recognising deferred tax assets
arising from deductible temporary differences. The existence of unused assessed tax
losses is strong evidence that future taxable profit may not be available. Therefore, when
an entity has a history of recent losses, the entity recognises a deferred tax asset arising
from unused assessed tax losses only to the extent that the entity has sufficient taxable
temporary differences or there is evidence that sufficient profit will be available against
which the unused assessed tax losses can be utilised.

An entity considers the following criteria in assessing the probability that taxable profit will
be available against which the unused assessed tax losses can be utilised:

 whether the entity has sufficient taxable temporary differences, which will result in
taxable amounts against which the unused tax losses can be utilised;
 whether it is probable that the entity will have taxable profits before the unused tax
losses expire;
 whether the tax losses have resulted from identifiable causes which are unlikely to
recur; and
 whether tax-planning opportunities are available to the entity that will create taxable
profit in the period in which the unused tax losses can be utilised.

To the extent that it is not probable that the taxable profit will be available against which
the unused tax losses can be utilised, the deferred tax asset is not recognised. (Refer to
example 12.)

At each end of the reporting period, an entity reassesses unrecognised deferred tax
assets. The entity recognises a previously unrecognised deferred tax asset to the extent
that it has become probable that future taxable profit will allow the deferred tax asset to be
recovered.

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For example, an improvement in trading conditions may make it more probable that the
entity will be able to generate sufficient taxable profit in the future to comply with the
criteria for the recognition of the deferred tax asset.

LECTURER’S COMMENT
Work through the relevant example in Descriptive Accounting, which
illustrate deferred tax on assessed tax losses.

1.7 MEASUREMENT

Current tax expenses, deferred tax assets and deferred tax liabilities are measured using
the enacted tax rates. If there had been a change in the tax rate during the year, the
opening balance of the deferred tax asset and deferred tax liability in the statement of
financial position should be adjusted with the applicable new tax rate.

The carrying amount of deferred tax assets and deferred tax liabilities may change even
though there is no change in the amount of the related temporary differences.

This can result from:

 a change in tax rates or tax laws;
 a re-assessment of the recoverability of deferred tax assets; or
 a change in the expected manner of recovery of an asset.

1.8 PRESENTATION AND DISCLOSURE

1.8.1 Statement of profit or loss and other comprehensive income

(a) Current tax and deferred tax should be recognised as an income or expense and
included in the net profit or loss for the period, except when the tax arises from:

 transactions or events which are recognised directly in equity; or

 a business combination that is an acquisition.

(b) The income tax expense or income relating to the net profit or loss should be
presented on the face of the statement of profit or loss and other comprehensive
income. The major components of income tax expense/(income) should be disclosed
separately. The components of income tax expense/(income) may include the
following:

 Current tax expense/(income).

 Any adjustments recognised in the period for current tax of prior periods. An
example of this is an over or underprovision of the previous years' current tax.
 The amount of deferred tax expense/(income) relating to the origination (taxable)
and reversal (deductible) of temporary differences.
 The amount of deferred tax expense/(income) relating to the changes in tax rate or
enactment of new taxes.

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 The amount of the benefit arising from a previously unrecognised tax loss, tax credit
or temporary difference of a prior period that is used to reduce the current and/or
deferred tax expense. This will happen when the deferred tax asset was not
recognised in respect of the tax loss because of uncertainty whether there would be
sufficient future taxable profit that would be available against which the unused tax
loss could be utilised. If in the current year it becomes clear that there will be
sufficient future taxable profit to recognise the unused tax loss, a deferred tax asset
is provided.
 Deferred tax expense arising from the write-down, or reversal of a previous write-
down, of a deferred tax asset.
 The amount of tax expense (income) relating to those changes in accounting
policies and errors that are included in profit or loss in accordance with IAS 8,
because they cannot be accounted for retrospectively.
 The amount of income tax relating to each component of other comprehensive
income.
 An explanation of changes in the applicable tax rate(s) compared to the previous
accounting period.

(c) An explanation is needed of the relationship between income tax expense/(income)

and the accounting profit in either rand or percentages. The explanation will reconcile
standard tax (applicable tax in rand or percentages) to effective tax (rand or
percentages).

Standard tax (applicable tax) is the income tax expense (in rand) calculated at 28%
(the current rate of tax for companies) of the accounting profit without considering
exempt differences, rate changes and other taxes. It is what the income tax expense
would have been had the matching principle been applied to all items. If the
reconciliation is done in terms of percentages, the standard tax rate is always the
official tax rate per the tax legislation – currently 28%.

Effective tax is the actual income tax expense disclosed in the statement of profit or
loss and other comprehensive income and does not necessarily equal 28% of profit
before tax. The reason being the income tax expense in the statement of profit or loss
and other comprehensive income would not have been provided for on exempt
differences and may also include other items like rate adjustments, over- and
underprovisions of current tax and other taxes like foreign taxes. The effective tax
percentage is the income tax expense/(income) divided by the accounting profit before
tax.

The most common reconciling items are:

(i) Exempt differences

No tax is provided on these differences and, as the income tax expense/(income) in the
statement of profit or loss and other comprehensive income is supposed to be 28% of the
accounting profit before tax, this forms part of the reconciliation, as it is included in the
accounting profit before tax. However, no tax has been provided on these items.

 Dividends
Dividends received are not taxable, but are included in the accounting profit before tax.
When calculating the taxable profit, dividends received are deducted and the tax
expense is calculated on a lower taxable profit than the accounting profit before tax.
The tax expense does not match with the accounting profit before tax because it was
calculated on accounting profit less dividends received. The "tax" on dividends
received will be deducted as a reconciling item from standard tax to arrive at effective
tax.

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EXAMPLE 9

The company's profit before tax for the current year is R10 000, which includes dividends
received of R2 000. There are no temporary differences. The tax computation will be as
follows if the official tax rate is 28%:

R
Profit before tax 10 000
Exempt differences – dividends received are not taxable (2 000)
Profit after exempt differences 8 000
Temporary differences –
Taxable profit 8 000
Current tax expense @ 28% 2 240
Deferred tax expense – there are no temporary differences –
SA normal tax 2 240

The SA normal tax of R2 240 is the effective tax.

The tax rate reconciliation (done in either rand or percentages) is as follows:

R OR %
Standard tax (or applicable tax) (10 000 x 28%) 2 800 28,0
Exempt differences – dividends received
(included in profit before tax, but not taxable, therefore
deducted from standard tax) (2 000 x 28%);
((2 000/10 000) x 28% x 100) (560) (5,6)
Effective tax ((2 240/10 000) x 100) 2 240 22,4

 Fines
Fines paid by the entity are not deductible for tax purposes since it has not been
incurred in the production of income. The fines would have been deducted as an
expense from profit before tax. When the tax computation is done, the fines paid must
be added back as an exempt difference.

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EXAMPLE 10
Assume the same information as in example 9, except that fines of R300 have also been
deducted from profit before tax. The tax computation and the tax reconciliation are as
follows:
R
Profit before tax 10 000
Exempt differences:
Dividends received (2 000)
Fines paid – deducted as an expense from the profit, but will have to be
added back for purposes of the tax computation 300
Profit after exempt differences 8 300
Temporary differences –
Taxable profit 8 300

Current tax expense @ 28% 2 324

Deferred tax expense – there are no temporary differences –
SA normal tax 2 324

The SA normal tax of R2 324 is the effective tax. The tax rate reconciliation (done in either
Rand or percentages) is as follows:

R OR %
Standard tax (or applicable tax) (10 000 x 28%) 2 800 28,0
Exempt differences – dividends received (explained in example 9) (560) (5,6)
(2 000 x 28%); ((2 000/10 000) x 28% x 100)
Fines – deducted from the profit before tax, but is not tax
deductible and must be added back to the standard tax 84 0,84
(300 x 28%); ((300/10 000) x 28% x 100)
Effective tax ((2 324/10 000) x 100) 2 324 23,24

 Other exempt differences

– Legal fees relating to items of a capital nature, such as legal fees incurred to purchase
a new business or to buy capital assets.
– Donations are not tax deductible.

(ii) Rate changes and over/underprovision of prior years' current tax expense are
also reconciling items.

The reason being that the rate adjustment relates to adjustments made to the opening
balance of the deferred tax account in the statement of financial position. The opening
balance of the deferred tax account relates to previous years' temporary differences and
not to the current years' profit before tax. The purpose of the tax reconciliation is to
reconcile the standard tax (applicable tax), which is based on the current years' profit
before tax, to the effective tax. The effective tax is the income tax expense amount dis-
closed in the statement of profit or loss and other comprehensive income and includes
current tax, deferred tax as well as rate changes and over(underprovisions) of previous
years' current tax. The effects of a rate change are dealt with in example 11. The effects of
a under/over provision are discussed in part 1.10 of this learning unit. Example 14 deals
with an underprovision of tax.

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LECTURER’S COMMENT
Work through the relevant example in Descriptive Accounting, which
illustrates the change in tax rate.

(d) The following is a summary of the income tax expense in the statement of profit or
loss and other comprehensive income:

Items included in the income tax expense in the statement of profit or loss and other
comprehensive income

Normal

Current Deferred

 current year = taxable  total current year adjust-

profits x tax rate ment = (total temporary
 under/(over) provision in a differences at end of year x
prior year = assessment – tax rate) – (total temporary
current tax recognised differences at beginning of
year x tax rate)
 total rate change adjust-
ment = opening deferred
tax balance ÷ old tax rate x
difference in tax rate (old
and new)

1.8.2 Statement of financial position

(a) Tax assets and tax liabilities should be presented separately from other assets and
liabilities in the statement of financial position. Deferred tax assets and deferred tax
liabilities should be distinguished from current tax assets and liabilities.

When an entity makes a distinction between current and non-current assets and
liabilities in its financial statements, it should classify deferred tax assets and liabilities
as non-current assets or liabilities.

An entity should offset current tax assets and current tax liabilities when they relate to
income taxes levied by the same tax authorities and the entity has a legally
enforceable right to set off current tax assets against current tax liabilities.

(b) The aggregate current and deferred tax relating to items that are charged or credited
to equity should be disclosed separately.

(c) The amount (and expiry date, if any) of deductible temporary differences, unused tax
losses and unused tax credits for which no deferred tax asset is recognised in the
statement of financial position should be disclosed separately.

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(d) The following is required in respect of each type of temporary difference, and in
respect of each type of unused tax losses and unused tax credits:

 The amount of the deferred tax assets and liabilities recognised in the statement of
financial position for each given period
 The amount of the deferred tax expense or income recognised in the statement
of profit or loss and other comprehensive income, if this amount is not apparent
from the changes in the amounts recognised in the statement of financial position

This means that the deferred tax balance in the statement of financial position must be
analysed and divided into the major types of temporary differences included in the
balance. It could relate to the following:
 Temporary differences that relate to property, plant and equipment and the differing
timing of the accounting deductions and tax allowances
 The deferred tax provided for on unused tax losses
 Other temporary differences that arise when income or expenses are included in
one period for accounting and another for tax purposes, such as deposits received
in advance and prepayments
(e) An entity should disclose the amount of a deferred tax asset and the nature of the
evidence supporting its recognition, when:

 the utilisation of the deferred tax asset is dependent on future taxable profits in
excess of the profits arising from the reversal of existing taxable temporary
differences; and
 the entity has suffered a loss in either the current or the preceding period in the tax
jurisdiction to which the deferred tax asset relates.

1.8.3 Summary of disclosure requirements

Suggested disclosure relevant to the areas of deferred tax studied in this learning unit is as
follows:

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR

THE YEAR ENDED … 20.12
Notes 20.12 20.11
R R
Profit before tax xxx xxx
Income tax expense 3 (xxx) (xxx)
Profit for the year xxx xxx
Total comprehensive income for the year xxx xxx

STATEMENT OF FINANCIAL POSITION AS AT ... 20.12

Notes 20.12 20.11
ASSETS/LIABILITIES R R
Non-current assets/Non-current liabilities
Deferred tax 4 xxx xxx

Current assets/Current liabilities

SA Revenue Service – Normal xxx xxx
SA Revenue Service – VAT xxx xxx

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NOTES FOR THE YEAR ENDED ... 20.12

20.12 20.11
3. Income tax expense R R

Major components of tax expense

Current tax expense xxx xxx
Current period xxx xxx
Under/(over)-provision in prior period xxx xxx
Deferred tax expense xxx xxx
Movement in temporary difference xxx xxx
Change in tax rate xxx xxx
xxx xxx

Income tax relating to the components of other

comprehensive income

Deferred tax relating to revaluation of building – xxx

Tax rate reconciliation (R or %)

Accounting profit xxx xxx
Tax at the standard rate (applicable tax) xxx xxx
Tax effects of:
Exempt differences
Non-taxable capital profits (xxx) (xxx)
Dividend income (xxx) (xxx)
Fines xxx xxx
Donations xxx xxx
Under/(over)-provision of current tax in a prior year xxx (xxx)
Adjustment to tax rate xxx (xxx)
Effective tax xxx xxx

4. Deferred tax asset/(liability)

Analysis of temporary differences
Provisions xxx xxx
Accelerated tax allowance for tax purposes xxx xxx
xxx xxx

5. The balance relating to an assessed loss for normal tax purposes for which no
deferred tax asset has been recognised due to uncertainty about the probability of
future taxable profits or dividend declarations, is as follows:

Unutilised assessed loss for which no deferred tax asset has been
recognised xxx (xxx)

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EXAMPLE 11

The trial balance of Aries Ltd for the year ended 31 December 20.12 is as follows:

R R
Credits
Share capital 500 000
Retained earnings: 1 January 20.12 1 036 400
Long-term liabilities 330 200
Accumulated depreciation: Buildings – 31 December 20.11 9 000
Accumulated depreciation: Plant and machinery –
31 December 20.11 38 500
Sale of goods 2 650 000
Accounts payable 72 500
Dividends received 45 000

Debits
Land: At cost 1 200 000
Buildings: At cost 450 000
Plant and machinery: At cost 385 000
Investments 660 990
Deferred tax asset: 1 January 20.12 2 610
Inventory 98 000
Accounts receivable 125 000
Cost of sales 1 325 000
Operating expenses (excluding depreciation) 362 000
Interest paid 23 000
Dividends paid 50 000
4 681 600 4 681 600

Additional information

1. The provision for the current tax expense and deferred tax expense must still be made
for the year ended 31 December 20.12. The following tax rates are applicable:

20.12 20.11
Normal tax rate 28% 29%

2. The assets of Aries Ltd were purchased as follows:

Land (owner-occupied) 1 January 20.11
Buildings (owner-occupied) 1 January 20.11
Plant and machinery 1 July 20.11

Aries Ltd accounts for all assets according to the cost model.

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3. The following are the differences between the allowances for tax purposes and the
allowances that the company applies in the financial statements:
Company SA Revenue
Service
Land None None
Buildings 2% per year None
Plant and machinery (apportioned) 20% reducing 20% straight
balance line
Allowance for credit losses Full list 25% of list
4. Included in operating expenses are donations of R15 000 and fines of R70 000 for
environmental pollution. The donations made by Aries Ltd and the fines incurred for
environmental pollution are not deductible for tax purposes.
5. The accounts receivable figure in the trial balance is made up as follows:
20.12 20.11
R R
Age analysis 145 000 180 000
Allowance for credit losses (20 000) (12 000)
125 000 168 000

6. The deferred tax balance at 31 December 20.11 arose as a result of deductible

temporary differences of R9 000 relating to the allowance for credit losses.
7. Deferred tax is provided on all temporary differences using the statement of financial
position approach. There is assurance beyond reasonable doubt that there will be
sufficient taxable profit in the future to realise any tax benefits.

REQUIRED
Prepare the income tax notes to the annual financial statements of Aries
Ltd for the year ended 31 December 20.12. Your answer must comply
with the requirements of International Financial Reporting Standards
(IAS 12).
Please note:
The movement in temporary differences in the current tax calculation
must be calculated using the statement of financial position method.

LECTURER’S COMMENT
HOW TO APPROACH A QUESTION WHEN THE DISCLOSURE OF
THE INCOME TAX EXPENSE NOTE, CURRENT TAX AND
DEFERRED TAX IS REQUIRED:
1. Calculate the deferred tax balance for the previous year if not given.
2. Calculate the deferred tax balance for the current year.
3. Calculate the deferred tax movement based on calculations (1) and
(2) above.
4. Calculate the tax rate change if any.
5. Calculate the current tax expense for the year.
6. Prepare the first part of the income tax expense note using the
information calculated in (1) to (5) above. Thereafter, prepare the tax
rate reconciliation note in rand or percentages (as required by the
question).
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SOLUTION 11
Calculations
1. Carrying amounts of property, plant and equipment
Plant and
Land Buildings machinery Total
R R R R
Purchase date 01/01/20.11 1 200 000 450 000 – 1 650 000
Purchase date 01/07/20.11 – – 385 000 385 000
Depreciation for the year
ended 31/12/20.11 – (9 000) (38 500) (47 500)
Carrying amount at
31/12/20.11 1 200 000 441 000 346 500 1 987 500
Depreciation for the year
ended 31/12/20.12 – (9 000) (69 300) (78 300)
Carrying amount at
31/12/20.12 1 200 000 432 000 277 200 1 909 200

2. Tax base of property, plant and equipment

Plant and
Land Buildings machinery
R R R
Purchase date 01/12/20.11 1 200 000 450 000 –
Purchase date 01/07/20.11 385 000
Tax allowance for year ended 31/12/20.11 (38 500)
Tax base at 31/12/20.11 – – 346 500
Tax allowance for year ended 31/12/20.12 (77 000)
Tax base at 31/12/20.12 – – 269 500

3. Deferred tax balance computation for the year ended 31 December 20.12 –
statement of financial position approach
Taxable/ Deferred
(deductible) tax asset/
Carrying temporary (liability)
amount Tax base differences @ 28%
R R R R
Property, plant and
equipment:
Property 1 200 000 – 1 200 000 –
(Exempt)
Buildings 432 000 – 432 000 –
(Exempt)
Plant and machinery1 277 200 269 500 7 700 (2 156)
Accounts receivable2 125 000 140 000 (15 000) 4 200
Net deferred tax asset at 31 December 20.12 (7 300) 2 044

Deferred tax movement – current year R R

Deferred tax asset on 1 January 20.12 (given) 9 000 (2 610)
Deferred tax asset at 31 December 20.12 (7 300) 2 044
Net movement for the year – debit to the P/L 1 700 (566)
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Made up as follows:
R
(566)
Rate change from 29% to 28% [2 610 – (2 610/0,29 x 0,28)] or 9 000 x 1% (90)
Temporary differences (1 700 (3) x 28%) (476)

(See current tax expense computation for details of the movement of temporary
differences for the year.)
1 Carrying amount of asset > tax base of asset, therefore a deferred tax liability exists
2 Tax base = (125 000 + 20 000 – (20 000 x 25%))
Carrying amount of asset < tax base of asset, therefore a deferred tax asset exists

LECTURER’S COMMENT

The temporary differences on the property and the buildings are exempt
in terms of paragraph .15 of IAS 12 as it arises from the initial
recognition of an asset in a transaction, which at the time of the
transaction affects neither accounting nor taxable profit.

4. Calculation of profit before tax in the statement of profit or loss and other
comprehensive income
20.12
R
Sales 2 650 000
Cost of sales (1 325 000)
Gross profit 1 325 000
Operating expenses (excluding depreciation) (362 000)
Depreciation: Building (9 000)
Depreciation: Plant and machinery (69 300)
Finance costs (23 000)
Investment income – dividends received 45 000
Profit before tax 906 700

5. Calculation of current tax expense for the year

20.12

R
Profit before tax 906 700
Exempt differences 49 000
Donations – not tax deductible 15 000
Fines for environmental pollution – not tax deductible 70 000
Depreciation: Building 9 000
Dividends received (45 000)
Profit after exempt differences 955 700
Movement in temporary differences (Calculation 3) (1 700)1
Taxable profit 954 000
Current tax expense at 28% 267 120

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LECTURER’S COMMENT

MOVEMENT IN TEMPORARY DIFFERENCES

A taxable temporary difference will only be taxable in future and will

result in a tax liability payable to the SARS in future. In the current year,
this taxable temporary difference is not taxable and must be deducted
from the taxable profit.

A deductible temporary difference will only be deductible in future and

will result in a tax saving in future. In the current year, this deductible
temporary difference is not deductible and must be added to the taxable
profit.

1 The movement in temporary differences consists of:

R
Depreciation for accounting purposes2 – add back 69 300
Tax allowance2 – deduct (77 000)
Allowance for credit losses3 (20 000 – 12 000) 8 000
Allowance for credit losses – 20.114 (12 000 x 25%) 3 000
Allowance for credit losses – 20.125 (20 000 x 25%) (5 000)
1 700

2 The depreciation has already been deducted in order to calculate the accounting
profit of R906 700. The SA Revenue Service calculates its own form of depreciation
called a capital allowance (tax allowance), therefore the depreciation must first be
added back (reversed) and then the tax allowance must be deducted.
3 The allowance for credit losses is a statement of financial position account (general
ledger account), therefore the movement in this account will either be debited or
credited to the statement of profit or loss and other comprehensive income (profit
before tax). The increase of R8 000 in the allowance for credit losses account will
therefore be debited to the statement of profit or loss and other comprehensive income
(profit before tax). This amount (R8 000) is not allowed as a deduction for tax
purposes and should therefore be added back (reversed).
4 This amount of R3 000 has already been allowed as a deduction for tax purposes in
20.11 and should therefore be added back.
5 This amount of R5 000 is allowed as a deduction for tax purposes in the current year
(20.12) and should therefore be deducted.

DISCLOSURE

ARIES LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.12

1. Accounting policy

The financial statements have been prepared in accordance with International Financial
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Reporting Standards.

The financial statements have been prepared on the historical cost basis, as modified by
the revaluation of land and buildings, investment property, available-for-sale financial
assets and financial assets and financial liabilities at fair value through profit or loss.

They incorporate the following principal accounting policies, which are consistent with the
policies applied in previous years, except where otherwise stated

1.1 Taxation

Current and deferred tax are recognised as income or an expense and included in profit or
loss for the period, except when the tax relates to items that are recognised outside profit
or loss. Tax that relates to items that are recognised in other comprehensive income are
also recognised in other comprehensive income. Tax that relates to items that are
recognised directly in equity are also recognised directly in equity.

Deferred tax

Deferred tax is recognised for all temporary differences according to the statement of
financial position approach and based on tax rates that have been enacted or
substantively enacted by the reporting date. The measurement of deferred tax reflects the
tax consequences that would follow from the manner in which the company expects to
recover or settle the carrying amount of its assets and liabilities at the reporting date.

Temporary differences are differences between the carrying amounts of assets and
liabilities (used in the financial statements) and the corresponding tax bases used in the
calculation of taxable profit.

Deferred tax liabilities are recognised for all taxable temporary differences, unless the
deferred tax liability arises from

 the initial recognition of goodwill; or

 the initial recognition of an asset and liability in a transaction which
 is not a business combination; and
 at the time of the transaction, affects neither accounting profit nor taxable profit
(tax loss).

Deferred tax assets are recognised for all deductible temporary differences to the extent
that it is probable that taxable profit will be available against which the deductible
temporary difference can be utilised, unless the deferred tax asset arises on the initial
recognition of an asset and liability in a transaction which:

 is not a business combination; and

 at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).

A deferred tax asset is recognised for the carry forward of unused tax losses and unused
tax credits to the extent that it is probable that future taxable profit will be available against
which the unused tax losses and unused tax credits can be utilised.

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Current tax

Current tax payable is based on the taxable profit for the year, calculated in terms of the
Income Tax Act. Taxable profit differs from the profit for the period as reported in the
statement of profit or loss and other comprehensive income, as it excludes items of
income or expense that are taxable or deductible in a different period or that are never
taxable or deductible. The liability for current tax is calculated using tax rates that have
been enacted or substantively enacted by the reporting date.

2. Taxation

2.1 Income tax expense

R
Major components of tax expense
Current tax expense – current year (see calculation 5) 267 120
Deferred tax expense 566
– Movement in temporary differences (see calculation 3) 476
– Change in tax rate (see calculation 3) 90
267 686

2.2 Tax rate reconciliation R

Accounting profit 906 700
Tax at the standard rate of 28% (906 700 x 28%) 253 876
Exempt differences
Capital allowances on buildings (9 000 x 28%) 2 520
Donations (15 000 x 28%)(2) 4 200
Fines for environmental pollution (70 000 x 28%)(3) 19 600
Dividends received (45 000 x 28%) (12 600)
Adjustments to tax rate (see calculation 3) 90
Effective tax 267 686

OR

R
Accounting profit 906 700
%
Tax at the standard rate 28,00
Exempt differences
Capital allowances on building ((9 000/906 700) x 28% x 100) 0,28
Donations ((15 000/906 700) x 28% x 100)(2) 0,46
Fines for environmental pollution (3) ((70 000/906 700) x 28% x 100) 2,16
Dividends received ((45 000/906 700) x 28% x 100) (1,39)
Adjustments to tax rate (90/906 700 x 100) (4) 0,01
Effective tax rate (267 686/906 700 x 100) 29,52

The government enacted a change in the tax rate during 20.12 from 29% to 28%.

(1) Standard tax (should be 28% of profit before tax according to the matching principle).
(2) Donations – not tax deductible and should be added back.
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(3) Fines for environmental pollution – not tax deductible, should be added back.
(4) Adjustment to tax rate – the rate was reduced from 29% to 28%, therefore the
deferred tax asset in the statement of financial position is reduced (credited) and the
tax expense in the statement of profit or loss and other comprehensive income is
increased (debited).

3. Deferred tax

Analysis of temporary differences

R
Accelerated tax allowance for tax purposes (2 156)
[The difference between the carrying amount and the tax base of the
plant and machinery ((277 200 – 269 500) x 28%)]
Allowance for credit losses
[(140 000 – 125 000) x 28%] 4 200
Deferred tax asset 2 044

EXAMPLE 12

Fox Ltd was incorporated on 1 January 20.11. The profit before tax for the year ended
31 December 20.12 amounted to R410 000.

The following items are included in the calculation of profit before tax:
20.12
R
Depreciation
Plant and machinery 30 000

The South African Revenue Service allows the following deductions:

 Tax allowance on plant 120 000

Additional information

1. During December 20.12 rental amounting to R24 000 was received in respect of
January 20.13. The rental is taxable in the tax year ending 31 December 20.12.

2. The assessment for the 20.11 tax year showed an assessed loss of R160 000. This
agreed with the records of the company.

3. The company operates in a risky industrial sector and at this early stage of the
company's existence, there is no certainty of future taxable income against which tax
losses can be utilised.

4. For the 20.11 tax year temporary differences consisted of taxable temporary
differences on the plant amounting to R130 000, before taking into account the
assessed loss. The cost price of the plant was R300 000 and depreciation on the
plant amounted to R30 000 for 20.11.

5. Deferred tax is provided on all temporary differences using the statement of financial
position approach. The tax rate for both years is 28%.

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6. Assume that the residual value, useful life and depreciation method of all assets were
reviewed at each financial year end and that there were no changes.

REQUIRED

Prepare the income tax notes to the annual financial statements of Fox
Ltd for the year ended 31 December 20.12. Your answer must comply
with the requirements of International Financial Reporting Standards.
Comparative amounts are not required.

SOLUTION 12

a. Calculation of current tax expense

R
Profit before tax (given) 410 000
Movement in temporary differences (excluding tax loss) (196 000 – 130 000) (66 000)
Taxable income 344 000
Assessed tax loss utilised (160 000)
Taxable income 184 000
Current tax expense @ 28% 51 520

Calculation of deferred tax expense

Taxable/ Deferred
Carrying (deductible) tax
amount Tax temporary asset/
base differences (liability)
R R R R
31 December 20.11
Plant (1) 270 000 140 000 130 000 (36 400)
Assessed tax loss (2) – 160 000 (160 000) 36 400
– –
31 December 20.12
Plant (3) 240 000 20 000 220 000 (61 600)
Rental income received in
advance 24 000 – (24 000) 6 720
196 000 (54 880)

Deferred tax liability – 31 December 20.12 196 000 54 880

Deferred tax liability – 31 December 20.11 – –
Deferred tax movement (Dr to P/L) 196 000 54 880

(1) 300 000 – 30 000 = 270 000; 270 000 – 130 000 (given) = 140 000
(2) 160 000 x 28% = 44 800, but only R36 400 (max) can be recognised before a debit
balance is created. R8 400 (44 800 – 36 400) is therefore unprovided
(3) 270 000 – 30 000 = 240 000; 140 000 – 120 000 = 20 000

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LECTURER’S COMMENT

The assessed loss that only arose during 20.11 amounted to R160 000.
A deferred tax asset was recognised in respect of only R130 000
(R36 400/28 x 100) of the loss. The remaining R30 000 caused a
reconciling item in the tax rate reconciliation, as no deferred tax was
provided on it. This will also be the case when the loss is utilised to
reduce current tax in 20.12.

b. Disclosure – IAS 12

FOX LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.12

1. Income tax expense

R
Major components of tax expense
Current tax expense – current year 51 520
Deferred tax expense – movement in temporary differences 54 880
106 400

Tax rate reconciliation R OR %

Standard tax (applicable tax) (410 000 x 28%) 114 800 28,00
Utilisation of unrecognised portion of tax loss (8 400) (2,04)
(44 800 – 36 400); (44 800 – 36 400)/410 000 x 100)
Effective tax (106 400/410 000 x 100) 106 400 25,96

2. Deferred tax 20.12

R
Analysis of temporary differences:
Accelerated tax allowance (a) 61 600
Rental income received in advance (a) (6 720)
Deferred tax liability 54 880

1.9 PROVISIONAL TAX

Provisional taxpayers are required to make and may volunteer advance payments, known
as provisional tax payments, on account of their estimated liability for normal tax for a
particular year of assessment. All companies are provisional taxpayers.

All provisional taxpayers are obliged to make two obligatory estimates of taxable income
for each year of assessment. The first of these estimates must be made on or before the
last day of the sixth month of the year of assessment, while the second estimate must be
made on or before the last day of the year of assessment.

It is on the basis of these estimates that compulsory payments of provisional tax will be
made.

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The following journal entry will be made in the company's accounting records on payment
of provisional tax:
Dr Cr
R R
SA Revenue Service (SFP) xxx
Bank xxx
Recording of provisional tax payment.

1.10 THE FORMAL TAX ASSESSMENT AND THE RESULTING

OVER/UNDER PROVISION OF CURRENT TAX

After the company has finalised its financial statements and its estimate of its current tax
charge for the year, this estimate is submitted to the SA Revenue Service. The
SA Revenue Service assesses the estimate made by the company and send a copy of this
assessment back to the company.

The assessment shows the tax charge for the whole year according to the tax authority,
minus the provisional payments made by the company, leaving a balance owing to, or by
the tax authority.

Generally, the current tax that is estimated by the company should equal the actual current
tax per the assessment. In some cases, however, the tax authority may not allow the
deduction of certain of the expenses claimed, for example. In an instance like this, it will
mean that the current income tax charged per the assessment will be greater than the
estimate of the current income tax that has been recognised in the company's financial
statements.

Since the company receives the assessment after the financial statements have been
finalised, the adjustment relating to the tax expense of the previous year has to be
processed in the current financial year. The adjustment appears as an under-provision or
over-provision of tax in the statement of profit or loss and other comprehensive income.
This adjustment is calculated as follows:
R
Tax charge per the assessment for year 20.11 (received in year 20.12) xxx
Less current tax estimated for 20.11 and processed in 20.11 statement of (xxx)
profit or loss and other comprehensive income

Under/(over)-provision in 20.11, journalised in 20.12 statement of profit or loss

and other comprehensive income xxx

The journal entry for an underprovision is as follows:

Dr Current tax expense (P/L)

Cr Current tax payable (SA Revenue Service) (SFP)
The underprovision of tax in year 1 is adjusted in year 2.

The journal entry for an overprovision is as follows:

Dr Current tax payable (SA Revenue Service) (SFP)

Cr Current tax expense (P/L)
The overprovision of tax in year 1 is adjusted in year 2.

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EXAMPLE 13

The following is the abridged trial balance of Winny Ltd at 31 July 20.12:

Dr Cr
R R
Share capital – 13 000
Retained earnings – 31 July 20.11 – 160 450
Long-term borrowing – 550 000
Deferred tax liability – 31 July 20.11 – 42 042
Land at cost (it is not depreciated) 70 000 –
Factory building at cost 600 000 –
Plant at cost 250 000 –
Accumulated depreciation – factory building – 180 000
Accumulated depreciation – plant – 70 000
Investments at fair value 65 000 –
Prepayments (balance at 31 July 20.11 – Rnil) 30 000 –
Accounts receivable 110 000 –
Bank 137 492 –
Accounts payable – 50 000
Profit before tax – 227 000
SA Revenue Service – provisional tax payments 30 000 –
1 292 492 1 292 492

Additional information

1. The trial balance has not been finalised since the tax computation for the year is still
outstanding.

2. Included in profit before tax are dividends received of R10 000, fines paid of R2 500
and the total depreciation charge for the year of R85 000.

3. The tax base of the property, plant and equipment at 31 July 20.12 is as follows:

R
Land – no allowance is claimable -
Factory building – tax allowance of 20% p.a. straight-line 240 000
Plant – tax allowance of 16,7% p.a. straight-line 133 100
373 100

The total tax allowances claimable on property, plant and equipment for the year
ended 31 July 20.12 are R161 750.

4. The company provides for deferred tax on all temporary differences using the
statement of financial position approach. There are no other temporary differences
except for those mentioned in the question. The deferred tax balance at
31 July 20.11 arose as a result of taxable temporary differences of R150 150 which
relate to accelerated capital allowances for tax purposes.

5. The tax rate remained at 28% for the past two years.

6. The long-term borrowing is a mortgage loan financing the land and factory building.
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7. There is no assessed tax loss to be carried forward from previous years.

8. The company made the following provisional tax payments:

31 January 20.12 R15 000
31 July 20.12 R15 000

9. On 31 October 20.11 the company received the tax assessment for the 20.11 tax
year and paid R5 500 in respect of current tax due for the year ended 31 July 20.11.

REQUIRED

PART A

Disclose income tax in the notes to the annual financial statements of

Winny Ltd for the year ended 31 July 20.12 in accordance with the
requirements of International Financial Reporting Standards. Accounting
policy notes are not required.

Please note:
The movement in temporary differences in the current tax calculation
must be calculated using the statement of financial position method.

All calculations must be done to the nearest R1.

PART B

Prepare the general ledger accounts in respect of tax in the general

ledger of Winny Ltd for the year ended 31 July 20.12.

HOW SHOULD YOU ATTEMPT THIS QUESTION?

1. Read the "REQUIRED" section. Only tax information for the general ledger accounts
and "notes to the financial statements" is required. As soon as you are familiar with
what is required, you can start by calculating the amounts to be disclosed.
2. Use the information in the question calculate the deferred tax balance for the current
year.
3. Calculate the carrying amounts of all assets and liabilities evident from the information.
4. For each asset and liability identified, determine the relevant tax base.
5. Thereafter calculate the temporary differences by taking into account the carrying
amount and tax base of each asset and liability.
6. For each temporary difference, determine whether the difference results in a deferred
tax asset or a liability.
7. Each temporary difference must then be multiplied with the tax rate.
8. The net deferred tax liability or asset for the current year should then be determined.
9. As soon as the deferred tax liability or asset has been determined for the current year,
the deferred tax movement (movement in temporary differences) in the statement of
profit or loss and other comprehensive income can be calculated as the difference
between the opening and closing balance of the deferred tax liability or asset.
10. Disclose tax in the notes to the financial statements according to IAS 12 – Income
taxes.
11. Prepare the relevant general ledger accounts.

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SOLUTION 13
PART A
WINNY LTD
NOTES FOR THE YEAR ENDED 31 JULY 20.12
1. Income tax expense
Major components of tax expense R
Current tax expense: current year (2) 31 570
Deferred tax expense: movement in temporary differences (1) or 29 890
(106 750 (2) x 28%)
61 460
Tax rate reconciliation
R OR %
Standard rate of tax (227 000 x 28%) 63 560 28,0
Adjusted for exempt differences:
Dividends received (10 000 x 28%);
[(10 000 / 227 000) x 28% x 100] (2 800) (1,23)
Fines (2 500 x 28%); [(2 500 / 227 000) x 28% x 100] 700 0,31
Effective rate of tax (61 460 / 227 000 x 100) 61 460 27,08
2. Deferred tax
Analysis of temporary differences
R
Accelerated capital allowances for tax purposes (50 400 + 13 132) 63 532
Prepayment 8 400
Deferred tax liability (1) 71 932

Calculations
1. Deferred tax balance
Taxable/ Deferred
(deductible) tax asset/
Carrying Tax temporary (liability)
amount base differences @ 28%
R R R R
Factory building 420 0001 240 000 180 000 (50 400)
Carrying amount of asset > tax
base of asset therefore
deferred tax liability @ 28%
Plant 180 0002 133 100 46 900 (13 132)
Carrying amount of asset > tax
base of asset therefore
deferred tax liability @ 28%
Prepayment 30 000 – 30 000 (8 400)
Carrying amount of asset > tax
base of asset therefore
deferred tax liability @ 28%
Total deferred tax liability 256 900 (71 932)

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1 600 000 – 180 000

2 250 000 – 70 000

Deferred tax movement – current year

Taxable/ Deferred
(deductible) tax
temporary liability
differences @ 28%
R R
Deferred tax liability at 1 August 20.11 (given) (150 150) 42 042
Movement in temporary differences – current year (106 750) 29 890
(balancing figure) (debit to P/L)
Deferred tax liability at 31 July 20.12 (256 900) 71 932

2. Taxable income for the year

R
Profit before tax 227 000
Exempt differences (7 500)
Dividends received (10 000)
Fines paid 2 500
Profit after exempt differences 219 500
Movement in temporary differences (1) (106 750)

Taxable income for the year 112 750

Current tax expense at 28% 31 570

The movement in temporary differences consist of:

R
Depreciation 85 000
Tax allowance (161 750)
Prepayments – deductible for tax purposes (30 000)
(106 750)

LECTURER’S COMMENT

MOVEMENT IN TEMPORARY DIFFERENCES

A taxable temporary difference will only be taxable in future and will

result in a tax liability payable to the SARS in future. In the current year,
this taxable temporary difference is not taxable and must be deducted
from the taxable profit.

A deductible temporary difference will only be deductible in future and

will result in a tax saving in future. In the current year, this deductible
temporary difference is not deductible and must be added to the taxable
profit.

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PART B

Dr Current tax expense (P/L) Cr

31/7/20.12 SA Revenue Service 31/7/20.12 Statement of profit or
(SFP) 31 570 loss and other com-
prehensive income 31 570

Dr Deferred tax expense (P/L) Cr

31/7/20.12 Deferred tax (SFP) 29 890 31/7/20.12 Statement of profit or
loss and other com-
prehensive income 29 890

Dr SA Revenue Service – current tax (SFP) Cr

31/10/20.11 Bank (20.11 1/8/20.11 Opening
tax year) 5 500 balance b/d 5 500
31/1/20.12 Bank (20.12 31/7/20.12 Current tax
tax year) 15 000 expense
31/7/20.12 Bank (20.12 (20.12
tax year) 15 000 year)(P/L) 31 570
31/7/20.12 Closing
balance c/d 1 570
37 070 37 070
1/8/20.12 Opening
balance b/d 1 570

Dr Deferred tax (SFP) Cr

31/7/20.12 Closing 1/8/20.11 Opening balance b/d 42 042
balance c/d 71 932 31/7/20.12 Deferred tax
expense (P/L) 29 890
71 932 71 932
1/8/20.12 Opening balance b/d 71 932

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EXAMPLE 14
The following is an extract from the statement of financial position general ledger accounts
of Rigoletto Ltd, a manufacturer of bicycles, for the year ended 29 February 20.12:

Dr SA Revenue Service – current tax Cr

31/8/20.11 Bank (for 20.12 1/3/20.11 Opening b/d 7 600
tax year) 18 000 balance
30/9/20.11 Bank (for 15/8/20.11 Current tax
20.11 tax year) 16 000 expense (20.11
29/2/20.12 Bank (for 20.12 tax adjustment) 8 120
tax year) 18 000 29/2/20.12 Current tax
29/2/20.12 Closing balance c/d 3 620 expense (for
20.12 tax year) 39 900
55 620 55 620
1/3/20.12 Opening
balance b/d 3 620

Dr UK Inland Revenue Service Cr

29/2/20.12 Closing balance c/d 21 000 29/2/20.12 Tax expense 21 000
(for 20.12 tax
year)
21 000 21 000
1/3/20.12 Opening
balance b/d 21 000

Dr Deferred tax Cr
1/3/20.11 Deferred tax 1/3/20.11 Opening b/d 43 500
expense balance
(rate 29/2/20.12 Deferred tax
adjustment) 1 500 expense (for
20.12 tax year) 8 400
29/2/20.12 Closing
balance c/d 50 400
51 900 51 900
1/3/20.12 Opening
balance b/d 50 400

Additional information

1. The SA normal tax rate changed from 29% in 20.11 to 28% in 20.12
2. The deferred tax balance account comprised of a taxable temporary differences
relating to an accelerated tax allowance on plant and machinery. Deferred tax is
provided for on all temporary differences using the statement of financial position
approach.
3. The adjustment in respect of the 20.11 current tax expense relates to the 20.11 tax
assessment received on 15 August 20.11. Rigoletto Ltd claimed expenses of R28 000
which were not allowed as a deduction by the SA Revenue Service.
4. The profit before tax for the year ended 29 February 20.12 amounted to R325 000.
Included in profit before tax are the following items:

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R
Donations paid 5 500
Dividends received – unlisted investment 20 000
Fines paid on late payment of PAYE 2 000
Income received from the United Kingdom (UK) 140 000

5. The income received from the UK is not taxable in South Africa in terms of a double
taxation agreement.
6. You can assume that the calculations of current tax and deferred tax in the above
general ledger accounts are correct.

REQUIRED

Disclose tax in the notes to the annual financial statements of Rigoletto

Ltd for the year ended 29 February 20.12 according to the requirements
of IAS 12 – Income taxes. The tax rate reconciliation must be given using
R - values only.
No calculations of current tax and deferred tax are required.

No accounting policy notes are required.

No other notes are required.

Comparatives are not required.

