Accounting Standards

Accounting policies are the specific principles, bases, conventions, rules, and practices applied by an entity in preparing and presenting financial statements. Examples: depreciation method chosen, inventory cost formula, revenue recognition method.

When an IFRS specifically applies to a transaction, the policy is determined by applying that standard. When no standard applies, management uses judgement to develop a policy that results in relevant and faithfully represented information, considering (in descending order):

1. Requirements of IFRSs dealing with similar issues
2. Definitions, recognition criteria, and measurement concepts in the Conceptual Framework

Changes in accounting policy are made only when:

• Required by a new or amended IFRS standard, OR
• The change results in financial statements providing more reliable and relevant information

Treatment: RETROSPECTIVE application. The entity adjusts its financial statements as if the new policy had always been applied:

• Prior period comparative figures are restated
• The opening balance of the earliest period presented is adjusted for the cumulative effect
• If retrospective application is impracticable, apply prospectively from the earliest date practicable

Accounting estimates are monetary amounts in financial statements that are subject to measurement uncertainty. Examples: useful life of an asset, residual value, percentage for allowance for receivables, warranty provision amount, fair value where not directly observable.

Estimates may need revision if circumstances change or new information becomes available. A change in accounting estimate is not the correction of an error — it reflects new information.

Treatment: PROSPECTIVE application. The change affects:

• The current period (the period of the change), and
• Future periods (if the change affects both)

Prior periods are NOT restated.

Examples:

• Changing the useful life of an asset from 10 years to 8 years: prospective — recalculate depreciation from the current period over the revised remaining life. Do not restate prior years.
• Changing the allowance for receivables from 3% to 5%: prospective — apply the new percentage to current-period receivables.
• Changing the depreciation method (e.g., straight-line to reducing balance): IAS 8 treats this as a change in estimate (not a policy change) because it reflects a change in the expected pattern of consumption of benefits. Applied prospectively.

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 was available when those financial statements were authorised for issue and could reasonably be expected to have been obtained.

Examples: mathematical mistakes, mistakes in applying accounting policies, oversight of facts, fraud.

Treatment: RETROSPECTIVE restatement (same as a policy change):

• Restate the comparative amounts for the prior period(s) in which the error occurred
• If the error occurred before the earliest period presented, restate the opening balances of assets, liabilities, and equity for the earliest period presented

Key exam point — how to distinguish the three:

Adjusting events provide evidence of conditions that existed at the reporting date. The financial statements are adjusted to reflect this evidence.

Examples of adjusting events:

• Settlement of a court case after the reporting date, confirming the entity had an obligation at the reporting date — adjust the provision
• Bankruptcy of a customer after year end, where the customer was already in financial difficulty — write off or increase the allowance for the receivable
• Sale of inventory after year end at below cost, confirming NRV was below cost at the reporting date — write inventory down
• Discovery of fraud or errors that show the financial statements were incorrect
• Determination of the cost of assets purchased or proceeds of assets sold before the reporting date

Non-adjusting events are indicative of conditions that arose after the reporting date. They are not adjusted in the financial statements but must be disclosed in the notes if they are material (their nature and an estimate of financial effect, or a statement that such an estimate cannot be made).

Examples of non-adjusting events:

• A major business combination (acquisition) or disposal after the reporting date
• Announcement of a plan to discontinue an operation
• Major purchase or disposal of assets after year end
• Destruction of a major production plant by fire or flood after year end
• Announcing or commencing a major restructuring after the reporting date
• Decline in fair value of investments after the reporting date (reflects conditions that arose after year end)
• Dividends declared (proposed) after the reporting date — NOT a liability at the reporting date because no obligation exists until shareholders approve the dividend. Disclosed in notes.
• Abnormally large changes in asset prices or foreign exchange rates after year end

If management determines after the reporting date that it intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so, the financial statements should NOT be prepared on a going concern basis. This is a fundamental change in the basis of preparation, not merely an adjusting or non-adjusting event.

At each reporting date, an entity must assess whether there are any indicators of impairment. If indicators exist, a formal impairment test is required.

External indicators:

• Significant decline in an asset's market value beyond normal wear
• Significant adverse changes in technology, markets, economy, or the legal environment
• Increases in market interest rates or discount rates (reducing value in use)
• The entity's market capitalisation falls below its net asset value

Internal indicators:

• Evidence of physical damage or obsolescence
• Significant adverse changes in the extent to which, or manner in which, an asset is used (e.g., plans for discontinuation, restructuring, early disposal)
• Internal reporting evidence that the asset's economic performance is, or will be, worse than expected

Mandatory annual testing (regardless of indicators):

• Goodwill acquired in a business combination
• Intangible assets with indefinite useful lives
• Intangible assets not yet available for use

Recoverable amount = Higher of (Fair value less costs of disposal, Value in use)

Fair value less costs of disposal (FVLCD): The amount obtainable from the sale of the asset in an arm's length transaction between knowledgeable, willing parties, less costs of disposal (legal fees, transport, commissions, etc.).

Value in use (VIU): The present value of estimated future cash flows expected to be derived from continuing use of the asset and from its eventual disposal. Calculated by:

1. Estimating future cash inflows and outflows from the asset's continued use and ultimate disposal
2. Discounting those cash flows at an appropriate pre-tax discount rate reflecting current market assessments of the time value of money and the risks specific to the asset

If either FVLCD or VIU exceeds carrying amount, the asset is not impaired — there is no need to calculate the other.