SOLUTION 14

RIGOLETTO LTD

NOTES FOR THE YEAR ENDED 28 FEBRUARY 20.12

1. Income tax expense

Major components of tax expense

R
Current tax expense 48 020
– current year 39 900
– underprovision prior year 8 120
Deferred tax expense 6 900
– movement in temporary differences 8 400
– rate change (1 500)
Foreign tax 21 000
75 920

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Tax rate reconciliation

R
Standard rate of tax (325 000 x 28%) 91 000
Adjusted for exempt differences:
Fines (2 000 x 28%) 560
Foreign income ((140 000 x 28%) – 21 000) (18 200)
Donations (5 500 x 28%) 1 540
Dividends received (20 000 x 28%) (5 600)
Tax rate change (1 500)
Underprovision prior year 8 120
75 920

2. Deferred tax
Analysis of temporary difference:
R
Accelerated tax allowance on plant and machinery 50 400

1.11 CAPITAL GAINS TAX ON COMPANIES

General

Capital gains tax (part of current tax) is payable on capital gains realised on assets sold
after 1 October 2001. For assets acquired before 1 October 2001, only the part of the gain
arising after 1 October 2001 will be subject to capital gains tax. If the portion after
1 October 2001 is a loss, it may be set off against other capital gains during that financial
year. If the sum of all the capital gains and capital losses for the financial year results in a
capital gain, 80% thereof must be included in the company's taxable income and subjected
to tax at a rate of 28%. The effect is thus an effective tax of 22,4%. If the sum of all capital
gains and capital losses for the financial year results in a capital loss, that loss must be
carried forward to the following year of assessment.

From 1 October 2001 50% of the capital gain arising on the sale of an asset is subject to
capital gains tax at the normal tax rate (currently 28%). The capital gains inclusion rate
increased to 66,6% from 1 March 2012 and to 80% from 1 March 2016.
Framework for capital gains tax
Add all the individual capital gains and losses
together for current year

Deduct

Assessed capital loss brought forward from

previous year to arrive at net capital gain or
loss for current year

PROFIT LOSS

Apply inclusion rate – (80% for Carry forward loss to next year’s CGT
legal person e.g. companies) calculation

TAXABLE CAPITAL GAIN TO BE INCLUDED

IN TAX RETURN

The capital gain is calculated as the difference between the proceeds on disposal of an
asset and the asset's "base cost".
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The base cost of the asset acquired before 1 October 2001 can be calculated by any of
the following methods:

 the market value of the asset on 1 October 2001;

 20% of the proceeds received; and
 a time-based apportionment basis (the total gain is apportioned over the period the
asset was held before and after 1 October 2001).

The base cost of an asset acquired after 1 October 2001 should be determined as follows:

Inclusions

 Cost of acquisition
 Cost of moving an asset and improvement cost
 Cost incurred directly in the acquisition or disposal of an asset, such as legal fees,
agents' commission, broker's fees, stamp duty, transfer duty, advertising and valuation
costs
 Vat paid and not claimed as an input
 Costs of maintaining rights to an asset, such as legal costs

Exclusions

 Holding costs such as interest, repairs and insurance premiums

 All recoverable expenses and expenses deductible for income tax purposes
 Adjustment for inflation

The following steps are followed when capital gains tax is calculated:

 Add all the individual capital gains and losses together for the current year.
 Deduct any assessed capital loss brought forward from previous years to arrive at the
net capital gain (increased loss) for the year.
 Multiply the net capital gain with 80% (rate for companies) to arrive at the taxable
capital gain to be included in other taxable income in the current tax calculation for the
year.
Please note: For exam purposes the capital gains tax inclusion rate of 80% will be used.

EXAMPLE 15

The purpose of this example is not to give a detailed explanation of the determination of
capital gains/(losses) for tax purposes (including the calculation of the base cost), but to
show the accounting treatment and disclosure of these capital gains.

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Fashion Ltd, incorporated on 1 March 20.10, is a manufacturer of quality costume

jewellery. The jewellery is distributed through a network of independent consultants
throughout South Africa.

The following is an extract of the trial balance of Fashion Ltd for the years ended
28 February 20.11 and 29 February 20.12
Dr/(Cr) Dr/(Cr)
20.12 20.11
R R
Profit before tax (400 000) (550 000)
Machinery at cost 300 000 250 000
Accumulated depreciation – machinery (37 500) (37 500)

Machinery in the above extract of the trial balance includes only machine X which was
replaced by machine Y. On 31 August 20.11, the old machine, machine X, was withdrawn
from the manufacturing process and was sold for R270 000. The carrying amount and tax
base of machine X at the date of the sale amounted to R193 750 and R150 000
respectively. On 1 September 20.11, the new machine, machine Y, with a cost price of
R300 000, was brought into use. Depreciation on machine X is written off at 15% per
annum according to the straight-line method. The directors decided to depreciate the
newly acquired machine Y over four years according to the straight-line method. Included
in profit before tax is depreciation on these machines amounting to R56 250 (20.11:
R37 500), as well as the profit on the disposal of machine X.

The SA Revenue Service allows a tax allowance of 20% p.a. according to the straight-line
method on machinery. The tax allowance is not apportioned on a pro rata basis for periods
shorter than a year.

Deferred tax is provided on all temporary differences using the statement of financial
position approach. There are no other temporary differences except those mentioned in
the question. There is certainty beyond reasonable doubt that there will be sufficient
taxable profit in future to utilise tax losses.

The normal tax rate remained unchanged at 28% for the past two years. All capital gains
are taxable at 80%.

REQUIRED

(a) Calculate the deferred tax balance in the statement of financial

position of Fashion Ltd for both the years ended 28 February 20.11
and 29 February 20.12, using the statement of financial position
approach, and indicate whether it is an asset or a liability.

(b) Calculate the current tax expense of Fashion Ltd for the years ended
28 February 20.11 and 29 February 20.12.

Please note:
The movement in temporary differences in the current tax calculation
must be calculated using the statement of financial position
method.

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SOLUTION 15
Calculations

a. Deferred tax balance for the year ended 28 February 20.11

Taxable/ Deferred
(deductible) tax asset/
Carrying temporary (liability)
amount Tax base difference @ 28%
R R R R
Machine X 212 5001 200 0002 12 500 (3 500)
Deferred tax liability 12 500 (3 500)

1 250 000 – 37 500

2 250 000 – (250 000 x 20%)

Deferred tax balance for the year ended 29 February 20.12

Taxable/ Deferred
(deductible) tax asset/
Carrying temporary (liability)
amount Tax base difference @ 28%
R R R R
Machine Y 262 5001 240 0002 22 500 (6 300)
Deferred tax liability 22 500 (6 300)

1 300 000 – 37 500 (given)

2 300 000 – (300 000 x 20%)
Taxable/ Deferred
(deductible) tax
temporary (liability)
differences @ 28%
Deferred tax movement – current year R R
Deferred tax liability at 1 March 20.11 12 500 (3 500)
Movement in temporary differences – current year (balancing 10 000 (2 800)
figure) debit to the P/L
Deferred tax liability at 29 February 20.12 22 500 (6 300)

LECTURER’S COMMENT

If the selling price (SP) (proceeds on sale) is higher than the original
cost price (CP) of the asset sold, then
 the difference between the SP and the CP is a capital profit, of which
80% is taxable in the case of companies and which results in an
exempt difference; and
 the difference between the CP and the carrying amount (CA) is a
profit on sale, which results in a temporary difference.

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b. Current tax expense

20.12 20.11
R R
Profit before tax (given) 400 000 550 000
Exempt differences:
Capital profit on sale of asset (100% – 80%) x
(270 000 – 250 000) (4 000) –
396 000 550 000
Movement in temporary differences (a) (10 000) (12 500)
Taxable income 386 000 537 500
Current tax expense @ 28% 108 080 150 500

The movement in temporary differences consists of:

20.12 20.11
R R
Depreciation (given) 56 250 37 500
Tax allowance (110 000) (50 000)
[(250 000 x 20%) + (300 000 x 20%)]; (250 000 x 20%)
Profit on disposal (250 000 – 193 750) (56 250) –
Recoupment of tax allowance (250 000 – 150 000) 100 000 –
(10 000) (12 500)

LECTURER’S COMMENT

MOVEMENT IN TEMPORARY DIFFERENCES

A taxable temporary difference will only be taxable in future and will

result in a tax liability payable to the SARS in future. In the current year,
this taxable temporary difference is not taxable and must be deducted
from the taxable profit.

A deductible temporary difference will only be deductible in future and

will result in a tax saving in future. In the current year, this deductible
temporary difference is not deductible and must be added to the taxable
profit.

1.12 DIVIDENDS TAX (Withholding tax on dividends)

OVERVIEW

Dividends tax replaced secondary tax on companies on 1 April 2012. Dividends tax is
applicable to any dividend declared on or after 1 April 2012. The relevant legislation has
been developed and passed in to the Income Tax Act (refer to sections 64D to 64N of the
Income Tax Act No. 58 of 1962). Dividends tax is a tax on the beneficial owners of
dividends (normally this will be the shareholder) on the amount of any dividend received
from a company. A dividend is defined in section 1 of the Act, but in essence is any
payment by a company for the benefit of a shareholder in respect of a share in that
company (excluding the return of contributed tax capital, i.e. consideration received by a
company for the issue of shares). Dividends are usually given as cash (cash dividend), but
they can also take the form of an asset or other property (in specie dividend). The
dividends tax is a withholding tax and should be withheld from dividend distributions and
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paid to SARS by the company paying the dividend or, where the company makes use of a
withholding agent, by the latter.

1.12.1 Tax liability

As a general principal, the liability for dividends tax triggered by payment falls on the
recipient (i.e. the beneficial owner) of the dividend, and is withheld from the dividend
payment by either the company distributing or, where relevant, certain withholding agents.
A beneficial owner is a person who is entitled to receive a dividend attaching to a share. In
most cases, this person is also the shareholder.
The current dividend tax is 20% effective from 22 February 2017 in respect of dividends
distributed by:
 South African resident companies; and
 non-resident companies in respect of shares listed on the JSE Limited.

Prior to 22 February 2017 the dividend tax rate was 15% in respect of dividends distributed
by:
 South African resident companies; and
 non-resident companies in respect of shares listed on the JSE Limited.

The dividends tax has to be paid by the end of the month following the month in which the
dividend was paid or became payable to the beneficial owner(s).
 Cash dividend – the beneficial owner is liable for paying dividend tax, but the company
withholds the tax and pays over the amount to the SA Revenue Service on behalf of
the beneficial owner.
 In specie dividend – the company declaring and paying the dividend must pay the
dividend tax and not the beneficial owner.

1.12.2 Accounting treatment

EXAMPLE 16
On 28 February 2017, Money Ltd declared and paid a dividend of R1 000 to Mr Own, its
only shareholder, for the financial year ended 31 March 2017. The dividend tax was paid
by Money Ltd on 10 April 2017 to the SA Revenue Service (SARS).
R
Dividend paid in cash 1 000
Amount paid to shareholder as a dividend 800
Dividends tax payable by company -
Dividends tax payable by Mr Own (shareholder) 200

Dividend tax rate 20%

The following journal entries are applicable to Money Ltd:

Dr Cr
R R
28 February 2017 Dividends paid (equity) 1 000
Bank (SFP) 800
SARS – dividends tax payable (SFP) 200
Dividend paid and dividend tax withheld on cash
dividend paid.

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10 April 2017 SARS – dividends tax payable (SFP) 200

Bank (SFP) 200
Recording of dividends tax paid.

Please note: For exam purposes the dividend tax rate of 20% will be used.

1.12.3 Dividends tax – exemptions

A company will be exempt from dividends tax if the beneficial owners are any of the
following:
 South African resident companies
 Government, provincial administration or municipality organisations
 Public benefit organisations (approved ito section 30(3) of the Act)
 Mining rehabilitation trusts (section 37A of the Act)
 Persons referred to in section 10(1)(cA) of the Act
 Section 10(1)(d) funds (such as a pension fund, provident fund, RA or medical
scheme)
 Persons referred to in section 10(1)(t) (such as the CSIR and SANRAL)
 Shareholders in a registered micro business (Schedule 6)(in so far as the dividend
does not exceed R200 000 per year)
 Non-residents where the dividend is received from a foreign company listed on the
JSE Limited (such as a dual listed company)

1.13 FRG 1 – SUBSTANTIVELY ENACTED TAX RATES AND TAX LAWS

1. Background

The minister of finance may announce changes in tax rates and tax laws during the
annual budget statement. In terms of paragraphs .46 and .47 of IAS 12, both
current and deferred tax assets and liabilities are to be measured using the tax
rates and tax laws that have been enacted or substantively enacted by the end of
the reporting period.

2. Issue

When should changes in tax rates and tax laws that are announced by the minister
of finance during the annual budget statement be regarded as substantively
enacted?

3. Consensus

 Changes in tax rates should be regarded as substantively enacted from the time
that they are announced in the minister of finance's budget statement. However,
this only applies to scenarios in which the change in tax rates is not inextricably
linked to other changes in the tax laws. To be regarded as substantively enacted
there should be the required degree of certainty that the announced changes would
be promulgated in a substantially unchanged manner.
 When changes in the tax rates are inextricably linked to other changes in the tax
laws, they should be regarded as being substantively enacted when they have been
approved by parliament and signed by the president.
 Changes in tax laws other than those covered in the above-mentioned paragraphs
should be regarded as being substantively enacted when they have been approved
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by parliament and signed by the president.

 The changes in tax rates and tax laws should be applied to the period to which they
relate. For example, a change in tax rates could be announced during a tax year as
being applicable to the following year, in which case the current tax balances in the
statement of financial position would be based on the previous tax rate, whereas the
deferred tax balance in the statement of financial position would be based on the
new tax rate.

LECTURER’S COMMENT

Work through the illustrative examples and disclosure guidance with

specific reference to IE4–IE6 of FRG 1.

ASSESSMENT CRITERIA
Are you now able to do the following?

 Calculate the current tax expense of a company.

 Explain the difference between exempt and temporary differences.

 Calculate deferred tax of a company using the statement of financial

position approach.

 Disclose deferred and current tax properly in the annual financial

statements of companies in accordance with International Financial
Reporting Standards.

 Calculate and disclose dividends tax in the accounting records of a

company.

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FAC3701

LEARNING UNIT 2
ACCOUNTING POLICIES,
CHANGES IN ACCOUNTING
ESTIMATES AND ERRORS
(IAS 8)

General Financial Reporting

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LEARNING OUTCOMES

Learners should be able to calculate, select and disclose the effects of accounting policies,
changes in accounting estimates and errors in accordance with the requirements of
International Financial Reporting Standards.

OVERVIEW

This learning unit is divided into the following:

2.1 Definitions
2.2 Accounting policies
2.2.1 Selection and application of accounting policies
2.2.2 Changes in accounting policies
2.2.3 Disclosure
2.3 Changes in accounting estimates
2.3.1 Accounting treatment of a change in accounting estimates
2.3.2 Disclosure
2.4 Errors
2.4.1 Prior period errors
2.4.2 Retrospective correction of errors
2.4.3 Disclosure
2.5 Summary of changes in accounting policies, changes in accounting estimates and
errors

STUDY

PRESCRIBED
Descriptive Accounting
The chapter relevant to IAS 8 – Accounting policies, Changes in accounting estimates and
errors

RECOMMENDED
IFRS Standards – The Annotated IFRS Standards
IAS 8 – Accounting policies, Changes in accounting estimates and errors

OVERVIEW OF THE LEARNING UNIT

The objective of this learning unit is to prescribe the criteria for selecting and changing
accounting policies, together with the accounting treatment and disclosures of changes in
accounting policies, changes in accounting estimates and corrections of errors. IAS 8 is
intended to enhance the relevance and reliability of an entity’s financial statements, and
the comparability of those financial statements over time and with the financial statements
of other entities.

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2.1 DEFINITIONS

The following are terms used in IAS 8.5 and their definitions:

Accounting policies are the specific principles, bases, conventions, rules and practices
applied by an entity in preparing and presenting financial statements.

A change in accounting estimate is an adjustment of the carrying amount of an asset or

a liability, or the amount of the periodic consumption of an asset, which results from the
assessment of the present status of, and expected future benefits and obligations
associated with, assets and liabilities. Changes in accounting estimates result from new
information or new developments and accordingly are not corrections of errors.

Material omissions or misstatements of items are material if they could, individually or

collectively, influence the economic decisions of users taken on the basis of the financial
statements. Materiality depends on the size and nature of the omission or misstatement
judged in the surrounding circumstances. The size or nature of the item, or a combination
of both, could be the determining factor.

Prior period errors are omissions from and misstatements in the entity's financial
statements for one or more prior periods arising from a failure to use or misuse of reliable
information that

(a) was available when financial statements for those periods were authorised for issue;
and
(b) could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of those financial statements.

Retrospective application is applying a new accounting policy to transactions, other

events and conditions as if that policy has always been applied.

Retrospective restatement is correcting the recognition, measurement and disclosure of

amounts of elements of financial statements as if a prior period error has never occurred.

Prospective application of a change in accounting policy and of recognising the effect of

a change in an accounting estimate, respectively, includes

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

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2.2 ACCOUNTING POLICIES

2.2.1 Selection and application of accounting policies

When a statement or an interpretation specifically applies to a transaction, another event

or a condition, the accounting policy or policies applied to that item must be determined by
applying the statement or interpretation and considering any relevant Implementation
Guidance issued by the International Accounting Standards Board for the statement or
interpretation.

In the absence of a statement, management must use its judgement in developing and
applying an accounting policy that results in information that is

 relevant to the economic decision-making needs of users; and

 reliable, in that the financial statements
- represent faithfully the financial position, financial performance and cash flows of
the entity;
- reflect the economic substance of transactions, other events and conditions, and
not merely the legal form;
- are neutral, that is free from bias;
- are prudent; and
- are complete in all material respects (IAS 8.10).

The accounting policies must be consistently applied for similar transactions, other events
and conditions, unless a statement or interpretation requires categorisation of items for
which different policies may be appropriate (IAS 8.13).

The accounting policies should be stated clearly, fairly and briefly by way of a note to the
annual financial statements, with the heading "Accounting policies". This note is the first
note to the annual financial statements.

2.2.2 Changes in accounting policies

A change in accounting policy should only be made if

 required by a statement or an interpretation; or

 it results in the financial statements providing reliable and more relevant information
about the effects of transactions, other events or conditions on the entity's financial
position, financial performance or cash flows (IAS 8.14).

(a) Change in accounting policy due to initial adoption of statement or

interpretation

If the change in accounting policy is required due to the initial application of a statement or
interpretation, the change should be accounted for in accordance with the transitional
provisions of that statement or interpretation. If no transitional provisions are supplied, the
change should be accounted for retrospectively (IAS 8.19)(a) and (b).

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(b) Voluntary change in accounting policy

If the change in accounting policy is made to reflect more relevant and reliable information
(a voluntary change in accounting policy), the change should be accounted for
retrospectively (IAS 8.19b).

(c) Retrospective application

When a change in accounting policy is applied retrospectively, the entity adjusts the
opening balance of each affected component of equity for the earliest prior period
presented and the other comparative amounts disclosed for each prior period presented
as if the new accounting policy has always been applied (IAS 8.22).

(d) Prospective application

When it is impracticable to determine the cumulative effect at the beginning of the current
period for all prior periods, the entity must adjust the comparative information to apply the
new accounting policy prospectively from the earliest date practicable (IAS 8.25).

2.2.3. Disclosure

(a) Application of IAS 1

The revised IAS 1.40A has introduced a requirement to include a third statement of
financial position as at the beginning of the preceding period whenever an entity

 retrospectively applies an accounting policy;

 makes a retrospective restatement of items in its financial statements;
 reclassifies items in its financial statements; and
 such adjustments have a material effect on the information in the statement of financial
position at the beginning of the preceding period.

In the above circumstances, an entity is required to present a minimum of three

statements of financial position, together with the related notes. A statement of financial
position must be prepared as at

 the end of the current period;

 the end of the preceding period; and
 the beginning of the preceding period (IAS1.40B).

(b) Initial application of a statement or interpretation

The following should be disclosed if an initial application of a statement or interpretation

has an effect on the current period or any prior period presented, or may an effect on
future periods:

 the title of the statement or interpretation;

 when applicable, that the change in accounting policy is made in accordance with its
transitional provisions;
 the nature of the change in accounting policy;

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 when applicable, a description of the transitional provisions;

 when applicable, the transitional provisions that might have an effect on future periods;
 for the current period and each prior period presented, to the extent practicable, the
amount of the adjustment for each financial statement line item affected and for basic
and diluted earnings per share, if presented as per IAS 33;
 the amount of the adjustment relating to periods before those presented, to the extent
practicable; and
 if retrospective application is impracticable for a particular prior period, or for periods
before those presented, the circumstances that led to the existence of that condition
and a description of how and from when the change in accounting policy has been
applied (IAS 8.28).

Financial statements of subsequent periods need not repeat these disclosures.

(c) Voluntary change

The following should be disclosed if a voluntary change has an effect on the current period
or any prior period presented, or may have an effect on future periods:

 the nature of the change in accounting policy;

 the reasons why applying the new accounting policy provides reliable and more relevant
information;
 for the current period and each prior period presented, to the extent practicable, the
amount of the adjustment for each financial statement line item affected and for basic
and diluted earnings per share, if presented as per IAS 33;
 the amount of the adjustment relating to periods before those presented, to the extent
practicable; and
 if retrospective application is impracticable for a particular prior period, or for periods
before those presented, the circumstances that led to the existence of that condition
and a description of how and from when the change in accounting policy has been
applied (IAS 8.29).

Financial statements of subsequent periods need not repeat these disclosures.

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Examples 1 and 2 are both examples of changes in accounting policy applied

retrospectively.

EXAMPLE 1

The following information is an extract from the books of Elegance Ltd at

30 September 20.12. The company is involved in the manufacturing and selling of furniture
and curtains.
20.12 20.11
Dr/(Cr) Dr/(Cr)
R R
Sales of furniture (452 000) (300 000)
Sales of curtains (145 000) (65 000)
Cost of sales 225 580 221 000
Interest received on staff loans (4 800) -
Retained earnings at beginning of year (223 350) (150 000)
Loss on sale of machinery 3 000 -
(Tax loss of machinery: R3 000)
Advertising expenses 24 000 15 000
Bad debts written back (6 200) -
(SA Revenue Service: R6 200)
Loss as a result of the expropriation of land 37 880 -
(Not deductible for tax purposes)
Current tax expense 99 518 36 120
Dividends paid 25 000 10 500

Additional information

1. Assume that the calculation of the current tax expense is correct.

2. After the afore-mentioned information had been obtained from the books of the
company, the directors of the company decided to change the accounting policy with
respect to the valuation of inventory. Elegance Ltd previously accounted for its
inventory on the last-in, first-out (LIFO) method, but it has changed its policy of
accounting for inventory to the first-in, first-out (FIFO) method in order to comply with
the requirements of the accounting statement that disallows the use of the LIFO
method of inventory valuation.

The value of inventory based on the two methods was as follows:

At 30 September 20.09 20.10 20.11 20.12

R R R R
LIFO 45 000 62 500 32 000 26 000
FIFO 48 500 67 000 37 500 33 700

3. Assume that all amounts are material and that the tax rate has remained unchanged at
28%. The SA Revenue Service will not reopen the previous years' tax
assessments, but the new policy will be accepted for tax purposes.

4. The implications of capital gains tax and dividends tax should be ignored.

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REQUIRED

Prepare the statement of profit or loss and other comprehensive income

(expenses by function), the statement of changes in equity (only retained
earnings section) and notes thereto of Elegance Ltd for the year ended
30 September 20.12 in accordance with International Financial Reporting
Standards.

SOLUTION 1
ELEGANCE LTD

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR

THE YEAR ENDED 30 SEPTEMBER 20.12

Notes 20.12 20.11

R R
Revenue 597 0001 365 0001
Cost of sales (223 380)2 (220 000)2
Gross profit 373 620 145 000
Other expenses (58 680)3 (15 000)
Other investment income 4 800 –
Profit before tax (1) 2 319 740 130 000
Income tax expense 3 (100 134) (36 400)
PROFIT FOR THE YEAR 219 606 93 600
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 219 606 93 600

1 (452 000 + 145 000); (300 000 + 65 000)

2 (225 580 – 2 200(2)); (221 000 – 1 000(2))
3 (24 000 – 6 200 + 3 000 + 37 880)

ELEGANCE LTD

STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 30 SEPTEMBER 20.12

Retained
Note earnings
R
Balance at 1 October 20.10 150 000
Changes in equity for 20.10
Change in accounting policy (2) 4 3 240
Restated balance 153 240
Total comprehensive income for the year (restated) 93 600
Dividends (10 500)
Balance at 30 September 20.11 236 340
Changes in equity for 20.12
Total comprehensive income for the year 219 606
Dividends (25 000)
Balance at 30 September 20.12 430 946

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ELEGANCE LTD

NOTES FOR THE YEAR ENDED 30 SEPTEMBER 20.12

1. Accounting policy

The financial statements have been prepared in accordance with International Financial
Reporting Standards.

The financial statements have been prepared on the historical cost basis, as modified by
the revaluation of land and buildings, investment property and financial assets and
financial liabilities at fair value.

They incorporate the following principal accounting policies which are consistent with the
policies applied in previous years, except where otherwise stated.

1.1 Revenue

Revenue is recognised at the fair value of the consideration received or receivable.

Revenue represents the transfer of promised goods and services to customers in an
amount that reflects the consideration to which the entity expects to be entitled in
exchange for those goods and services. Revenue is recognised from contracts with
customers when performance obligations are satisfied.

Interest is recognised on a time proportion basis.

1.2 Inventory

Inventory is valued on the first-in, first-out method of inventory valuation, at the lower of
cost or net realisable value.

1.3 Taxation

Current and deferred tax are recognised as income or expenses and included in profit or
loss for the period, except when the tax relates to items that are recognised outside profit
or loss. Tax, which relates to items that are recognised in other comprehensive income, is
also recognised in other comprehensive income. Tax, which relates to items that are
recognised directly in equity, is also recognised directly in equity.

Deferred tax

Deferred tax is generally recognised for all temporary differences using the statement of
financial position approach and based on tax rates that have been enacted or
substantively enacted by the reporting date. The measurement of deferred tax reflects the
tax consequences that would follow from the manner in which the company expects to
recover or settle the carrying amount of its assets and liabilities at the reporting date.

Temporary differences are differences between the carrying amounts of assets and
liabilities (used in the financial statements), and the corresponding tax bases used in the
calculation of taxable profit.

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Deferred tax liabilities are recognised for all taxable temporary differences, unless the
deferred tax liability arises from:
 the initial recognition of goodwill; or
 the initial recognition of an asset and liability in a transaction which:
 is not a business combination; and
 at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).

Deferred tax assets are recognised for all deductible temporary differences to the extent
that it is probable that taxable profit will be available against which the deductible
temporary difference can be utilised, unless the deferred tax asset arises on the initial
recognition of an asset and liability in a transaction which
 is not a business combination; and
 at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).

A deferred tax asset is recognised for the carrying forward of unused tax losses and
unused tax credits to the extent that it is probable that future taxable profit will be available
against which the unused tax losses and unused tax credits can be utilised.

Current tax

Current tax payable is based on the taxable profit for the year, calculated in terms of the
Income Tax Act. Taxable profit differs from the profit for the period as reported in the
statement of profit or loss and other comprehensive income, as it excludes items of
income or expense that are taxable or deductible in a different period or that are never
taxable or deductible. The liability for current tax is calculated using tax rates that have
been enacted or substantively enacted by the reporting date.

2. Profit before tax

Profit before tax is stated after taking the following items into account:
20.12 20.11
Income R R
Income from sale of goods 597 000 365 000
Bad debts written back 6 200 –

Expenses
Loss – sale of machinery 3 000 –
Loss – expropriation of land 37 880 –

3. Income tax expense

20.12 20.11
Major components of tax expense R R
Current tax expense – current year [99 518 + 2 156 (2)] 101 674 36 120
Deferred tax expense – movement in temporary differences (3) (1 540) 280
100 134 36 400

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4. Change in accounting policy

During the year, the company changed its accounting policy on the valuation of inventory.
Elegance Ltd previously accounted for its inventory on the last-in, first-out (LIFO) method,
but has changed its policy of accounting for inventory to the first-in, first-out (FIFO) method
in order to comply with the new accounting statement that disallows the use of the LIFO
method of inventory valuation.

This change in accounting policy has been accounted for retrospectively and the
comparative amounts have been appropriately restated.

The effect of this change is as follows:

20.12 20.11 1/10/20.10
R R R
Decrease in cost of sales (2) 2 200 1 000
Increase in taxation expense (2 200 x 28%);
(1 000 x 28%) (616) (280)
Increase in profit 1 584 720
Increase in inventory (2) 7 700 5 500 4 500
Increase in current tax due (7 700 x 28%) (2 156) - -
Increase in deferred tax liability
(5 500 x 28%);(4 500 x 28%) - (1 540) (1 260)
Increase in equity 5 544 3 960 3 240
Increase in retained earnings at beginning
of year 3 960 3 240

Calculations
1. Profit before tax
20.12 20.11
R R
Gross profit for the year 371 4201 144 0002
Adjustment – change in accounting policy (inventory) (2) 2 200 1 000
373 620 145 000
Interest received 4 800 –
Loss on sale of machinery (3 000) –
Advertising expenses (24 000) (15 000)
Bad debts written back 6 200 –
Loss – expropriation of land (37 880) –
319 740 130 000
1 452 000 + 145 000 – 225 580
2 300 000 + 65 000 – 221 000

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2. Change in accounting policy

At 30 September 20.10 Differ- 20.11 Differ- 20.12

ence ence
R R R R R
FIFO (new policy) 67 000 37 500 33 700
LIFO (old policy) (62 500) (32 000) (26 000)
Increase in profit
before tax due to
increase in closing
inventory 4 500 1 000 5 500 2 200 7 700
Income tax expense (1 260) (280) (1 540) (616) (2 156)
Increase in profit
after tax due to
increase in closing
inventory 3 240 720 3 960 1 584 5 544

3. Current tax and deferred tax – calculations and explanations

3.1 20.10 Carrying Tax Temporary

amount base difference
R R R
Closing inventory 20.10 67 000 62 500 4 500

The carrying amount of the asset is greater than the tax base that will result in an increase
in taxable income in future years. Provide for a deferred tax liability of R1 260
(4 500 x 28%).

Journal to provide for deferred tax liability for 20.10:

Dr Cr
R R
Deferred tax (P/L) 1 260
Deferred tax liability (SFP) 1 260

R
Deferred tax closing balance 30 September 20.10 1 260
Deferred tax opening balance 30 September 20.09 –
Deferred tax movement (Dr to P/L) 1 260

3.2 20.11 Carrying Tax Temporary

amount base difference
R R R
Closing inventory 20.11 37 500 32 000 5 500

The carrying amount of the asset is greater than the tax base, which will result in an
increase in taxable income in future years. The deferred tax liability will have to be
increased to R1 540 (5 500 x 28%). R1 260 has already been provided for in 20.10. Thus
the journal to provide for deferred tax for 20.11 is:

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Dr Cr
R R
Deferred tax (P/L) (1 540 – 1 260) 280
Deferred tax liability (SFP) 280

R
Deferred tax closing balance 30 September 20.11 1 540
Deferred tax opening balance 30 September 20.10 (1 260)
Deferred tax movement (Dr to P/L) 280

3.3 20.12 Carrying Tax Temporary

amount base difference
R R R
Closing inventory 20.12 33 700 33 700 Nil

LECTURER’S COMMENT

If the SA Revenue Service does not accept the new inventory valuation
method, then the tax base of closing inventory in 20.12 is R26 000.

The carrying amount and tax base are equal and no deferred tax liability exists. Deferred
tax provided in previous years on the asset (closing inventory) therefore has to be
reversed. The journal for the reversal of the deferred tax liability is:

Dr Cr
R R
Deferred tax liability (SFP) 1 540
Deferred tax (P/L) 1 540

R
Deferred tax closing balance 30 September 20.12 –
Deferred tax opening balance 30 September 20.11 1 540
Deferred tax movement (Cr. to P/L) 1 540

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LECTURER’S COMMENT

Before answering a question about the change in accounting policy it is

important to determine the following:

1. Would the SA Revenue Service reopen the previous years' tax

assessments?
2. Would the SA Revenue Service accept the new accounting policy?

In this question, the change in accounting policy is accepted by the SA

Revenue Service, but the question states that the previous years'
assessment will not be reopened. Normally, when the SA Revenue
Service accepts the change in accounting policy and is prepared to reopen
the previous years' assessments, there will be no deferred tax implication
as the tax base of the closing inventory will be equal to the carrying
amount of closing inventory. The current tax of each year will then be
adjusted with the tax effect of the change in accounting policy.

However, in this example the correction of the tax effect of the change in
accounting policy affects deferred tax because the carrying amount and
tax base of closing inventory differ for the 20.10 and 20.11 tax years, as
can be seen above

Deferred tax in the statement of profit or loss and other comprehensive income is debited
in 20.10 with R1 260, which resulted in an opening retained earnings adjustment in 20.11
of R3 240 (4 500 – 1 260). In 20.11, deferred tax in the statement of profit or loss and
other comprehensive income is debited with R280, which brought the total provision for
deferred tax in the statement of financial position to R1 540 at the end of 20.11. In 20.12,
the SA Revenue Service taxes Elegance Ltd on the total increase in profit as part of
current tax because the previous years' assessments have not been reopened.

Current tax in 20.12 increases with R2 156 [(4 500 + 1 000 + 2 200) x 28%] of which
R1 540 has already been provided for as deferred tax in the 20.10 and 20.11 years.
Deferred tax in the statement of profit or loss and other comprehensive income is now
credited/reversed to bring the tax expense in the statement of profit or loss and other
comprehensive income in line with profit before tax.

The calculation of SA normal tax in the statement of profit or loss and other
comprehensive income for 20.12 is as follows:
R
Current tax as previously reported 99 518
Current tax increase due to increase in profit 2 156
(only taxed by the SA Revenue Service in the current year)
[(4 500 + 1 000 + 2 200) x 28%]
101 674
Reversal of deferred tax already provided for (1 540)
SA normal taxation 20.12 100 134

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The calculation of SA normal tax in the statement of profit or loss and other
comprehensive income for 20.11 is as follows:
R
Current tax as previously reported 36 120
Deferred tax (3.2) 280
36 400

2.3 CHANGES IN ACCOUNTING ESTIMATES

2.3.1 Accounting treatment of a change in accounting estimates

As a result of the uncertainties inherent in business activities, many items in financial

statements cannot be measured with precision but can only be estimated. Examples of
estimates are as follows:

 bad debts;
 obsolete inventory;
 the fair value of financial assets or financial liabilities;
 the useful lives of, or expected pattern of consumption of the future economic benefits
embodied in, depreciable assets; and
 warranty obligations.

The effect of a change in accounting estimate should be included in the determination of

net profit or loss prospectively in

 the period of the change, if the change effects that period only; or
 the period of the change and future periods, if the change affects both (IAS 8.36).

The useful life of any item of property, plant and equipment and the depreciation method
that is applied, should be revised periodically. When it is apparent that an adjustment is
required in either of the two cases, the adjustment is treated as a change in estimate in
agreement with IAS 8. The depreciation charges for the current and future periods are
adjusted and no adjustment is made to the depreciation charges of prior years.

Should it happen that a change in an accounting estimate gives rise to changes in assets
and liabilities (without affecting equity), or relates to an item of equity (such as a
revaluation reserve), the change should be accounted for by adjusting the carrying amount
of the related asset, liability or equity item in the period of the change, instead of adjusting
profit or loss (IAS 8.37).

2.3.2 Disclosure

Changes in accounting estimates can be disclosed in two ways, namely

 by including them in the profit or loss from operating activities without disclosing them
separately, where the effect is not material; or
 by including them in operating activities and disclosing them separately for items that
require separate disclosure in terms of IAS 8.

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The following should be disclosed in respect of changes in accounting estimates:

 the nature of the change;

 the amount of the change; and
 the effect on future periods, if practicable to estimate, otherwise a statement that the
future effect is impracticable to estimate (IAS 8.39–.40).

A change of estimate made in the current period need not again be disclosed separately in
future periods.

EXAMPLE 2

Rekbel Ltd commenced business on 1 January 20.09, at which date machinery to the
value of R1 000 000 was purchased. The expected useful life at this date was 11 years.

Machinery is depreciated on the reducing balance method at 20% per annum. During
December 20.12 the directors decided to change this method to the straight-line method.
For purposes of this question you may assume that for each year a tax rate of 28% on
taxable income is applicable. Net profit and taxable income earned for the years ended
20.11 and 20.12 amounted to R435 000 and R490 000 respectively, before providing for
depreciation. The SA Revenue Service does not apply the new method for tax purposes
and calculates the tax allowance at 20% per annum on the reducing balance method.
Dividends amounting to R100 000 were declared in both years. Retained earnings at
31 December 20.10 were R223 000. Ignore the implications of dividends tax.

REQUIRED

Prepare the statement of profit or loss and other comprehensive income,

the statement of changes in equity (only retained earnings section) and
notes thereto for the year ended 31 December 20.12 for Rekbel Ltd. Your
answer must comply with the requirements of International Financial
Reporting Standards.

SOLUTION 2

REKBEL LTD

EXTRACT FROM THE STATEMENT OF PROFIT OR LOSS AND OTHER COM-

PREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20.12

Notes 20.12 20.11

R R
Profit before tax (2) 2 426 000 307 000
Income tax expense 3 (119 280) (85 960)
PROFIT FOR THE YEAR 306 720 221 040
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 306 720 221 040

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REKBEL LTD

EXTRACT FROM STATEMENT OF CHANGES IN EQUITY FOR THE YEARS ENDED

31 DECEMBER 20.11 AND 20.12:
Retained
earnings
R
Balance at 1 January 20.11 223 000
Changes in equity for 20.11
Total comprehensive income for the year 221 040
Dividends (100 000)
Balance at 31 December 20.11 344 040
Changes in equity for 20.12
Total comprehensive income for the year 306 720
Dividends (100 000)
Balance at 31 December 20.12 550 760

REKBEL LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.12

1. Accounting policy

The financial statements have been prepared in accordance with International Financial
Reporting Standards.

The financial statements have been prepared on the historical cost basis, as modified by
the revaluation of land and buildings, investment property, financial assets and financial
liabilities at fair value.

They incorporate the following principal accounting policies that are consistent with the
policies applied in previous years, except where otherwise stated.

1.1 Property, plant and equipment

Property, plant and equipment are initially recognised at cost price. Property, plant and
equipment are subsequently measured at cost less accumulated depreciation and
accumulated impairment losses. Depreciation is provided for on the straight-line method
over the expected useful life of the asset. The remaining useful life of the machinery at
31 December 20.12 is seven years. This represents a change in accounting estimate as
the asset has previously been written off at 20% on the reducing balance basis. The
residual values and estimated lives of all items of property, plant and equipment are
reviewed and adjusted, if necessary, at the end of each reporting period.

1.2 Taxation

Current and deferred taxes are recognised as income or expenses and included in profit or
loss for the period, except when the tax relates to items that are recognised outside profit
or loss. Tax, which relates to items that are recognised in other comprehensive income, is
also recognised in other comprehensive income. Tax, which relates to items that are
recognised directly in equity, is also recognised directly in equity.

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Deferred tax

Deferred tax is generally recognised for all temporary differences using the statement of
financial position approach and based on tax rates that have been enacted or
substantively enacted by the reporting date. The measurement of deferred tax reflects the
tax consequences that would follow from the manner in which the company expects to
recover or settle the carrying amount of its assets and liabilities at the reporting date.

Temporary differences are differences between the carrying amounts of assets and
liabilities (used in the financial statements) and the corresponding tax bases used in the
calculation of taxable profit.

Deferred tax liabilities are recognised for all taxable temporary differences, unless the
deferred tax liability arises from
 the initial recognition of goodwill; or
 the initial recognition of an asset and liability in a transaction which:
 is not a business combination; and
 at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).

Deferred tax assets are recognised for all deductible temporary differences to the extent
that it is probable that taxable profit will be available against which the deductible
temporary difference can be utilised, unless the deferred tax asset arises on the initial
recognition of an asset and liability in a transaction which
 is not a business combination; and
 at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).

A deferred tax asset is recognised for the carrying forward of unused tax losses and
unused tax credits to the extent that it is probable that future taxable profit will be available
against which the unused tax losses and unused tax credits can be utilised.

Current tax
Current tax payable is based on the taxable profit for the year, calculated in terms of the
Income Tax Act. Taxable profit differs from the profit for the period as reported in the
statement of profit or loss and other comprehensive income, as it excludes items of
income or expense that are taxable or deductible in a different period or that are never
taxable or deductible. The liability for current tax is calculated using tax rates that have
been enacted or substantively enacted by the reporting date.

2. Profit before tax 20.12 20.11

R R
The profit before tax includes the following item:
Depreciation on property, plant and equipment 64 000 128 000

Included in depreciation for 20.12 is a change in estimate of R38 400, arising from the
decision to depreciate machinery on the straight line method instead of the reducing
balance method. This change will result in an increase* of depreciation in future periods of
R38 400.

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* The change in estimate will result in an increase in depreciation in the future because the
carrying amount of the machinery calculated according to the new depreciation method is
greater than the carrying amount of machinery calculated according to the old depreciation
method.
Carrying amount of machinery according to old method
(512 000 – 102 400) = R409 600
Carrying amount of machinery according to new method
(512 000 – 64 000) = R448 000

3. Income tax expense

20.12 20.11
Major components of tax expense R R
Current tax expense – current year (3) 108 528 85 960
Deferred tax expense – movement in temporary differences (1) 10 752 –
119 280 85 960
Calculations

1. Schedule of depreciation and wear and tear

Tem-
porary
Carrying Tax differ- Deferred
Year ended 31 December amount base ences tax
R R R R
Cost 1 000 000 1 000 000 – –
20.09 Depreciation (200 000) (200 000) – –
Balance – 31 December 20.09 800 000 800 000 – –
20.10 Depreciation (160 000) (160 000) – –
Balance – 31 December 20.10 640 000 640 000 – –
20.11 Depreciation (128 000) (128 000) – –
Balance – 31 December 20.11 512 000 512 000 – –
20.12 Depreciation (64 000) (102 400) 38 400 10 752
(512 000 / 8); (512 000 x 20%)
Balance – 31 December 20.12 448 000 409 600 38 400 10 752

The carrying amount of machinery is greater than the tax base of machinery on
31 December 20.12, which will result in taxable profit in future years. A deferred tax liability
of R10 752 (R38 400 x 28%) must be provided. The journal to provide for the deferred tax
liability is as follows:
Dr Cr
R R
Deferred tax (P/L) 10 752
Deferred tax liability (SFP) 10 752

2. Profit before tax

20.12 20.11
R R
Profit for the year – given 490 000 435 000
Depreciation: Straight-line method (64 000) –
: Reducing balance method – (128 000)
426 000 307 000

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3. Current tax
20.12 20.11
R R
Profit for the year before depreciation 490 000 435 000
Tax allowance (102 400) (128 000)
Taxable income 387 600 307 000
Tax payable @ 28% 108 528 85 960

2.4 ERRORS

2.4.1 Prior period errors

Errors can arise in respect of the recognition, measurement, presentation or disclosure of

elements of financial statements. Financial statements do not comply with International
Financial Reporting Standards if they contain either material errors or immaterial errors
made intentionally to achieve a particular presentation of an entity's financial position,
financial performance or cash flows. Potential current period errors discovered in that
period are corrected before the financial statements are authorised for issue. However,
material errors are sometimes not discovered until a subsequent period, and these prior
period errors are corrected in the comparative information presented in the financial
statements for that subsequent period (IAS 8.41).

Errors that relate to a prior period but are discovered in the current period normally arise
from the following type of situations:

 mathematical miscalculations;
 misinterpretation of facts;
 fraud; and
 the incorrect application of an accounting policy.

2.4.2 Retrospective correction of errors

An entity should correct material prior period errors retrospectively in the first set of
financial statements authorised for issue after their discovery:

 by restating the comparative amounts for the prior period(s) presented in which the
error occurred; or
 if the error occurred before the earliest prior period presented, by restating the opening
balances of assets, liabilities and equity for the earliest prior period presented
(IAS 8.42).

2.4.3 Disclosure

Disclosures concerning the correction of prior period errors need only be presented in the
year of the correction and not in subsequent periods, and consist of the following:

 the nature of the prior period error;

 for each prior period presented, to the extent practicable, the amount of the correction
for each financial statement line item affected and for basic and diluted earnings per
share, if presented; as per IAS 33;

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 the amount of the correction at the beginning of the earliest prior period presented;
and
 if retrospective restatement is impracticable for a particular prior period, the
circumstances that led to the existence of that condition and a description of how and
from when the error has been corrected (IAS 8.49).

The following is an example of a retrospective correction of prior period errors.

EXAMPLE 3

The following information of Cirrus Ltd is available for the years ended 31 December 20.11
and 20.12:

CIRRUS LTD

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR

THE YEAR ENDED 31 DECEMBER 20.12

20.12 20.11
R R
Profit before tax 422 000 300 000
Income tax expense (118 160) (84 000)
PROFIT FOR THE YEAR 303 840 216 000
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 303 840 216 000

CIRRUS LTD

EXTRACT FROM THE STATEMENT OF CHANGES IN EQUITY FOR THE YEARS

ENDED 31 DECEMBER 20.11 AND 20.12
Retained
earnings
R
Balance at 1 January 20.11 168 000
Changes in equity for 20.11
Total comprehensive income for the year 216 000
Dividends (7 500)
Balance at 31 December 20.11 376 500
Changes in equity for 20.12
Total comprehensive income for the year 303 840
Dividends (10 000)
Balance at 31 December 20.12 670 340

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Additional information

1. After the financial statements for 31 December 20.11 had been published, the
directors of the company discovered that machinery to the value of R50 000, which
had been purchased on 1 July 20.11, had been expended instead of being capitalised.
The bookkeeper had incorrectly stated that the cheque had been made out to BKN
Electrical Supplies, a supplier from whom the company purchases electrical
components. The cheque was then posted to material purchased. The company
makes use of a periodic stocktaking system for inventory control. To date no
adjustment has been made in the books of the company.

2. The company depreciates machinery at 20% per annum according to the straight-line
method, which is in agreement with the policy applied by the SA Revenue Service.

3. Assume a tax rate of 28%.

4. The SA Revenue Service will issue a revised assessment in respect of the 20.11 tax
year.

REQUIRED

Prepare the statement of profit or loss and other comprehensive income,

the statement of changes in equity (only the retained earnings section)
and notes to the annual financial statements of Cirrus Ltd for the year
ended 31 December 20.12. Your answer must comply with the
requirements of International Financial Reporting Standards.

SOLUTION 3

CIRRUS LTD

EXTRACT FROM STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE

INCOME FOR THE YEAR ENDED 31 DECEMBER 20.12

Notes 20.12 20.11

R R
Profit before tax (1) 2 412 000 345 000
Income tax expense (2) 3 (115 360) (96 600)
PROFIT FOR THE YEAR 296 640 248 400
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 296 640 248 400

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CIRRUS LTD

EXTRACT FROM STATEMENT OF CHANGES IN EQUITY FOR THE YEARS ENDED

31 DECEMBER 20.11 AND 20.12
Retained
earnings
R
Balance at 1 January 20.11 168 000
Changes in equity for 20.11
Total comprehensive income for the year (restated) 248 400
Dividends (7 500)
Balance at 31 December 20.11 408 900
Changes in equity for 20.12
Total comprehensive income for the year 296 640
Dividends (10 000)
Balance at 31 December 20.12 695 540

CIRRUS LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.12

1. Accounting policy

The financial statements have been prepared in accordance with International Financial
Reporting Standards.

The financial statements have been prepared on the historical cost basis, as modified by
the revaluation of land and buildings, investment property, financial assets and financial
liabilities at fair value.

They incorporate the following principal accounting policies, which are consistent with the
policies applied in previous years unless otherwise stated.

1.1 Machinery

Machinery is stated at historical cost less accumulated depreciation. Depreciation is

calculated on the straight-line method at rates considered appropriate to write off the cost
of the asset over its estimated useful life as follows:

Machinery – 20% per annum.

1.2 Taxation

Current and deferred tax are recognised as income or an expense and included in profit or
loss for the period, except when the tax relates to items that are recognised outside profit
or loss. Tax, which relates to items that are recognised in other comprehensive income, is
also recognised in other comprehensive income. Tax, which relates to items that are
recognised directly in equity, is also recognised directly in equity.

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Deferred tax

Deferred tax is generally recognised for all temporary differences using the statement of
financial position approach based on tax rates that have been enacted or substantively
enacted by the reporting date. The measurement of deferred tax reflects the tax
consequences that would follow from the manner in which the company expects to recover
or settle the carrying amount of its assets and liabilities at the reporting date.

Temporary differences are differences between the carrying amounts of assets and
liabilities (used in the financial statements) and the corresponding tax bases used in the
calculation of taxable profit.

Deferred tax liabilities are recognised for all taxable temporary differences, unless the
deferred tax liability arises from

 the initial recognition of goodwill; or

 the initial recognition of an asset and liability in a transaction which
 is not a business combination; and
 at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).

Deferred tax assets are recognised for all deductible temporary differences to the extent
that it is probable that taxable profit will be available against which the deductible
temporary difference can be utilised, unless the deferred tax asset arises on the initial
recognition of an asset and liability in a transaction which

 is not a business combination; and

 at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).

A deferred tax asset is recognised for the carrying forward of unused tax losses and
unused tax credits to the extent that it is probable that future taxable profit will be available
against which the unused tax losses and unused tax credits can be utilised.

Current tax

Current tax payable is based on the taxable profit for the year, calculated in terms of the
Income Tax Act. Taxable profit differs from the profit for the period as reported in the
statement of profit or loss and other comprehensive income, as it excludes items of
income or expense that are taxable or deductible in a different period or that are never
taxable or deductible. The liability for current tax is calculated using tax rates that have
been enacted or substantively enacted by the reporting date.

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2. Profit before tax

20.12 20.11
R R

Included in profit before tax is the following:

Depreciation (1) 10 000 5 000

3. Income tax expense

Major components of tax expense

Current tax expense – current year (2) 115 360 96 600

LECTURER’S COMMENT

Note that no deferred tax arises as a result of the error, since the
previous tax assessments were re-opened to correct the error made
earlier. If this were not the case, it would have resulted in deferred tax.

4. Prior period error

Correction of error in respect of machinery purchased being expended instead of being

capitalised in 20.11. The effect of the correction of this error on the results of 20.11 is as
follows:
20.11
R
Decrease in expenses (50 000 – 5 000) 45 000
Increase in tax expense (14 000 – 1 400) (12 600)
Increase in profit 32 400
Increase in machinery account 45 000
Increase in current tax due (12 600)
Increase in equity 32 400

LECTURER’S COMMENT

Note that the effect of the adjustment on each line item must be
disclosed.

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Calculations

1. Profit before tax

20.12 20.11
R R
Profit before tax – given 422 000 300 000
Plus: Cost of machinery expended – 50 000
422 000 350 000
Less: Depreciation (10 000) (5 000)
(50 000 x 20%); (50 000 x 20% x 6/12)
412 000 345 000

2. Income tax expense

20.12 20.11
R R
Current tax expense – given 118 160 84 000
Adjustments:
Cost of machinery expended (50 000 x 28%) – 14 000
Tax allowance (2 800) (1 400)
(50 000 x 20% x 28%); ((50 000 x 20% x 6/12) x 28%)
115 360 96 600

EXAMPLE 4
The profit before tax as reflected in the draft statement of profit or loss and other
comprehensive income of Sword Ltd for the financial years ended 31 December 20.12 and
31 December 20.11 respectively was as follows:

20.12 20.11
R R
Profit before tax 1 661 000 950 000

Additional information

The following items have not yet been accounted for in the above-mentioned draft
statement of profit or loss and other comprehensive income of Sword Ltd:

1. The board of directors decided on 31 December 20.12, after completing the draft
statement of profit or loss and other comprehensive income, to change the accounting
policy with respect to the inventory valuation from the weighted average method to the
first-in, first-out method in order to give a fairer presentation of the financial position
and operating results due to fluctuations in inventory prices.

Inventory is valued as follows using both methods:

20.10 20.11 20.12
R R R
Weighted average method 62 000 132 000 226 000
First-in, first-out method 67 000 167 400 263 500

The SA Revenue Service will not re-open the previous years' tax assessments as a
result of this new method of valuation of inventory, but the new policy will be accepted
for tax purposes from 20.12.

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2. Retained earnings at 31 December 20.10 amounted to R150 000.

3. During the current year the accountant found a batch of sales invoices not processed
due to misfiling, to the value of R90 000 (excluding VAT) for the year ended
31 December 20.11. The sales invoices were filed in the order pending file instead of
the sales invoice file. However, the costs of sales associated with these invoices were
taken into account in 20.11. The effect thereof is considered material on the financial
statements and the SA Revenue Service has re-opened the 20.11 assessment as a
result of this error.
4. The current tax rate of 28% has remained unchanged for the past five years.
5. Deferred tax is provided for on all temporary differences using the statement of
financial position approach.
6. Taxable income and profit before tax were the same for the past five years.
7. The implications of value added tax must be ignored.

REQUIRED

Prepare the statement of profit or loss and other comprehensive income,

statement of changes in equity (only the retained earnings section) and
only the following notes to the annual financial statements of Sword Ltd
for the year ended 31 December 20.12:

 change in accounting policy; and

 error.
Your answer must comply with the requirements of International Financial
Reporting Standards.
Comparative figures are required.
No accounting policy notes are required.

SOLUTION 4

SWORD LTD

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR

THE YEAR ENDED 31 DECEMBER 20.12

20.12 20.11
R R
Profit before tax 1 663 1001 1 070 4002
Income tax expense (465 668)3 (299 712)4
PROFIT FOR THE YEAR 1 197 432 770 688
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 1 197 432 770 688

1 1 661 000 + 2 100(1)

2 950 000 + 30 400(1) + 90 000
3 475 580(2.1) – 9 912(2.2)
4 291 200(2.1) + 8 512(2.2)

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SWORD LTD

EXTRACT FROM THE STATEMENT OF CHANGES IN EQUITY FOR THE YEAR

ENDED 31 DECEMBER 20.12
Retained
earnings
R
Balance at 1 January 20.11 150 000
Changes in equity for 20.11
Change in accounting policy ((67 000 – 62 000) x 72%)) 3 600
Restated balance 153 600
Total comprehensive income for the year (restated) 770 688
Balance at 31 December 20.11 924 2881
Changes in equity for 20.12
Total comprehensive income for the year 1 197 432
Balance at 31 December 20.12 2 121 720

1 150 000 + 950 000 – (950 000 x 28%) + 3 600 + 21 888(1) + (90 000 x 72%)

SWORD LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.12

1. Change in accounting policy

During the financial year, the company changed its accounting policy on the valuation of
inventories from the weighted average method to the first-in, first-out method. This change
was necessary to give a fairer presentation of the financial position and operating results
due to fluctuations in inventory prices. This change in policy was accounted for
retrospectively and comparative amounts have been appropriately restated.

The effect of the change is as follows:

20.12 20.11 1/1/20.11

R R
Decrease in cost of sales (1) 2 100 30 400
Increase in taxation expense (1) (588) (8 512)
Increase in profit 1 512 21 888

Increase in inventory (1) 37 500 35 400 5 000

Increase in current tax due (10 500) - -
(37 500 x 28%)
Increase in deferred tax liability - (9 912) (1 400)
(35 400 x 28%);(5 000 x 28%)
Increase in equity 27 000 25 488 3 600

Increase in retained earnings beginning of year (1) 25 488 3 600

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2. Prior period error

Sales invoices, which were not processed due to misfiling, were corrected. The sales
invoices were filed in the order-pending file instead of the sales invoice file. The
comparative figures have been appropriately restated. The effect of the correction on the
results of 20.11 is as follows:

20.11
R
Increase in sales 90 000
Increase in current tax expense (90 000 x 28%) (25 200)
Increase in profit 64 800

Increase in debtors 90 000

Increase in current tax due (90 000 x 28%) (25 200)
Increase in equity 64 800

Calculations

1. Effect of the change in accounting policy

20.10 Differ- 20.11 Differ- 20.12

ence ence
Inventory R R R R R
New method 67 000 167 400 263 500
Old method (62 000) (132 000) (226 000)
Increase in profit 5 000 30 400 35 400 2 100 37 500
due to increase in
inventory
Tax effect (1 400) (8 512) (9 912) (588) (10 500)
3 600 21 888 25 488 1 512 27 000

2. Income tax expense

2.1 Current tax expense

20.12 20.11
R R
Profit before tax (given) 1 661 000 950 000
Increase in profit before tax resulting from increase
in closing inventory 37 5001 –
Correction of error – 90 000
Taxable income 1 698 500 1 040 000

Current tax expense @ 28% 475 580 291 200

15 000 + 30 400 + 2 100

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2.2 Deferred tax expense

Deferred
tax
Carrying Tax Temporary liability
amount base difference @ 28%
R R R R
31 December 20.10
Closing inventory 67 000 62 000 5 000 1 400

The carrying amount of asset > tax base of asset,

therefore deferred tax liability
Deferred tax balance 1 January 20.10 –
Deferred tax liability 31 December 20.10 1 400
Deferred tax expense (Dr to P/L) 1 400

Deferred
tax
Carrying Tax Temporary liability
amount base difference @ 28%
31 December 20.11 R R R R
Closing inventory 167 400 132 000 35 400 9 912

The carrying amount of asset > tax base of asset, therefore

deferred tax liability R
Deferred tax liability 1 January 20.11 1 400
Deferred tax liability 31 December 20.11 (9 912)
Deferred tax expense (Dr to P/L) (8 512)

31 December 20.12
Deferred
tax
Carrying Tax Temporary liability
amount base difference @ 28%
R R R R
Closing inventory 263 500 263 500 – –

The carrying amount of asset is equal to the tax base

of the asset, therefore no deferred tax
Deferred tax liability 1 January 20.12 (9 912)
Deferred tax balance 31 December 20.12 –
Deferred tax expense (Cr to P/L) (9 912)

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2.5 SUMMARY OF CHANGES IN ACCOUNTING POLICIES, CHANGES IN

ACCOUNTING ESTIMATES AND ERRORS

Changes in accounting Changes in accounting Errors

policy estimates
Definition Change in the specific An adjustment of the Omissions from and
 principles; carrying amount of an misstatements in the
 bases; asset or liability, or the entity's financial state-
 conventions; amount of the periodic ments for one or more
 rules; and consumption of an prior periods arising
 practices asset, that results from from a failure to use or
applied by an entity in the assessment of the the misuse of reliable
preparing and present- present status of and information that:
ing financial statements expected future benefits (a) was available when
(IAS 8.5) and obligations financial statements
associated with assets for those periods
and liabilities were authorised for
issue; and
Changes in accounting (b) could reasonably be
estimates result from expected to have
new information or new been obtained and
developments and taken into account in
accordingly are not cor- the preparation and
rections of errors presentation of those
(IAS 8.5) financial statements
(IAS 8.5)
When An entity changes an Change in estimate if Errors can arise in
applicable accounting policy only if (a) changes occur in the respect of the
the change circumstances on  recognition;
(a) is required by a which the estimate  measurement;
standard or an inter- was based; or  presentation; or
pretation; or (b) new information is  disclosure
(b) results in the financial available or more of elements of financial
statements providing experience has been statements (IAS 8.41)
reliable and more gained (IAS 8.34).
relevant information
about the effects of
transactions, other
events or conditions
on the entity's
financial position,
financial performance
or cash flows.
(IAS 8.14)

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Changes in accounting Changes in accounting Errors

policy estimates
Accounting Retrospective Prospective application Retrospective restate-
treatment application by adjusting is recognising the effect ment is correcting the
the prior year figures of the change in the recognition, measure-
except to the extent that current and future ment and disclosure of
it is impracticable (IAS periods affected by the amounts of elements of
8.19(b), .22, .23) change (IAS 8.36) financial statements as if
a prior period error has
Retrospective appli- never occurred (IAS
cation is applying a new 8.42)
accounting policy to
transactions, other
events and conditions as
if that policy had always
been applied (IAS 8.5)
Examples Change in inventory (a) Bad debts (a) Incorrect recording of
valuation method (b) Inventory VAT (input and
obsolescence. output)
(c) Fair value of financial (b) Incorrect capitalis-
assets or liabilities ation of an expense
(d) The useful lives or (c) Incorrect expensing
expected pattern of of assets
consumption of the (d) Incorrect classifica-
future economic tion of general ledger
benefits embodied in accounts
depreciable as-sets
(e) Warranty obligations
(IAS 8.32)
Disclosure (a) The revised IAS 1 (a) The nature and a- (a) The nature of the
has introduced a mount that has an prior period error
requirement to effect in the current (b) For each prior period
include a third period or is expected presented the
statement of financial to have an effect in amount of the cor-
position as at the future periods rection for each
beginning of the (b) Disclose the fact if financial statement
preceding period the amount of the line item affected,
whenever an entity effect in future and for basic and
 retrospectively periods is not diluted earnings per
applies an accounting disclosed because it share, if presented
policy; is impracticable (c) The amount of the
 makes a retrospect- (IAS 8.39–.40) correction at the
ive restatement of beginning of the
items in its financial earliest prior period
statements; or presented
(d) If retrospective re-
statement is

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Changes in accounting Changes in Errors

policy accounting estimates
Disclosure  when it reclassifies impracticable for a
(continued) items in its financial particular prior period,
statements. the circumstances that
In the above circum- have led to the
stances, an entity is existence of that
required to present a condition and a
minimum of three description of how and
statements of financial from when the error
position, together with the has been corrected
related notes. (IAS 8.49)
A statement of financial
position must be prepared
as at
 the end of the current
period;
 the end of the pre-
ceding period; and
 the beginning of the
preceding period.
(b) the title of the stan-
dard or interpretation;
(c) when applicable, that
the change in
accounting policy is
made in accordance
with its transitional
provisions;
(d) the nature of the
change in accounting
policy;
(e) when applicable, a
description of the
transitional provisions;
(f) when applicable, the
transitional provisions
that might have an
effect on future
periods;
(g) for the current period
and each prior period
presented, to the ex-
tent practicable, the
amount of the adjust-
ment for each financial
statement line item
affected, and for basic
and diluted earnings
per share, if presented;

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Changes in accounting Changes in Errors

policy accounting estimates
Disclosure (h) the amount of the
(continued) adjustment relating to
periods before those
presented, to the
extent practicable; and
(i) if retrospective applica-
tion is impracticable for
a particular prior
period, or for periods
before those presen-
ted, the circumstances
that have led to the
existence of that con-
dition and a description
of how and from when
the change in account-
ting policy has been
applied (IAS 8.28).

ASSESSMENT CRITERIA

Are you now able to do the following?

 Define accounting policies, change in accounting estimates and

errors as contained in IAS 8.
 Determine whether an error in the preparation of the financial
statements of prior periods discovered in the current year should be
reported as an error or not.
 Determine whether an adjustment because of the revision of an
estimate should be accounted for as a change in accounting
estimate or as a change in accounting policy.
 Record a change in accounting estimates, a change in accounting
policies and the correction of an error accurately in the financial
statements in accordance with International Financial Reporting
Standards.

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LEARNING UNIT 3
THE CONCEPTUAL
FRAMEWORK FOR
FINANCIAL REPORTING
2018

General Financial Reporting

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This learning unit will be included in a separate tutorial letter.

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LEARNING UNIT 4
PREFACE TO
INTERNATIONAL FINANCIAL
REPORTING STANDARDS

General Financial Reporting

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LEARNING OUTCOMES
Learners should understand the scope and authority of International Financial Reporting
Standards as well as the accounting standard setting process.

OVERVIEW
This learning unit is divided into the following:

4.1 Objectives of the International Accounting Standards Board (IASB)

4.2 Scope and authority of International Financial Reporting Standards (IFRS)
4.3 Harmonisation of Statements of Generally Accepted Accounting Practice (GAAP)
4.4 Legal requirements for Generally Accepted Accounting Practice

STUDY
PRESCRIBED:
Descriptive Accounting
The chapter relevant to the Preface to International Financial Reporting Standards.

RECOMMENDED:
IFRS Standards – The Annotated IFRS Standards
Preface to International Financial Reporting Standards

OVERVIEW OF LEARNING UNIT

This preface was issued to set out the objectives and process of the International
Accounting Standards Board (IASB) and to explain the scope, authority and timing of
application of International Financial Reporting Standards (IFRS).

4.1 Objectives of the IASB

The objectives of the IASB are

(a) to develop, in the public interest, a single set of high quality, understandable,
enforceable and globally accepted financial reporting standards based on clearly
articulated principles These standards should require high-quality, transparent and
comparable information in financial statements and other financial reporting to help
investors, other participants in the various capital markets of the world and other users
of financial information make economic decisions.
(b) to promote the use and rigorous application of those standards;
(c) in fulfilling the objectives associated with (a) and (b), to take account of, as
appropriate, the needs of a range of sizes and types of entities in diverse economic
settings; and
(d) to promote and facilitate the adoption of IFRSs, being the standards and
interpretations issued by the IASB, through the convergence of national accounting
standards and IFRSs (par .06).

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4.2 Scope and authority of International Financial Reporting

Standards

The IASB achieves its objectives primarily by developing and publishing IFRSs and
promoting the use of those standards in general-purpose financial statements and other
financial reporting. Other financial reporting comprises information provided outside
financial statements that assists in the interpretation of a complete set of financial
statements or improves users' ability to make efficient economic decisions (par .07).

IFRSs set out recognition, measurement, presentation and disclosure requirements for
transactions and events that are important in general-purpose financial statements. They
may also set out such requirements for transactions and events that arise mainly in
specific industries. IFRSs are based on the Conceptual Framework, which addresses the
concepts underlying the information presented in general-purpose financial statements.
The objective of the Conceptual Framework is to facilitate the consistent and logical
formulation of IFRSs (par .08).

IFRSs apply to all general-purpose financial statements. Such financial statements are
directed towards the common information needs of a wide range of users, for example
shareholders, creditors, employees and the public at large. The objective of financial
statements is to provide information about the financial position, performance and cash
flows of an entity that is useful to those users in making economic decisions (par .10).

A complete set of financial statements includes a statement of financial position, a

statement of profit or loss and other comprehensive income, a statement of changes in
equity, a statement of cash flows, and accounting policies and explanatory notes. When a
separate statement of profit or loss is presented in accordance with IAS 1 – Presentation
of financial statements (as revised in 2007), it is part of that complete set (par .11).

4.3 Harmonisation of Statements of Generally Accepted Accounting

Practice (GAAP)

The South African Accounting Practices Board (APB), who has traditionally been
responsible for the setting of South African accounting standards, committed itself during
1993 to eliminating the differences between South African accounting standards and
standards issued by the International Accounting Standards Board (IASB). South African
standards have substantially been harmonised with international standards (the
harmonisation project).

IASB standards are published in a series of pronouncements called IFRSs and IFRICs.
Standards issued by the IASB are designated "IFRS", while IASs and SICs, issued by the
International Accounting Standards Committee (1973 – 2001), the IASB's predecessor,
continue to be designated as part of IFRSs. IFRSs therefore include IFRSs, IFRICs, IASs,
and SICs.

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In February 2004, the APB took a decision that it would approve the text of the
International Financial Reporting Standards for issue in South Africa, without amendment.
Statements of Generally Accepted Accounting Practice were, except for some effective
dates, an exact replica of the relevant International Financial Reporting Standards.
However, the Accounting Practice Board (APB) was dissolved and replaced by the
Financial Reporting Standards Council (FRSC).

The consequences of the aforementioned discontinuation of the APB and the

establishment of the FRSC included the effective withdrawal of SA GAAP effective for
financial statements prepared in respect of year-ends after May 2012. Furthermore,
companies currently applying SA GAAP need to prepare for conversion to IFRS, or IFRS
for SMEs. The FRSC will propose changes to the regulations to include a provision to give
the FRSC the power to issue Financial Reporting Pronouncements (FRPs) to take account
of specific aspects that only occur in the South African context not specifically covered by
IFRS or IFRS for SMEs. The first FRPs are intended to cover current South African
interpretations of SA GAAP, the AC 500 series.

4.4 Legal requirements for Generally Accepted Accounting Practice

Users of financial statements, such as investors, require compliance with accounting

standards in order to provide them with assurance that financial statements fairly present
the affairs of the entity. In order to provide such assurance, legal backing for accounting
standards will now be achieved by the Companies Act (71 of 2008).

In terms of the Companies Act (71 of 2008), two categories of companies are recognised,
namely profit companies and non-profit companies.

4.4.1 Profit companies

Profit companies are defined as companies incorporated for the purpose of financial gain
for their shareholders. They include the following categories of companies:

 State-owned company (SOC Ltd)

A company that meets the criteria for state-owned enterprises or that is owned by a
municipality.

 Private company ((Pty) Ltd)

A company that is neither a state-owned company nor a personal liability company. Its
memorandum of incorporation also prohibits it from offering its securities to the public and
restricts the transferability of those securities.

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 Personal liability company (Inc)

A private company whose memorandum of incorporation states that it is a personal liability

company.

 Public company (Ltd)

A profit company that is not a state-owned company, a private company or a personal

liability company. A public company can either be listed on the JSE Limited or be a non-
listed entity.

4.4.2 Non-profit companies (NPC)

A non-profit company is incorporated for public benefit and its income and property are not
distributable to its members, incorporators, directors, officers or related persons. This
category of company may be regarded as a successor to the Section 21 companies.

4.4.3 Reporting of respective companies

Different financial reporting standards can be established for profit and non-profit
companies, as well as for different categories of profit companies. The respective financial
reporting standards applicable are the following:

Category of profit company Financial reporting

State-owned companies (SOCs) IFRS, but should there be any conflict with
the Public Finance Management Act (1 of
1999), the latter prevails
Listed public companies IFRS
Public companies not listed IFRS or IFRSs for SMEs
Profit companies, other than SOCs or public IFRS or IFRSs for SMEs
companies, with a public interest score (PIS)
for the particular financial year of at least 350
Profit companies, other than SOCs or public IFRS or IFRSs for SMEs
companies, with a PIS for the particular
financial year of at least 100, but less than
350
Profit companies, other than SOCs or public IFRS or IFRSs for SMEs
companies, with a PIS for the particular
financial year of less than 100, and whose
statements are independently compiled
Profit companies, other than SOCs or public The financial reporting standard as
companies, with a PIS for the particular year determined by the company for as long as
of less than 100, and whose statements are no financial reporting standards are
internally compiled prescribed

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The PIS (public interest score) is the sum of

 a number of points equal to the average number of employees during the financial
year;
 one point for every R1 million (or portion thereof) in third-party liabilities at the end of
the financial year;
 one point for every R1 million (or portion thereof) in turnover during the financial year;
and
 one point for every individual who has a direct or indirect, beneficial interest in any of
the profit company's issued securities at the end of the financial year.

In all cases, a company can choose to comply with a "higher" level of financial reporting
standard (such as applying IFRS even if IFRSs for SMEs was allowed). Companies that
may apply IFRSs for SMEs in terms of the company regulations may only do so if the
company meets the scoping requirements of IFRS for SMEs.

JSE Ltd

In terms of section 8.62 of the listing requirements of the JSE, the annual financial
statements of listed companies must be drawn up in accordance with the national law
applicable to a listed company and be prepared in accordance with IFRSs and the South
African accounting standards as issued by the APB.

ASSESSMENT CRITERIA

Are you now able to do the following?

 Define the objectives of the IASB.
 Define the scope and authority of International Financial Reporting
Standards.
 Understand the legal requirements for Generally Accepted Accounting
Practice.
 Understand the harmonisation of Generally Accepted Accounting
Practice.

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LEARNING UNIT 5
PRESENTATION OF
FINANCIAL STATEMENTS
(IAS 1)

General Financial Reporting

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LEARNING OUTCOMES
Learners should be able to prepare general-purpose financial statements using the
structure and contents of IAS 1 in order to improve comparability with the entity's own
financial statements of previous periods and with the financial statements of other entities.

OVERVIEW
This learning unit is divided into the following:

5.1 Purpose of financial statements

5.2 General features
5.3 Structure and content
5.4 Structure and content: Statement of financial position
5.5 Structure and content: Statement of profit or loss and other comprehensive income
5.6 Structure and content: Statement of changes in equity
5.7 Structure and content: Notes to the financial statements
5.8 Example: Presentation of financial statements
5.9 The structure of illustrative financial statements

STUDY
PRESCRIBED
Descriptive Accounting
The chapter relevant to IAS 1 - Presentation of Financial Statements.

RECOMMENDED:
IFRS Standards – The Annotated IFRS Standards
IAS 1 - Presentation of Financial Statements

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OVERVIEW OF LEARNING UNIT

International Accounting Standard 1 (IAS 1) covers the presentation of financial

statements. This includes the layout of general-purpose financial statements and the
considerations to be taken into account when preparing the content of these financial
statements.

The objective of IAS 1 is to prescribe the basis of presentation of general-purpose financial

statements in order to ensure comparability both in terms of the entity's own financial
statements from one financial period to another, and with regard to the financial
statements of other entities.

IAS 1 refers to general-purpose financial statements. Financial statements prepared in

terms of this accounting standard form the basis or starting point for the preparation of
financial statements. If another accounting standard requires additional disclosure this is in
addition to that required by IAS 1.

IAS 1 does not apply to the preparation of condensed interim financial statements, but it
does apply equally to the financial statements of individual entities and the preparation of
group financial statements.

It is the responsibility of the board of directors or management of an entity to prepare and

present the financial statements.

5.1 Purpose of financial statements (IAS 1 par .09–.10)

The financial statements are a structured representation of the financial position of the
entity and the results of the operations undertaken by the entity.

The objective of preparing financial statements is to provide information about the financial
position (assets, liabilities and equity), performance (income and expenses, including
gains and losses), and cash flows of an entity in order to provide useful information to the
users of the financial statements in making economic decisions. It also serves as proof of
the results of management's stewardship of the resources of the entity.

A complete set of financial statements consists of

 a statement of financial position;

 a statement of profit or loss and other comprehensive income;
 a statement of changes in equity;
 a statement of cash flows;
 accounting policies and explanatory notes;

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 a statement of financial position at the beginning of the earliest comparative period

when an entity applies an accounting policy retrospectively or makes a retrospective
restatement of items in its financial statements or when it reclassifies items in its
financial statements; and
 comparative information in respect of the preceding periods as specified in paragraphs
.38 and .38A of IAS 1

5.2 General features

When preparing the annual financial statements, the following general features must be
taken into account:

 Fair presentation and compliance with IFRSs (IAS 1 par .15–.23)

The financial statements should fairly present the financial position (referring to the
statement of financial position), financial performance (referring to the statement of profit
or loss and other comprehensive income) and cash flows (referring to the statement of
cash flows) of an entity. If the International Financial Reporting Standards (IFRSs) are
properly applied, and when in certain circumstances additional disclosure is necessary and
presented, the financial statements achieve fair presentation.

If management should conclude that the compliance with a requirement in an IFRS conflict
with the objective of the financial statements set out in the Framework (a rare occurrence)
then management would adopt requirements that would ensure fair presentation and
would disclose the following:

(a) Management has concluded that the financial statements present fairly the entity’s
financial position, financial performance and cash flows.
(b) It has complied with applicable IFRSs, except that it has departed from a particular
requirement to achieve a fair presentation.
(c) The title of the IFRS from which the entity has departed, the nature of the departure,
including the treatment the IFRS would require and the reason why that treatment
would be so misleading in the circumstances that it would conflict with the objective of
financial statements set out in the Framework and the treatment adopted.
(d) For each period presented, the financial effect that the departure had on each item in
the financial statements that would have been reported in compliance with the
requirement.

 Going concern (IAS 1 par .25–.26)

This consideration is based on the fundamental accounting concept that the entity will
continue to exist in the foreseeable future.

When management assesses whether the going concern assumption is appropriate, it

takes into account all the relevant information for at least 12 months from the statement of
financial position reporting period.

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When financial statements are not prepared on a going concern basis, that fact should be
disclosed together with the basis on which the financial statements are prepared and the
reason why the entity is not considered a going concern.

 Accrual basis of accounting (IAS 1 par .27–.28)

Financial statements, except cash flow information, are prepared using the accrual basis
of accounting. When the accrual basis of accounting is used, an entity recognises the
elements of the financial statements when they satisfy the definitions and recognition
criteria.

 Consistency of presentation (IAS 1 par .45–.46)

The presentation and classification of items in the financial statements should be retained
within each accounting period, and from one accounting period to the next.

Consistency consists of two important aspects, namely

 consistency over time; and

 consistency of disclosure of similar items.

 Materiality and aggregation (IAS 1 par .29–.31)

Each material class of similar items should be presented separately in the financial
statements. Items of a dissimilar nature or function should be presented separately unless
they are immaterial.

If a line item is not individually material, it is aggregated with other items either in those
statements or in the notes.

 Offsetting (IAS 1 par .32–.35)

This consideration refers to the netting off of assets and liabilities, and income and
expenses. This is not allowed unless specifically required in terms of a Standard or an
Interpretation.

 Comparative financial information (IAS 1 par .38–.44)

Numerical information in the financial statements should be disclosed with the comparative
figures for the previous period. Comparative information in respect of the previous
accounting period should also be disclosed for all narrative and descriptive information. If
either the presentation or the classification of items in the financial statements is amended,
then the comparative amounts should be reclassified unless the reclassification is
impracticable.

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5.3 Structure and content

IAS 1 outlines the broad disclosure requirements for preparing financial statements. It is
left to the specific International Financial Reporting Standards (IFRSs) to prescribe the
specific disclosure requirements of items in the financial statements.

This accounting standard requires particular disclosures to be made in the financial

statements.

 Identification of financial statements (IAS 1 par .49–.53)

The financial statements should be clearly identified. This includes information about the
name of the reporting entity, whether the financial statements are for the individual entity
or for a group of entities, the reporting date and currency, as well as the level of rounding
of the figures (for example R'000).

 Frequency of reporting (IAS 1 par .36–.37)

It is a requirement that financial statements should be presented at least annually. In

exceptional cases, in which an entity's reporting date changes, with the result that the
financial statements are presented for a period shorter or longer than one year, the
following additional information should be provided:
 The reason for using the longer or shorter period
 The fact that the comparative amounts of the financial statements are not entirely
comparable

The financial statements must also be presented within a reasonable time from the end of
the financial year; otherwise, the information will be of little or no use to the users of the
financial statements.

5.4 Structure and content: Statement of financial position

 Current/Non-current distinction (IAS 1 par .60–.65)

An important classification in terms of the statement of financial position is whether an item

should be disclosed as a current or as a non-current item.

 Current assets (IAS 1 par .66–.68)

An asset is classified as a current asset when it satisfies any of the following requirements:

 It is expected to be realised in, or is intended for sale or consumption in, the entity's
normal operating cycle.
 It is held primarily for the purpose of being traded.

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 It is expected to be realised within 12 months after the year-end date.

 It is cash or a cash equivalent.

All other assets are classified as non-current assets.

The operating cycle of an entity is the time between the acquisition for processing and the
realisation of its assets for cash or cash equivalents.

 Current liabilities (IAS 1 par .69–.70)

A liability is classified as current when it satisfies any of the following requirements:

 It is expected to be settled in the entity's normal operating cycle.

 It is held primarily for the purpose of being traded.
 It is due to be settled within 12 months after the reporting period.
 The entity does not have an unconditional right to defer settlement of the liability for at
least 12 months after the year-end date.

All other liabilities are classified as non-current liabilities.

 Information to be presented on the face of the statement of financial position

(IAS 1 par .54–.59)

The following line items should be included on the face of the statement of financial
position:

(a) Property, plant and equipment

(b) Investment property
(c) Intangible assets
(d) Financial assets (excluding e, h and i)
(e) Investments accounted for using the equity method
(f) Biological assets
(g) Inventories
(h) Trade and other receivables
(i) Cash and cash equivalents
(j) The total of assets classified as held for sale and assets included in disposal groups
classified as held for sale
(k) Trade and other payables
(l) Provisions
(m) Financial liabilities (excluding k and l)
(n) Liabilities and assets for current tax
(o) Deferred tax liabilities and deferred tax assets
(p) Liabilities included in disposal groups classified as held for sale
(q) Non-controlling interest presented within equity
(r) Issued capital and reserves attributable to owners of the parent

Paragraph .54 of IAS 1 refers to information to be presented on the face of the statement
of financial position. What follows is an extract of the accounting statement on financial
instruments (IAS 32) which is not covered by this module. You need to be introduced to it
to understand the statement of financial position classifications.
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A financial instrument is defined as "any contract that gives rise to both a financial asset
of one entity and a financial liability or equity instrument of another entity".

A financial asset is defined as any asset that is

 cash;
 any equity instrument of another entity;
 a contractual right
 to receive cash or another financial asset from another financial entity; or
 to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity; or

 a contract that will or may be settled in the entity's own equity instruments and is
 a non-derivative for which the entity is or may be obliged to receive a variable
number of the entity's own equity instruments; or
 a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity's own
equity instruments. For this purpose the entity's own equity instruments do not
include instruments that are themselves contracts for the future receipt or delivery
of the entity's own equity instruments.

An equity instrument is defined as any contract that evidences a residual interest in the
assets of an entity after deducting all its liabilities. (This refers to an entity's investment in
the equity shares of another entity.)

Examples of financial assets are

 cash;
 deposits at financial institutions;
 promissory notes receivable;
 loans receivable;
 bonds receivable;
 investments in listed companies;
 investments in unlisted companies; and
 investments in associates.

In terms of paragraph .54 of IAS 1, financial assets other than "investments accounted for
using the equity method, trade and other receivables, and cash and cash equivalents" are
grouped together under the heading "Other financial assets". This is the category for the
disclosure of for example listed and unlisted investments.

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The following are not examples of financial assets:

 property, plant and equipment;

 leased assets;
 inventories;
 goodwill, patents and trademarks;
 prepaid expenses (such as an insurance premium paid in advance, which is not the
right to receive cash or another financial asset, but the right to the receipt of goods or
services in the future); and
 income taxes that are created as a result of statutory requirements imposed by
government.

A financial liability is defined as any liability that is

a contractual obligation
 to deliver cash or another financial asset to another entity, or
 to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; or

a contract that will or may be settled in the entity's own equity instruments and is

 a non-derivative for which the entity is or may be obliged to deliver a variable

number of the entity's own equity instruments; or
 a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity's own
equity instruments. For this purpose the entity's own equity instruments do not
include instruments that are themselves contracts for the future receipt or delivery
of the entity's own equity instruments.

In the case of preference shares, they can be classified as either financial liabilities or
equity.

Where the rights of a preference share

 provide for mandatory redemption by the issuer for a fixed or determinable amount at a
fixed or determinable future date; or
 give the holder the right to require redemption at or after a particular date for a fixed or
determinable amount, it meets the definition of a financial liability and it should be
disclosed (classified) as such.

If the above does not apply, then issued preference shares will be classified as part of
equity.

A preference share that provides for redemption at the option of the issuer (that is at the
company's discretion) is not a financial liability because the issuer does not have a present
obligation to transfer financial assets to the shareholders.

These are examples of financial liabilities:

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 trade and other creditors;

 promissory notes payable;
 loans payable; and
 bonds payable.

In the case of financial assets and financial liabilities, one party's contractual right to
receive cash (or its obligation to pay) is matched by the other party's corresponding
obligation to pay (or the right to receive).

 Information to be presented either on the face of the statement of financial

position or in the notes (IAS 1 par .77–.80A)

Further subclassifications of line items presented should be disclosed either on the face of
the statement of financial position or in the notes. The disclosures vary for each item, for
example:
 Property, plant and equipment are disaggregated into classes according to IAS 16.
 Receivables are disaggregated into amounts receivable from trade customers,
receivables from related parties, prepayments and other amounts.
 Inventories are subclassified according to IAS 2.
 Provisions are disaggregated into provisions for employee benefits and other items.
 Equity capital and reserves are disaggregated into various classes, such as paid-up
capital, share premium and reserves.

5.5 Structure and content: Statement of profit or loss and other

comprehensive income (IAS 1 par .81A–.81B)

The statement of profit or loss and other comprehensive income presents the following in
addition to profit or loss and other comprehensive income sections:

(a) profit or loss;

(b) total comprehensive income; and
(c) comprehensive income for the period (the total profit or loss and other comprehensive
income)

If an entity presents a separate statement of profit or loss, it does not present the profit or
loss section in the statement of profit or loss and other comprehensive income.

An entity must present the following items, in addition to the profit or loss and other
comprehensive income sections, as allocation of profit or loss and other comprehensive
income for the period:

(a) Profit or loss for the period attributable to

(i) non-controlling interests; and

(ii) owners of the parent.

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(b) Comprehensive income for the period attributable to

(i) non-controlling interests; and

(ii) owners of the parent.

If an entity presents profit or loss in a separate statement, it must present (a) in that
statement.

 Information to be presented in the profit or loss section or the statement of

profit or loss (IAS 1 par .82)

In addition to items required by other IFRSs the profit or loss section or the statement of
profit or loss must include line items that present the following amounts for the period:
 revenue;
 gains and losses arising from the derecognition of financial assets measured at
amortised cost;
 finance costs;
 share of the profit or loss of associates and joint ventures accounted for using the
equity method;
 if a financial asset is reclassified so that it is measured at fair value, any gain or loss
arising from a difference between the previous carrying amount and its fair value at the
reclassification date;
 tax expense; and
 a single amount for the total of discontinued operations.

An entity must not present any income or expense items as extraordinary items in the
statement of profit or loss and other comprehensive income or in the notes.

 Information to be presented in the other comprehensive income section

(IAS 1 par .82A)

The other comprehensive income section must present line items for amounts of other
comprehensive income in the period, classified by nature (including share of the other
comprehensive income of associates and joint ventures accounted for using the equity
method) and grouped into those that, in accordance with other IFRSs

(a) will not be reclassified subsequently to profit or loss; and

(b) will be reclassified subsequently to profit or loss when specific conditions are met.

 Profit or loss for the period (IAS 1 par .88–.89)

An entity must recognise all items of income and expense in a period in profit or loss
unless an IFRS requires or permits otherwise.

 Other comprehensive income for the period (IAS 1 par .90–.96)

An entity must disclose the amount of income tax relating to each item of other
comprehensive income, including reclassification adjustments, either in the statement of
profit or loss and other comprehensive income or in the notes.

An entity may present items of other comprehensive income either

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 net of related tax effects; or

 before related tax effects with one amount shown for the aggregate amount of income
tax relating to those items.

 Information to be presented either in the statement of profit or loss and other

comprehensive income or in the notes (IAS 1 par .97–.105)

The nature and amount of all income and expense items must be disclosed separately if
they are material.

The following circumstances give rise to separate disclosure of income and expense
items:

 inventories written down to net realisable value and reversals of these write-downs;
 property, plant and equipment written down to recoverable amount and reversals of
these write-downs;
 restructuring of an entity's activities and reversals of provisions made for the costs of
restructuring;
 disposal of property, plant and equipment;
 disposal of investments;
 discontinuing operations;
 litigation settlements; and
 other reversals of provisions.

LECTURER’S COMMENT

The statement of profit or loss and other comprehensive income can be

presented in two ways: either by classifying income and expenditure in
terms of the functions that give rise to them, or by classifying income and
expenditure in terms of their nature.

THIS MODULE'S PREFERENCE IS THE CLASSIFICATION OF

INCOME AND EXPENSES ACCORDING TO FUNCTION.

When income and expenditure are classified in terms of the functions which give rise to
them, additional information about the nature of the expenditure should be provided in the
notes to the statement of profit or loss and other comprehensive income, including the
following:

 depreciation;
 amortisation; and
 employee benefit expense.

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5.6 Structure and content: Statement of changes in equity

(IAS 1 par .106–.110)

A statement of changes in equity forms part of the financial statements. What is essentially
required is a reconciliation of equity at the beginning of the financial year with equity at the
end of the financial year.

The statement should include the following:

 total comprehensive income for the period, showing separately the total amounts
attributable to owners of the parent and non-controlling interest;
 the effects of retrospective application or retrospective restatement recognised in
accordance with IAS 8 for each component of equity; and
 for each component of equity, a reconciliation between the carrying amount at the
beginning and the end of the period.

Dividends paid for the period and related dividend per share can be disclosed either in the
statement of changes in equity or in the notes.

5.7 Structure and content: Notes to the financial statements

(IAS 1 par .112–.138)

The notes to the annual financial statements should

 present information about the basis of preparation of the financial statements;

 present the specific accounting policies selected and applied for significant
transactions and events;
 disclose information required not presented elsewhere in the financial statements; and
 provide additional information not presented elsewhere in the financial statements, but
which is relevant to an understanding of any of them, for example information about
contingent liabilities.

Notes to the annual financial statements should be

 presented in a systematic manner; and

 each item on the statements should be cross-referenced to the notes.

An entity should disclose the following in the summary of significant accounting policies:

 the measurement basis (or bases) used in preparing the financial statements, for
example, historical costs, net realisable value and fair value; and
 the other accounting policies used that are relevant to an understanding of the
financial statements.

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5.8 Example: Presentation of Financial Statements

The following is an example of financial statements prepared in terms of the requirements

of IAS 1. Please note that this is a very detailed example and not all the items in this
example are covered in this module.

XYZ GROUP

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20.12

20.12 20.11
R’000 R’000
ASSETS
Non-current assets X X
Property, plant and equipment X X
Investment property X X
Goodwill X X
Other intangible assets X X
Investments in associates X X
Investments in non-current assets X X
Deferred tax X X

Current assets X X
Inventories X X
Trade and other receivables X X
Other investments in current assets X X
Cash and cash equivalents X X
Total assets X X

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20.12 20.11
R’000 R’000
EQUITY AND LIABILITIES

Total equity X X

Equity attributable to owners of the parent X X

Share capital X X
Retained earnings X X
Other components of equity X X

Non-controlling interest X X

Total liabilities X X
Non-current liabilities X X
Long-term borrowings X X
Other financial liabilities X X
Long-term provisions X X
Deferred tax X X

Current liabilities X X
Trade and other payables X X
Short-term borrowings X X
Current portion of long-term borrowings X X
Short-term provisions X X
Other financial liabilities X X
Current tax payable X X

Total equity and liabilities X X

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XYZ GROUP

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR

THE YEAR ENDED 31 DECEMBER 20.12
(Illustrating the classification of expenses by function – this method is preferred by
Unisa)
20.12 20.11
R'000 R'000
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
PROFIT FOR THE YEAR X X
Other comprehensive income:
Items that will not be reclassified to profit or loss:
Gains on property revaluation X X
Remeasurements on defined benefit pension plans X X
Share of gain (loss) on property revaluation of associates X X
Income tax relating to items that will not be reclassified (X) (X)
X X
Items that may be reclassified subsequently to profit or loss:
Exchange differences on translating foreign operations X X
Available-for-sale financial assets X X
Cash flow hedges X X
Income tax relating to items that may be reclassified (X) (X)
X X
Other comprehensive income for the year, net of tax X X
TOTAL COMPREHENSIVE INCOME FOR THE YEAR X X
Profit attributable to
Owners of the parent X X
Non-controlling interests X X
X X
Total comprehensive income attributable to
Owners of the parent X X
Non-controlling interests X X
X X

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XYZ GROUP

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR
ENDED 31 DECEMBER 20.12
(Illustrating the classification of expenses by nature)
20.12 20.11
R'000 R'000
Revenue X X
Other income X X
Changes in inventories of finished goods and work in progress (X) X
Work performed by the entity and capitalised X X
Raw material and consumables used (X) (X)
Employee benefits expense (X) (X)
Depreciation expense (X) (X)
Amortisation expense (X) (X)
Impairment of property, plant and equipment (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
PROFIT FOR THE YEAR X X
Other comprehensive income:
Items that will not be reclassified to profit or loss:
Gains on property revaluation X X
Remeasurements on defined benefit pension plans X X
Share of gain (loss) on property revaluation of associates X X
Income tax relating to items that will not be reclassified (X) (X)
X X
Items that may be reclassified subsequently to profit or loss:
Exchange differences on translating foreign operations X X
Available-for-sale financial assets X X
Cash flow hedges X X
Income tax relating to items that may be reclassified (X) (X)
X X
Other comprehensive income for the year, net of tax X X
TOTAL COMPREHENSIVE INCOME FOR THE YEAR X X
Profit attributable to
Owners of the parent X X
Non-controlling interests X X
X X
Total comprehensive income attributable to
Owners of the parent X X
Non-controlling interests X X
X X

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LECTURER’S COMMENT

In a statement of profit or loss and other comprehensive income in which

expenses are classified by nature, an impairment of property, plant and
equipment is shown as a separate line item. By contrast, if expenses are
classified by function, the impairment is included in the function(s) to
which it relates, and separately disclosed in the note on profit before tax.
The same applies to employees’ costs, depreciation and amortisation.

An entity may choose to split the statement of profit of loss and other comprehensive
income into two separate statements. The one statement, called a statement of profit or
loss, then deals with the profit for the year, while the other statement, called a statement of
profit or loss and other comprehensive income, shows the total profit for the year as well
as the components of other comprehensive income.

XYZ GROUP

STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20.12

20.12 20.11
R'000 R'000
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
PROFIT FOR THE YEAR X X

Profit attributable to
Owners of the parent X X
Non-controlling interests X X
X X

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XYZ GROUP

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR

THE YEAR ENDED 31 DECEMBER 20.12

20.12 20.11
R'000 R'000
Profit for the year X X
Other comprehensive income:
Items that will not be reclassified to profit or loss:
Gains on property revaluation X X
Remeasurements on defined benefit pension plans X X
Share of gain (loss) on property revaluation of associates X (X)
Income tax relating to items that will not be reclassified (X) (X)
X X
Items that may be reclassified subsequently to profit or loss:
Exchange differences on translating foreign operations X X
Available-for-sale financial assets X X
Cash flow hedges X X
Income tax relating to items that may be reclassified (X) (X)
X X
Other comprehensive income for the year, net of tax X X
TOTAL COMPREHENSIVE INCOME FOR THE YEAR X X

Total comprehensive income attributable to

Owners of the parent X X
Non-controlling interests X X
X X

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FAC3701/501/3/2019
XYZ GROUP
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20.12

Translation Investment Cash Non-

Share Retained of foreign in equity flow Revaluation controlling Total
capital earnings operations instruments hedges surplus Total interest equity
R’000 R’000 R’000 R’000 R’000 R’000 R’000 R’000 R’000
Balance at 1 January 20.11 X X X X X – X X X
Changes in accounting policy – X – – – – X X X
Restated balance X X X X X X X X X

Changes in equity for 20.11

Dividends – X – – – – X – X
Total comprehensive income for the year – X X X X X X X X
Balance at 31 December 20.11 X X X X X X X X X

Changes in equity for 20.12

Issue of share capital X – – – – – X – X
Dividends – X – – – – X – X
Total comprehensive income for the year – X X X X X X X X
Transfer to retained earnings – X – – – X – – –
Balance at 31 December 20.12 X X X X X X X X X

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LECTURER’S COMMENT

Statement of changes in equity

IAS 1 requires disclosure of dividend per share in the statement of

changes in equity, or alternatively in the notes.

The statement of changes in equity reflects the opening and closing

balances of all the share capital and reserve accounts, the effects of
changes in accounting policies/correction of prior period errors, the total
comprehensive income for the period (reported as a single line item), the
issue of shares, the repurchase of shares, dividends paid and transfers
between reserves.

5.9 Illustrative financial statement structure

Work carefully through the appendix to IAS 1. Note the layout of the statement of financial
position, statement of profit or loss and other comprehensive income and statement of
changes in equity and the required forms of disclosure. At all times take into account what
you have already learnt in this section of the study material.

The following detailed example illustrates all aspects of financial statements. The
examination will not include a question of this detail and length.

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Example 1

The following trial balance is available for A Ltd at 31 December 20.12:

Dr Cr
R R
Share capital – issued and fully paid:
Ordinary shares 50 000
7% redeemable preference shares 15 000
Accumulated depreciation of plant and equipment 8 250
(31/12/20.11)
Accumulated amortisation of patents and trademarks 1 500
(31/12/20.11)
Plant and equipment at cost (31/12/20.11) 90 500
Land and buildings at fair value (cost R34 545) 37 875
Patents and trademarks at cost (31/12/20.11) 7 500
Investment at fair value 16 500
Revenue (sales to customers, excluding VAT) 60 250
Raw material purchased 11 750
Work in progress – 31 December 20.11 2 000
Finished goods on hand – 31 December 20.11 12 000
Raw materials on hand – 31 December 20.11 1 500
(valued at cost on FIFO basis)
Selling and distribution expenses 3 800
Administrative expenses 22 200
Proceeds on sale of plant and equipment 4 500
Loss on expropriation of land 1 000
Retained earnings – 31 December 20.11 18 750
Dividends received – B Ltd 2 700
Bank overdraft 19 500
Trade and other payables 71 525
Trade and other receivables 45 350
251 975 251 975

Additional information

1. Trade and other receivables

Includes provisional tax payments of R7 000.

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2. Trade and other payables

Creditors are secured by plant to the value of R35 000 (payable within one year).
Accrued interest on debentures also forms part of creditors.

3. Administrative expenses include the following:

R
Interest on bank overdraft 1 450
Auditors' remuneration – for audit 1 000
Managing director's salary – executive 1 500
Directors' remuneration – executive 300
Salaries and wages 12 500
Rent paid 2 500

4. Property, plant and equipment

 Land and buildings held for capital appreciation are considered by the directors to
be investment properties and are valued at fair value. Operating expenses of the
investment property amounted to R2 000 for the year ended 31 December 20.12.
Land with fair value of R15 000 (cost R12 000) was expropriated during the year.
Land and buildings are valued by an independent valuer with a recognised and
relevant qualification. There were no fair value adjustments for the year ended
31 December 20.12.
 During the year, plant which had a cost of R6 000 was sold for R4 500. The
depreciation provided on this plant to 31 December 20.11 is R1 250. There were
no other sales of plant and equipment during the year.
 Depreciation on plant and equipment must still be provided for the year. The
details are as follows:
R
Depreciation from beginning of year to date of disposal of plant 1 000
Depreciation on remaining plant and equipment 3 500
4 500

 The tax bases and carrying amounts of property, plant and equipment were equal
at the beginning of the year. Depreciation per the accounts is the same as that
allowed by the SA Revenue Service.

5. Patents and trademarks

The patents and trademarks are amortised over five years according to the straight-
line method. The amortisation charge for 20.12 is R1 500, which is the same as that
allowed by the SA Revenue Service.

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6. Authorised and issued share capital

 The authorised and issued share capital consists of

 50 000 ordinary shares.

 15 000 7% redeemable preference shares.
The redeemable preference shares are redeemable at the company's discretion,
on or before 1 July 20.13, at a premium of 5%.

 There were no new issues of shares during the year.

7. Investment

Investment consists of 7 500 ordinary shares of R1 each in B Ltd, which is quoted on

the JSE Limited (SA). The market value on 31 December 20.12 was R2,20 per share.

8. Provision must be made for the following:

 Current tax at 28%. It may be assumed that "selling and distribution expenses"
and "administrative expenses" do not include any disallowable expenditure for
income tax purposes.
 Annual preference dividend.
 Dividends proposed to ordinary shareholders of R7 500.

9. Inventory

The value (lower of cost or net realisable value) of inventory at 31 December 20.12 is:

R
Raw materials 1 500
Work in progress 3 000
Finished goods 11 250

REQUIRED

Prepare the annual financial statements of A Ltd for the year ended
31 December 20.12. Your answer must comply with the requirements of
International Financial Reporting Standards.

Ignore the implications of capital gains tax.

Please note: The classification of financial assets and financial liabilities

in this question does not form part of this module.

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Solution 1

A LTD
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20.12

Notes R
ASSETS
Non-current assets 116 375
Property, plant and equipment 2 74 000
Investment property 3 37 875
Patents and trademarks 4 4 500
Current assets 72 700
Inventory 5 15 750
Trade and other receivables (5) 6 38 350
Other investments in current assets 6 16 500
SA Revenue Service (6) 2 100

Total assets 189 075

EQUITY AND LIABILITIES

Total equity 89 500
Share capital 7 65 000
Retained earnings 24 500
Total liabilities 99 575
Current liabilities 99 575
Trade and other payables 8 71 525
Dividends proposed (4) 8 550
Bank overdraft 8 19 500

Total equity and liabilities 189 075

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A LTD

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR

THE YEAR ENDED 31 DECEMBER 20.12
(according to classification of expenses by function)

Notes R
Revenue 9 60 250
Cost of sales (11 500)
(11 750 + 2 000 + 12 000 + 1 500 – 15 750)
Gross profit 48 750
Other income
[4 500 (proceeds) – (6 000 (cost) – 1 250 (acc depr)
– 1 000 (depr)) + 2 700 (div rec)] 3 450
Distribution costs (3 800)
Administrative expenses (22 200 – 1 450) (20 750)
Other expenses (4 500 (depr) + 1 500 (amort) + 1 000 (loss)) (7 000)
Finance costs (1 450)
Profit before tax 10 19 200
Income tax expense (1) 11 (4 900)
PROFIT FOR THE YEAR 14 300

TOTAL COMPREHENSIVE INCOME FOR THE YEAR 14 300

OR

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A LTD

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR

THE YEAR ENDED 31 DECEMBER 20.12
(according to classification of expenses by nature)

Notes R
Revenue 9 60 250
Other income 3 450
[4 500 – (6 000 – 1 250 – 1 000) + 2 700]
Changes in inventories of finished goods and work in progress
[(11 250 + 3 000) – (12 000 + 2 000)] 250
Raw material consumed (11 750)
Employee benefits expense (12 500)
Depreciation and amortisation expense (4 500 + 1 500) (6 000)
Other expenses (3) (13 050)
Finance costs (1 450)
Profit before tax 10 19 200
Income tax expense (1) 11 (4 900)
PROFIT FOR THE YEAR 14 300
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 14 300

(Note: If this classification is used, employee benefits expense and depreciation would not
be disclosed in the note dealing with the components of profit before tax.)

LECTURER’S COMMENT

Please note that the line item "other income" in the statement of profit or
loss and other comprehensive income includes both investment income
and operating income.

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A LTD

STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20.12

Share Retained Total

capital earnings Equity
R R R
Balance at 1 January 20.12 65 000 18 750 83 750
Changes in equity for 20.12
Total comprehensive income for the year 14 300 14 300
Dividends paid
– ordinary (1) (7 500) (7 500)
– preference (2) (1 050) (1 050)
Balance at 31 December 20.12 65 000 24 500 89 500

(1) Given
(2) 15 000 x 7%

A LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.12

1. Accounting policy

The financial statements have been prepared in accordance with International Financial
Reporting Standards.

The financial statements have been prepared on the historical cost basis, as modified by
the revaluation of land and buildings, investment property, financial assets and financial
liabilities at fair value through profit or loss, financial assets at fair value through other
comprehensive income and financial assets and financial liabilities at amortised cost.

They incorporate the following principal accounting policies that are consistent with the
policies applied in previous years, except where otherwise stated.

LECTURER’S COMMENT

IAS 1.16 requires disclosure of the fact that IFRSs have been complied
with.

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1.1 Property, plant and equipment

Property, plant and equipment are initially recognised at cost price. Plant and equipment
are subsequently measured at historical cost less accumulated depreciation and
accumulated impairment losses. Plant and equipment are depreciated according to the
straight-line method over their estimated useful lives, which were as follows on
1 January 20.12:

Plant and equipment – x years

The residual values and useful lives of all items of property, plant and equipment are
reviewed and adjusted, if necessary, in each reporting period.

1.2 Investment property

Investment property is land and buildings held to earn rentals, for capital appreciation, or
for both reasons. Investment property is initially recognised at cost and subsequently
measured at fair value, with fair-value adjustments recognised in profit or loss for the
period. The fair value of investment property is determined at the reporting period by an
independent sworn appraiser based on market evidence of the most recent prices
obtained in arm’s length transactions of similar properties in the same area.

1.3 Patents and trademarks

Patents and trademarks acquired are initially recognised at cost. Patents and trademarks
have a finite useful life and they are carried at cost less accumulated amortisation and
accumulated impairment losses. Amortisation on patents and trademarks is calculated
using the straight-line method over a period of five years.

1.4 Inventory

Inventory and work in progress are stated at the lower of cost or net realisable value. Cost
is determined according to the following methods pertaining to each class:

Raw materials – at actual cost calculated using the FIFO method

Work in progress – at manufacturing cost including overheads
Finished goods – at manufacturing cost including overheads

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1.5 Financial assets

Financial assets are recognised in the entity's statement of financial position when the
entity becomes a party to the contractual provisions of an instrument.

Financial instruments are initially measured at fair value plus or minus, in the case of a
financial asset or financial liability not at fair value through profit or loss, the transaction
costs directly attributable to the acquisition or issue of the financial asset or financial
liability.

The entity classifies its financial assets in the following categories: at amortised cost; at fair
value through profit or loss; or at fair value through other comprehensive income. The
entity's classification depends on the substance of the contractual arrangement and the
definition of a financial asset.

1.6 Financial liabilities

Financial liabilities are recognised in the entity's statement of financial position when the
entity becomes a party to the contractual provisions of the instrument. The classification
depends on the substance of the contractual arrangement and the definition of a financial
liability.

1.7 Revenue

Revenue is measured at the fair value of the consideration received or receivable.

Revenue represents the transfer of promised goods and services to customers in an
amount that reflects the consideration to which the entity expects to be entitled in
exchange for those goods and services. Revenue is recognised from contracts with
customers when performance obligations are satisfied.

2. Property, plant and equipment

R
Carrying amount at the beginning of the year 82 250
Cost 90 500
Accumulated depreciation (8 250)
Depreciation (4 500)
Disposals (3 750)
Carrying amount at end of the year 74 000
Cost (90 500 – 6 000) 84 500
Accumulated depreciation (2) (10 500)

Plant to the value of R35 000 serves as security for creditors.

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3. Investment property
R
Carrying amount at fair value – 31 December 20.11 52 875
Cost (34 545 + 12 000) 46 545
Fair value adjustments [(15 000 – 12 000) + (37 875 – 34 545)] 6 330
Expropriation of land (15 000)
Carrying amount at fair value – 31 December 20.12 37 875
Cost 34 545
Fair value adjustments (37 875 – 34 545) 3 330

Land and buildings are valued by an independent valuer with a recognised and relevant
qualification.

4. Patents and trademarks

R
Carrying amount at the beginning of the year 6 000
Cost 7 500
Accumulated amortisation (1 500)
Amortisation for the year (1 500)
Carrying amount at end of the year 4 500
Cost 7 500
Accumulated amortisation (3 000)

5. Inventory

Inventory consists of
R
Raw materials 1 500
Work in progress 3 000
Finished goods 11 250
15 750

6. Financial assets
R
Current financial assets
Trade receivables 38 350
Other investments in current assets
Financial assets at fair value through profit and loss
Listed investment: 7 500 shares in B Ltd at fair value 16 500

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7. Share capital
R
Authorised
50 000 ordinary shares 50 000
15 000 7% redeemable preference shares 15 000
65 000

Issued R
50 000 ordinary shares 50 000
15 000 7% redeemable preference shares 15 000
65 000

The 7% redeemable preference shares are redeemable at the company's discretion at a

premium of 5% on or before 1 July 20.13.

LECTURER’S COMMENT

Redeemable preference shares

Preference shares may be issued with various rights. In classifying a
preference share as a liability or equity, an entity assesses the particular
rights attaching to the share to determine whether or not it exhibits the
fundamental characteristic of a financial liability. For example, a
preference share that provides for redemption on a specific date or at the
option of the holder meets the definition of a financial liability if the issuer
has an obligation to transfer financial assets to the holder of the share.
An option of the issuer to redeem the share does not satisfy the definition
of a financial liability because the issuer does not have a present
obligation to transfer financial assets to the shareholders. Redemption of
the shares is solely at the discretion of the issuer. When preference
shares are non-redeemable, the appropriate classification is determined
by the other rights that may attach to them. When distributions to holders
of the preference shares are at the discretion of the issuer, the shares
are equity instruments (IAS 32 paragraphs 15–20).

8. Financial liabilities

Current financial liabilities

R
Trade and other payables 71 525
Other financial liabilities:
Bank overdraft 19 500

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9. Revenue
R

Sales to customers 60 250

10. Profit before tax

Profit before tax is stated after charging the following:

R
Income
Other income – profit on sale of plant 750
Income from investments – dividends received from listed investments 2 700

Expenses
Finance costs – interest paid on bank overdraft 1 450
Auditors' remuneration – for audit 1 000
Directors' remuneration – executive directors 1 800
As director 300
Other services 1 500
Depreciation on property, plant and equipment 4 500
Amortisation – patents and trademarks 1 500
Employee benefits expenses 12 500
Rent paid 2 500
Operating expenses relating to investment property which does not
generate rental income 2 000

LECTURER’S COMMENT

Note that IAS 1.104 requires that when expenses are classified by
function, additional information on the nature of total depreciation,
amortisation and staff costs should be disclosed in a note.

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11. Income tax expense

R
Major components of tax expense
Current tax expense – current year 4 900

Tax rate reconciliation

R OR %
Standard rate of tax (19 200 x 28%) 5 376 28,0
Adjusted for exempt differences:
Loss on expropriation of land (capital) (1 000 x 28%);
[((1 000 x 28%) ÷ 19 200) x 100] 280 1,4
Dividends received (2 700 x 28%); (756) (3,9)
[((2 700 x 28%) ÷ 19 200) x 100]
Effective rate of tax [(4 900 ÷ 19 200) x 100] 4 900 25,5

Calculations

1. Taxable income and tax payable

R
Profit before tax 19 200
Dividends received (not taxable) (2 700)
Loss on expropriation of land 1 000
Taxable income 17 500
Tax payable at 28% 4 900

2. Depreciation
R
Accumulated depreciation per trial balance 8 250
Accumulated depreciation in respect of plant sold (1 250)
7 000
Depreciation for the year 4 500
Depreciation for the year in respect of plant sold (1 000)
Accumulated depreciation at 31 December 20.12 10 500

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3. Other expenses (nature)

Total Nature
R R
Auditors' remuneration 1 000 1 000
Managing director's salary 1 500 1 500
Directors' remuneration 300 300
Interest on bank overdraft* 1 450 –
Staff costs* 12 500 –
Rent paid 2 500 2 500
Other (balancing figure) 2 950 2 950
Administrative expenses per trial balance 22 200
Selling and distribution costs 3 800
Loss on expropriation of land 1 000
Other expenses 13 050

*Disclosed separately

4. Dividends proposed
R
Ordinary shares (50 000 x 15%) 7 500
Preference shares (15 000 x 7%) 1 050
8 550

5. Trade and other receivables

R
Balance per trial balance 45 350
Provisional tax payments (7 000)
38 350

6. SA Revenue Service
R
Provisional tax payments 7 000
Current tax expense for the year (4 900)
2 100

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Example 2

The following list of balances of Door Ltd for the year ended 31 December 20.12 is available:

20.12 20.11
R'000 R'000
Credits
Share capital 147 834 147 834
Revaluation surplus (net after tax) 7 200 –
Retained earnings at beginning of year 29 446 33 802
Long-term loans 277 425 140 297
Deferred taxation 28 875 23 100
Sales 1 287 052 902 052
Trade and other payables 35 990 20 145
Current portion of long-term loans 83 042 24 639
Shareholders for dividends 17 409 11 606
Bank overdraft 1 652 –
1 915 925 1 303 475
Debits
Property, plant and equipment 33 269 21 496
Inventories 187 391 151 273
Trade and other receivables 427 536 222 833
Bank balances and cash – 1 465
Cost of sales 1 098 187 819 939
Operating costs 103 435 46 592
Interest paid 39 264 20 862
Income tax expense 5 621 3 877
Dividends paid 21 222 15 138
1 915 925 1 303 475

Additional information

1. Operating costs comprise out of the following items:

20.12 20.11
R'000 R'000
Depreciation 3 002 2 237
Loss on scrapping of equipment 500 –
Distribution costs 25 741 14 010
Administrative expenses 28 813 10 345
Staff costs 45 379 20 000
103 435 46 592

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2. Assume that the SA normal tax rate is 28%. The income tax expense as per list of
balances (assume correct) comprised of the following:

20.12 20.11
R'000 R'000
SA normal tax 5 621 3 877
– current 1 721 777
– deferred 3 900 3 100

3. The revaluation surplus relates to land which was revalued during the year by an
independent sworn appraiser.

4. Dividends amounting to R21 222 (20.11: R15 138) were paid to shareholders during
the year.

5. Ignore earnings and dividend per share.

6. The long-term loans are interest bearing.

7. Door Ltd classifies expenses by function in a single statement of profit or loss and
other comprehensive income.

REQUIRED

Prepare the annual financial statements of Door Ltd for the year ended
31 December 20.12. Your answer must comply with International
Financial Reporting Standards. The tax rate reconciliation is not required.

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Solution 2

DOOR LTD

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20.12

20.12 20.11
R'000 R'000
ASSETS
Non-current assets
Property, plant and equipment 33 269 21 496

Current assets 614 927 375 571

Inventories 187 391 151 273
Trade and other receivables 427 536 222 833
Cash and cash equivalents – 1 465
Total assets 648 196 397 067

EQUITY AND LIABILITIES

Total equity 203 803 177 280
Issued capital 147 834 147 834
Revaluation surplus 7 200 –
Retained earnings 48 769 29 446

Total liabilities 444 393 219 787

Non-current liabilities 306 300 163 397
Long-term borrowings 277 425 140 297
Deferred taxation 28 875 23 100
Current liabilities 138 093 56 390
Trade and other payables 35 990 20 145
Current portion of long-term borrowings 83 042 24 639
Shareholders for dividends 17 409 11 606
Bank overdraft 1 652 –
Total equity and liabilities 648 196 397 067

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DOOR LTD

STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20.12

Attributable to equity holders of parent

Share Revalua- Retained Total
capital tion- earnings equity
surplus
R'000 R'000 R'000 R'000
Balance at 1 January 20.11 147 834 – 33 802 181 636
Changes in equity for 20.11
Total comprehensive income for the
year – – 10 782 10 782
Dividends – – (15 138) (15 138)
Balance at 31 December 20.11 147 834 – 29 446 177 280

Changes in equity for 20.12

Total comprehensive income for the
year – 7 200 40 545 47 745
Dividends – – (21 222) (21 222)
Balance at 31 December 20.12 147 834 7 200 48 769 203 803

DOOR LTD

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR

THE YEAR ENDED 31 DECEMBER 20.12
Notes 20.12 20.11
R'000 R'000
Revenue 1 287 052 902 052
Cost of sales (1 098 187) (819 939)
Gross profit 188 865 82 113
Distribution costs (25 741) (14 010)
Administrative expenses (28 813) (10 345)
Other expenses (3 002 + 500 + 45 379);(2 237 + 20 000) (48 881) (22 237)
Finance cost (39 264) (20 862)
Profit before tax 46 166 14 659
Income tax expense 3 (5 621) (3 877)
PROFIT FOR THE YEAR 2 40 545 10 782
Other comprehensive income for the year, after tax:
Items that will not be reclassified to profit or loss:
Gains on property revaluation 4,5 7 200 –
Other comprehensive income for the year, net of tax 7 200 –
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 47 745 10 782

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DOOR LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.12

1. Accounting policy

1.1 Basis of preparation

The financial statements have been prepared in accordance with International Financial
Reporting Standards.

The financial statements have been prepared on the historical cost basis, except for land
that is revalued.

[Now provide the accounting policy for every transaction type. Note that you do not have
enough information to do it here.]

LECTURER’S COMMENT

IAS 1.16 requires disclosure of the fact that IFRSs have been complied
with.

2. Profit before tax

Included in profit before tax are the following:

20.12 20.11
R'000 R'000
Depreciation 3 002 2 237
Loss on scrapping of equipment 500 –
Staff costs 45 379 20 000

LECTURER’S COMMENT

1. Note that when expenses are classified according to function, the

following should be disclosed in the profit before tax note
(IAS 1.104):

 total depreciation
 total amortisation
 employee benefit expense

2. The loss on scrapping of equipment qualifies as a separately

disclosable item (IAS 1.98). Only the nature thereof and the amount
should be disclosed.

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3. Income tax expense

20.12 20.11
Major components of tax expense: R'000 R'000
Current tax expense – current year 1 721 777
Deferred tax expense – movement in temporary differences 3 900 3 100
5 621 3 877

Income tax relating to the components of other comprehensive income

20.12 20.11
R'000 R'000
Deferred tax relating to gain on property revaluation 2 800 –

4. Disclosure of components of other comprehensive income

20.12 20.11
R'000 R'000
Gains on property revaluation 7 200 –
Other comprehensive income for the year 7 200 –

5. Disclosure of tax effects relating to each component of other comprehensive

income
20.12 20.11
Before Tax Net of Before Tax Net
tax (expense)/ tax tax (expense) of tax
amount benefit amount amount /benefit amount
R'000 R'000 R'000 R'000 R'000 R'000
Gains on pro-
perty revaluation 10 000 (2 800) 7 200 – – –
Other compre-
hensive income 10 000 (2 800) 7 200 – – –

ASSESSMENT CRITERIA

Are you now able to do the following?

 State the purpose of preparing financial statements and name the

person responsible for this.

 Explain and describe the overall considerations to be taken into

account during the preparation of the financial statements.

 Prepare a comprehensive set of financial statements from given

information in accordance with the requirements of IAS 1.

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LEARNING UNIT 6

EVENTS AFTER THE

REPORTING PERIOD
(IAS 10)

General Financial Reporting

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LEARNING OUTCOMES
The learner should be able to identify events after the reporting period and disclose them
in the financial statements of the company in terms of the requirements of International
Financial Reporting Standards.

OVERVIEW
This learning unit is divided into the following:

6.1 Definitions
6.2 Recognition and measurement
6.2.1 Adjusting events after the reporting period
6.2.2 Non-adjusting events after the reporting period
6.2.3 Dividends
6.2.4 Going concern
6.3 Disclosure
6.3.1 Date of authorisation for issue
6.3.2 Updating of disclosure about conditions at the reporting period
6.3.3 Non-adjusting events after the reporting period
6.4 Schematic presentation of events after the reporting period

STUDY
PRESCRIBED
Descriptive Accounting
The chapter relevant to IAS 10 – Events after the reporting period.

RECOMMENDED:
IFRS Standards – The Annotated IFRS Standards
IAS 10 – Events after the reporting period

OVERVIEW OF THE LEARNING UNIT

This standard should be applied in the accounting for and disclosure of events after the
reporting period.

The objective of this standard is to prescribe

(a) when an entity should adjust its financial statements for events after the reporting
period; and

(b) What an entity should disclose about the date when the financial statements were
authorised for issue and about events after the reporting period.

The standard also requires that an entity should not prepare its financial statements on a
going concern basis if events after the reporting period indicate that the going concern
assumption is not appropriate.

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6.1 DEFINITIONS (IAS 10.3)

The following term is used in the standard with the meaning specified:

Events after the reporting period are those events, both favourable and unfavourable,
that occur between the reporting date and the date when the financial statements are
authorised for issue. Two types of events can be identified:

(a) those that provide evidence of conditions that existed at the end of the reporting period
(adjusting events after the reporting period); and
(b) those that are indicative of conditions that arose after the reporting period (non-
adjusting events after the reporting period).

The process involved in authorising the financial statements for issue varies depending on
the management structure, statutory requirements and procedures followed in preparing
and finalising the financial statements.

In some cases, an entity is required to submit its financial statements to its shareholders
for approval after the financial statements have already been issued. In such cases, the
financial statements are authorised for issue on the date of original issuance, not on the
date when shareholders approve the financial statements.

EXAMPLE 1

The management of an entity completes draft financial statements for the year ended
31 December 20.11 on 29 February 20.12. On 18 March 20.12, the board of directors
reviews the financial statements and authorises them for issue. The entity announces its
profit and selected other financial information on 19 March 20.12. The financial statements
are made available to shareholders and others on 1 April 20.12. The annual meeting of
shareholders approves the financial statements on 15 May 20.12 and the approved
financial statements are then filed with the regulatory body on 17 May 20.12.

The financial statements are authorised for issue on 18 March 20.12 (date when the Board
of directors authorised it for issue). Events after the reporting period will therefore include
those events that occur between the reporting date and 18 March 20.12.

In some cases, the management of an entity is required to issue its financial statements to
a supervisory board (made up solely of non-executives) for approval. In such cases, the
financial statements are authorised for issue when the management authorises them for
issue to the supervisory board.

EXAMPLE 2

On 18 March 20.12, the management of an entity authorises financial statements for issue
to its supervisory board. The supervisory board is made up solely of non-executives and
may include representatives of employees and other outside interest groups. The
supervisory board approves the financial statements on 26 March 20.12. The financial
statements are made available to shareholders and others on 1 April 20.12. The annual
meeting of shareholders receives the financial statements on 15 May 20.12 and the
financial statements are then filed with the regulatory body on 17 May 20.12.
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The financial statements are authorised for issue on 18 March 20.12 (date of authorisation
for issue to the supervisory board). Events after the reporting period will therefore include
those events that occur between the reporting date and 18 March 20.12.

Events after the reporting date include all events up to the date when the financial
statements are authorised for issue, even if those events occur after the publication of a
profit announcement or of other selected financial information.

6.2 RECOGNITION AND MEASUREMENT

6.2.1 Adjusting events after the reporting period (IAS 10 par .08–.09)

An entity must adjust the amounts recognised in its financial statements to reflect adjusting
events after the reporting period.

The following are examples of adjusting events after the reporting period that require
an entity to adjust the amounts recognised in its financial statements, or to
recognise items that were not previously recognised:

(a) The resolution after the reporting period of a court case which, because it confirms that
an entity already had a present obligation at the reporting period, requires the entity to
adjust a provision already recognised, or to recognise a provision instead of merely
disclosing a contingent liability.

(b) The receipt of information after the reporting period indicating that an asset was
impaired at the reporting date, or that the amount of a previously recognised
impairment loss for that asset needs to be adjusted. For example:

(i) The bankruptcy of a customer which occurs after the reporting period usually
confirms that a loss already existed at the reporting date on a trade receivable
account and that the entity needs to adjust the carrying amount of the trade
receivable account.
(ii) The sale of inventories after the reporting period may give evidence about their net
realisable value at the end of the reporting period.

(c) The determination after the reporting period of the cost of assets purchased or the
proceeds from assets sold before the reporting period.

(d) The determination after the reporting period of the amount of profit sharing or bonus
payments, if the entity had a present legal or constructive obligation at the reporting
date to make such payments as a result of events before that date. (According to the
statement on Employee Benefits – not part of this module).

(e) The discovery of fraud or errors that show that the financial statements were incorrect.

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EXAMPLE 3

The financial year end of Beta Ltd is 31 December 20.11 and the financial statements are
authorised for issue on 30 March 20.12.

On 5 January 20.12, the employees of the construction division of Beta Ltd found rock
formations at one of the company's construction projects that would delay construction to
such an extent that additional costs amounting to R500 000 would be incurred. This event
refers to a condition that existed at the reporting period, because the rock formations
existed at 31 December 20.11. The additional cost of R500 000 should therefore be
accounted for in the financial year ended 31 December 20.11.

6.2.2 Non-adjusting events after the reporting period (IAS 10 par .10–.11)

An entity must not adjust the amounts recognised in its financial statements to reflect non-
adjusting events after the reporting period.

An example of a non-adjusting event after the reporting period is a decline in market value
of investments between the reporting period and the date when the financial statements
are authorised for issue. The decline in fair value does not normally relate to the condition
of the investments at the reporting period, but reflects circumstances that have arisen
subsequently. Therefore, an entity does not adjust the amounts recognised in its financial
statements for the investments. Similarly, the entity does not update the amounts
disclosed for the investments as at the reporting date, although it may need to give
additional disclosure (see the paragraph dealing with disclosure).

The following are examples of non-adjusting events after the reporting period that may
be of such importance that non-disclosure would affect the ability of the users of the
financial statements to make proper evaluation and decisions (IAS 10.22):

(a) a major business combination after the reporting period (paragraph 59(b) and B66 of
IFRS 3 – Business combinations, requires specific disclosures in such cases – not part
of this module) or disposing of major subsidiary;
(b) announcing a plan to discontinue operation, disposing of assets or settling liabilities
attributable to a discontinuing operation or entering into binding agreements to sell
such assets or settle such liabilities;
(c) major purchases and disposals of assets, or expropriation of major assets by
government;
(d) the destruction of a major production plant by a fire after the reporting period;
(e) announcing, or commencing the implementation of, a major restructuring (see
IAS 37 – Provisions, contingent liabilities and contingent assets);
(f) major ordinary share transactions and potential ordinary share transactions after the
reporting period (IAS 33 – Earnings per share, encourages an entity to disclose a
description of such transactions, other than capitalisation issues and share splits – not
part of this module);
(g) abnormally large changes after the reporting period in asset prices or foreign
exchange rates;

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(h) changes in tax rates or tax laws enacted or announced after the reporting period that
have a significant effect on current and deferred tax assets and liabilities (see
IAS 12 – Income taxes);
(i) entering into significant commitments or contingent liabilities, for example, by issuing
significant guarantees; and
(j) commencing major litigation arising solely out of events that occurred after the
reporting period.

6.2.3 Dividends (IAS 10.12–.13)

If dividends to holders of equity instruments (as defined in the statement on Financial

Instruments: Disclosure and Presentation – not part of this module) are proposed or
declared after the reporting period, an entity must not recognise those dividends as a
liability at the reporting period, as they do not meet the criteria of a present obligation. It is
important to note that an entity's past practice of paying dividends does not give rise to a
constructive obligation and therefore still does not warrant the recognition of a liability.
(See learning unit 7.)

6.2.4 Going concern (IAS 10.14–.16)

An entity must not prepare its financial statements on a going concern basis if
management determines after the reporting period either that it intends to liquidate the
entity or to cease trading or that it has no realistic alternative but to do so.

Deterioration in operating results and financial position after the reporting period may
indicate a need to consider whether the going concern assumption is still appropriate. If
the going concern assumption is no longer appropriate, the effect is so pervasive that this
standard requires a fundamental change in the basis of accounting, rather than an
adjustment to the amounts recognised within the original basis of accounting.

Paragraph .25 of the statement on the Presentation of Financial Statements (IAS 1),
requires certain disclosures if

(a) the financial statements are not prepared on a going concern basis; or
(b) management is aware of material uncertainties related to events or conditions that
may cast significant doubt upon the entity's ability to continue as a going concern. (The
events or conditions requiring disclosure may arise after the reporting period.)

The following disclosure is necessary in terms of paragraph .25 of IAS 1 when the financial
statements are not prepared on the going-concern basis:

(a) the fact that the statements are not prepared on the going-concern basis;
(b) the basis on which the financial statements have been prepared; and
(c) the reason why the entity is not considered to be a going concern.

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6.3 DISCLOSURE (IAS 10.17–.22)

6.3.1 Date of authorisation for issue (IAS 10.17–.18)

An entity must disclose the date when the financial statements were authorised for issue
and who gave that authorisation. If the entity's owners or others have the power to amend
the financial statements after issuance, the entity must disclose that fact.

It is important for users to know when the financial statements were authorised for issue,
as the financial statements do not reflect events after this date.

6.3.2 Updating of disclosure about conditions at the reporting date (IAS 10.19–.20)

If an entity receives information after the reporting period about conditions that existed at
the reporting date, the entity must update disclosures that relate to these conditions, in the
light of the new information.

In some cases, an entity needs to update the disclosures in its financial statements to
reflect information received after the reporting period, even when the information does not
affect the amounts that the entity recognises in its financial statements. One example of
the need to update disclosures is when evidence becomes available after the reporting
period about a contingent liability that existed at the reporting date. In addition to
considering whether it should now recognise a provision in terms of IAS 37 – Provisions,
contingent liabilities and contingent assets, an entity updates its disclosures about the
contingent liability in the light of that evidence.

6.3.3 Non-adjusting events after the reporting period (IAS 10.21–.22)

Where non-adjusting events after the reporting period are of such importance that non-
disclosure would affect the ability of the users of the financial statements to make proper
evaluations and decisions, an entity must disclose the following information for each
significant category of non-adjusting event after the reporting period:

(a) the nature of the event; and

(b) an estimate of its financial effect, or a statement that such an estimate cannot be
made.

LECTURER’S COMMENT

Work through the relevant chapter dealing with events after the reporting
period in Descriptive Accounting.

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EXAMPLE 4

Busy Bees Ltd is a manufacturer of computer equipment. The company's year-end is

31 December 20.11 and the following came to your attention before the financial
statements were finalised on 16 February 20.12:

1. The market value of a listed investment decreased in January 20.12 to R600 000.
Investments are stated at market value. Assume that the company does not speculate
with shares.
2. A debtor with an outstanding balance of R71 500 on 31 December 20.11, was declared
insolvent and placed under liquidation on 20 January 20.12. The liquidator indicated
that creditors will receive 30 cents in the rand. No allowance for credit losses was
made at reporting date.
3. On 15 January 20.12 the directors declared a dividend of 10 cents per share for the
year ended 31 December 20.11. There is 100 000 issued ordinary shares.
4. In January 20.12 inventory with a value of R20 000 was destroyed when a store was
burnt down during political unrest.

Assume a tax rate of 28%, that all amounts are material and that the company is a going
concern.

REQUIRED
(a) Define events occurring after the reporting period according to IAS 10.
(b) In each of the above events, do the following:

(i) Discuss briefly how the event will affect assets and liabilities in the
financial statements, that is, must the assets and/or liabilities be adjusted
or not?
(ii) Disclose this in the notes to the financial statements if required.

SOLUTION 4

(a) Events after the reporting period are those events, both favourable and
unfavourable, that occur between the reporting date and the date when the financial
statements are authorised for issue. Two types of events can be identified:

(i) those that provide evidence of conditions that existed at the end of the reporting
period (adjusting events after the reporting period); and
(ii) those that are indicative of conditions that arose after the reporting date (non-
adjusting events after the reporting period).

(b) 1. The decrease in market value in January 20.12 does not normally relate to the
condition of investments at the reporting period, but reflects circumstances that
have arisen subsequently. Therefore, an entity does not adjust the amounts
recognised in its financial statements for the investments. Thus, additional
disclosure will be required as non-disclosure would affect the ability of the users of
financial statements to make proper evaluations and decisions.

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Disclosure

BUSY BEES LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.11

Event after the reporting period

The market value of the listed investment decreased to R600 000
in January 20.12.

2. The bankruptcy of a client which occurs after the reporting period usually confirms
that a loss already existed at the reporting date. Thus the carrying amount of the
debtor needs to be adjusted in the financial statements for the year ended
31 December 20.11

Journal Dr Cr
R R
Credit losses (P/L) 50 050
Allowance for credit losses (SFP) 50 050
Correction of debtor placed under liquidation
71 500 – (71 500 x 0.30)

3. If dividends are declared after the reporting period, an entity should not recognise
those dividends as a liability as they do not meet the criteria of a present
obligation. Thus disclose in a note as non-disclosure would affect the ability of the
users of financial statements to make proper evaluations and decisions.

Disclosure

BUSY BEES LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.11

Event after the reporting period

In 15 January 20.12 the directors declared a dividend of R10 000 for the year
ended 31 December 20.11.

4. The inventory that was destroyed during January 20.12 in a fire is an event that
took place after the reporting period. There was no liability at the reporting date,
thus disclosure will be required as non-disclosure would affect the ability of the
users of financial statements to make proper evaluations and decisions.

Disclosure

BUSY BEES LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.11

Event after the reporting period

In January 20.12 inventory with a value of R20 000 was destroyed when a store
was burnt down during a political unrest.

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EXAMPLE 5
As the auditor of the under-mentioned companies, you are provided with the following
independent situations. The directors of these companies have asked your assistance in
deciding on the most appropriate method for the accounting treatment of the under
mentioned problem at the end of the 20.11 financial year in order to comply with the
requirements of International Financial Reporting Standards.

Alaska Ltd is a listed food preparation company with a 31 December year end. The vast
majority of Alaska Ltd's business includes the preparation of meals for airline companies.
On 15 February 20.12 one of the airlines, which was responsible for 80% of Alaska Ltd's
profit and 70% of Alaska Ltd's sales, announced that it is not going to renew its contract
with Alaska Ltd for the provision of food on its flights. The renewal date of the contract is
30 June 20.12. Alaska Ltd is in the process of finalising its financial statements for the year
ended 31 December 20.11. Stock exchange regulations require that the financial
statements should be published on or before 31 March 20.12.

REQUIRED
Discuss the appropriate accounting treatment in accordance with
International Financial Reporting Standards of the abovementioned
problem for the year ended 31 December 20.11.

SOLUTION 5
The loss on the contract represents an event after the reporting date, as events after the
reporting date are those events, both favourable and unfavourable, that occur between the
reporting date and the date when the financial statements are authorised for issue.

The loss of the contract represents a non-adjusting event after the reporting period,
because the event is indicative of conditions that arose after the reporting date. Therefore,
it will not be necessary to adjust assets and liabilities.

The following information about non-adjusting events after the reporting period should be
disclosed:

 the nature of the event; and

 an estimate of its financial effect, or a statement that such an estimate cannot be
made.

Consideration must be given to whether the going concern assumption is still appropriate.

An entity should not prepare its financial statements on a going concern basis if events
after the reporting period indicate that the going concern assumption is no longer
appropriate.

Current information indicates that a fundamental part of the enterprise's profit and sales is
generated by the contract.

This is sufficient information to draw up the financial statements according to the expected
liquidation values. The shareholders should be informed about the current state of affairs.
The above can only be avoided if there is a possibility of new contracts that can replace
the profit and sales.

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6.4 SCHEMATIC PRESENTATION OF EVENTS AFTER THE

REPORTING PERIOD

Events after the reporting period

are those events, both favourable and unfavourable, that occur between the reporting
period and the date on which the financial statements are authorised for issue

Year end of financial Event after the reporting Date of authorisation

statements period of financial statements

Adjusting events Non-adjusting events

Events that provide further evidence of Events that indicate conditions that
conditions that existed at the reporting period arose after the reporting period

Adjust assets and liabilities in the financial Do not adjust assets and liabilities in the
statements financial statements

Example Example
Inventories: After the reporting date evidence Inventories: After the reporting date
arise that there was a manufacturing default 50% of inventories that existed on the
which caused a decrease in the net reporting date was destroyed due to a
realisable value of inventory of R1 000 flood (before authorization of financial
(before authorisation of the financial statements)
statements)

Adjusting journal No adjustment to financial statements

Dr Cr
R R If material disclose
Inventories written  nature; and
down (P/L) 1 000  estimate of financial impact, or
Inventories (SFP) 1 000 statement if not possible to make
such an estimate

ASSESSMENT CRITERIA
Are you now able to do the following?

 Identify events after the reporting period.

 Record events after the reporting period accurately in the annual financial
statements according to International Financial Reporting Standards.
 Determine when to adjust financial statements for events after the
reporting period.

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LEARNING UNIT 7
PROVISIONS, CONTINGENT
LIABILITIES AND
CONTINGENT ASSETS
(IAS 37)

General Financial Reporting

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LEARNING OUTCOMES

Learners should be able to recognise, measure and disclose provisions, contingent

liabilities and contingent assets in the annual financial statements of a company.

OVERVIEW

This learning unit is divided into the following:

7.1 Scope
7.2 Definitions
7.3 Provisions and other liabilities
7.4 Recognition
7.4.1 Provisions
7.4.2 Contingent liabilities
7.4.3 Distinction between provisions and contingent liabilities
7.4.4 Contingent assets
7.5 Measurement
7.5.1 Best estimate
7.5.2 Risks and uncertainties
7.5.3 Present value
7.5.4 Future events
7.5.5 Expected disposal of assets
7.5.6 Reimbursements
7.5.7 Changes in and uses of provisions
7.6 Application of the recognition and measurement rules
7.6.1 Future operating losses
7.6.2 Onerous contracts
7.6.3 Staff retraining
7.6.4 Warranties
7.6.5 Constructive obligation
7.6.6 Leave pay provision
7.6.7 Possible legal liability
7.7 Disclosure
7.7.1 Provisions
7.7.2 Contingent liability
7.7.3 Contingent asset
7.8 Transitional provisions
7.9 Summary – IAS 37
7.10 Tax implications

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STUDY
PRESCRIBED
Descriptive Accounting
The chapter relevant to IAS 37 – Provisions, Contingent liabilities and Contingent assets.

RECOMMENDED:
IFRS Standards – The Annotated IFRS Standards
IAS 37 – Provisions, Contingent liabilities and Contingent assets

OVERVIEW OF THE LEARNING UNIT

The objective of the standard is to ensure

 proper recognition and measurement of provisions, contingent liabilities and contingent

assets; and
 sufficient disclosure of information about
– provisions: nature, timing and amount; and
– contingent liabilities and assets: nature, amount and uncertainties.

7.1 SCOPE OF IAS 37

The statement should be applied by all entities in accounting for provisions, contingent
liabilities and contingent assets, except

 those resulting from executory contracts, except where the contract is onerous; and
 those covered by another International Accounting Standard. (IAS 37.01).

This standard does not apply to financial instruments (including guarantees) that are within
the scope of IFRS 9 – Financial instruments: recognition and measurement.

Executory contracts are contracts under which neither party has performed any of its
obligations or both parties have partially performed their obligations to an equal extent.
The statement does not apply to executory contracts unless they are onerous. (IAS 37.03)

When another Standard of International Financial Reporting Standards deals with a

specific type of provision, contingent liability or contingent asset, an entity applies that
Standard instead of this Standard. For example, certain types of provisions are also
addressed in statements on

(a) income taxes; and

(b) leases.
(c) Employee benefits (IAS 37.05).

Some amounts treated as provisions may relate to the recognition of revenue, for example
where an entity gives guarantees in exchange for a fee. The statement does not address
the recognition of revenue which is covered in IFRS 15.

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7.2 DEFINITIONS

Provision

A provision is a liability of uncertain timing or amount.

Liability

A present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.

Obligating event

An event that creates a legal or constructive obligation that results in an entity having no
realistic alternative to settling that obligation.

Legal obligation

It is an obligation that derives from

(a) a contract (through its explicit or implicit terms);

(b) legislation; or
(c) other operation of law

Constructive obligation

It is an obligation that derives from an entity's actions where

(a) by an established pattern of past practice, published policies or a sufficiently specific

current statement, the entity has indicated to other parties that it will accept certain
responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties
that it will discharge those responsibilities.

Contingent liability

A contingent liability is

(a) a possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the entity; or
(b) a present obligation that arises from past events but is not recognised because
(i) it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.

In a general sense, all provisions are contingent because they are uncertain in timing or
amount. The difference between a provision and contingent liability is that there is more
uncertainty about a contingent liability with regard to the possibility of an outflow of
economic resources or the estimate of the amount of the outflow of the economic
resources. (IAS 37.12)
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Contingent asset

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

Onerous contract

A contract that causes the unavoidable costs of meeting the obligations under the contract
exceed the economic benefits to be received under it.

7.3 PROVISIONS AND OTHER LIABILITIES

Provisions can be distinguished from other liabilities such as trade payables and accruals
because there is uncertainty about the timing or amount of the future expenditure required
in settlement. By contrast

(a) trade payables are liabilities to pay for goods or services that have been received or
supplied and have been invoiced or formally agreed with the supplier; and
(b) accruals are liabilities to pay for goods or services that have been received or supplied
but have not been paid, invoiced or formally agreed with the supplier, including
amounts due to employees or electricity bills. (Although it is sometimes necessary to
estimate the amount or timing of accruals, the uncertainty is generally much less than
for provisions.)

Accruals are often reported as part of trade and other payables, whereas provisions are
reported separately (IAS 37.11).

7.4 RECOGNITION

7.4.1 Provisions

A provision must be recognised when

(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.

If not all these conditions are met, no provision should be recognised (IAS 37.14).

(a) Present obligation

In rare cases it is not clear whether or not there is a present obligation. In these cases, a
past event is deemed to give rise to a present obligation if, taking account of all available
evidence, it is more likely than not that a present obligation exists at the end of the
reporting date. (IAS 37.15)

In almost all cases it will be clear whether a past event has given rise to a present
obligation. In rare cases, for example, in a law suit, it may be disputed either whether or
not certain events have occurred or whether or not those events result in a present
obligation. In such a case, an entity determines whether or not a present obligation exists
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at the reporting date by taking account of all available evidence including, for example, the
opinion of experts. The evidence considered includes any additional evidence provided by
events after the reporting period. On the basis of such evidence

(a) where it is more likely than not that a present obligation exists at the reporting date,
the entity recognises a provision (if the recognition criteria are met); and
(b) where it is more likely that no present obligation exists at the reporting date, the entity
discloses a contingent liability, unless the possibility of an outflow of resources
embodying economic benefits is remote (IAS 37.16).

An obligation always involves another party to whom the obligation is owed. However it is
not necessary, to know the identity of the party to whom the obligation is owed – indeed
the obligation may be to the public at large. Because an obligation always involves a
commitment to another party, it follows that a management or board decision does not
give rise to a constructive obligation at the reporting date unless the decision has been
communicated before the reporting date to those affected by it in a sufficiently specific
manner to raise a valid expectation in them that the entity will discharge its responsibilities
(IAS 37.20).

(b) Past event

A past event that leads to a present obligation is called an obligating event. For an event to
be an obligating event, it is necessary that the entity has no realistic alternative to settling
the obligation created by the event. This is the case only

(a) where the settlement of the obligation can be enforced by law; or

(b) in the case of a constructive obligation, where the event (which may be an action of
the entity) creates valid expectations in other parties that the entity will discharge the
obligation (IAS 37.17).

Provisions are divided into two categories, namely

 legal obligations; and

 constructive obligations.

 Legal obligations

This category of obligations means that another party has the right to summons the entity
to perform. Such obligations are applicable, for example, when warranties are given to
customers, when such result from litigation and when self-insurance is applied, and in the
case of onerous contracts. The essential element in such cases is therefore an obligation
that can be enforced by law.

 Constructive obligations

Constructive obligations are those obligations that are not legally enforceable, but are
inescapable as a result of external factors or management policy and decisions. This
means that the entity is left no other realistic alternative than to incur the obligation;
constructive obligations therefore emanate from circumstances, in contrast to legal
obligations that arise from the operation of the law. If it is the policy of a trader to exchange
products within three days of the sale thereof if the customer is not completely satisfied,
this policy brings about a constructive obligation for the entity, because its name can be
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brought into disrepute by the non-fulfilment of the undertaking. Although the customer
cannot necessarily institute a legal action for the enforcement of the policy, and in this
sense no legal obligation can therefore arise, the obligation is nevertheless such that the
entity will want to fulfil it: it is therefore a constructive obligation. Another example of a
constructive obligation is that of contaminated ground around a factory plant. Public
opposition to such contamination may be such that it is obligatory for the entity to incur
costs to remove the contamination, even if it does not necessarily have a legal obligation
to do so. The mere presence of environmental pollution does not, however, give rise to an
obligation, even if it is caused by the entity's activities. Only when there is no realistic
alternative to rehabilitation does the obligation arise. This can be on the date that the
board makes a public announcement that cleaning up will take place, or when production
is inhibited by the pollution to such an extent that cleaning up can no longer be postponed.

Financial statements deal with the financial position of an entity at the end of its reporting
period and not its possible position in the future. Therefore, no provision is recognised for
costs that need to be incurred to operate in the future. The only liabilities recognised in an
entity's statement of financial position are those that exist at the end of the reporting period
(IAS 37.18).

For example: A machine used by a company in its production process needs to be

overhauled every 5 years for technical reasons. At the reporting date, the machine has
been in use for three years. No provision must be made for the cost of the overhaul since
there is no present obligation as a result of a past obligating event. The future cost of
overhauling the machine can be avoided by the future actions of the company, for example
by selling the machine. Even if the company has the intention to incur the expenditure, it
still depends on what happens in the future.

It is only those obligations arising from past events existing independently of an entity's
future actions (i.e. the future conduct of its business) that are recognised as provisions. An
example of such an obligation is penalties or clean-up costs for unlawful environmental
damage, both of which would lead to an outflow of resources embodying economic
benefits in settlement regardless of the future actions of the entity (IAS 37.19).

In contrast, because of commercial pressures or legal requirements, an entity may intend

or need to carry out expenditure to operate in a particular way in the future, for example by
fitting smoke filters in a certain type of factory. The entity can avoid the future expenditure
by its future actions, for example by changing its method of operation; it has no present
obligations for that future expenditure and no provision is recognised (IAS 37.19).

An event that does not give rise to an obligation immediately may do so at a later date
because of changes in the law or because an act (for example a sufficiently specific public
statement) by the entity gives rise to a constructive obligation. For example, when
environmental damage is caused there may be no obligation to remedy the consequences.
However, the causing of the damage will become an obligating event when a new law
requires the existing damage to be rectified or when the entity publicly accepts
responsibility for rectification in a way that creates a constructive obligation (IAS 37.21).

Where details of a proposed new law have yet to be finalised, an obligation arises only
when the legislation is virtually certain to be enacted as drafted (IAS 37.22).

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(c) Probable outflow of resources embodying economic benefits

For the purpose of the statement, an outflow of resources or other event is regarded as
probable if the event is more likely than not to occur, that is the probability that the event
will occur is greater than the probability that it will not. Where it is not probable that a
present obligation exists, an entity discloses a contingent liability, unless the possibility of
an outflow of resources embodying economic benefits is remote (IAS 37.23).

Where there are a number of similar obligations, for example, product warranties or similar
contracts the probability that an outflow will be required in settlement is determined by
considering the class of obligation as a whole. Although the likelihood of outflow for any
one item may be small, it may well be probable that some outflow of resources will be
needed to settle the class of obligations as a whole. If that is the case, a provision is
recognised (if the other recognition criteria are met) (IAS 37.24).

(d) Reliable estimate of the obligation

The use of estimates is an essential part of the preparation of financial statements and
does not undermine their reliability. This is especially true in the case of provisions, which
by their nature are more uncertain than most other statement of financial position items.
Except in extremely rare cases, an entity will be able to determine a range of possible
outcomes and can therefore make an estimate of the obligation that is sufficiently reliable
to use in recognising a provision (IAS 37.25).

In the extremely rare case where no reliable estimate can be made, a liability exists that
cannot be recognised. That liability is disclosed as a contingent liability (IAS 37.26).

7.4.2 Contingent liabilities

An entity must not recognise a contingent liability (IAS 37.27). However, a contingent
liability should be disclosed unless the possibility of an outflow of resources embodying
economic benefits is remote (IAS 37.28).

Where an entity is jointly and severally liable for an obligation, the part of the obligation,
which is expected to be met by other parties, is treated as a contingent liability (IAS 37.29).

Contingent liabilities may develop in a way not initially expected. Therefore, they are
assessed continually to determine whether or not an outflow of resources embodying
economic benefits has become probable. If it becomes probable that an outflow of future
economic benefits will be required for an item previously dealt with as a contingent liability,
a provision is recognised in the financial statements of the period in which the change in
probability occurs (except in the extremely rare circumstances where no reliable estimate
can be made) (IAS 37.30).

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Past event

Present obligation Possible obligation

Outflow of economic resources

Probable Not probable Remote

No provision is
No provision is recognised
recognised.
A provision is recognised and no disclosure is
Disclosure for contingent
required
liability is required

7.4.3 Distinction between provisions and contingent liabilities

Refer to the decision tree in the appendix B to IAS 37. The purpose of this decision tree is
to summarise the main recognition requirements of the statement on provisions and
contingent liabilities.

LECTURER’S COMMENT

Work through the relevant examples dealing with Provisions and

Contingent liabilities in Descriptive Accounting.

EXAMPLE 1
Fun-in-the Sun Ltd is an exclusive holiday resort situated on the KwaZulu-Natal North
Coast.

During the 20.11 financial year, the board of directors decided to reduce the maintenance
personnel of the company significantly. On 28 February 20.11 the balance of the provision
raised for the severance packages for these redundant employees amounted to R45 000.
During the current financial year severance packages amounting to R76 000 have been
paid to these redundant employees according to their service contracts.

On 15 January 20.12 a holidaymaker instituted a claim of R250 000 against Fun-in-the-

Sun Ltd after she was injured by a volleyball while strolling on the beach. There are
various billboards on the premises warning holidaymakers to be aware of flying volleyballs.
The legal advisors of Fun-in-the-Sun Ltd are of the opinion that the claim will be
unsuccessful. The legal costs to defend the claim are estimated at R25 000.

During January 20.11 various chalets in the resort were damaged as a result of heavy
rainstorms. The holidaymakers had to evacuate the damaged chalets. At the time
management estimated that R80 000 would have to be paid to these holidaymakers to

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compensate them for the inconvenience, and accounted for it in the financial statements
for the year ended 28 February 20.11. During the financial years ended 28 February 20.11
and 29 February 20.12 amounts of R5 000 and R60 000 respectively, were paid to these
holidaymakers. On 29 February 20.12 the financial director established that no further
payments were due to these holidaymakers.

REQUIRED
Disclose the above-mentioned in the notes to the annual financial
statements of Fun-in-the-Sun Ltd for the year ended 29 February 20.12
according to the requirements of IAS 37 – Provisions, contingent liabilities
and contingent assets.

SOLUTION 1
FUN-IN-THE-SUN LTD

NOTES FOR THE YEAR ENDED 29 FEBRUARY 20.12

1. Accounting policy

1.1 Provisions

The company recognises a provision when it has a present obligation because of a past
event and it is probable that the company will be required to settle the obligation.
Provisions are measured based on the best estimate of the expenditure required to settle
the present obligation at the reporting date.

Where the effect of the time value of money is material the amount of the provision is
discounted to present value using a pre-tax rate that reflects current assessments of the
time value of money. The increase in the amount of the provision as a result of the
passage of time is recorded in profit or loss for the year.

2. Contingent liability

On 15 January 20.12 a holidaymaker, instituted a claim of R250 000 against Fun-in-the-

Sun Ltd after she was injured by a volleyball. The legal advisors of Fun-in-the-Sun Ltd are
of the opinion that the claim will be unsuccessful. The legal costs to defend the claim are
estimated at R25 000.
3. Provisions
3.1 Provision for holidaymakers – inconvenience
R
Carrying amount at beginning of the year (80 000 – 5 000) 75 000
Amount used during the year (60 000)
Unused amounts transferred to the statement of profit or loss and other
comprehensive income during the year (15 000)
Carrying amount at end of year –

During January 20.11 various chalets of the resort were damaged as a result of heavy
rainstorms which resulted in the evacuation and relocation of holidaymakers. The financial
director established that no further payments are due to these holidaymakers at
29 February 20.12.

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3.2 Provision for severance packages – redundant employees

R
Carrying amount beginning of the year 45 000
Amount used during the year (45 000)
Carrying amount end of year –

During the 20.11 financial year the board of directors decided to reduce the maintenance
personnel of the company significantly and paid severance packages to these redundant
employees according to their service contracts.

LECTURER’S COMMENT
To summarise, a provision is defined in IAS 37.10 as a liability of which
the amount or timing are uncertain. A contingent liability is

 a possible obligation that arises from past events and whose

existence will be confirmed only by the occurrence or non-occurrence
of one or more uncertain future events not wholly within the control of
the entity; or
 a present obligation that arises from past events but is not
recognised because
 it is not probable that an outflow of resources embodying
economic benefits will be required to settle the obligation; or
 the amount of the obligation cannot be measured with sufficient
reliability.

7.4.4 Contingent assets

An entity must not recognise a contingent asset (IAS 37.31). A contingent asset is
disclosed where an inflow of economic benefits is probable (IAS 37.34). However, when
the realisation of income is virtually certain, the related asset is not a contingent asset and
its recognition is appropriate (IAS 37.33).

Contingent assets usually arise from unplanned or other unexpected events that give rise
to the possibility of an inflow of economic benefits to the entity. An example is a claim that
an entity is pursuing through legal processes, where the outcome is uncertain (IAS 37.32).

Contingent assets are assessed continually to ensure that developments are appropriately
reflected in the financial statements. If it has become virtually certain that an inflow of
economic benefits will arise, the asset and the related income are recognised in the
financial statements of the period in which the change occurs (IAS 37.35).

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Where, as a result of past events, there is a contingent asset whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the enterprise

The inflow of The inflow of The inflow is

economic economic not probable.
benefit is benefits is
virtually probable, but
certain. not virtually
certain.

The asset is not No asset is No asset is re-

contingent and recognised cognised
is recognised as (par .31). (par .31). No
an asset Disclosure is disclosure is
(par .33) required as a required
contingent asset (par .89)
(par .89)

LECTURER’S COMMENT

Work through the relevant example dealing with Contingent assets in

Descriptive Accounting.

EXAMPLE 2

Fun-in-the-Sun Ltd is an exclusive holiday resort situated on the KwaZulu-Natal North

Coast. On 17 January 20.12 Fun-in-the-Sun Ltd instituted a claim of R100 000 against
Holidays Galore Ltd. They gained unauthorised access to Fun-in-the-Sun Ltd's database
of holidaymakers to promote their own resorts. At year-end on 29 February 20.12 the court
case is in process and the lawyers of Fun-in-the-Sun Ltd are of the opinion that the claim
will probably succeed, but they are not virtually certain.

REQUIRED
Disclose the above-mentioned in the notes to the annual financial
statements of Fun-in-the-Sun Ltd for the year ended 29 February 20.12
according to the requirements of IAS 37 – Provisions, contingent liabilities
and contingent assets.

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SOLUTION 2

FUN-IN-THE-SUN LTD

NOTES FOR THE YEAR ENDED 29 FEBRUARY 20.12

1. Contingent asset

A claim was instituted against a company for gaining unauthorised access to Fun-in-the-
Sun Ltd's database of holidaymakers for promoting their own resorts. According to the
company's legal advisors it is probable that the claim will be successful but the realisation
of income is not virtually certain. If the claim were to succeed, Fun-in-the-Sun Ltd would
receive R100 000 before tax.

7.5 Measurement

7.5.1 Best estimate

The amount recognised as a provision must be the best estimate of the expenditure
required to settle the present obligation at the end of the reporting date (IAS 37.36).

It will often be impossible or prohibitively expensive to settle or transfer an obligation at the

reporting date. However, the estimate of the amount than an entity would rationally pay to
settle or transfer the obligation gives the best estimate of the expenditure required to settle
the present obligation at the reporting date (IAS 37.37).

The estimate of outcome and financial effect are determined by the judgement of the
management of the entity, supplemented by experience of similar transactions and, in
some cases, reports from independent experts. The evidence considered includes any
additional evidence provided by events after the reporting period (IAS 37.38).

Risks and uncertainties surrounding the amount to be recognised as a provision must be

taken into account and are dealt with by various means according to the circumstances.
For example:
(a) Where the provision being measured involves a large population of items, the
obligation is estimated by weighting all possible outcomes by their associated
probabilities. The name for this statistical method of estimation is "expected value"
(IAS 37.39).
(b) Where a single obligation is being measured, the individual most likely outcome may
be the best estimate of the liability. However, even in such a case, the entity
considers other possible outcomes. For example, if an entity has to rectify a serious
fault in a major plant that it has constructed for a customer, the individual most likely
outcome may be for the repair to succeed at the first attempt at a cost of R1 000, but
a provision for a larger amount is made if there is a significant chance that further
attempts will be necessary (IAS 37.40).

7.5.2 Risks and uncertainties

The risks and uncertainties that inevitably surround many events and circumstances must
be taken into account in reaching the best estimate of a provision.

Risk therefore describes variability of outcome. A risk adjustment may increase the
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amount at which liability is measured. Caution is needed in making judgements under

conditions of uncertainty, so that income or assets are not overstated and expenses or
liabilities are not understated.

However, uncertainty does not justify the creation of excessive provisions or a deliberate
overstatement of liabilities. For example, if the projected costs of a particularly adverse
outcome are estimated on a prudent basis, that outcome is not then deliberately treated as
more probable than is realistically the case. Care is needed to avoid duplicating
adjustments for risk and uncertainty, with the consequent overstatement of a provision
(IAS 37.43).

The provision is measured before tax, as the tax consequences of the provision, and
changes in it, are dealt with in the Statement on Income Taxes. (IAS 37.41) The
deductibility of the provision for income tax purposes is determined by the requirements of
section 11(a) of the Income Tax Act, No. 58 of 1962 namely that it should constitute a
cost/expense actually incurred during the year.

7.5.3 Present value

Where the effect of the time value of money is material, the amount of a provision must be
the present value of the expenditure expected to be required to settle the obligation
(IAS 37.45).

The effect of time value of money is greater where cash outflows of the same amount arise
later. Provisions are therefore discounted, where the effect is material.

The discount rate(s) should be a pre-tax rate(s) that reflect(s) current market assessments
of the time value of money and the risks specific to the liability. The discount rate(s) must
not reflect risks for which future cash flow estimates have been adjusted (IAS 37.47).

EXAMPLE 3
Acid MineWater Ltd is a large mining company that operates in South Africa and other
parts of Africa. The increased importance of nature conservation in South Africa has made
the company conscious of costs to be incurred to preserve the areas in which the
company operates.
Legislation stipulates that a mining company must repair all damage caused by their
operations to the environment at their own cost as soon as mining activities have ceased.

It was determined that damage has been caused evenly over the period of the mines
activity.

Acid MineWater Ltd is currently in the process of commissioning a new mine close to the
Benoni Lake. The total damage to the surrounding area was reliably estimated during
commencement of activities at a future amount of R100 000. The mining activities
commenced on 1 January 20.11 and the estimated date when activities will cease is
31 December 20.14.
The market-related interest rate for calculation purposes is 12%.
The effect of the time value of money is seen as material for the financial statements of the
company.

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REQUIRED
Disclose the above information in the relevant note to the financial
statements of Acid MineWater Ltd for the year ended
31 December 20.12 according to the requirements of IAS 37.

Ignore accounting policy notes.

SOLUTION 3

ACID MINEWATER LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.12

1. Provision for environmental repair costs

20.12 20.11
R R
Carrying amount at beginning of year 71 1781 –

Initial recognition – 63 552¹

Increase in provision due to time value of money 8 5414 7 6262
Carrying amount at end of the year 79 7193 71 1781

The provision is related to future environmental repair costs payable with the ceasing of
mining activities at the Benoni Lake Mine. The mining activities will in all probability cease
on 31 December 20.14. The future expense is estimated on the best available information
at the end of the financial year.

There are certain uncertainties regarding the estimation of the rehabilitation costs as
certain information only becomes available when mining operations start. (These
uncertainties mainly comprise assumptions.)

1. (100 000 x 1/(1.12)3) = R71 178; (100 000 x 1/(1.12)4) = R63 552 (refer to lecturer’s comment)
2. (100 000 x 1/(1.12)3) – (100 000 x 1/(1.12)4) or 71 178 – 63 552
3. (100 000 x 1/(1.12)2) = R79 719 (refer to lecturer’s comment)
4. (100 000 x 1/(1.12)2) – (100 000 x 1/(1.12)3) or 79 719 – 71 178

LECTURER’S COMMENT
IAS 37.45 states that if the effect of discounting is significant, the
provision must be measured at the present value of the expected future
outflow of resources. This applies to the liabilities that have an effect over
the long term, as often occurs in the case of environmental costs, for
example, rehabilitation of disturbed land in the mining industry. The
discount rate and the cash flows must both be expressed in either
nominal terms (including the effect of inflation) or in real terms (excluding
the effect of inflation) AND on a before tax basis.
When discounting is used in the measurement of a provision, the
carrying amount will increase on an annual basis over time. The debit
entry as a result of the increase in provision is recognised as finance
costs in the profit or loss section of the Statement of profit or loss and
other comprehensive income. The following formulas are used for
calculations:
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Formulas for the calculation of time value of money

1. Future value
= Original amount x (1 + interest rate per period)Number of periods
OR
= PV x (1 + i)n

2. Present value
= FV x (1 + i)–n

3. When using a financial calculator (a Hewlett Packard 10BII

financial calculator was used for the following calculations)
Calculation 1 20.11 20.11

Future value (FV) R100 000 R100 000

Periods (N) 3 4
P/YR 1 payment per year 1 payment per
year
Interest rate (I) 12% 12%
Payment (PMT) R0,00 R0,00
Comp present value R71 178 R63 552
(PV)

Calculation 3 20.12

Future Value (FV) R100 000

Periods (N) 2
P/YR 1 payment per year
Interest rate (I) 12%
Payment (PMT) R0,00
Comp present value R79 719
(PV)

LECTURER’S COMMENT

Work through the relevant examples dealing with Provisions and the time
value of money and Measurement of a provision using expected values in
Descriptive Accounting.

7.5.4 Future events

Future events that may affect the amount required to settle an obligation must be reflected
in the amount of a provision where there is sufficient objective evidence that they will occur
(IAS 37.48).

For example, an entity may believe that the cost of cleaning up a site at the end of its life
will be reduced by future changes in technology. Thus it is appropriate to include, for
example, expected cost reductions associated with increased experience in applying
existing technology or the expected cost of applying existing technology to a larger or
more complex clean-up operation that has previously been carried out. However, an entity
does not anticipate the development of a completely new technology for cleaning up
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unless it is supported by sufficient objective evidence (IAS 37.49).

The effect of possible new legislation is taken into consideration in measuring an existing
obligation when sufficient objective evidence exists that the legislation is virtually certain to
be enacted. The variety of circumstances that arise in practice makes it impossible to
specify a single event that will provide sufficient objective evidence in every case. In many
cases, sufficient objective evidence will not exist until the new legislation is enacted
(IAS 37.50).

7.5.5 Expected disposal of assets

Gains from the expected disposal of assets are not taken into account in measuring a
provision (IAS 37.51).

Gains on the expected disposal of assets are not taken into account in measuring a
provision, even if the expected disposal is closely linked to the event giving rise to the
provision. Instead, an entity recognises gains on expected disposals of assets at the time
specified by the statement of International Financial Reporting Standards dealing with the
assets concerned (IAS 37.52).

7.5.6 Reimbursements

Where some or all of the expenditure required to settle a provision is expected to be

reimbursed by another party, the reimbursement is recognised when, and only when, it is
virtually certain that reimbursement will be received if the entity settles the obligation. The
reimbursement is treated as a separate asset. The amount recognised for the
reimbursement may not exceed the amount of the provision (IAS 37.53).

In the statement of profit or loss and other comprehensive income, the expense relating to
a provision may be presented net of the amount recognised for a reimbursement
(IAS 37.54).

The other party may either reimburse amounts paid by the entity or pay the amounts
directly (IAS 37.55).

In most cases, for example insurance contracts, suppliers' warranties, etc, the entity will be
liable for the whole of the amount in question so that the entity would have to settle the full
amount if the third party failed to pay for any reason. However, the entity may be able to
look to another party to pay part or all of the expenditure. In this situation, a provision is
recognised for the full amount of the liability, and a separate asset for the expected
reimbursement is recognised when it is virtually certain that reimbursement will be
received if the entity settles the liability (IAS 37.56).

As noted in paragraph .29, an obligation for which an entity is jointly and severally liable is
a contingent liability to the extent that it is expected that the obligation will be settled by the
other parties (IAS 37.58).

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Some or all of the expenditure required to settle a provision is expected to be reimbursed

by another party.

The entity has no The obligation for the The obligation for the
obligation for part of the amount expected to be amount expected to be
expenditure to be reimbursed remains with reimbursed remains with the
reimbursed by the other the entity and it is enterprise and the
party. virtually certain that reimbursement is not
reimbursement will be virtually certain if the
received if the entity enterprise settles the
settles the provision. provision.

The entity has no liability The reimbursement is The expected reimburse-

for the amount to be recognised as a sepa- ment is not recognised as
reimbursed rate asset in the state- an asset (par .53).
(par .57). ment of financial position
and may be offset
against the expense in
the statement of profit or
loss and other compre-
hensive income. The
amount recognised for
the expected reimburse-
ment does not exceed
the liability
(par .52 and .54).

No disclosure is required. The reimbursement is The expected reimburse-

disclosed together with ment is disclosed
the amount recognised (par .85(c)).
for the reimbursement
(par .85(c)).

7.5.7 Changes in and uses of provisions

Provisions must be reviewed at each reporting date and must be adjusted to reflect the
current best estimate. If it is no longer probable that an outflow of resources embodying
economic benefits will be required to settle the obligation, the provision should be
reversed. The reason for the reversal being that a provision must be used only for
expenditures for which the provision was originally recognised (IAS 37.59).

Where discounting is used, the carrying amount of a provision increases in each period to
reflect the passage of time. This increase is recognised as a borrowing cost (IAS 37.60).

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7.6 APPLICATION OF THE RECOGNITION AND MEASUREMENT

RULES
7.6.1 Future operating losses

Provisions must not be recognised for future operating losses (IAS 37.63).

Future operating losses do not meet the definition of a liability and the general recognition
criteria set out for provisions; therefore, it is not a present obligation.

7.6.2 Onerous contracts

If an entity has a contract that is onerous, the present obligation under the contract must
be recognised and measured as a provision (IAS 37.66).

Some contracts establish both rights and obligations for each of the contracting parties.
Where events make such a contract onerous, the contract falls within the scope of the
statement and a liability exists which is recognised (IAS 37.67).

The statement defines an onerous contract as a contract in which the unavoidable costs of
meeting the obligations under the contract exceed the economic benefits expected to be
received under it. The unavoidable costs under a contract reflect the least net cost of
exiting from the contract, which is the lower of the cost of fulfilling it and any compensation
or penalties arising from failure to fulfil it (IAS 37.68).

Before a separate provision for an onerous contract is established, an entity recognises

any impairment loss that has occurred on assets dedicated to that contract (refer IAS 36 -
Impairment of assets - not part of this module) (IAS 37.69).

LECTURER’S COMMENT

Work through the relevant example dealing with onerous lease contracts in
Descriptive Accounting.

7.6.3 Staff retraining

A company has to incur training cost for its financial personnel after government has
announced changes to the Income Tax Act. These changes were significant and led to the
necessity of training the personnel in these new requirements to ensure continued
compliance with the Income Tax Act. At the reporting date, no training of staff had taken
place.
There are two reasons why provisions will not be provided:

(a) There is not a present obligation because of a past event. The changes to the Income
Tax Act represent the past event but the company has no fixed obligation to retrain the
staff.
(b) The retraining will lead to an outflow of economic resources in the future but at the
reporting date, the obligating event has not taken place.

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7.6.4 Warranties

A company sells its products with a warranty attached to it. The warranty undertakes to
make good, by repair or replacement, manufacturing defects that become apparent within
years from the date of sale. The warranty is an assurance type warranty. From previous
years’ experience, it is probable that there will be about 7% of the sales returned with a
claim against the warranty.

The company provides a provision for the following reasons:

(a) There is a present obligation because of a past event. The obligation is as a result of a
sale of the products with a warranty. A defect product leads to a legal obligation.
(b) The claims under the warranty will result in an outflow of resources embodying
economic benefits in settlement.
(c) A reasonable estimate of the expenditure required to settle the present obligation at
the reporting date could be made. Previous experience will be used as a guideline for
the estimate.

7.6.5 Constructive obligation

A company mines coal in an opencast mine. There is no environmental policy on the

rehabilitation of a matured opencast mine. However, the entity has a widely published
environmental policy in which it undertakes to clean up and rehabilitate the mine. The
company has a history of honouring this published policy.

A provision will be provided because of the following:

(a) There is a constructive obligation to rehabilitate the land on which the company has
mined. The past event is the mining of coal on the land. The constructive obligation
has been created by the expectation created with the public with the widely published
environmental policy of the company to rehabilitate land.
(b) It is probable that an outflow of resources embodying economic benefits will result
from rehabilitating the land.
(c) The company would be able to estimate the costs involved in rehabilitating the land.

7.6.6 Leave pay provision

The employees of a company are entitled to twenty working days leave per annum. The
policy is that an employee must take at least ten days leave per annum. The unused leave
will be accumulated and paid out on retirement or resignation.

A provision will be provided because of the following:

(a) There is a present obligation as a result of a past event. The past event is the fact that
the employee's leave is accumulating while working for a company. The present
obligation exists because the employee is entitled to the accumulated leave being paid
out upon resignation or retirement.
(b) There is an outflow of resources embodying economic benefits when paying the
accumulated leave to the employee.
(c) It is possible to reliably estimate the amount of unpaid leave pay that the company will
be liable for by referring to the accumulated leave days per employee and the rate of
pay of an employee.
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7.6.7 Possible legal liability

A hotel-owning company has had legal proceeding brought in against it. A guest has
slipped on a wet floor in one of its hotels and injured his back. The guest is seeking
compensation from the hotel for his hospital bills and discomfort to the amount of
R500 000. Up to the date of approval of the financial statements for the year ended
31 December 20.11, the company's lawyer advised that it is probable that the entity would
not be found liable. However when the company prepared the financial statements for the
year ended 31 December 20.12, the lawyers advised that due to new evidence in the
case, it is probable that the company would be found liable.

At 31 December 20.11

No provision will be provided because on the basis of the evidence available it appears
that there is no present obligation as a result of a past event. The past event is the guest
falling and injuring his back.

These are the reasons why a contingent liability will be disclosed:

(a) A possible obligation arose from a past event and whose existence will be confirmed
by the outcome of future events not wholly within the control of the entity.
(b) The amount of the possible obligation can be measured sufficiently.
(c) The probability of an outflow is not remote.

At 31 December 20.12

These are the reasons why a provision is provided:

(a) There is a present obligation because of a past event.

(b) It is possible that an outflow of resources embodying economic benefits in settlement
exists.
(c) A reliable estimate of the amount to settle the obligation is available.

LECTURER’S COMMENT

Work through the appendix of IAS 37 for additional examples.

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7.7 DISCLOSURE

7.7.1 Provisions

Provisions are disclosed as a separate line item on the face of the statement of financial
position.

The following must be disclosed for each category of provisions in the notes to the
financial statements:

 A brief description of the nature of the obligation and the expected timing of any
resulting outflows of economic benefits (IAS 37.85).
 An indication of the uncertainties about the amount or timing of these outflows. Where
necessary to provide adequate information an entity must disclose the major
assumptions made concerning future events, as addressed in par .48 (IAS 37.85).
 The amount of any expected reimbursement, stating the amount of any asset that has
been recognised for that expected reimbursement (IAS 37.85).
 The carrying amount at the beginning and the end of the period (IAS 37.84).
 Movements in each category of provisions must be reflected separately, with an
indication of
 additional provisions made in the period and increases to existing provisions;
 amounts incurred (utilised) during the period;
 unused amounts reversed during the period; and
 the increase during the period in the discounted amount arising from the passage of
time and the effect of any change in the discount rate (IAS 37.84).

7.7.2 Contingent liability

The following disclosure requirements apply in the case of contingent liabilities:

For each class of contingent liability, a brief description of its nature is given, as well as,
where practicable
 an estimate of its financial effect;
 an indication of the uncertainties relating to the amount or timing of any outflow; and
 the possibility of any reimbursement (IAS 37.86).
 Where a provision and a contingent liability arise to the same set of circumstances,
the disclosure for the contingent liability is cross-referenced to the disclosure for the
provision to clearly illustrate the relationship (IAS 37.88).
 Where the disclosure of the above information does not take place as it would be
impracticable and is not disclosed for this reason, the fact must be stated (IAS
37.91).
 The above disclosure requirements do not apply when the possibility of any outflow
of resources is remote – then no disclosure is required.
 No specific disclosure is required in cases where the disclosure of information, as set
out above, can prejudice the position of the entity in negotiations with other parties in
respect of the matter to which the contingency relates, however IAS 37.92 does,
indicate that these circumstances are extremely rare. The general nature of the
circumstances and the fact that the information is not disclosed, as well as the
reason why it is not disclosed, should be stated. See IAS 37, Appendix D, example 3,
for an illustration.

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EXAMPLE 4

1. On 31 January 20.12, the marketing director of Orange Ltd informed management of

the possibility that the new logo of the company appearing on all its aircraft would have
to be changed after complaints had been received from its main competitor, Mango
Ltd. The competitor claimed that the new logo was similar to its own logo and it started
legal proceedings against Orange Ltd. However, on 29 February 20.12, the legal
advisors of Orange Ltd are of the opinion that it is not probable that Mango Ltd will be
successful with their legal claim against the company.

2. After a review of the company's insurance policy covering possible claims from
passengers for damaged or lost baggage and flight delays, the financial director of
Orange Ltd recommended that the company cancel their current insurance policy with
Quicksure Ltd on 1 March 20.10 and self-insure in future. Based on previous years'
records, the financial director estimated that these claims from passengers amounted
to approximately R240 000 a year. For the year ended 28 February 20.11, 25 claims
amounting to R185 000 in total were submitted by passengers. On 28 February 20.11,
it was possible that these claims of R185 000 would be successful. On 15 April 20.11,
the court ruled that an amount of R178 000 should be paid for all the claims submitted
during the previous financial year, which was subsequently paid out. Claims
amounting to R260 000 in total were submitted by passengers during the year ended
29 February 20.12. The final outcome of these claims will be determined during the
court hearings scheduled for April 20.12. On 29 February 20.12, the legal advisors of
Orange Ltd advised the company that the possibility is remote that the company will be
found liable for R65 000 of the claims submitted during the current financial year due
to incomplete records.

REQUIRED
1. Prepare the journal entries for the above-mentioned transactions in
the books of Orange Ltd for the year ended 29 February 20.12.
2. Disclose the above transactions in the notes to the annual financial
statements of Orange Ltd for the year ended 29 February 20.12
according to the requirements of IAS 37 – Provisions, contingent
liabilities and contingent assets.
Ignore accounting policy notes.

SOLUTION 4
1. Journals
Debit Credit
R R
Provision for claims (SFP) 178 000
Bank (SFP) 178 000
Payment of claims iro 20.11

Provision for claims (SFP) (185 000 – 178 000) 7 000

Claims (P/L) 7 000
Reversal of unused provision of claims iro 20.11

Claims (P/L) (260 000 – 65 000) 195 000

Provisions for claims (SFP) 195 000
Recording of provisions for claims iro 20.12
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2. Disclosure

ORANGE LTD

NOTES FOR THE YEAR ENDED 29 FEBRUARY 20.12

1. Contingent liability

On 31 January 20.12, the marketing director informed management that the new logo of
the company appearing on all its aircraft would have to change after complaints had been
received from its main competitor, Mango Ltd and they started legal proceedings against
the company. It claimed that the new logo was very similar to its own logo. On
29 February 20.12, the legal advisors of Orange Ltd is of the opinion that it is not probable
that Mango Ltd will win their legal action.

2. Provision for claims

R
Carrying amount at beginning of year 185 000
Provision used during the year (178 000)
Unused provision reversed during the year (185 000 – 178 000) (7 000)
Provision created for the year (260 000 – 65 000) 195 000
Carrying amount at the end of the year 195 000

After a review of the company's insurance policy covering possible claims from
passengers for damaged or lost baggage and flight delays, the financial director of Orange
Ltd recommended that the company cancel their current insurance policy with Quicksure
Ltd on 1 March 20.10 and self-insure in future. The final outcome of claims submitted by
passengers during the year ended 29 February 20.12 will be determined during the court
hearings scheduled for April 20.12.

7.7.3 Contingent asset

Should an inflow of economic benefits be probable, the following disclosure requirements

apply to contingent assets:

 A brief description of the nature of the contingent asset at the end of the reporting
period (IAS 37.89).
 An estimate of the financial effect of the contingent asset, measured according to the
same principles that apply to provisions and contingent liabilities, provided it is
practicable to obtain this information (IAS 37.89).
 Where the disclosure of the above information does not take place, as it would be
impracticable, and is not disclosed for this reason, the fact must be disclosed
(IAS 37.91).
 No specific disclosure is required in cases in where the disclosure of information, as
set out above, can prejudice the position of the entity in negotiations with other parties
in respect of the matter to which the contingency relates. However IAS 37.92 does,
indicate that these circumstances are extremely rare. The general nature of the
circumstances and the fact that the information is not disclosed, as well as the reason
why it is not disclosed, must be stated.

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EXAMPLE 5

Herselman Ltd is a building contractor of shopping centres in Gauteng. During May 20.12,
the roof of a shopping centre in Sandton, erected by Herselman Ltd, collapsed and five
people were injured. After numerous investigations it was determined that the cause of the
accident was the inferior-quality building materials used by Herselman Ltd. The injured
started legal proceedings against Herselman Ltd seeking damages of R120 000, but the
company disputed the claim. At year end, on 31 December 20.12 the company's lawyers
advised the directors of Herselman Ltd that it was probable that the company would be
found liable. As a result of this, Herselman Ltd instituted a claim of R100 000 against
Cemento Ltd, the supplier of the inferior building materials used for the shopping centre.
On 31 December 20.12, Herselman Ltd's legal advisors are of the opinion that the claim
against Cemento Ltd will probably succeed but they are not virtually certain.

As a result of the negative publicity after the accident at the shopping centre in Sandton,
the directors of Herselman Ltd estimated that the operating loss for the next financial year
would probably amount to R240 000. At a board meeting held on 30 November 20.12, the
board of directors decided to take precautions and to reduce its workforce by twenty-five
employees. Employees were notified and severance packages amounting to a total of
R225 000 would be paid to these redundant employees according to their service
contracts.

On 30 September 20.12, Herselman Ltd decided to replace the old computer it currently
leases in terms of an operating lease agreement from Machines Galore with the latest
model. However, the current lease agreement expires on 31 March 20.13 only and cannot
be cancelled or sub-leased to another user. The monthly lease instalment of this old
computer amounts to R12 250. The operating lease instalments of this old computer were
up to date until 31 December 20.12.

During 20.11, Herselman Ltd reviewed its insurance arrangements for its liability for
accidents sustained by its construction workers on site and decided to cancel its policy
with an insurance broker and self-insure from 1 July 20.11. Based on experience, the
directors estimated that the costs of these accidents amount to approximately R120 000
per annum. Four claims amounting to R65 000 in total were submitted during 20.11 by
construction workers being injured on site.

On 31 December 20.11, it was probable that these claims of R65 000 would be successful.

The court ruled on 14 January 20.12 that an amount of R54 000 should be paid for these
claims submitted during 20.11. Three claims amounting to R25 000 in total were submitted
during 20.12 by construction workers being injured on site. The outcome of these claims
would be decided during the court hearing in January 20.13. At year end on
31 December 20.12, the legal advisors of Herselman Ltd advised the company that it is
probable that the company will not be found liable for the claims submitted during the
current financial year.

On 1 June 20.12 Herselman Ltd purchased an imported bulldozer from Germany. Owing
to the nature of the recent construction contracts it is being used for, the company expects
to replace component parts of the bulldozer at regular intervals. The directors estimated
that a provision of R5 000 per month to cover the costs of replacing the component parts
of the bulldozer would be adequate. No replacements of the component parts for the
bulldozer were required for the current financial year.
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On 1 November 20.12, Herselman Ltd gave a guarantee to Loanshark Bank for a personal
overdraft facility of R500 000 for the managing director, Mr Liberace. On
31 December 20.12, the financial position of the managing director is considered to be
doubtful as he has filed for protection from his creditors.
REQUIRED
Disclose the above-mentioned information relating to provisions,
contingent liabilities and contingent assets only in the notes to the
statement of financial position of Herselman Ltd for the year ended
31 December 20.12. Your answer must comply with the requirements of
International Financial Reporting Standards.

Ignore any tax implications.

Ignore accounting policy notes.
Comparative figures are not required.
Assume that all amounts are material.

SOLUTION 5

HERSELMAN LTD

NOTES FOR THE YEAR ENDED 31 DECEMBER 20.12

1. Contingent asset

A claim for R100 000 has been instituted against a supplier, Cemento Ltd, for building
material delivering of an inferior quality. This was the cause of a roof of a shopping centre
in Sandton, erected by Herselman Ltd, collapsing during May 20.12, injuring five people.
The claim receivable by Herselman Ltd will be taxable. On 31 December 20.12 Herselman
Ltd’s legal advisors are of the opinion that the claim against Cemento Ltd will probably
succeed, but they are not virtually certain.

2. Provisions

2.1 Provision for legal claims

R
Carrying amount at 1 January 20.12 –
Provision created during the year 120 000
Carrying amount at 31 December 20.12 120 000

During May 20.12 the roof of a shopping centre in Sandton, erected by Herselman Ltd,
collapsed because Herselman Ltd used building materials of an inferior quality and five
people were injured. The injured started legal proceedings against Herselman Ltd seeking
damages, but the company disputes the claim. The company's lawyers advised the
directors of Herselman Ltd that it is probable that the company will be found liable.

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2.2 Provision for severance packages

R
Carrying amount at 1 January 20.12 –
Provision created during the year 225 000
Carrying amount at 31 December 20.12 225 000

At a board meeting held on 30 November 20.12, the board of directors decided to take
precautions and to reduce its workforce by 25 employees. Severance packages will be
paid to the redundant employees according to their service contracts.
2.3 Provision for onerous contract
R
Carrying amount at 1 January 20.12 –
Provision created during the year (3 x R12 250) 36 750
Carrying amount at 31 December 20.12 36 750

Herselman Ltd decided to replace the old computer it currently leases from Machines
Galore in terms of an operating lease agreement with the latest model. However, the
current lease agreement only expires on 31 March 20.13 and cannot be cancelled or
subleased to another user.

2.4 Provision for claims of employees injured on site

R
Carrying amount at 1 January 20.12 65 000
Amount used during the year (54 000)
Unused amounts reversed during the year (11 000)
Carrying amount at 31 December 20.12 –

During 20.11, Herselman Ltd decided to cancel its insurance policy for its possible liability
in the case of accidents sustained by its employees on site and to self-insure from
1 July 20.11. Provision of R65 000 was made for claims of employees injured on the
construction site during 20.11. However, the court ruled on 14 January 20.12 that only an
amount of R54 000 had to be paid for these claims submitted during 20.11.

2.5 Provision for guarantee given

R
Carrying amount at 1 January 20.12 –
Provision created during the year 500 000
Carrying amount at 31 December 20.12 500 000

Herselman Ltd gave a guarantee to Loanshark Bank for a personal loan of R500 000 of
the managing director, Mr Liberace, on 1 November 20.12. At year end, the financial
position of the managing director is considered to be doubtful as he has filed for protection
from his creditors.
3 Contingent liability

Three claims amounting to R25 000 in total were submitted during the year by construction
workers being injured on site. The outcome would be decided during the court hearing in
January 20.13. The legal advisors of Herselman Ltd advised the company that it was
probable that the company would not be found liable.

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LECTURER’S COMMENT

No provision should be made for the future operating loss of R240 000
and future replacement costs of component parts of R5 000 per month,
as a present obligation does not exist at year end.

7.8 TRANSITIONAL PROVISIONS

The effect of adopting this statement on its effective date (or earlier) must be reported as
an adjustment to the opening balance of retained earnings for the period in which the
statement is first adopted.
Entities are encouraged, but not required, to adjust the opening balance of retained
earnings for the earliest period presented and to restate comparative information. If
comparative information is not restated, this fact must be disclosed (IAS 37.93).

7.9 SUMMARY – IAS 37

Liabilities under different levels of uncertainty may be summarised as follows:

Liabilities

Provisions Contingent Contingent

liabilities liabilities

 Present obligation  Present obligation  Possible obligation

 as a result of past  as a result of past  as a result of past events
events events
 the settlement of which  the settlement of  the existence of which is
is expected to result in which is expected to to be confirmed by the
an outflow from the result in an outflow occurrence or non-
entity of resources from the entity of occurrence of uncertain
embodying economic resources embodying future event/s that are not
benefits economic benefits wholly within the control
of the entity
 where the amount or  the liability may not be
timing of payments is recognised where the
uncertain following recognition
are not met:
 the amount is not
reliably measured
or
 it is not probable
that the future
outflow of economic
benefits is needed
to settle the
obligation

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7.10 TAX IMPLICATIONS

This only gives an overview of the most important aspects of tax related to provisions,
contingent liabilities and contingent assets.
It is only provisions that will have any tax implications, as it will result in an expense in the
statement of profit or loss and other comprehensive income and a credit balance in the
statement of financial position.
Contingent liabilities and contingent assets will only be disclosed in a note to the annual
financial statements and will not result in any accounting entries; therefore, it will not have
any tax implications.
For tax purposes, an expense is not deductible until the expense is actually paid or
incurred. In terms of section 23(e) of the Income Tax Act a taxpayer may not claim a
deduction when determining taxable income if this deduction originates from a reserve
transfer or any other capitalisation of income (raising a provision). This section is in line
with the general deduction formula in section 11(a), which determines that expenses can
only be deducted for tax purposes when actually incurred, unless the Income Tax Act
provides otherwise.

EXAMPLE 6
Dot Ltd has raised a provision of R100 000 for warranty claims during the current financial
year. The warranty is an assurance type of warranty. For accounting purposes, the
following journal entry is processed:
Debit Credit
R R
Warranty claims (P/L) 100 000
Provision for warranty claims (SFP) 100 000
Calculation of deferred tax
Carrying Tax Temporary Deferred
amount base difference tax asset
@ 28%
R R R R
Provision for warranty claims 100 000 –* 100 000 28 000
* The tax base of the provision is the carrying amount less the amount that will be
deductible for tax purposes in future. Owing to the deductibility of actual expenses
incurred, the tax base will be nil because the claim will only be deductible for tax purposes
when it is settled.

ASSESSMENT CRITERIA
Are you now able to do the following?
 Define provisions, contingent assets and contingent liabilities in detail.
 Determine if an item should be accounted for as a provision,
contingent liability or as a contingent asset.
 Record a provision, contingent liability and contingent asset accurately
in the annual financial statements to enable users to understand the
nature, timing and amounts of provisions, contingent liabilities and
contingent assets.

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LEARNING UNIT 8
FAIR VALUE
MEASUREMENT (IFRS 13)

General Financial Reporting

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LEARNING UNIT 8: FAIR VALUE MEASUREMENT

LEARNING OUTCOMES

Learners should be able to measure fair value for financial reporting according to the
framework set out in IFRS 13.

OVERVIEW

This learning unit is divided into the following:

A. INTRODUCTION
8.1 Objectives and scope

B. MEASUREMENT
8.2 Definitions
8.3 The elements of fair value measurement
8.3.1 The asset or liability
8.3.2 Orderly transaction
8.3.3 Market participants
8.3.4 Price
8.4 Applications of fair value measurement
8.4.1 Application to non-financial assets
8.4.2 Application to liabilities and the entity’s own equity instruments
8.4.3 Application to financial assets and liabilities with offsetting positions in market
risks or counterparty credit risk
8.5 Fair value at initial recognition
8.6 Valuation techniques
8.6.1 General remarks
8.6.2 Application guidance: valuation techniques
8.7 Inputs to valuation techniques
8.7.1 General principles
8.7.2 Inputs based on bid and ask prices
8.8 Fair value hierarchy
8.8.1 Introduction
8.8.2 Level 1 inputs: quoted prices in active markets for identical assets or liabilities
8.8.3 Level 2 inputs: other than quoted prices in active markets for assets or liabilities
8.8.4 Level 3 inputs: unobservable inputs for assets or liabilities

STUDY

PRESCRIBED
Descriptive Accounting
The chapter relevant to IFRS 13– Fair value measurement
RECOMMENDED
IFRS Standards – The Annotated IFRS Standards
IFRS 13 – Fair value measurement

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A. INTRODUCTION
IFRS 13 explains how to measure fair value for financial reporting. It does not require fair
value measurements in addition to those already required or permitted by other IFRSs and
is not intended to establish valuation standards or affect valuation practices outside
financial reporting (IFRS 13: IN4).
Some IFRSs require or permit entities to measure or disclose the fair value of assets,
liabilities or their own equity instruments. Because those IFRSs were developed over
many years, the requirements for measuring fair value and for disclosing information about
fair value measurements were dispersed and in many cases did not articulate a clear
measurement or disclosure objective (IFRS 13: IN5).
As a result, some of those IFRSs contained limited guidance about how to measure fair
value, whereas others contained extensive guidance and that guidance was not always
consistent across those IFRSs that refer to fair value. Inconsistencies in the requirements
for measuring fair value and for disclosing information about fair value measurements
have contributed to diversity in practice and have reduced the comparability of information
reported in financial statements. IFRS 13 remedies that situation (IFRS 13: IN6).
Main features of IFRS 13

IFRS 13 defines fair value as the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at the
measurement date (i.e. an exit price) (IFRS 13.9).

The definition of fair value emphasises that fair value is a market-based measurement, not
an entity-specific measurement. When measuring fair value, an entity uses the
assumptions that market participants would use when pricing the asset or liability under
current market conditions, including assumptions about risk. As a result, an entity’s
intention to hold an asset or to settle or otherwise fulfill a liability is not relevant when
measuring fair value.

8.1 OBJECTIVES AND SCOPE (IFRS 13.1 – 8)

The purpose of IFRS 13 is to:

 define fair value;

 set out in a single IFRS a framework for measuring fair value; and
 describe disclosure requirements about fair value measurements.

The objective of a fair value measurement is:

 to estimate the price at which an orderly transaction (to sell an asset or to transfer a
liability) would take place;
 between market participants;
 at the measurement date; and
 under current market conditions.

Fair value is a market-based measurement and not one that is only specific to the entity.
Market transactions or market information for some assets and liabilities might or might not
be observable (available). When a price is unobservable, an entity measures fair value
using another valuation technique that maximises the use of relevant observable inputs
and minimises the use of unobservable inputs. As a market-based measurement, the fair
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value is measured using the assumptions that market participants would use when pricing
the asset or liability, including assumptions about risk. The intention of the entity (to hold
the asset or settle the liability) is therefore not relevant in fair value measurement.

The definition of fair value focuses on assets or liabilities, as they are primary subjects of
accounting measurements. IFRS 13 also applies to an entity’s own equity instruments
measured at fair value.

IFRS 13 applies to IFRSs that require or permit fair value measurements or disclosures
about fair value measurements. It also applies to measurements such as fair value less
costs to sell, which are based on fair values and their disclosures. The fair value
measurement framework applies to both the initial and the subsequent measurement.

IFRS 13 does not apply in the following circumstances:

 The measurement and disclosure requirements do not apply to IFRS 2 (share-based

payment transactions), IFRS 16 (leasing transactions), IAS 2 (the net realisable value
of inventories) and IAS 36 (the value in use of impairment assets).
 The disclosure requirements do not apply to IAS 19 (plan assets measured at fair
value), IAS 26 (retirement benefit plan investments measured at fair value) and IAS 36
(assets for which the recoverable amount is fair value less costs of disposal).

B. MEASUREMENT

8.2 DEFINITIONS (IFRS 13 appendix A)

Active market is a market in which transactions for the asset or liability take place with
sufficient frequency and volume to provide pricing information on an ongoing basis.

Cost approach is a valuation technique that reflects the amount that would be required
currently to replace the service capacity of an asset (often referred to as current
replacement cost).

Entry price is the price paid to acquire an asset or received to assume a liability in an
exchange transaction.

Exit price is the price that would be received to sell an asset or paid to transfer a liability.

Expected cash flow is the probability-weighted average (i.e. mean of the distribution) of
possible future cash flows.

Fair value is the price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date.

Highest and best use is the use of a non-financial asset by market participants that would
maximise the value of the asset or the group of assets and liabilities (e.g. a business)
within which the asset would be used.

Income approach is valuation techniques that convert future amounts (e.g. cash flows or
income and expenses) to a single current (i.e. discounted) amount. The fair value
measurement is determined on the basis of the value indicated by current market
expectations about those future amounts.

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Inputs are the assumptions that market participants would use when pricing the asset or
liability, including assumptions about risk, such as:
(a) the risk inherent in a particular valuation technique used to measure fair value (such
as a pricing model); and
(b) the risk inherent in the inputs to the valuation technique.

Inputs may be observable or unobservable.

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or
liabilities that the entity can access at the measurement date.

Level 2 inputs are inputs (other than quoted prices included within Level 1) that are
observable for the asset or liability, either directly or indirectly.

Level 3 inputs are unobservable inputs for the asset or liability.

Market approach is a valuation technique that uses prices and other relevant information
generated by market transactions involving identical or comparable (i.e. similar) assets,
liabilities or a group of assets and liabilities, such as a business.

Market-corroborated inputs are inputs that are derived principally from or corroborated
by observable market data by correlation or other means.

Market participants are buyers and sellers in the principal (or most advantageous)
market for the asset or liability that have all of the following characteristics.
(a) They are independent of each other, although the price in a related party transaction
may be used as an input to a fair value measurement if the entity has evidence that the
transaction was entered into at market terms.
(b) They are knowledgeable, having a reasonable understanding about the asset or liability
and the transaction using all available information, including information that might be
obtained through due diligence efforts that are usual and customary.
(c) They are able to enter into a transaction for the asset or liability.
(d) They are willing to enter into a transaction for the asset or liability, in other words they
are motivated but not forced or otherwise compelled to do so.

Most advantageous market is the market that maximises the amount that would be
received to sell the asset or minimises the amount that would be paid to transfer the
liability, after taking into account transaction costs and transport costs.

Non-performance risk is the risk that an entity will not fulfill an obligation. Non-
performance risk includes, but may not be limited to, the entity’s own credit risk.

Observable inputs are inputs that are developed using market data, such as publicly
available information about actual events or transactions, and that reflect the assumptions
that market participants would use when pricing the asset or liability.

Orderly transaction is a transaction that assumes exposure to the market for a period
before the measurement date to allow for marketing activities that are usual and
customary for transactions involving such assets or liabilities; it is not a forced transaction
(e.g. a forced liquidation or distress sale).

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Principal market is the market with the greatest volume and level of activity for the asset
or liability.

Risk premium is compensation sought by risk-averse market participants for bearing the
uncertainty inherent in the cash flows of an asset or a liability. It is also referred to as a risk
adjustment.

Transaction costs are the costs to sell an asset or transfer a liability in the principal (or
most advantageous) market for the asset or liability that are directly attributable to the
disposal of the asset or the transfer of the liability and meet both of the following criteria:

(a) They result directly from and are essential to that transaction.
(b) They would not have been incurred by the entity had the decision to sell the asset or
transfer the liability not been made.

Transport costs are the costs that would be incurred to transport an asset from its current
location to its principal (or most advantageous) market.

Unit of account is the level at which an asset or a liability is aggregated or disaggregated

in an IFRS for recognition purposes.

Unobservable inputs are inputs for which market data are not available and that are
developed using the best information available about the assumptions that market
participants would use when pricing the asset or liability.

The following definitions, which do not form part of this statement, are given as
these terms are used in the statement:

A financial instrument is any contract that gives rise to a financial asset of one entity and
a financial liability or equity instrument of another entity.

A financial asset is any asset that is:

(a) cash;
(b) any equity instrument of another entity;
(c) a contractual right:

- to receive cash or another financial asset from another entity; or

- to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity; or

(d) a contract that will or may be settled in the entity's own equity instruments and is:

- a non-derivative for which the entity is or may be obliged to receive a variable

number of the entity's own equity instruments; or
- a derivative that will or may be settled other than by the exchange of a fixed amount
of cash or another financial asset for a fixed number of the entity's own equity
instruments. For this purpose the entity's own equity instruments do not include
instruments that are themselves contracts for the future receipt or delivery of the
entity's own equity instruments.

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A financial liability is any liability that is:

(a) a contractual obligation:

- to deliver cash or another financial asset to another entity; or

- to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; or

(b) a contract that will or may be settled in the entity's own equity instruments and is:

- a non-derivative for which the entity is or may be obliged to deliver a variable

number of the entity's own equity instruments; or
- a derivative that will or may be settled other than by the exchange of a fixed amount
of cash or another financial asset for a fixed number of the entity's own equity
instruments. For this purpose the entity’s own equity instruments do not include
instruments that are themselves contracts for the future receipt or delivery of the
entity's own equity instruments.

A business combination is a transaction or other event in which an acquirer obtains

control of one or more businesses.

An intangible asset is an identifiable non-monetary asset without physical substance.

A cash generating unit is the smallest identifiable group of assets that generates cash
inflows that are largely independent of the cash inflows from other assets or groups of
assets.

Investment property is property held (by the owner or by the lessee under a finance
lease) to earn rentals or for capital appreciation or both, rather than for:

- use in the production or supply of goods or services or for administrative purposes;

or
- sale in the ordinary course of business.

A related party (related to the reporting entity) is a person or entity that is related to the
entity that is preparing its financial statements.

8.3 THE ELEMENTS OF FAIR VALUE MEASUREMENT

8.3.1 The asset or liability (IFRS 13.11–14)

A fair value measurement is for a particular asset or liability. The entity must therefore take
into account what the characteristics of the asset or liability are if the market participants
would take those characteristics into account when the asset or liability is priced on the
measurement date. Characteristics include the following:

 The condition and location of the asset.

 Any restrictions on the sale or use of the asset.

The effect on the measurement arising from a particular characteristic will differ depending
on how that characteristic would be taken into account by market participants.
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The asset or liability measured at fair value might be either of the following:

(a) A stand-alone asset or liability (e.g. a financial instrument or a non-financial asset).

(b) A group of assets, or group of liabilities or a group of assets and liabilities (e.g. a cash-
generating unit or a business).

8.3.2 Orderly transaction (IFRS 13.15–21)

A fair value measurement assumes that the asset or liability is exchanged in an orderly
transaction between market participants to sell the asset or transfer the liability at the
measurement date under current market conditions.

A fair value measurement assumes that such a transaction takes place either:

(a) in the principal market for the asset or liability; or

(b) in the absence of a principal market, in the most advantageous market for the asset or
liability.

An entity need not undertake an exhaustive search of all possible markets to identify the
principal market or the most advantageous market, but it shall take into account all
information that is reasonably available. In the absence of evidence to the contrary, the
market in which the entity would normally enter into a transaction to sell the asset or to
transfer the liability is presumed to be the principal market or, if absent, the most
advantageous market.

8.3.3 Market participants (IFRS 13.22–23)

An entity shall measure the fair value of an asset or a liability using the assumptions that
market participants would use when pricing the asset or liability, assuming that market
participants act in their economic best interest.

In developing those assumptions, an entity need not identify specific market participants.
Rather, the entity shall identify characteristics that distinguish market participants
generally, considering factors specific to:

(a) the asset or liability;

(b) the principal (or most advantageous) market for the asset or liability; and
(c) market participants with whom the entity would enter into a transaction in that market.

8.3.4 Price (IFRS 13.24–26)

Fair value is the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction in the principal (or most advantageous) market at the measurement
date under current market conditions (i.e. an exit price) regardless of whether that price is
directly observable or estimated using another valuation technique.

The price in the principal (or most advantageous) market used to measure the fair value of
the asset or liability shall not be adjusted for transaction costs. Transaction costs shall be
accounted for in accordance with other IFRSs. Transaction costs are not a characteristic of
an asset or a liability. Rather, they are specific to a transaction and will differ depending on
how an entity enters into a transaction for the asset or liability.

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Transaction costs do not include transport costs. If location is a characteristic of the asset
(as might be the case, for example, for a commodity), the price in the principal (or most
advantageous) market shall be adjusted for the costs, if any, that would be incurred to
transport the asset from its current location to that market.

LECTURER’S COMMENT

Work through the relevant example dealing with transaction costs and
transport cost in Descriptive Accounting

8.4 APPLICATIONS OF FAIR VALUE MEASUREMENT

A fair value measurement requires an entity to determine:

(a) the particular asset or liability being measured;

(b) for a non-financial asset, the highest and best use of the asset and whether the asset
is used in combination with other assets or on a stand-alone basis;
(c) the market in which an orderly transaction would take place for the asset or liability;
and
(d) the appropriate valuation technique(s) to use when measuring fair value. The valuation
technique(s) used should maximise the use of relevant observable inputs and
minimise unobservable inputs. Those inputs should be consistent with the inputs a
market participant would use when pricing the asset or liability (IFRS 13 IN8–10).

8.4.1 Application to non-financial assets (IFRS 13.27–.33)

Highest and best use for non-financial assets

A fair value measurement of a non-financial asset takes into account a market participant’s
ability to generate economic benefits by using the asset in its highest and best use or by
selling it to another market participant that would use the asset in its highest and best use.
Examples of non-financial assets are property, plant and equipment and investment
properties.The highest and best use of a non-financial asset takes into account the use of
the asset that is physically possible, legally permissible and financially feasible, as follows:

(a) A use that is physically possible takes into account the physical characteristics of
the asset that market participants would take into account when pricing the asset (e.g.
the location or size of a property).

(b) A use that is legally permissible takes into account any legal restrictions on the use
of the asset that market participants would take into account when pricing the asset
(e.g. the zoning regulations applicable to a property).

(c) A use that is financially feasible takes into account whether a use of the asset that
is physically possible and legally permissible generates adequate income or cash
flows (taking into account the costs of converting the asset to that use) to produce an
investment return that market participants would require from an investment if that
asset is put to that use.

The highest and best use is determined from the perspective of market participants, even
if the entity intends a different use. However, an entity’s current use of a non-financial
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asset is presumed to be its highest and best use unless market or other factors suggest
that a different use by market participants would maximise the value of the asset.

LECTURER’S COMMENT

Work through the relevant examples dealing with highest and best use in
Descriptive Accounting

8.4.2 Application to liabilities and an entity’s own equity instruments

(IFRS 13.34–.47)

(a) General principles

A fair value measurement assumes that a financial or non-financial liability or an entity’s

own equity instrument (e.g. equity interests issued as consideration in a business
combination) is transferred to a market participant at the measurement date. The transfer
of a liability or an entity’s own equity instrument assumes the following:

(a) A liability would remain outstanding and the market participant transferee would be
required to fulfill the obligation. The liability would not be settled with the counterparty
or otherwise extinguished on the measurement date.
(b) An entity’s own equity instrument would remain outstanding and the market participant
transferee would take on the rights and responsibilities associated with the instrument.
The instrument would not be cancelled or otherwise extinguished on the measurement
date.
Even when there is no observable market to provide pricing information about the transfer
of a liability or an entity’s own equity instrument (e.g. because contractual or other legal
restrictions prevent the transfer of such items), there might be an observable market for
such items if they are held by other parties as assets (e.g. a corporate bond or a call
option on an entity’s shares).
In all cases, an entity shall maximise the use of relevant observable inputs and minimise
the use of unobservable inputs to meet the objective of a fair value measurement, which is
to estimate the price at which an orderly transaction to transfer the liability or equity
instrument would take place between market participants at the measurement date under
current market conditions.
Liabilities and equity instruments held by other parties as assets
When a quoted price for the transfer of an identical or a similar liability or entity’s own
equity instrument is not available and the identical item is held by another party as an
asset, an entity shall measure the fair value of the liability or equity instrument from the
perspective of a market participant that holds the identical item as an asset at the
measurement date.
In such cases, an entity shall measure the fair value of the liability or equity instrument as
follows:
(a) Using the quoted price in an active market for the identical item held by another party
as an asset, if that price is available
(b) If that price is not available, using other observable inputs, such as the quoted price in
a market that is not active for the identical item held by another party as an asset
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(c) If the observable prices in (a) and (b) are not available, using another valuation
technique, such as:
(i) an income approach (e.g. a present value technique that takes into account the
future cash flows that a market participant would expect to receive from holding the
liability or equity instrument as an asset; refer Application guidance B10 and B11);

(ii) a market approach (e.g. using quoted prices for similar liabilities or equity
instruments held by other parties as assets; refer Application guidance B5–B7)

LECTURER’S COMMENT

Work through the relevant examples dealing with debt obligation (quoted
price) and debt obligation (present value technique) in Descriptive
Accounting

Liabilities and equity instruments not held by other parties as assets

When a quoted price for the transfer of an identical or a similar liability or entity’s own
equity instrument is not available and the identical item is not held by another party as an
asset, an entity shall measure the fair value of the liability or equity instrument using a
valuation technique from the perspective of a market participant that owes the liability or
has issued the claim on equity. For example, when applying a present value technique an
entity might take into account either of the following:

(a) The future cash outflows that a market participant would expect to incur in fulfilling the
obligation, including the compensation that a market participant would require for
taking on the obligation (refer Application Guidance paragraphs B31–B33 for
examples)

(b) The amount that a market participant would receive to enter into or issue an identical
liability or equity instrument, using the assumptions that market participants would use
when pricing the identical item (e.g. having the same credit characteristics) in the
principal (or most advantageous) market for issuing a liability or an equity instrument
with the same contractual terms

LECTURER’S COMMENT

Work through the relevant example dealing with decommissioning liability

(expected present value technique) in Descriptive Accounting

8.4.3 Application to financial assets and financial liabilities with offsetting

positions in market risks or counterparty credit risk (IFRS 13.48–.56)

This section of the statement does not form part of this module.

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8.5 FAIR VALUE AT INITIAL RECOGNITION (IFRS 13.57–.60)

When an asset is acquired or a liability is assumed in an exchange transaction for that

asset or liability, the transaction price is the price paid to acquire the asset or received to
assume the liability (an entry price). In contrast, the fair value of the asset or liability is the
price that would be received to sell the asset or paid to transfer the liability (an exit price).
Entities do not necessarily sell assets at the prices paid to acquire them. Similarly, entities
do not necessarily transfer liabilities at the prices received to assume them.

In many cases the transaction price will equal the fair value (e.g. that might be the case
when on the transaction date the transaction to buy an asset takes place in the market in
which the asset would be sold).

When determining whether fair value at initial recognition equals the transaction price, an
entity shall take into account factors specific to the transaction and to the asset or liability.
For example, the transaction price might not represent the fair value of an asset or a
liability at initial recognition if any of the following conditions exist:

(a) The transaction is between related parties, although the price in a related party
transaction may be used as an input into a fair value measurement if the entity has
evidence that the transaction was entered into at market terms.
(b) The transaction takes place under duress or the seller is forced to accept the price in
the transaction. That might be the case if the seller is experiencing financial difficulty.
(c) The unit of account represented by the transaction price is different from the unit of
account for the asset or liability measured at fair value. For example, that might be the
case if the asset or liability measured at fair value is only one of the elements in the
transaction (e.g. in a business combination), the transaction includes unstated rights
and privileges that are measured separately in accordance with another IFRS, or the
transaction price includes transaction costs.
(d) The market in which the transaction takes place is different from the principal market
(or most advantageous market). For example, those markets might be different if the
entity is a dealer that enters into transactions with customers in the retail market, but
the principal (or most advantageous) market for the exit transaction is with other
dealers in the dealer market.

LECTURER’S COMMENT

Work through the relevant example dealing with fair value at initial
recognition in Descriptive Accounting

8.6 VALUATION TECHNIQUES (IFRS 13.61–.66)

8.6.1 General remarks
An entity shall use valuation techniques that are appropriate in the circumstances and for
which sufficient data are available to measure fair value, maximising the use of relevant
observable inputs and minimising the use of unobservable inputs.
The objective of using a valuation technique is to estimate the price at which an orderly
transaction to sell the asset or to transfer the liability would take place between market
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participants at the measurement date under current market conditions. Three widely used
valuation techniques are the market approach, the cost approach and the income
approach. The main aspects of those approaches are summarised in Application
Guidance paragraphs B5–B11.
Valuation techniques used to measure fair value shall be applied consistently. However, a
change in a valuation technique or its application (e.g. a change in its weighting when
multiple valuation techniques are used or a change in an adjustment applied to a valuation
technique) is appropriate if the change results in a measurement that is equally or more
representative of fair value in the circumstances. That might be the case if, for example,
any of the following events take place:
(a) new markets develop;
(b) new information becomes available;

(c) information previously used is no longer available;

(d) valuation techniques improve; or

(e) market conditions change.

Revisions resulting from a change in the valuation technique or its application shall be
accounted for as a change in accounting estimate in accordance with IAS 8. However,
the disclosures in IAS 8 for a change in accounting estimate are not required for revisions
resulting from a change in a valuation technique or its application.

8.6.2 Application guidance: valuation techniques

(a) Market approach (IFRS 13 .B5–.B6)

The market approach uses prices and other relevant information generated by market
transactions involving identical or comparable (i.e. similar) assets, liabilities or a group of
assets and liabilities, such as a business.

For example, valuation techniques consistent with the market approach often use market
multiples derived from a set of comparables. Multiples might be in ranges with a different
multiple for each comparable. The selection of the appropriate multiple within the range
requires judgement, considering qualitative and quantitative factors specific to the
measurement.

LECTURER’S COMMENT

Work through the relevant example dealing with market approach in

Descriptive Accounting

(b) Cost approach (IFRS 13 .B8–.B9)

The cost approach reflects the amount that would be required currently to replace the
service capacity of an asset (often referred to as current replacement cost).

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From the perspective of a market participant seller, the price that would be received for the
asset is based on the cost to a market participant buyer to acquire or construct a substitute
asset of comparable utility, adjusted for obsolescence. That is because a market
participant buyer would not pay more for an asset than the amount for which it could
replace the service capacity of that asset. Obsolescence encompasses physical
deterioration, functional (technological) obsolescence and economic (external)
obsolescence, and is broader than depreciation for financial reporting purposes (an
allocation of historical cost) or tax purposes (using specified service lives). In many cases
the current replacement cost method is used to measure the fair value of tangible assets
that are used in combination with other assets or with other assets and liabilities.

LECTURER’S COMMENT

Work through the relevant example dealing with cost approach in

Descriptive Accounting

(c) Income approach (IFRS 13 .B10–.B11)

The income approach converts future amounts (e.g. cash flows or income and expenses)
to a single current (i.e. discounted) amount. When the income approach is used, the fair
value measurement reflects current market expectations about those future amounts.

Those valuation techniques include, for example:

(a) present value techniques;

(b) option pricing models, such as the Black-Scholes-Merton formula or a binomial model
(i.e. a lattice model), that incorporate present value techniques and reflect both the
time value and the intrinsic value of an option; and
(c) the multi-period excess earnings method, which is used to measure the fair value of
some intangible assets.

8.7 INPUTS TO VALUATION TECHNIQUES (IFRS 13 .67–.71)

8.7.1 General principles

Valuation techniques used to measure fair value shall maximise the use of relevant
observable inputs and minimise the use of unobservable inputs.

Examples of markets in which inputs might be observable for some assets and liabilities
(e.g. financial instruments) include exchange markets, dealer markets, brokered markets
and principal-to-principal markets.

8.7.2 Inputs based on bid and ask prices

If an asset or a liability measured at fair value has a bid price and an ask price (e.g. an
input from a dealer market), the price within the bid-ask spread that is most representative
of fair value in the circumstances shall be used to measure fair value regardless of where
the input is categorised within the fair value hierarchy. The use of bid prices for asset
positions and ask prices for liability positions is permitted but not required.

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This IFRS does not preclude the use of mid-market pricing or other pricing conventions
that are used by market participants as a practical expedient for fair value measurements
within a bid-ask spread.

8.8 Fair value hierarchy (IFRS 13 .72–.90)

8.8.1 Introduction

To increase consistency and comparability in fair value measurements and related

disclosures, this IFRS establishes a fair value hierarchy that categorises into three levels
the inputs to valuation techniques used to measure fair value. The fair value hierarchy
gives the highest priority to quoted prices (unadjusted) in active markets for identical
assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3
inputs).

8.8.2 Level 1 inputs: quoted prices in active markets for identical assets or
liabilities

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or
liabilities that the entity can access at the measurement date. A quoted price in an active
market provides the most reliable evidence of fair value and shall be used without
adjustment to measure fair value whenever available, except as specified in paragraph
13.79 of IFRS 13.

A Level 1 input will be available for many financial assets and financial liabilities, some of
which might be exchanged in multiple active markets (e.g. on different exchanges).
Therefore, the emphasis within Level 1 is on determining both of the following:

(a) the principal market for the asset or liability or, in the absence of a principal market, the
most advantageous market for the asset or liability; and

(b) whether the entity can enter into a transaction for the asset or liability at the price in
that market at the measurement date.

EXAMPLE 1: Principle (or most advantageous) market: Level 1

This example illustrates the use of Level 1 inputs to measure the fair value of an asset that
trades in different active markets at different prices.

An asset is sold in two different active markets at different prices. An entity enters into
transactions in both markets and can access the price in those markets for the asset at the
measurement date. In Market A, the price that would be received is R26, transaction costs
in that market are R3; and the costs to transport the asset to that market are R2 (i.e. the
net amount that would be received is R21). In Market B, the price that would be received is
R25; transaction costs in that market are R1; and the costs to transport the asset to that
market are R2 (i.e. the net amount that would be received in Market B is R22).

If Market A is the principal market for the asset (i.e. the market with the greatest volume
and level of activity for the asset), the fair value of the asset would be measured using the
price that would be received in that market, after taking into account transport costs (R24).

If neither market is the principal market for the asset, the fair value of the asset would be
measured using the price in the most advantageous market. The most advantageous
market is the market that maximises the amount that would be received to sell the asset,

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after taking into account transaction costs and transport costs (i.e. the net amount that
would be received in the respective markets).

Because the entity would maximise the net amount that would be received for the asset in
Market B (R22), the fair value of the asset would be measured using the price in that
market (R25), less transport costs (R2), resulting in a fair value measurement of R23.

Although transaction costs are taken into account when determining which market is the
most advantageous market, the price used to measure the fair value of the asset is not
adjusted for those costs (although it is adjusted for transport costs).

8.8.3 Level 2 inputs: other than quoted prices for assets or liabilities

Level 2 inputs are inputs other than quoted prices included at Level 1 that are observable
for the asset or liability, either directly or indirectly.

If the asset or liability has a specified (contractual) term, a Level 2 input must be
observable for substantially the full term of the asset or liability. Level 2 inputs include the
following:

(a) quoted prices for similar assets or liabilities in active markets;

(b) quoted prices for identical or similar assets or liabilities in markets that are not active;

(c) inputs other than quoted prices that is observable for the asset or liability, for example;

(i) interest rates and yield curves observable at commonly quoted intervals;

(ii) implied volatilities;

(iii) credit spreads; and

(d) market-corroborated inputs.

Adjustments to Level 2 inputs will vary depending on factors specific to the asset or
liability. Those factors include the following:

(a) the condition or location of the asset;

(b) the extent to which inputs relate to items that are comparable to the asset or liability
(including those factors described in IFRS13.39); and
(c) the volume or level of activity in the markets within which the inputs are observed.

An adjustment to a Level 2 input that is significant to the entire measurement might result
in a fair value measurement categorised within Level 3 of the fair value hierarchy if the
adjustment uses significant unobservable inputs.

8.8.4 Level 3 inputs: unobservable inputs for assets or liabilities

Level 3 inputs are unobservable inputs for the asset or liability.

Unobservable inputs shall be used to measure fair value to the extent that relevant
observable inputs are not available, thereby allowing for situations in which there is little, if
any, market activity for the asset or liability at the measurement date. However, the fair
value measurement objective remains the same (an exit price at the measurement date
from the perspective of a market participant that holds the asset or owes the liability).

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Therefore unobservable inputs shall reflect the assumptions that market participants would
use when pricing the asset or liability, including assumptions about risk.

Assumptions about risk include the risk inherent in a particular valuation technique used to
measure fair value (such as a pricing model) and the risk inherent in the inputs to the
valuation technique. A measurement that does not include an adjustment for risk would not
represent a fair value measurement if market participants would include one when pricing
the asset or liability. For example, it might be necessary to include a risk adjustment when
there is significant measurement uncertainty (e.g. when there has been a significant
decrease in the volume or level of activity when compared with normal market activity for
the asset or liability, or similar assets or liabilities, and the entity has determined that the
transaction price or quoted price does not represent fair value, as described in Application
Guidance B37–B47).

An entity shall develop unobservable inputs using the best information available in the
circumstances, which might include the entity’s own data. In developing unobservable
inputs, an entity may begin with its own data, but it shall adjust those data if reasonably
available information indicates that other market participants would use different data or
there is something particular to the entity that is not available to other market participants
(e.g. an entity-specific synergy). An entity need not undertake exhaustive efforts to obtain
information about market participant assumptions. However, an entity shall take into
account all information about market participant assumptions that is reasonably available.
Unobservable inputs developed in the manner described above are considered market
participant assumptions and meet the objective of a fair value measurement.

Identifying transactions that are not orderly

To determine whether a transaction is orderly or not is more difficult if there has been a
significant decrease in the volume or level of activity for the asset or liability in relation to
normal market activity for the asset or liability (or similar assets or liabilities). In such
circumstances it is not appropriate to conclude that all transactions in that market are not
orderly (i.e. forced liquidations or distress sales). Circumstances that may indicate that a
transaction is not orderly include the following:

(a) There was not adequate exposure to the market for a period before the measurement
date to allow for marketing activities that are usual and customary for transactions
involving such assets or liabilities under current market conditions.

(b) There was a usual and customary marketing period, but the seller marketed the asset
or liability to a single market participant.

(c) The seller is in or near bankruptcy or receivership (i.e. the seller is distressed).

(d) The seller was required to sell to meet regulatory or legal requirements (i.e. the seller
was forced).

(e) The transaction price is an outlier when compared with other recent transactions for
the same or a similar asset or liability. An entity shall evaluate the circumstances to
determine whether, on the weight of the evidence available, the transaction is orderly.

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An entity shall consider all the following when measuring fair value or estimating market
risk premiums:

(a) If the evidence indicates that a transaction is not orderly, an entity shall place little, if
any, weight (compared with other indications of fair value) on that transaction price.

(b) If the evidence indicates that a transaction is orderly, an entity shall take into account
that transaction price. The amount of weight placed on that transaction price when
compared with other indications of fair value will depend on the facts and
circumstances, such as the following:

(i) the volume of the transaction;

(ii) the comparability of the transaction to the asset or liability being measured;

(iii) the proximity of the transaction to the measurement date.

(c) If an entity does not have sufficient information to conclude whether a transaction is
orderly, it shall take into account the transaction price. However, that transaction price
may not represent fair value (i.e. the transaction price is not necessarily the sole or
primary basis for measuring fair value or estimating market risk premiums). When an
entity does not have sufficient information to conclude whether particular transactions
are orderly, the entity shall place less weight on those transactions when compared
with other transactions that are known to be orderly.

Using quoted prices provided by third parties

IFRS 13 does not preclude the use of quoted prices provided by third parties, such as
pricing services or brokers, if an entity has determined that the quoted prices provided by
those parties are developed in accordance with this IFRS.

If there has been a significant decrease in the volume or level of activity for the asset or
liability, an entity shall evaluate whether the quoted prices provided by third parties are
developed using current information that reflects orderly transactions or a valuation
technique that reflects market participant assumptions (including assumptions about risk).
In weighting a quoted price as an input to a fair value measurement, an entity places less
weight (when compared with other indications of fair value that reflect the results of
transactions) on quotes that do not reflect the result of transactions.

Furthermore, the nature of a quote (e.g. whether the quote is an indicative price or a
binding offer) shall be taken into account when weighting the available evidence, with
more weight given to quotes provided by third parties that represent binding offers.

ASSESSMENT CRITERIA
Are you now able to:
 define fair value and related concepts in detail?
 describe and apply all the aspects of fair value measurement of an
asset, liability or an equity instrument?

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LEARNING UNIT 9
REVENUE FROM
CONTRACTS WITH
CUSTOMERS (IFRS 15)

General Financial Reporting

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LEARNING UNIT 9: REVENUE FROM CONTRACTS WITH CUSTOMERS

LEARNING OUTCOME
Learners should be able to recognise revenue to depict the transfer of promised goods or
services to customers in an amount that reflects the consideration to which the entity
expects to be entitled in exchange for those goods or services and to disclose revenue
properly in accordance with the requirements of International Financial Reporting
Standards.

OVERVIEW
This learning unit is divided into the following sections:

9.1 Definitions
9.2 Five steps for revenue recognition
9.2.1 Step 1 – Identify the contract(s) with a customer
9.2.2 Step 2 – Identify the performance obligations in the contract
9.2.3 Step 3 – Determine the transaction price
9.2.4 Step 4 – Allocate the transaction price to the performance obligations in the contract
9.2.5 Step 5 – Recognise revenue when (or as) the entity satisfies a performance
obligation
9.4 Contract costs
9.4.1 Costs of fulfilling a contract
9.4.2 Incremental costs of obtaining a contract
9.4.3 Amortisation and impairment
9.5 Appendix B: Application guidance
9.6 Presentation
9.7 Disclosure

STUDY
PRESCRIBED
Descriptive Accounting
The chapter relevant to IFRS 15 – Revenue from contracts with customers

RECOMMENDED
IFRS Standards – The Annotated IFRS Standards
IFRS 15 – Revenue from contracts with customers

OVERVIEW OF LEARNING UNIT

This Standard establishes the principles that an entity must apply to report useful
information to users of financial statements about the nature, amount, timing and
uncertainty of revenue and cash flows arising from contracts with customers.

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9.1 DEFINITIONS

The following terms are used in this Standard with the meanings specified (the defined
terms appear in Appendix A of this Standard):

A contract is an agreement between two or more parties, which creates enforceable

rights and obligations.

A contract asset is an entity’s right to consideration in exchange for goods or services,

which the entity has transferred to a customer when that right is subject to something
other than the passage of time (for example, the entity’s future performance).

A contract liability is an entity’s obligation to transfer to a customer goods or services

for which the entity has received consideration (or the amount is due) from the
customer.

A customer is a party that has contracted with an entity to obtain goods or services that
are an output of the entity’s ordinary activities in exchange for consideration.

Income is increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in an increase in
equity, other than those relating to contributions from equity participants.

A performance obligation is a promise in a contract with a customer to transfer either

a good or a service (or a bundle of goods or services) that is distinct or a series of
distinct goods or services that are substantially the same and that have the same
pattern of transfer to the customer.

Revenue is income arising in the course of an entity’s ordinary activities.

The stand-alone selling price (of a good or service) is the price at which an entity
would sell a promised good or service separately to a customer.

The transaction price (for a contract with a customer) is the amount of consideration to
which an entity expects to be entitled in exchange for transferring promised goods or
services to a customer, excluding amounts collected on behalf of third parties (for
example, VAT).

LECTURER'S COMMENT

The above definitions must be studied. They are also provided for ease of
reference when working through the examples in both Descriptive
Accounting and this learning unit.

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9.2 FIVE STEPS FOR REVENUE RECOGNITION

The core principle of IFRS 15 – Revenue from contracts with customers is that an entity
recognises revenue to depict the transfer of promised goods or services to customers in
an amount that reflects the consideration to which the entity expects to be entitled in
exchange for those goods or services (IFRS 15 .02). To be able to apply this core principle
an entity performs the following five steps for revenue recognition:

Step 1 Identify the contract(s) with a customer

Step 2 Identify the performance obligations in the contract

Step 3 Determine the transaction price

Step 4 Allocate the transaction price to the performance obligations in the contract

Step 5 Recognise revenue when (or as) the entity satisfies a performance obligation

Each of the five steps will be discussed separately in this learning unit.
9.2.1 Step 1 – Identify the contract(s) with a customer
A contract is an agreement between two or more parties that creates (legally) enforceable
rights and obligations. Contracts can be in a written or oral format or can be implied by an
entity’s customary business practices (IFRS 15 .10). An entity accounts for a contract with
a customer only when all of the following criteria are met:

(a) The parties to the contract have approved the contract (in writing, orally or in
accordance with other customary business practices) and they are committed to
perform their respective obligations.
(b) The entity can identify each party’s rights regarding the goods or services to be
transferred.
(c) The entity can identify the payment terms for the goods or services to be transferred.
(d) The contract has commercial substance (the risk, timing or amount of the entity’s future
cash flows is expected to change because of the contract).
(e) It is probable that the entity will collect the consideration to which it will be entitled in
exchange for the goods or services that it will transfer to the customer (IFRS 15 .09).

A contract does not exist if each party to the contract exercises their unilateral enforceable
right to terminate a wholly unperformed contract without compensating the other party (or
parties). A contract is wholly unperformed if both of the following criteria are met:

(a) The entity has not yet transferred any promised goods or services to the customer.
(b) The entity has not yet received, and is not yet entitled to receive, any consideration in
exchange for promised goods or services (IFRS 15 .12).

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Combination of contracts

The Standard specifies the accounting for individual contracts with customers, except in
the following two instances, where an entity may combine two or more contracts and apply
this Standard to a combination of contracts:

(a) The entity has a portfolio of contracts (or performance obligations) with similar
characteristics, and it reasonably expects that the effects on the financial statements of
applying this Standard to the portfolio would not differ materially from applying this
Standard to the individual contracts (or performance obligations) within that portfolio
(IFRS 15 .04).
(b) The entity entered into two or more contracts at or near the same time with the same
customer (or related parties of the customer) and one or more of the following criteria
are met:

(i) The contracts are negotiated as a package with a single commercial objective.
(ii) The amount of consideration to be paid in one contract depends on the price or
performance of the other contract.
(iii) The goods or services promised in the contracts (or some goods or services
promised in each of the contracts) constitute a single performance (IFRS 15 .17).

Contract modifications

A contract may be modified after its inception. A contract modification is a change in the
scope or price (or both) of a contract that is approved by the parties to the contract. A
contract modification exists when the parties to a contract approve (in writing, orally or
implied) a modification that either creates new or changes existing enforceable rights and
obligations of the parties to the contract. If the parties to the contract have not approved a
contract modification, an entity must continue to apply this Standard to the existing
contract until the contract modification has been approved (IFRS 15 .18).

An entity accounts for a contract modification as a separate contract if both of the following
conditions are present:

(a) the scope of the contract increases because of the addition of promised goods or
services that are distinct
(b) the price of the contract increases by an amount of consideration that reflects the
entity’s stand-alone selling prices of the additional promised goods or services and any
appropriate adjustments to that price to reflect the circumstances of the particular
contract (IFRS 15 .20)

LECTURER’S COMMENT

Work through the relevant examples in Descriptive Accounting that deals

with:
 modifications that result in a separate contract; and
 remaining goods/services are distinct from those transferred on or
before modification date.

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For a contract modification that is not accounted for as a separate contract in accordance
with requirements above, an entity accounts for the promised goods or services not yet
transferred at the date of the contract modification (the remaining promised goods or
services) as follows:

If the remaining goods or services are

Distinct from those Not distinct and part of a A combination of the

transferred on or before single performance former cases (distinct and
the modification date obligation that is partially single performance
satisfied obligation)

Allocate the promised Update the transaction Account for the effects of
consideration included in price and the measure of the modification on the
the estimate of the progress on a cumulative unsatisfied (and partially
transaction price (not catch-up basis at the unsatisfied) performance
recognised as revenue) modification date (treat it obligations in a manner
and promised as part of as part of the existing that is consistent with the
the contract modification contract (IFRS 15 .21(b)) objectives of this
to the remaining paragraph
performance obligations (IFRS 15 .21(c))
(treat it as a termination of
the existing contract and a
creation of a new contract
(IFRS 15 .21(a))

EXAMPLE 1 – MODIFICATION RESULTING IN A CUMULATIVE CATCH-UP

ADJUSTMENT TO REVENUE

A construction company enters into a contract to construct a commercial building for a

customer on customer-owned land for a promised consideration of R1 million and a bonus
of R200 000 if the building is completed within 24 months. The entity accounts for the
promised bundle of goods and services as a single performance obligation satisfied over
time because the customer controls the building during construction. At the inception of the
contract, the entity expects the following:

R
Transaction price 1 000 000
Expected costs 700 000
Expected profit (30%) 300 000

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At contract inception, the entity excludes the R200 000 bonus from the transaction price
because it cannot conclude that it is highly probable that a significant reversal of the
amount of cumulative revenue recognised will not occur. Completion of the building is
highly subject to factors outside the entity’s influence, including weather and regulatory
approvals. In addition, the entity has limited experience with similar types of contracts.

The entity determines that the input measure, based on costs incurred, provides an
appropriate measure of progress towards complete satisfaction of the performance
obligation. By the end of the first year, the entity has satisfied 60% of its performance
obligation based on costs incurred to date (R420 000) relative to total expected costs
(R700 000). The entity reassesses the variable consideration and concludes that the
amount is still constrained in accordance with paragraphs 56 to 58 of IFRS 15.
Consequently, the cumulative revenue and costs recognised for the first year are as
follows:

R
Revenue (420 000/700 000 x 1 000 000) 600 000
Costs 420 000
Gross profit 180 000

In the first quarter of the second year, the parties to the contract agree to modify the
contract by changing the floor plan of the building. As a result, the fixed consideration and
expected costs increase by R150 000 and R120 000, respectively. Total potential
consideration after the modification is R1 350 000 (R1 150 000 fixed consideration +
R200 000 completion bonus). In addition, the allowable time for achieving the R200 000
bonus is extended by 6 months to 30 months from the original contract inception date. At
the date of the modification, based on its experience and the remaining work to be
performed – which is primarily inside the building and not subject to weather conditions –
the entity concludes that it is highly probable that including the bonus in the transaction
price will not result in a significant reversal of the amount of cumulative revenue
recognised. Therefore, it includes the R200 000 in the transaction price. In assessing the
contract modification, the entity evaluates and concludes that the remaining goods and
services to be provided using the modified contract are not distinct from the goods and
services transferred on or before the date of contract modification; that is, the contract
remains a single performance obligation.

Consequently, the entity accounts for the contract modification as if it were part of the
original contract. The entity updates its measure of progress and estimates that it has
satisfied 51,2% of its performance obligation (R420 000 actual costs incurred ÷ R820 000
total expected costs). The entity recognises additional revenue of R91 200 ((51,2%
complete × R1 350 000 modified transaction price) – R600 000 revenue recognised to
date) at the date of the modification as a cumulative catch-up adjustment.

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9.2.2 Step 2 – Identify the performance obligations in the contract

The next step is to identify the performance obligations in the contract at its inception by
assessing the goods or services promised in a contract with a customer and identifying as
a performance obligation each promise to transfer to the customer, either

(a) a good or service (or a bundle of goods or services) that is distinct; or

(b) a series of distinct goods or services that are substantially the same and that have the
same pattern of transfer to the customer (IFRS 15 .22)

A good or service that is promised to a customer is distinct if both of the following are met:

(a) The customer can benefit from the good or service either on their own or together with
other resources that are readily available to the customer.
(b) The entity’s promise to transfer the good or service to the customer is separately
identifiable from other promises in the contract (i.e. the good or service is distinct within
the context of the contract) (IFRS 15 .27).

Factors indicating that an entity’s promise to transfer a good or service to a customer is

separately identifiable include, but are not limited to, the following:

(a) The entity does not provide a significant service of integrating the good or service with
other goods or services promised in the contract into a bundle of goods or services that
represent the combined output for which the customer has contracted (the good or
service is not used as an input to produce or deliver the combined output).
(b) The good or service does not significantly modify or customise another good or service
promised in the contract.
(c) The good or service is not highly dependent on, or highly interrelated with, other goods
or services promised in the contract. The fact that a customer could decide not to
purchase the good or service without significantly affecting the other goods or services
promised in the contract might indicate that the good or service is not highly dependent
on, or highly interrelated with, those other promised goods or services (IFRS 15 .29).

If a promised good or service is not distinct, that good or service should be combined with
other promised goods or services until the entity identifies a bundle of goods or services
that is distinct (IFRS 15 .30).

Performance obligations do not include activities that an entity must undertake to fulfil a
contract, unless those activities transfer a good or service to a customer. For example, a
services provider may need to perform various administrative tasks to set up a contract.
The performance of these tasks does not transfer a service to the customer and therefore,
these setup activities are not a performance obligation (IFRS 15 .25). Depending on the
contract, promised goods or services may include, but are not limited to

(a) sale of goods produced by an entity (inventory of a manufacturer);

(b) resale of goods purchased by an entity (merchandise of a retailer);

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(c) resale of rights to goods or services purchased by an entity (a ticket resold by an entity
acting as a principal);
(d) performing a contractually agreed-upon task (or tasks) for a customer;
(e) providing a service of being ready to provide goods or services (unspecified updates to
software that are provided on a when-and-if-available basis) or of making goods or
services available to a customer for use as and when the customer decides;
(f) providing a service of arranging for another party to transfer goods or services to a
customer (acting as an agent of another party);
(g) granting rights to goods or services, to be provided in the future, which a customer can
resell or provide to its customer (an entity selling a product to a retailer promises to
transfer an additional good or service to an individual who purchases the product from
the retailer);
(h) constructing, manufacturing or developing an asset on behalf of a customer;
(i) granting licences; and
(j) granting options to purchase additional goods or services (when those options provide
a customer with a material right) (IFRS 15 .26).

LECTURER’S COMMENT

Work through the relevant examples in Descriptive Accounting relating to:

 separate performance obligations that exist; and
 separate performance obligations that do not exist.

EXAMPLE 2 – DETERMINING WHETHER GOODS OR SERVICES ARE DISTINCT

HiLo Ltd, a software developer, enters into a contract with Flow Ltd to transfer a software
licence, perform an installation service and provide unspecified software updates and
technical (online and telephonic) support for a two-year period. HiLo Ltd sells the licence,
installation service and technical support separately. The installation service includes
changing the web screen for each type of user (for example, marketing, inventory
management, and information technology). The installation service is routinely performed
by other entities and it does not significantly modify the software. The software remains
functional without the updates and the technical support.

HiLo Ltd assesses the goods and services promised to Flow Ltd to determine which goods
and services are distinct (refer to IFRS 15 .27). HiLo Ltd observes that the software is
delivered before the other goods and services and remains functional without the updates
and the technical support. Thus, HiLo Ltd concludes that Flow Ltd can benefit from each of
the goods and services either on their own or together with the other goods and services
that are readily available (refer IFRS 15 .27(a)).

HiLo Ltd also considers the factors in paragraph 29 of IFRS 15 and determines that the
promise to transfer each good and service to Flow Ltd is separately identifiable from each
of the other promises (refer IFRS 15 .27(b)). In particular, HiLo Ltd observes that the
installation service does not significantly modify or customise the software itself and, as
such, the software and the installation service are separate outputs promised by HiLo Ltd
instead of inputs used to produce a combined output.

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Based on the above assessment, HiLo Ltd identifies four performance obligations in the
contract for the following goods or services:
(a) the software licence;
(b) an installation service;
(c) software updates; and
(d) technical support.
EXAMPLE 3 – GOODS AND SERVICES ARE NOT DISTINCT
A contractor enters into a contract to build a hospital for a customer. The entity is
responsible for the overall management of the project and identifies various goods and
services to be provided, including engineering, site clearance, foundation, procurement,
construction of the structure, piping and wiring, installation of equipment, and finishing.
The promised goods and services are capable of being distinct, as the customer can
benefit from the goods and services either on their own or together with other readily
available resources. This is evidenced by the fact that the entity, or competitors of the
entity, regularly sells many of these goods and services separately to other customers. In
addition, the customer could generate economic benefit from the individual goods and
services by using, consuming, selling or holding those goods or services.
However, the goods and services are not distinct within the context of the contract, as the
entity’s promise to transfer individual goods and services in the contract is not separately
identifiable from other promises in the contract. This is evidenced by the fact that the entity
provides a significant service of integrating the goods and services (the inputs) into the
hospital (the combined output) for which the customer has contracted.
Because both criteria in paragraph .27 of IFRS 15 are not met, the goods and services are
not distinct. The entity accounts for all of the goods and services in the contract as a single
performance obligation.
LECTURER’S COMMENT
The identification of performance obligations and if they are to be
accounted for separately is a key judgement in applying IFRS 15 –
Revenue from contracts with customers.

9.2.3 Step 3 – Determine the transaction price

The next step is to determine the transaction price for the contract, which is the amount of
consideration to which an entity expects to be entitled (in terms of both the contract and its
customary business practices) in exchange for transferring promised goods or services to
a customer, excluding amounts collected on behalf of third parties (VAT). The
consideration promised in a contract with a customer may include fixed amounts, variable
amounts, or both (IFRS 15 .47).

The nature, timing and amount of consideration promised by a customer will affect the
estimate of the transaction price, and an entity considers the effects of all of the following
(IFRS 15 .48):

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a) Variable consideration

If the consideration promised includes a variable amount, an entity estimates (and updates
the estimate at each reporting date (IFRS 15 .59)) the amount of consideration to which
the entity will be entitled in exchange for transferring the promised goods or services to a
customer (IFRS 15 .50). An amount of consideration can vary because of discounts,
rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties
or other similar items or because the entity’s entitlement to the consideration is contingent
on the occurrence or non-occurrence of a future event. For example, an amount of
consideration would be variable if either a product was sold with a right of return or a fixed
amount is promised as a performance bonus on achievement of a specified milestone
(IFRS 15 .51). An entity estimates an amount of variable consideration by using either of
the following methods consistently throughout the contract, depending on which method
the entity expects to better predict the amount of consideration to which it will be entitled:

(i) The expected value is the sum of probability-weighted amounts in a range of

possible consideration amounts. This method may be appropriate if an entity has a
large number of contracts with similar characteristics.
(ii) The most likely amount is the single most likely amount in a range of possible
consideration amounts. This method may be appropriate if the contract has two
possible outcomes only (an entity either achieves a performance bonus or does not)
(IFRS 15 .53–54).

LECTURER’S COMMENT

Work through the relevant examples that deal with variable considerations
in Descriptive Accounting.

b) Constraining estimates of variable consideration

The estimated amount of variable consideration should only be included in the transaction
price to the extent that it is highly probable that a significant reversal of the amount of
cumulative revenue recognised will not occur when the uncertainty associated with the
variable consideration is subsequently resolved (IFRS 15 .56). Factors that could increase
the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of
the following:

(i) The amount of consideration is highly susceptible to factors outside the entity’s
sphere of influence (volatility in a market, the judgement or actions of third parties,
weather conditions and a high risk of obsolescence of the promised good or
service).
(ii) The uncertainty about the amount of consideration is not expected to be resolved
for a long time.
(iii) The entity’s experience (or other evidence) with similar types of contracts is limited
or that experience has limited predictive value.
(iv) The entity has a practice of either offering a broad range of price concessions or
changing the payment terms and conditions of similar contracts in similar
circumstances.

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(v) The contract has a large number and broad range of possible consideration
amounts (IFRS 15 .57).

LECTURER’S COMMENT

Work through the relevant example that deals with constraining the
amount of revenue in Descriptive Accounting.

c) The existence of a financing component in the contract

The promised amount of consideration is adjusted for the effects of the time value of
money if the timing of payments agreed to by the parties to the contract (either explicitly or
implicitly) provides the customer or the entity with a significant benefit of financing the
transfer of goods or services to the customer (IFRS 15 .60).

The objective of the adjustment is for an entity to recognise revenue at an amount that
reflects the price that a customer would have paid for the promised goods or services if the
customer had paid cash for those goods or services (cash selling price). An entity
considers all relevant facts and circumstances in assessing whether a contract contains a
significant financing component, including both of the following:

(i) the difference, if any, between the amount of promised consideration and the cash
selling price of the promised goods or services
(ii) the combined effect of both of the following:

 the expected length of time between transferring the promised goods or

services to the customer and payment
 the prevailing interest rates in the relevant market (IFRS 15 .61)

An entity uses the discount rate that would be reflected in a separate financing transaction
between the entity and its customer at contract inception. That rate would reflect the credit
characteristics of the party receiving financing and any collateral or security provided by
the customer or the entity. The rate may be the rate that discounts the nominal amount of
the promised consideration to the price that the customer would pay in cash for the goods
or services when (or as) they are transferred to the customer (IFRS 15 .64).

A contract with a customer does not have a significant financing component if any of the
following factors exist:

(i) The customer paid for the goods or services in advance and the timing of the transfer
is at the discretion of the customer.
(ii) A substantial amount of the consideration promised by the customer is variable and
the amount or timing of that consideration varies based on the occurrence or non-
occurrence of a future event that is not substantially within the control of the
customer or the entity (sales-based royalty).

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(iii) The difference between the promised consideration and the cash-selling price arises
for reasons other than the provision of finance to either the customer or the entity,
and the difference between those amounts is proportional to the reason for the
difference. The payment terms might provide the entity or the customer with
protection from the other party failing to fulfil some or all of its obligations under the
contract adequately (IFRS 15 .62).

As a practical expedient, an entity does not have to adjust the promised amount of
consideration for the effects of a significant financing component if the entity expects, at
contract inception, that the period between transfer of a promised good or service to a
customer and payment by the customer for that good or service will be one year or less
(IFRS 15 .63).

The effects of financing (interest revenue or interest expense) are presented separately
from revenue from contracts with customers in the statement of profit or loss and other
comprehensive income. Interest revenue or interest expense is recognised only to the
extent that a contract asset (or receivable) or a contract liability is recognised in
accounting for a contract with a customer (IFRS 15 .65).

LECTURER’S COMMENT

Work through the relevant example that deals with the time value of
money in Descriptive Accounting.

d) Non-cash consideration

The transaction price for contracts in which a customer promises consideration in a form
other than cash is measured at fair value of the non-cash consideration. If an entity cannot
reasonably estimate the fair value of the non-cash consideration, the entity measures the
consideration indirectly by reference to the stand-alone selling price of the goods or
services promised to the customer in exchange for the consideration (IFRS 15 .66–67).

e) Consideration payable to a customer

Consideration payable to a customer includes cash amounts that an entity pays, or

expects to pay, to the customer. Consideration payable to a customer also includes credit
or other items (a coupon or voucher) that can be applied against amounts owed to the
entity. An entity accounts for consideration payable to a customer as a reduction of the
transaction price and, therefore, of revenue, unless payment to the customer is in
exchange for a distinct good or service that the customer transfers to the entity
(IFRS 15. 70). If consideration payable to a customer is payment for a distinct good or
service, then an entity accounts for the purchase of the good or service in the same way
that it accounts for other purchases from suppliers. If the amount of consideration payable
to the customer exceeds the fair value of the distinct good or service that the entity

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receives from the customer, then the entity accounts for such an excess as a reduction of
the transaction price. If the entity cannot reasonably estimate the fair value of the good or
service received, it accounts for all of the consideration payable to the customer as a
reduction of the transaction price (IFRS 15 .71).

If consideration payable to a customer is accounted for as a reduction of the transaction

price, an entity recognises the reduction of revenue when (or as) the later of either of the
following events occur:

(i) the entity recognises revenue for the transfer of the related goods or services to the
customer; or
(ii) the entity pays or promises to pay the consideration (even if the payment is
conditional on a future event) (IFRS 15 .72).

EXAMPLE 4 – SIGNIFICANT FINANCING COMPONENT AND RIGHT OF RETURN

XYZ Ltd sells a trailer to a customer for R121 000 that is payable 24 months after delivery.
The customer obtains control of the product at contract inception. The contract permits the
customer to return the trailer within 90 days. The trailer is new, and XYZ Ltd has no
relevant historical evidence of product returns or other available market evidence.

The cash-selling price of the trailer is R100 000, which represents the amount that the
customer would pay upon delivery for the same product sold under otherwise identical
terms and conditions as at contract inception. XYZ Ltd’s cost of the trailer is R80 000.

REQUIRED

Discuss when revenue should be recognised and prepare the journal

entries in the accounting records of XYZ Ltd to recognise the revenue
transaction according to IFRS 15 – Revenue from contracts with
customers.

SOLUTION 4

XYZ Ltd does not recognise revenue when control of the product transfers to the
customer. This is because the existence of the right of return and the lack of relevant
historical evidence mean that the entity cannot conclude that it is highly probable that a
significant reversal in the amount of cumulative revenue recognised will not occur
(IFRS 15 .56–.58). Consequently, revenue is recognised only after 90 days, when the right
of return lapses.

The contract includes a significant financing component (IFRS 15 .60–.62). This is evident
from the difference between the amount of promised consideration of R121 000 and the
cash-selling price of R100 000 at the date at which the goods are transferred to the
customer. The contract includes an implicit interest rate of 10% (the interest rate that
discounts the promised consideration of R121 000 to the cash selling price of R100 000
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over 24 months). XYZ Ltd evaluates the rate and concludes that it is commensurate with
the rate that would be reflected in a separate financing transaction between the entity and
its customer at contract inception.

The following journal entries illustrate how XYZ Ltd accounts for this contract:

Dr Cr
R R
Asset for right to recover trailer to be returned1 80 000
Inventory 80 000
Recognise asset for right to recover the trailer to be returned when
the trailer is transferred.

Trade receivable 100 000

Revenue 100 000
Recognise revenue for the transfer of the trailer when the right of
return lapses, as the product is not returned.

Cost of sales 80 000

Asset for right to recover trailer to be returned 80 000
Recognise cost of sales for the transfer of the trailer when the right of
return lapses, as the product is not returned.

1 Take note that this example does not consider the expected costs to recover the trailer.

LECTURER’S COMMENT

 No interest is recognised during the three-month right of return

period, because no contract asset or receivable has been recognised
(IFRS 15 .65).
 The receivable recognised is measured in accordance with IFRS 9.
This example assumes there is no material difference between the
fair value of the receivable at contract inception and the fair value of
the receivable when it is recognised at the time the right of return
lapses. This example does not consider the impairment accounting
for the receivable.

EXAMPLE 5 – VOLUME DISCOUNT INCENTIVE

LOL Ltd enters into a contract with CHAT Ltd on 1 January 20.14 to sell cellular phone
devices for R100 per device. If CHAT Ltd purchases more than 1 000 cellular phone
devices in a calendar year, the contract specifies that the price per device be reduced
retrospectively to R90 per device. Consequently, the consideration in the contract is
variable.

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For the first quarter ended 31 March 20.14, LOL Ltd sells 75 cellular phone devices to
CHAT Ltd. LOL Ltd estimates that CHAT Ltd’s purchases will not exceed the 1 000-unit
threshold required for the volume discount in the calendar year. LOL Ltd considers the
requirements for constraining estimates of variable consideration. LOL Ltd determines that
it has significant experience with this product and with the purchasing pattern of CHAT Ltd.
Thus, LOL Ltd concludes that it is highly probable that a significant reversal in the
cumulative amount of revenue recognised (R100 per device) will not occur when the
uncertainty is resolved (namely, when the total amount of purchases is known).
Consequently, LOL Ltd recognises revenue of R7 500 (75 devices x R100 per device) for
the quarter ended 31 March 20.14.

In May 20.14, CHAT Ltd acquires another company and in the second quarter ended
30 June 20.14, LOL Ltd sells an additional 500 units of cellular phone devices to CHAT
Ltd. In the light of this new fact, LOL Ltd estimates that CHAT Ltd’s purchases will exceed
the 1 000-unit threshold for the calendar year and therefore, it will be required to reduce
the price per device to R90 retrospectively. Consequently, LOL Ltd recognises revenue of
R44 250 for the quarter ended 30 June 20.14. That amount is calculated based on
R45 000 for the sale of 500 devices (500 devices x R90 per device) less the change in
transaction price of R750 (75 devices x R10 price reduction) for the reduction of revenue
relating to devices sold for the quarter ended 31 March 20.14.

9.2.4 Step 4 – Allocate the transaction price to the performance obligations in the
contract

The next step is to allocate the transaction price to the performance obligations identified
earlier. An entity allocates the transaction price to each performance obligation (or distinct
good or service) in an amount that depicts the amount of consideration to which the entity
expects to be entitled in exchange for transferring the promised goods or services to the
customer (IFRS 15 .73). An entity allocates the transaction price to each performance
obligation on a relative stand-alone selling price basis, taking into account discounts and
variable amounts (IFRS 15 .74).

The stand-alone selling price of the distinct good or service underlying each performance
obligation in the contract is determined at contract inception, and the transaction price is
allocated in proportion to those stand-alone selling prices (IFRS 15 .76). The stand-alone
selling price is the price at which an entity would sell a promised good or service
separately to a customer. The best evidence of a stand-alone selling price is the
observable price when the entity sells that good or service separately in similar
circumstances and to similar customers (IFRS 15 .77).

If a stand-alone selling price is not directly observable, an entity estimates the stand-alone
selling price by considering all information (market conditions, entity-specific factors and
information about the customer or class of customer) that is reasonably available to the
entity. An entity maximises the use of observable inputs and applies estimation methods
consistently in similar circumstances (IFRS 15 .78).

Suitable methods for estimating the stand-alone selling price of a good or service include
the following:

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(a) Adjusted market assessment approach. An entity could evaluate the market in which it
sells goods or services and estimate the price that a customer in that market would be
willing to pay for those goods or services. That approach might also include referring to
prices of the entity’s competitors of similar goods or services and adjusting those prices
as necessary to reflect the entity’s costs and margins.
(b) Expected cost plus a margin approach. An entity forecasts its expected costs of
satisfying a performance obligation and adds an appropriate margin for that good or
service.
(c) Residual approach. An entity may estimate the stand-alone selling price by referring to
the total transaction price less the sum of the observable stand-alone selling prices of
other goods or services promised in the contract. However, an entity may use a
residual approach to estimate the stand-alone selling price of a good or service, only if
one of the following criteria is met:

(i) The entity sells the same good or service to different customers (at or near the
same time) for a broad range of amounts.
(ii) The entity has not yet established a price for that good or service and the good or
service has not been sold previously on a stand-alone basis (IFRS 15 .79).

A customer receives a discount for purchasing a bundle of goods or services if the sum of
the stand-alone selling prices of those goods or services promised in the contract exceeds
the promised consideration in the contract. Except when an entity has observable
evidence to allocate the entire discount to only one or more, but not all, performance
obligations in a contract, the entity allocates a discount proportionately to all performance
obligations in the contract (IFRS 15 .81).

LECTURER’S COMMENT

Work through the relevant example that deals with the allocation of the
transaction price in Descriptive Accounting.

An entity allocates a discount entirely to one or more, but not all, performance obligations
in the contract if all of the following criteria are met:

(a) The entity regularly sells each distinct good or service (or each bundle) in the contract
on a stand-alone basis.
(b) The entity also regularly sells on a stand-alone basis a bundle (or bundles) of some of
those distinct goods or services at a discount to the stand-alone selling prices of the
goods or services in each bundle.
(c) The discount attributable to each bundle of goods or services described in (b) above is
substantially the same as the discount mentioned in the contract, and an analysis of
the goods or services in each bundle provides observable evidence of the performance
obligation to which the entire discount in the contract belongs (IFRS 15 .82).

If a discount is allocated entirely to one or more performance obligations in the contract in

accordance with paragraph 82 above, an entity allocates the discount before using the
residual approach to estimate the stand-alone selling price of a good or service in
accordance with paragraph 79(c) (IFRS 15 .83).

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Similarly, variable consideration that is promised in a contract may be attributable to the

entire contract or to a specific part of the contract, such as either

(a) one or more, but not all, performance obligations in the contract (a bonus may be
contingent on an entity transferring a promised good or service within a specified
period); or
(b) one or more, but not all, distinct goods or services promised in a series of distinct
goods or services that form part of a single performance obligation (the consideration
promised for the second year of a two-year cleaning service contract will increase,
based on movements in a specified inflation index) (IFRS 15 .84).

An entity allocates a variable amount (and subsequent changes to that amount) entirely to
a performance obligation if both of the following criteria are met:

(a) The terms of a variable payment relate specifically to the entity’s efforts to satisfy the
performance obligation or transfer the distinct good or service.
(b) Allocating the variable amount of consideration entirely to the performance obligation or
the distinct good or service is consistent with the allocation objective in paragraph 73
when considering all of the performance obligations and payment terms in the contract
(IFRS 15 .85).

The allocation requirements in paragraphs 73 to 83 are applied to allocate the remaining

amount of the transaction price that does not meet the criteria in paragraph 85 above
(IFRS 15 .86).

After contract inception, the transaction price may change for various reasons
(IFRS 15 .87). An entity allocates to the performance obligations in the contract any
subsequent changes in the transaction price on the same basis as at contract inception.
Amounts allocated to a satisfied performance obligation are recognised as revenue, or as
a reduction of revenue, in the period in which the transaction price changes (IFRS 15 .88).

An entity accounts for a change in the transaction price that arises from a contract
modification in accordance with paragraphs 18 to 21. However, for a change in the
transaction price that occurs after a contract modification, an entity applies paragraphs 87
to 89 to allocate the change in the transaction price in whichever of the following ways that
is applicable:

(a) An entity allocates the change in the transaction price to the performance obligations
identified in the contract before the modification if, and to the extent that, the change in
the transaction price is attributable to an amount of variable consideration promised
before the modification and the modification is accounted for in accordance with
paragraph 21(a).
(b) In all other cases, in which the modification was not accounted for as a separate
contract in accordance with paragraph 20, an entity allocates the change in the
transaction price to the performance obligations in the modified contract (IFRS 15 .90).

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EXAMPLE 6 – ALLOCATING A DISCOUNT AND VARIABLE CONSIDERATION

An entity regularly sells products A, B and C individually, thereby establishing the following
stand-alone selling prices:
Stand-
Product alone
selling
price
R
Product A 40
Product B 55
Product C 45
140
In addition, the entity regularly sells products B and C together for R60.

Case A – Allocating a discount to one or more performance obligations

The entity enters into a contract with a customer to sell products A, B and C in exchange
for R100. The entity will satisfy the performance obligations for each of the products at
different points in time. The contract includes a discount of R40 on the overall transaction,
which would be allocated proportionately to all three performance obligations when
allocating the transaction price, using the relative stand-alone selling price method
(IFRS 15 par .81). However, because the entity regularly sells products B and C together
for R60 and product A for R40, it has evidence that the entire discount should be allocated
to the promises to transfer products B and C (IFRS 15 .82).

If the entity transfers control of products B and C at the same point in time, then the entity
could, as a practical matter, account for the transfer of those products as a single
performance obligation. The entity could, in other words, allocate R60 of the transaction
price to the single performance obligation and recognise revenue of R60 when products B
and C are simultaneously transferred to the customer.

If the contract requires the entity to transfer control of products B and C at different points
in time, then the allocated amount of R60 is individually allocated to the promises to
transfer product B (stand-alone selling price of R55) and product C (stand-alone selling
price of R45) as follows:
Allocated
Product transaction
price
R
Product B 33 1
Product C 27 2
Total 60
1 R55/R100 (total stand-alone selling price) x R60
2 R45/R100 (total stand-alone selling price) x R60

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Case B – Residual approach is appropriate

The entity enters into a contract with a customer to sell products A, B and C as described
in case A. The contract also includes a promise to transfer product D. Total consideration
in the contract is R130. The stand-alone selling price for product D is highly variable (IFRS
15 .79(c)) because the entity sells product D to different customers at a broad range of
amounts (R15–R45). Consequently, the entity decides to estimate the stand-alone selling
price of product D using the residual approach.

Before estimating the stand-alone selling price of product D using the residual approach,
the entity determines whether any discount should be allocated to the other performance
obligations in the contract (IFRS 15 .82 –.83).

As in case A, because the entity regularly sells products B and C together for R60 and
product A for R40, the entity has observable evidence that R100 should be allocated to
those three products and a R40 discount should be allocated to the promises to transfer
products B and C (IFRS 15 .82). Using the residual approach, the entity estimates the
stand-alone selling price of product D to be R30 as follows:
Stand-
Product alone
selling
price
R
Product A (the stand-alone selling price is directly observable) 40
Products B & C (the stand-alone selling price is directly observable with a
discount) 60
Product D (the stand-alone selling price is estimated using the residual
approach) 30
130

The entity observes that the resulting R30 allocated to product D is within the range of its
observable selling prices (R15–R45). Therefore, the resulting allocation is consistent with
the allocation objective (IFRS 15 .73 and .78).

Case C – Residual approach is inappropriate

The same facts as in case B apply to case C, except for the transaction price, which is
R105 instead of R130. Consequently, the application of the residual approach would result
in a stand-alone selling price of R5 for product D (R105 transaction price less R100
allocated to products A, B and C). The entity concludes that R5 would not faithfully depict
the amount of consideration to which the entity expects to be entitled in exchange for
satisfying its performance obligation to transfer product D because R5 does not
approximate the stand-alone selling price of product D, which ranges from R15 to R45.
Consequently, the entity reviews its observable data, including its sales and margin
reports, to estimate the stand-alone selling price of product D using another suitable

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method. The entity allocates the transaction price of R105 to products A, B, C and D using
the relative stand-alone selling prices of those products (IFRS 15 .73– 80).

LECTURER’S COMMENT

The above example illustrates the considerations and process followed to

allocate a discount and variable consideration in different scenarios.

9.2.5 Step 5 – Recognise revenue when (or as) the entity satisfies a performance
obligation

The next step is to recognise revenue when (or as) the entity satisfies a performance
obligation by transferring a promised good or service (for example an asset) to a customer.
An asset is transferred when (or as) the customer obtains control of that asset (IFRS
15 .31). For each performance obligation identified, an entity determines at contract
inception whether it satisfies the performance obligation over time or at a point in time. If
an entity does not satisfy a performance obligation over time, the performance obligation is
satisfied at a point in time (IFRS 15 .32).

Goods and services are assets, even if only momentarily, when they are received and
used. Control of an asset refers to the ability to direct the use of, and obtain substantially
all of the remaining benefits from, the asset. Control includes the ability to prevent other
entities from directing the use of, and obtaining the benefits from, an asset. The benefits of
an asset are the potential cash flows (inflows or savings in outflows) that can be obtained
directly or indirectly in many ways, such as by

(a) using the asset to produce goods or provide services (including public services);
(b) using the asset to enhance the value of other assets;
(c) using the asset to settle liabilities or reduce expenses;
(d) selling or exchanging the asset;
(e) pledging the asset to secure a loan; and
(f) holding the asset (IFRS 15 .33).

Control may be transferred either over time or at a point in time.

Performance obligations satisfied over time

An entity transfers control of a good or service over time and, therefore, satisfies a
performance obligation and recognises revenue over time, if one of the following criteria is
met:

(a) The entity simultaneously receives and consumes the benefits provided by the entity’s
performance as the entity performs.
(b) The entity’s performance creates or enhances an asset (work in progress) that the
customer controls as the asset is created or enhanced.

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(c) The entity’s performance does not create an asset with an alternative use to the entity
and the entity has an enforceable right to payment for performance completed to date
(IFRS 15 .35).

An asset created by an entity’s performance does not have an alternative use to an entity
if the entity is either restricted contractually from readily directing the asset for another use
during the creation or enhancement of that asset or limited practically from readily directing
the asset in its completed state for another use. The assessment of whether an asset has
an alternative use to the entity is made at contract inception. After contract inception, an
entity does not update the assessment of the alternative use of an asset unless the parties
to the contract approve a contract modification that substantively changes the performance
obligation (IFRS 15 .36).

An entity considers the terms of the contract, as well as any laws applying to the contract,
when evaluating whether it has an enforceable right to payment for performance
completed to date in accordance with paragraph 35(c). The right to payment for
performance completed to date does not need to be for a fixed amount. However, at all
times throughout the duration of the contract, the entity must be entitled to an amount that
at least compensates it for performance completed to date if the contract is terminated by
the customer or another party for reasons other than the entity’s failure to perform as
promised (IFRS 15 .37).

Performance obligations satisfied at a point in time

If a performance obligation is not satisfied over time, an entity satisfies the performance
obligation at a point in time. To determine the point in time at which a customer obtains
control of a promised asset and the entity satisfies a performance obligation, the entity
considers the requirements for control and the indicators of the transfer of control, which
include, but are not limited to, the following:

(a) The entity has a present right to payment for the asset.
(b) The customer has legal title to the asset.
(c) The entity has transferred physical possession of the asset.
(d) The customer has the significant risks and rewards of ownership of the asset.
(e) The customer has accepted the asset (IFRS 15 .38).

LECTURER’S COMMENT

Work through the relevant example that deals with performance

obligations satisfied at a point in time in Descriptive Accounting.

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Measuring progress towards complete satisfaction of a performance obligation

For each performance obligation satisfied over time, an entity recognises revenue over
time by measuring the progress towards complete satisfaction of that performance
obligation to depict the transfer of control of goods or services promised (IFRS 15 .39).

A single method of measuring progress for each performance obligation satisfied over time
should be applied consistently to similar performance obligations and in similar
circumstances. Progress towards complete satisfaction of a performance obligation
satisfied over time is remeasured at the end of each reporting period (IFRS 15 .40).

Appropriate methods of measuring progress include output methods and input methods
(IFRS 15 .41).

LECTURER’S COMMENT

Work through the relevant example that deals with the input method in
Descriptive Accounting.

When applying a method for measuring progress, an entity excludes from the measure of
progress any goods or services for which it does not transfer control to a customer.
Conversely, an entity includes in the measure of progress any goods or services for which
it does transfer control to a customer when satisfying that performance obligation (IFRS
15 .42).

As circumstances change over time, an entity updates its measure of progress to reflect
any changes in the outcome of the performance obligation. Such changes to an entity’s
measure of progress are accounted for as a change in the accounting estimates in
accordance with IAS 8 – Accounting policies, changes in accounting estimates and errors
(IFRS 15 .43).

An entity recognises revenue for a performance obligation satisfied over time only if it can
reasonably measure its progress towards complete satisfaction of the performance
obligation (IFRS 15 .44). In some circumstances (early stages of a contract), an entity may
not be able to measure the outcome of a performance obligation reasonably, but it may
still expect to recover the costs incurred in satisfying the performance obligation. In these
circumstances, the entity recognises revenue only to the extent of the costs incurred until
such time that it can reasonably measure the outcome of the performance obligation (IFRS
15 .45).

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EXAMPLE 7 – MEASURING PROGRESS WHEN MAKING GOODS OR SERVICES

AVAILABLE

Italiano Ltd, an owner and manager of health clubs, enters into a contract with a customer
for one year of access to any of its health clubs. The customer has unlimited use of the
health clubs and he promises to pay R100 per month. Italiano Ltd determines that its
promise to the customer is to provide a service of making the health clubs available for the
customer's use as and when the customer wishes. This is because the extent to which the
customer uses the health clubs does not affect the number of the remaining goods and
services to which the customer is entitled. The entity concludes that the customer
simultaneously receives and consumes the benefits of the entity's performance in making
the health clubs available. Consequently, the entity’s performance obligation is satisfied
over time in terms of paragraph 35(a).

Italiano Ltd also determines that the customer benefits from the entity’s service of making
the health clubs available evenly throughout the year (that is, the customer benefits from
the health clubs being available, regardless of whether the customer uses them or not).
Consequently, the entity concludes that the best measure of progress towards complete
satisfaction of the performance obligation over time is a time-based measure and it
recognises revenue on a straight-line basis throughout the year at R100 per month.

9.4 CONTRACT COSTS

9.4.1 Costs of fulfilling a contract

If the costs incurred in fulfilling a contract with a customer are not within the scope of
another Standard (IAS 2 – Inventories, IAS 16 – Property, plant and equipment or IAS 38 –
Intangible assets), an entity recognises an asset from the costs incurred to fulfil a contract
only if those costs meet all of the following criteria:

(a) The costs relate directly to a contract or to an anticipated contract that the entity can
specifically identify.
(b) The costs generate or enhance resources of the entity, which will be used in satisfying
performance obligations in the future.
(c) The costs are expected to be recovered (IFRS 15 .95).

Costs that relate directly to a contract include any of the following:

(a) direct labour;

(b) direct materials;
(c) allocations of costs that relate directly to the contract or to contract activities (costs of
contract management and supervision, insurance and depreciation of tools and
equipment used in fulfilling the contract);
(d) costs that are explicitly chargeable to the customer under the contract; and
(e) other costs that are incurred only because an entity entered into the contract
(payments to subcontractors) (IFRS 15 .97).

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An entity recognises the following costs as expenses when incurred:

(a) general and administrative costs;

(b) costs of wasted materials, labour or other resources to fulfil the contract, which were
not reflected in the price of the contract;
(c) costs that relate to satisfied performance obligations in the contract; and
(d) costs for which an entity cannot distinguish whether the costs relate to unsatisfied
performance obligations or to satisfied performance obligations (IFRS 15 .98).

9.4.2 Incremental costs of obtaining a contract

An entity recognises as an asset the incremental costs of obtaining a contract with a

customer if the entity expects to recover those costs (IFRS 15 .91). The incremental
costs of obtaining a contract are those costs that an entity incurs to obtain a
contract with a customer that it would not have incurred if the contract had not been
obtained, for example, sales commissions (IFRS 15 .92).

9.4.3 Amortisation and impairment

Contract costs recognised as an asset is amortised on a systematic basis that is

consistent with the transfer to the customer of the goods or services to which the asset
relates (IFRS 15 .99).

An entity updates the amortisation to reflect a significant change in the entity’s expected
timing of transfer to the customer of the goods or services to which the asset relates as a
change in the accounting estimates in accordance with IAS 8 (IFRS 15 .100).

An entity recognises an impairment loss in profit or loss to the extent that the carrying
amount of an asset recognised exceeds

(a) the remaining amount of consideration that the entity expects to receive in exchange
for the goods or services to which the asset relates less
(b) the costs that relate directly to providing those goods or services and that have not
been recognised as expenses (IFRS 15 .101).

To determine the amount of consideration that an entity expects to receive, the entity uses
the principles of determining the transaction price (except for the requirements for
constraining estimates of variable consideration) and adjusts that amount to reflect the
effects of the customer’s credit risk (IFRS 15 .102).

Before an entity recognises an impairment loss for an asset recognised in accordance with
the above requirements, it recognises any impairment loss for assets related to the
contract, which are recognised in accordance with another Standard (IAS 2, IAS 16 and
IAS 38) (IFRS 15 .103).

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An entity recognises in profit or loss a reversal of some or all of an impairment loss

previously recognised when the impairment conditions no longer exist or have improved.
The increased carrying amount of the asset must not exceed the amount that would have
been determined (net of amortisation) if no impairment loss had been recognised
previously (IFRS 15 .104).

LECTURER’S COMMENT

Work through the relevant examples that deal with the collectability of the
consideration that the entity expects to receive and contract costs in
Descriptive Accounting.

EXAMPLE 8 – COSTS THAT GIVE RISE TO AN ASSET

An entity enters into a service contract to manage a customer’s information-technology

data centre for five years. The contract is renewable for subsequent one-year periods. The
average customer term is seven years. The entity pays an employee a R10 000 sales
commission upon the customer signing the contract. Before providing the services, the
entity designs and builds a technology platform for its internal use, which interfaces with
the customer’s systems. This platform is not transferred to the customer, but it will be used
to deliver services to the customer. The initial setup costs relate primarily to activities to
fulfil the contract but they do not relate to transferring goods or services to the customer.

The initial costs incurred to set up the technology platform are as follows:

R
Design services 40 000
Hardware 120 000
Software 90 000
Migration and testing of data centre 100 000
Total costs 350 000

REQUIRED

Discuss the accounting treatment of the costs incurred to obtain and fulfil
the contract according to the requirements of IFRS 15 – Revenue from
contracts with customers.

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SOLUTION 8

Incremental costs of obtaining a contract

The entity recognises an asset for the R10 000 incremental costs of obtaining the contract
for the sales commission because it expects to recover those costs through future fees for
the services to be provided (IFRS 15 .91). The entity amortises the asset over seven years
because the asset relates to the services transferred to the customer during the contract
term of five years, and the entity anticipates that the contract will be renewed for two
subsequent one-year periods in accordance with paragraph .99.

Costs to fulfil a contract

The entity accounts for the initial setup costs as follows:

(a) Hardware costs – accounted for in accordance with IAS 16 – Property, plant and
equipment.
(b) Software costs – accounted for in accordance with IAS 38 – Intangible assets.
(c) Costs of the design, migration and testing of the data centre – assess to determine
whether an asset can be recognised for the costs of fulfilling the contract (IFRS 15 .95).
Any resulting asset would be amortised on a systematic basis over the seven-year
period (the five-year contract term and two anticipated one-year renewal periods) in
which the entity expects to provide services related to the data centre.

9.5 APPENDIX B: APPLICATION GUIDANCE

The application guidance appears in Appendix B of IFRS 15 – Revenue from contracts

with customers. It describes the application of the paragraphs in this Standard. The
following is a summary of revenue recognition criteria for certain transactions.

Performance obligations satisfied over time

 Simultaneous receipt and consumption of the benefits of the entity’s performance

Assessing whether a customer receives the benefits and simultaneously consumes those
benefits as they are received may be straightforward and may include routine or recurring
services (such as a cleaning service) (IFRS 15 .B3). However, if an entity is not able to
readily identify whether a customer simultaneously receives and consumes the benefits
from the entity's performance as the entity performs, then a performance obligation is
satisfied over time if an entity determines that another entity would not need to
substantially re-perform the work that the entity has completed to date, if that other entity
were to fulfil the remaining performance obligation to the customer (IFRS 15 .B4).

 An entity’s performance does not create an asset with an alternative use

In assessing whether an asset has an alternative use to an entity, an entity considers the
effects of substantive contractual restrictions and practical limitations on its ability to
readily direct that asset for another use, such as selling it to a different customer (IFRS
15 .B6). A contractual restriction is substantive if a customer could enforce its rights to the
promised asset if the entity sought to direct the asset for another use. A contractual
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restriction is not substantive if an asset is largely interchangeable with other assets that
the entity could transfer to another customer without breaching the contract and without
incurring significant costs (IFRS 15 .B7).

A practical limitation on an entity’s ability to direct an asset for another use exists if an
entity would incur significant economic losses to direct the asset for another use
(significant costs to rework the asset or selling the asset at a significant loss). Practical
limitations may include design specifications that are unique to a customer or remote
locations (IFRS 15 .B8).

 Right to payment for performance completed to date

An entity has a right to payment for performance completed to date if it would be entitled to
an amount that at least compensates it for its performance completed to date in the event
that the customer or another party terminates the contract for reasons other than the
entity’s failure to perform as promised. An amount that would compensate an entity for
performance completed to date would be an amount that approximated the selling price of
the goods or services transferred to date (recovery of the costs incurred by an entity in
satisfying the performance obligation plus a reasonable profit margin) rather than
compensation for the entity’s potential loss of profit only, if the contract were to be
terminated. An entity should be entitled to compensation for either of the following
amounts:

(a) a proportion of the expected profit margin in the contract that reasonably reflects the
extent of the entity’s performance under the contract before termination by the
customer; or
(b) a reasonable return on the entity’s cost of capital for similar contracts (or the entity’s
typical operating margin for similar contracts) if the contract-specific margin is
higher than the return the entity usually generates from similar contracts (IFRS
15 .B9).

Methods for measuring progress towards complete satisfaction of a performance

obligation

An entity may use either output methods or input methods to measure progress towards
complete satisfaction (IFRS 15 .B14):

Output methods
Output methods recognise revenue based on direct measurements of the value to the
customer of the goods or services transferred to date relative to the remaining goods or
services promised under the contract. Output methods include methods such as surveys
of performance completed to date, appraisals of results achieved, milestones reached,
time elapsed, and units produced or units delivered (IFRS 15 .B15).

The disadvantages of output methods to measure progress are that the outputs used may
not be directly observable and the information required to apply them may not be available
to an entity without undue cost (IFRS 15 .B17).

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Input methods

Input methods recognise revenue based on the entity’s efforts or inputs to the satisfaction
of a performance obligation (resources consumed, labour hours expended, costs incurred,
time elapsed or machine hours used) relative to the total expected inputs to the
satisfaction of that performance obligation. If the entity’s efforts or inputs are expended
evenly throughout the performance period, it may be appropriate for the entity to recognise
revenue on a straight-line basis (IFRS 15 .B18).

A shortcoming of input methods is that there may not be a direct relationship between an
entity’s inputs and the transfer of control of goods or services to a customer. An entity
should therefore exclude the effects of any inputs that do not depict the entity’s
performance in transferring control of goods or services to the customer (costs of
unexpected amounts of wasted materials, labour or other resources).

Sale with a right of return

Some contracts also grant the customer the right to return the product for various reasons
(such as dissatisfaction with the product) and to receive any combination of the following:

(a) a full or partial refund of any consideration paid;

(b) a credit that can be applied against amounts owed, or that will be owed, to the entity;
(c) another product in exchange (IFRS 15 .B20).

To account for the transfer of products with a right of return (and for some services that are
provided, subject to a refund), an entity recognises all of the following:

(a) revenue for the transferred products in the amount of consideration to which the entity
expects to be entitled (therefore, revenue would not be recognised for the products
expected to be returned);
(b) a refund liability;
(c) an asset (and corresponding adjustment to cost of sales) for its right to recover
products from customers on settling the refund liability (IFRS 15 .B21).

For any amounts received (or receivable), to which an entity does not expect to be entitled,
the entity does not recognise revenue when it transfers products to customers, as a refund
liability is recognised. Subsequently, at the end of each reporting period, the entity updates
its assessment of amounts, to which it expects to be entitled, in exchange for the
transferred products and makes a corresponding change to the transaction price and,
therefore, in the amount of revenue recognised (IFRS 15 .B23).

An asset recognised for an entity’s right to recover products from a customer on settling a
refund liability is initially measured by reference to the former carrying amount of the
product (inventory) less any expected costs to recover those products (including potential
decreases in the value to the entity of returned products). At the end of each reporting
period, an entity must update the measurement of the asset arising from changes in
expectations about products to be returned. An entity must present the asset separately
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from the refund liability (IFRS 15 .B25).

Exchanges by customers of one product for another of the same type, quality, condition
and price (one colour or size for another) are not considered returns (IFRS 15 .B26).

Warranties

An entity may provide (in accordance with the contract, the law or customary business
practices) a warranty in connection with the sale of a product (good or service). Some
warranties provide a customer with assurance that the related product will function as the
parties intended because it complies with agreed-upon specifications. Other warranties
provide the customer with a service in addition to the assurance that the product complies
with agreed-upon specifications (IFRS 15 .B28).

If a customer has the option to purchase a warranty separately (the warranty is priced or
negotiated separately), the warranty is a distinct service because the entity promises to
provide the service to the customer in addition to the product that has the functionality
described in the contract. The promised warranty is accounted for as a performance
obligation, and a portion of the transaction price is allocated to that performance obligation
(IFRS 15 .B29).

If a customer does not have the option to purchase a warranty separately, an entity
accounts for the warranty in accordance with IAS 37 – Provisions, contingent liabilities and
contingent assets, unless the promised warranty provides the customer with a service in
addition to the assurance that the product complies with agreed-upon specifications (IFRS
15 .B30).

In assessing whether a warranty provides a customer with a service in addition to

assurance, an entity considers factors such as the following:

(a) Whether the warranty is required by law. If the warranty is required by law, the
existence of that law indicates that the promised warranty is not a performance
obligation.
(b) The length of the warranty coverage period. The longer the coverage period, the more
likely it is that the promised warranty is a performance obligation.
(c) The nature of the tasks that the entity promises to perform. If it is necessary for an
entity to perform specified tasks to provide the assurance that a product complies with
agreed-upon specifications (a return shipping service for a defective product), then
those tasks are not likely to give rise to a performance obligation (IFRS 15 .B31).

If a warranty provides a customer with a service in addition to the assurance that the
product complies with agreed-upon specifications, the promised service is a performance
obligation and the transaction price should be allocated to the product and the service
(IFRS 15 .B32).

Principal versus agent considerations

When another party is involved in providing goods or services to a customer, the entity

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must determine whether the nature of its promise is a performance obligation to provide
the specified goods or services itself (a principal) or to arrange for the other party to
provide those goods or services (an agent) (IFRS 15 .B34).

An entity is a principal if it controls a promised good or service before it transfers the good
or service to a customer. When an entity, which is a principal, satisfies a performance
obligation, it recognises revenue in the gross amount of consideration, to which it expects
to be entitled, in exchange for those goods or services transferred (IFRS 15 .B35).

An entity is an agent if its performance obligation is to arrange for the provision of goods or
services by another party. When an entity that is an agent satisfies a performance
obligation, it recognises revenue in the amount of any fee or commission to which it
expects to be entitled in exchange for arranging for the other party to provide its goods or
services (IFRS 15 .B36).

Indicators that an entity is an agent include the following:

(a) another party is primarily responsible for fulfilling the contract;

(b) the entity does not have inventory risk before or after the goods have been ordered by
a customer, during shipping or on return;
(c) the entity does not have discretion in establishing prices for the other party’s goods or
services and, therefore, the benefit that the entity can receive from those goods or
services is limited;
(d) the entity’s consideration is in the form of a commission; and
(e) the entity is not exposed to credit risk for the amount receivable from a customer in
exchange for the other party’s goods or services (IFRS 15 .B37).

Customer options for additional goods or services

Customer options to acquire additional goods or services for free or at a discount take on
many forms, such as sales incentives, customer award credits (or points), contract renewal
options or other discounts on future goods or services (IFRS 15 .B39).

An option granted to the customer to acquire additional goods or services is accounted for
as a performance obligation in the contract only if the option provides a material right to
the customer that it would not receive without entering into that contract. If the option
provides a material right to the customer, the customer in effect pays the entity in advance
for future goods or services, and the entity recognises revenue when those future goods or
services are transferred or when the option expires (IFRS 15 .B40).

An entity allocates the transaction price to performance obligations on a relative stand-

alone selling price basis. If the stand-alone selling price for a customer’s option to acquire
additional goods or services is not directly observable, an entity estimates it. That estimate
reflects the discount that the customer would obtain when exercising the option, adjusted
for both of the following:

(a) any discount that the customer could receive without exercising the option; and
(b) the likelihood that the option will be exercised (IFRS 15 .B42).

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Customers’ unexercised rights

Upon receipt of a prepayment from a customer, an entity recognises a contract liability in

the amount of the prepayment for its performance obligation to transfer, or to be ready to
transfer, goods or services in the future. An entity derecognises that contract liability (and
recognises revenue) when it satisfies its performance obligation (IFRS 15 .B44).

A customer’s non-refundable prepayment to an entity gives the customer a right to receive

a good or service in the future. However, customers may not exercise all of their
contractual rights, which are often referred to as breakage (IFRS 15 .B45). If an entity
expects to be entitled to a breakage amount in a contract liability, the entity recognises the
expected breakage amount as revenue in proportion to the pattern of rights exercised by
the customer (IFRS 15 .B46).

Non-refundable upfront fees (and some related costs)

In some contracts, an entity charges a customer a non-refundable upfront fee at or near

contract inception. Examples include joining fees in health-club membership contracts,
activation fees in telecommunication contracts, setup fees in some services contracts, and
initial fees in some supply contracts (IFRS 15 .B48).

To identify performance obligations in such contracts, an entity assesses whether the fee
relates to the transfer of a promised good or service. In many cases, even though a non-
refundable upfront fee relates to an activity that the entity is required to undertake at or
near contract inception to fulfil the contract, that activity does not result in the transfer of a
promised good or service to the customer. Instead, the upfront fee is an advance payment
for future goods or services and, therefore, it would be recognised as revenue when those
future goods or services are provided. The revenue recognition period would extend
beyond the initial contractual period if the entity grants the customer the option to renew
the contract and that option provides the customer with a material right (IFRS 15 .B49).

If the non-refundable upfront fee relates to a good or service, the entity evaluates whether
to account for the good or service as a separate performance obligation (IFRS 15 .B50).

Licensing

A licence establishes a customer’s rights to the intellectual property of an entity. Licences

of intellectual property may include, but are not limited to

(a) software and technology;

(b) motion pictures, music and other forms of media and entertainment;
(c) franchises; and
(d) patents, trademarks and copyrights (IFRS 15 .B52).

In addition to a promise to grant a licence to a customer, an entity may promise to transfer

other goods or services to the customer. As in other types of contracts, an entity identifies
each of the performance obligations in the contract (IFRS 15 .B53).

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If the promise to grant a licence is not distinct from other goods or services promised in the
contract, an entity accounts for the promise to grant a licence and those other promised
goods or services together as a single performance obligation. Examples of licences that
are not distinct from other goods or services promised in the contract include the following:

(a) a licence that forms a component of a tangible good and that is integral to the
functionality of the good; and
(b) a licence from which the customer can benefit only in conjunction with a related service
(such as an online service provided by the entity that, by granting a licence, enables
the customer to access content) (IFRS 15 .B54).

If the licence is not distinct, an entity determines whether the single performance obligation
is a performance obligation that is satisfied over time or satisfied at a point in time (IFRS
15 .B55).

If the promise to grant the licence is distinct from the other goods or services promised in
the contract, an entity determines whether the licence transfers to a customer either at a
point in time or over time. An entity considers whether the nature of the entity’s promise in
granting the licence to a customer is to provide the customer with either

(a) a right to access the entity’s intellectual property as it exists throughout the licence
period; or
(b) a right to use the entity’s intellectual property as it exists at the point in time at which
the licence is granted (IFRS 15 .B56).

To determine the nature of its promise, an entity considers whether a customer can direct
the use of, and obtain substantially all of the remaining benefits from, a licence at the point
in time at which the licence is granted. A customer cannot direct the use of, and obtain
substantially all of the remaining benefits from, a licence at the point in time at which the
licence is granted if the intellectual property, to which the customer has rights, changes
throughout the licence period. The intellectual property will change when the entity
continues to be involved with its intellectual property and undertakes activities that
significantly affect the intellectual property to which the customer has rights. In these
cases, the licence provides the customer with a right to access the entity’s intellectual
property. In contrast, a customer can direct the use of, and obtain substantially all of the
remaining benefits from, the licence at the point in time at which the licence is granted if
the intellectual property, to which the customer has rights, will not change. In those cases,
any activities undertaken by the entity merely change its own asset (i.e. the underlying
intellectual property), which may affect its ability to provide future licences. However, those
activities would not affect the determination of what the licence provides or what the
customer controls (IFRS 15 .B57).

The nature of an entity’s promise is to provide a right to access the entity’s intellectual
property if all of the following criteria are met:

(a) The contract requires, or the customer reasonably expects, that the entity will
undertake activities that significantly affect the intellectual property to which the
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customer has rights.

(b) The rights granted by the licence directly expose the customer to any positive or
negative effects of the entity’s activities identified.
(c) Those activities do not result in the transfer of a good or a service to the customer as
those activities occur (IFRS 15 .B58).

If the above criteria are met, an entity accounts for the promise to grant a licence as a
performance obligation satisfied over time because the customer will simultaneously
receive and consume the benefit from the entity’s performance of providing access to its
intellectual property as the performance occurs (IFRS 15 .B60).

If the above criteria are not met, the nature of an entity’s promise is to provide a right to
use the entity’s intellectual property as that intellectual property exists at the point in time
at which the licence is granted to the customer. It means that the customer can direct the
use of, and obtain substantially all of the remaining benefits from, the licence at the point in
time at which the licence transfers. The performance obligation is satisfied at a point in
time (IFRS 15 .B61).

Sales based or usage based

An entity recognises revenue for a sales-based or usage-based royalty promised in

exchange for a licence of intellectual property only when (or as) the later of the following
events occurs:

(a) the subsequent sale or usage occurs; and

(b) the performance obligation to which some or all of the sales-based or usage-based
royalty has been allocated is satisfied (or partially satisfied) (IFRS 15 .B63).

Repurchase agreements

A repurchase agreement is a contract in which an entity sells an asset and also promises,
or has the option, to repurchase the asset (IFRS 15 .B64).

Consignment arrangements

When an entity delivers a product to another party (such as a dealer or a distributor) for
sale to end customers, the entity evaluates whether that other party has obtained control
of the product at that point in time. A product that has been delivered to another party may
be held in a consignment arrangement if that other party has not obtained control of the
product. Accordingly, an entity does not recognise revenue upon delivery of a product to
another party if the delivered product is held on consignment (IFRS 15 .B77). Indicators
that an arrangement is a consignment arrangement include the following:

(a) The product is controlled by the entity until a specified event occurs, such as the sale of
the product to a customer of the dealer or until a specified period expires.
(b) The entity is able to require the return of the product or to transfer the product to a third
party (such as another dealer).
(c) The dealer does not have an unconditional obligation to pay for the product
(IFRS 15 .B78).
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Bill-and-hold arrangements

A bill-and-hold arrangement is a contract under which an entity bills a customer for a

product but the entity retains physical possession of the product until it is transferred to the
customer at a point in time in the future. A customer may request an entity to enter into
such a contract because of the customer’s lack of available space for the product or
because of delays in the customer’s production schedules (IFRS 15 .B79).

An entity determines when it has satisfied its performance obligation to transfer a product
by evaluating when a customer obtains control of that product. For some contracts, control
is transferred either when the product is delivered to the customer’s site or when the
product is shipped, depending on the terms of the contract (including delivery and shipping
terms). However, for some contracts, a customer may obtain control of a product even
though that product remains in an entity’s physical possession. In that case, the customer
has the ability to direct the use of, and obtain substantially all of the remaining benefits
from, the product, even though the customer has decided not to exercise its right to take
physical possession of that product. Consequently, the entity does not control the product.
Instead, the entity provides custodial services to the customer in respect of the customer’s
asset (IFRS 15 .B80).

All of the following criteria must be met for a customer to have obtained control of a
product in a bill-and-hold arrangement:

(a) The reason for the bill-and-hold arrangement must be substantive (the customer has
requested the arrangement).
(b) The product must be identified separately as belonging to the customer.
(c) The product currently must be ready for physical transfer to the customer.
(d) The entity cannot have the ability to use the product or to direct it to another customer
(IFRS 15 .B81).

If an entity recognises revenue for the sale of a product on a bill-and-hold basis, it

considers whether it has remaining performance obligations (custodial services), to which
it allocates a portion of the transaction price (IFRS 15 .B82).

Customer acceptance

Customer acceptance clauses allow a customer to cancel a contract or require an entity to

take remedial action if a good or service does not meet agreed-upon specifications. An
entity considers such clauses when evaluating when a customer obtains control of a good
or service (IFRS 15 .B83).

If an entity can objectively determine that control of a good or service has been transferred
to the customer in accordance with the agreed-upon specifications in the contract, then
customer acceptance is a formality that would not affect the entity’s determination of when
the customer has obtained control of the good or service. If the customer acceptance

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clause were based on meeting specified size and weight characteristics, an entity would
be able to determine whether those criteria have been met before receiving confirmation of
the customer’s acceptance (IFRS 15 .B84).

However, if an entity cannot determine objectively that the good or service provided to the
customer is in accordance with the agreed-upon specifications in the contract, then the
entity would not be able to conclude that the customer has obtained control until the entity
receives the customer’s acceptance (IFRS 15 .B85).

LECTURER’S COMMENT

Work through the relevant example that deals with customer incentives in
Descriptive Accounting.

9.6 PRESENTATION

When either party to a contract has performed, an entity presents the contract in the
statement of financial position as a contract asset or a contract liability, depending on the
relationship between the entity’s performance and the customer’s payment. An entity
presents any unconditional rights to consideration separately as a receivable
(IFRS 15 .105).

If a customer pays consideration, or an entity has a right to an amount of consideration

that is unconditional (a receivable), before the entity transfers a good or service to the
customer, the entity presents the contract as a contract liability when payment is made or
payment is due (whichever is earlier). A contract liability is an entity’s obligation to transfer
goods or services to a customer for which the entity has received consideration (or
consideration is due) from the customer (IFRS 15 .106).

If an entity performs by transferring goods or services to a customer before the customer

pays consideration or before payment is due, the entity presents the contract as a contract
asset, excluding any amounts presented as a receivable. A contract asset is an entity’s
right to consideration in exchange for goods or services that the entity has transferred to a
customer (IFRS 15 .107).

A receivable is an entity’s right to consideration that is unconditional. A right to

consideration is unconditional if only the passage of time is required before payment of
that consideration is due (IFRS 15 .108).

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EXAMPLE 9 – CONTRACT LIABILITY AND RECEIVABLE

Case A – Cancellable contract

On 1 January 20.14, an entity enters into a cancellable contract to transfer a product to a

customer on 31 March 20.14. The contract requires the customer to pay consideration of
R1 000 in advance on 31 January 20.14. The customer pays the consideration on
1 March 20.14. The entity transfers the product on 31 March 20.14. The following journal
entries illustrate how the entity accounts for the contract:

Dr Cr
Cash received on 1 March 20.14 (cash is received in advance of R R
performance):
Cash 1 000
Contract liability 1 000

The entity satisfies the performance obligation on 31 March 20.14:

Contract liability 1 000
Revenue 1 000

Case B – Non-cancellable contract

The same facts as in case A apply to case B, except that the contract is non-cancellable.
The following journal entries illustrate how the entity accounts for the contract:

Dr Cr
The amount of consideration is due on 31 January 20.14 (which is R R
when a receivable is recognised because it has an unconditional right
to consideration)1:
Trade receivable 1 000
Contract liability 1 000

Cash received on 1 March 20.14:

Cash 1 000
Trade receivable 1 000

Performance obligation satisfied on 31 March 20.14:

Contract liability 1 000
Revenue 1 000

1 If the entity issued the invoice before 31 January 20.14 (the due date of the
consideration), the entity would not present the receivable and the contract liability on a
gross basis in the statement of financial position because it does not yet have a right to
consideration that is unconditional.

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EXAMPLE 10 – CONTRACT ASSET AND RECEIVABLE RECOGNISED FOR THE

ENTITY’S PERFORMANCE

a) Contract asset recognised for the entity’s performance

On 1 January 20.14, an entity enters into a contract to transfer products A and B to a

customer in exchange for R1 000. The contract requires product A to be delivered first and
states that payment for delivery of product A is conditional on delivery of product B. In
other words, the consideration of R1 000 is due only after the entity has transferred both
products A and B to the customer. Consequently, the entity does not have a right to
consideration that is unconditional (a receivable) until both products A and B are
transferred to the customer. The entity identifies the promises to transfer products A and B
as performance obligations and allocates R400 to the performance obligation to transfer
product A, and R600 to the performance obligation to transfer product B, based on their
relative stand-alone selling prices. The entity recognises revenue for each respective
performance obligation when control of the product is transferred to the customer.

b) Receivable recognised for the entity’s performance

An entity enters into a contract with a customer on 1 January 20.14 to transfer products to
the customer for R150 per product. If the customer purchases more than 1 million products
in a calendar year, the contract indicates that the price per unit is reduced retrospectively
to R125 per product. Consideration is due when control of the products is transferred to
the customer. Therefore, the entity has an unconditional right to consideration (a
receivable) for R150 per product until the retrospective price reduction applies after
1 million products have been shipped.

In determining the transaction price, the entity concludes at contract inception that the
customer will meet the one million products threshold and therefore, estimates that the
transaction price is R125 per product.

REQUIRED

Provide the journal entries to recognise the revenue transaction in a) and

b) above according to IFRS 15 – Revenue from contracts with customers.

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SOLUTION 10

a) Contract asset recognised for the entity’s performance

Dr Cr
The entity satisfies the performance obligation to transfer product A: R R
Contract asset 400
Revenue 400

The entity satisfies the performance obligation to transfer product B and

to recognise the unconditional right to consideration:
Trade receivable 1 000
Contract asset 400
Revenue 600

b) Receivable recognised for the entity’s performance

Upon the first shipment to the customer of 100 products, the entity recognises the
following:
Dr Cr
The entity satisfies the performance obligation to transfer product B and R R
to recognise the unconditional right to consideration:
Trade receivable (R150 per product x 100 products) 15 000
Revenue (R125 transaction price per product x 100 products) 12 500
Refund liability (contract liability) 2 500

LECTURER’S COMMENT

The refund liability (IFRS 15 .55) represents a refund of R25 per product,
which is expected to be provided to the customer for the volume-based
rebate (the difference between the R150 price stated in the contract that
the entity has an unconditional right to receive and the R125 estimated
transaction price).

9.7 DISCLOSURE

The objective of the disclosure requirements is to enable users of financial statements to

understand the nature, amount, timing and uncertainty of revenue and cash flows arising
from contracts with customers. To achieve that objective, an entity discloses qualitative
and quantitative information about all of the following:

(a) its contracts with customers;

(b) the significant judgements, and changes in the judgements, made in applying this
Standard to those contracts; and
(c) any assets recognised from the costs to obtain or to fulfil a contract with a customer
(IFRS 15 .110).
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The level of detail and the amount of emphasis placed on each of the various
requirements will vary, and an entity appropriately aggregates or disaggregates
disclosures to disclose useful information that satisfies the disclosure objective (IFRS
15 .111).

Contracts with customers

An entity discloses all of the following amounts for the reporting period unless those
amounts are presented separately in the statement of comprehensive income in
accordance with other Standards:

(a) revenue recognised from contracts with customers, which the entity discloses
separately from its other sources of revenue; and
(b) any impairment losses recognised on any receivables or contract assets arising from
an entity’s contracts with customers, which the entity discloses separately from
impairment losses from other contracts (IFRS 15 .113).

Disaggregation of revenue

An entity disaggregates revenue recognised from contracts with customers into categories
that depict how the nature, amount, timing and uncertainty of revenue and cash flows are
affected by economic factors (IFRS 15 .114).

Disclosure of disaggregated revenue

Examples of categories that might be appropriate include, but are not limited to, all of the
following:

(a) type of good or service (major product lines);

(b) geographical region (country or region);
(c) market or type of customer (government and non-government customers);
(d) type of contract (fixed-price and time-and-materials contracts);
(e) contract duration (short-term and long-term contracts);
(f) timing of transfer of goods or services (revenue from goods or services transferred to
customers at a point in time and revenue from goods or services transferred over time);
and
(g) sales channels (goods sold directly to consumers and goods sold through
intermediaries) (IFRS 15 .B89).

Contract balances

An entity discloses all of the following:

(a) the opening and closing balances of receivables, contract assets and contract liabilities
from contracts with customers, if not otherwise presented or disclosed separately;
(b) revenue recognised in the reporting period that was included in the contract liability
balance at the beginning of the period; and
(c) revenue recognised in the reporting period from performance obligations satisfied (or
partially satisfied) in previous periods (changes in transaction price) (IFRS 15 .116).
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An entity explains how the timing of satisfaction of its performance obligations relates to
the typical timing of payment and the effect of those factors on the contract asset and the
contract liability balances. The explanation provided may contain qualitative information
(IFRS 15 .117).

An entity provides an explanation of the significant changes in the contract asset and the
contract liability balances during the reporting period. The explanation includes qualitative
and quantitative information. Examples of changes in the entity’s balances of contract
assets and contract liabilities include any of the following:

(a) changes due to business combinations;

(b) cumulative catch-up adjustments to revenue affecting the corresponding contract asset
or contract liability, including adjustments arising from a change in the measure of
progress, a change in an estimate of the transaction price (including any changes in
the assessment of whether an estimate of variable consideration is constrained) or a
contract modification;
(c) impairment of a contract asset;
(d) a change in the time frame for a right to consideration to become unconditional (for a
contract asset to be reclassified to a receivable); and
(e) a change in the time frame for a performance obligation to be satisfied (for the
recognition of revenue arising from a contract liability) (IFRS 15 .118).

EXAMPLE 11 – DISAGGREGATION OF REVENUE: QUANTITATIVE DISCLOSURE

In accordance with IFRS 8 – Operating segments, Camel Ltd reports on the following
segments: consumer products, transportation and energy. Take note that IFRS 8 –
Operating segments does not form part of this module. The purpose of this example
is to illustrate to you the disaggregation of revenue for disclosure requirements.
When the entity prepares its investor presentations, it disaggregates revenue into primary
geographical markets, major product lines and timing of revenue recognition (goods
transferred at a point in time or services transferred over time).

Camel Ltd determines that the categories used in the investor presentations can be used
to meet the objective of the disaggregation disclosure requirement (IFRS 15 .114), which
is to disaggregate revenue from contracts with customers into categories depicting how
the nature, amount, timing and uncertainty of revenue and cash flows are affected by
economic factors. The following table illustrates the disaggregation disclosure by primary
geographical market, major product line and timing of revenue recognition, including a
reconciliation of how the disaggregated revenue ties in with the consumer products,
transportation and energy segments (IFRS 15 .115).

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Segments Consumer Transport Energy Total

products
R R R R
Primary geographical markets
North America 990 2 250 5 250 8 490
Europe 300 750 1 000 2 050
Asia 700 260 - 960
1 990 3 260 6 250 11 500

Major goods/service lines

Office supplies 600 - - 600
Appliances 990 - - 990
Clothing 400 - - 400
Motorcycles - 500 - 500
Automobiles - 2 760 - 2 760
Solar panels - - 1 000 1 000
Power plant - - 5 250 5 250
1 990 3 260 6 250 11 500
R R R R
Timing of revenue recognition
Goods transferred at a point in time 1 990 3 260 1 000 6 250
Services transferred over time - - 5 250 5 250
1 990 3 260 6 250 11 500

Performance obligations

An entity discloses information about its performance obligations in contracts with

customers, including a description of all of the following:

(a) when the entity typically satisfies its performance obligations (upon shipment, upon
delivery, as services are rendered or upon completion of service), including when
performance obligations are satisfied in a bill-and-hold arrangement;
(b) the significant terms of payment (when payment is typically due, whether the contract
has a significant financing component, whether the consideration amount is variable
and whether the estimate of variable consideration is typically constrained);
(c) the nature of the goods or services that the entity has promised to transfer, highlighting
any performance obligations to arrange for another party to transfer goods or services
(if the entity is acting as an agent);
(d) obligations for returns, refunds and other similar obligations; and
(e) types of warranties and related obligations (IFRS 15 .119).

Transaction price allocated to the remaining performance obligations

An entity discloses the following information about its remaining performance obligations:

(a) the aggregate amount of the transaction price allocated to the performance obligations
that are unsatisfied (or partially unsatisfied) as of the end of the reporting period;
(b) an explanation of when the entity expects to recognise as revenue the amount
disclosed in (a) above, which the entity discloses in one of the following ways:

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(i) on a quantitative basis using the time bands that would be most appropriate for the
duration of the remaining performance obligations; or
(ii) by using qualitative information (IFRS 15 .120).

Significant judgements in the application of this Standard

An entity discloses the judgements, and changes in the judgements, made in applying this
Standard that significantly affect the determination of the amount and timing of revenue
from contracts with customers. In particular, an entity explains the judgements, and
changes in the judgements, used in determining both of the following:

(a) the timing of satisfaction of performance obligations; and

(b) the transaction price and the amounts allocated to performance obligations (IFRS
15 .123).

Determining the timing of satisfaction of performance obligations

For performance obligations that an entity satisfies over time, an entity discloses both of
the following:

(a) the methods used to recognise revenue (a description of the output methods or input
methods used and how those methods are applied); and
(b) an explanation of why the methods used provide a faithful depiction of the transfer of
goods or services (IFRS 15 .124).

For performance obligations satisfied at a point in time, an entity discloses the significant
judgements made in evaluating when a customer obtains control of promised goods or
services (IFRS 15 .125).

Determining the transaction price and the amounts allocated to performance

obligations

An entity discloses information about the methods, inputs and assumptions used for

(a) determining the transaction price, which includes, but is not limited to, estimating
variable consideration, adjusting the consideration for the effects of the time value of
money and measuring non-cash consideration;
(b) assessing whether an estimate of variable consideration is constrained;
(c) allocating the transaction price, including estimating stand-alone selling prices of
promised goods or services and allocating discounts and variable considerations to a
specific part of the contract (if applicable); and
(d) measuring obligations for returns and refunds and other similar obligations (IFRS
15 .126).

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Assets recognised from the costs to obtain or to fulfil a contract with a customer

An entity describes both of the following:

(a) the judgements it makes in determining the amount of the costs incurred to obtain or to
fulfil a contract with a customer; and
(b) the method it uses to determine the amortisation for each reporting period (IFRS
15 .127).

An entity discloses all of the following:

(a) the closing balances of assets recognised from the costs incurred to obtain or to fulfil a
contract with a customer, by main category of asset (costs to obtain contracts with
customers, pre-contract costs pand setup costs); and
(b) the amount of amortisation and any impairment losses recognised in the reporting
period (IFRS 15 .128).

ASSESSMENT CRITERIA

Are you now able to do the following?

 Measure revenue accurately and determine when revenue should be

recognised in the annual financial statements.

 Record revenue in the annual financial statements of companies

according to the requirements of the International Financial Reporting
Standards.

©
UNISA
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