Impairment loss = Carrying amount − Recoverable amount

Recognition:

• For assets carried under the cost model: the impairment loss is recognised in profit or loss
• For revalued assets (IAS 16 revaluation model): the impairment loss is first charged against the revaluation surplus (through OCI) to the extent of any existing surplus for that asset. Any excess is recognised in profit or loss.

After impairment: The asset's carrying amount is reduced to the recoverable amount. Future depreciation is based on the revised carrying amount over the remaining useful life.

Reversal of impairment:

• If circumstances change (e.g., market conditions improve), an impairment loss may be reversed
• The reversal cannot increase the carrying amount above what it would have been (net of depreciation) had no impairment been recognised
• CRITICAL: Impairment of goodwill is NEVER reversed
• Reversal is recognised in profit or loss (or in OCI if the asset is revalued, to restore the revaluation surplus)

Many assets do not generate cash flows independently — they contribute to the cash flows of a group of assets. In such cases, impairment is tested at the level of the cash-generating unit (CGU).

CGU: 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.

Goodwill allocation: Goodwill acquired in a business combination is allocated to the CGU (or group of CGUs) expected to benefit from the synergies of the combination. It is then tested for impairment at this level.

Allocating an impairment loss within a CGU:

1. First: reduce the carrying amount of any goodwill allocated to the CGU
2. Then: reduce the carrying amounts of the other assets of the CGU pro rata on the basis of their carrying amounts

However, no individual asset within the CGU should be reduced below the highest of: its FVLCD, its VIU, or zero.

A provision is a liability of uncertain timing or amount. It is recognised when ALL THREE of the following criteria are met:

1. Present obligation (legal or constructive) as a result of a past event
2. It is probable (more likely than not — i.e., >50% probability) that an outflow of resources embodying economic benefits will be required to settle the obligation
3. A reliable estimate can be made of the amount of the obligation

If any of these criteria is not met, no provision is recognised.

Measurement: The amount recognised should be the best estimate of the expenditure required to settle the present obligation at the reporting date. This is the amount the entity would rationally pay to settle or transfer the obligation.

• For a single obligation: the best estimate is the most likely outcome
• For a large population of items (e.g., warranties): use the expected value method (probability-weighted average of all possible outcomes)
• Where the time value of money is material (i.e., settlement is expected significantly in the future): the provision is discounted to present value. The unwinding of the discount is recognised as a finance cost each period.

Common types of provision:

• Warranties: Obligation to repair or replace faulty goods. Measured using expected value of claims.
• Environmental/decommissioning: Legal obligation to restore a site. Often recognised at the same time as the related asset (IAS 16 — dismantling costs added to asset cost).
• Restructuring: Recognised only when the entity has a detailed formal plan AND has raised a valid expectation in those affected (e.g., by announcing the plan). A board decision alone is not enough.
• Onerous contracts: A contract where the unavoidable costs of meeting the obligations exceed the economic benefits expected. The provision is the lower of: the cost of fulfilling the contract and the cost of terminating it (penalties).
• Legal claims: Recognised when all three criteria are met — a present obligation exists, outflow is probable, and a reliable estimate can be made.

IAS 37 prohibits provisions for:

• Future operating losses — these do not meet the definition of a liability (no past event creating a present obligation)
• General/unspecified risks — a provision must relate to a specific obligation

A contingent liability is either:

• A possible obligation arising from past events whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the entity's control, OR
• A present obligation that does not meet the recognition criteria because: (a) it is not probable that an outflow will be required, or (b) the amount cannot be estimated reliably

Treatment:

• NOT recognised in the financial statements (i.e., not shown as a liability on the SoFP)
• Disclosed in the notes — describe the nature of the contingency, estimate of financial effect, uncertainties, and possibility of reimbursement
• Exception: If the possibility of outflow is remote (very unlikely), no disclosure is required

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

Treatment:

• NEVER recognised in the financial statements (to avoid recognising income that may never materialise)
• Disclosed in the notes only if the inflow of economic benefits is probable
• If the inflow is virtually certain, it is no longer contingent — it is a real asset and is recognised

The IAS 37 decision tree — summary:

Note the asymmetry: provisions are recognised at the "probable" level, but contingent assets are only disclosed at that level and not recognised until virtually certain. This reflects the principle of prudence — caution against premature recognition of income.

Step 1: Identify the contract with a customer

A contract exists when: (a) the parties have approved it and are committed, (b) each party's rights can be identified, (c) payment terms can be identified, (d) the contract has commercial substance, and (e) it is probable the entity will collect the consideration. Contracts can be written, oral, or implied by customary business practices.

Step 2: Identify the performance obligations in the contract

A performance obligation is a promise to transfer a distinct good or service (or a bundle of goods/services) to the customer. A good or service is distinct if:

• The customer can benefit from it on its own or with readily available resources, AND
• It is separately identifiable from other promises in the contract (not highly interrelated or significantly modified by other goods/services in the contract)

Example: a contract to sell a laptop and provide a 2-year support service → two performance obligations (the laptop is distinct; the service is distinct).

Step 3: Determine the transaction price

The transaction price is the amount of consideration the entity expects to be entitled to in exchange for transferring goods/services. Consider:

• Variable consideration: Estimated using the expected value method (probability-weighted average) or the most likely amount method. Subject to a constraint: include variable consideration only to the extent it is highly probable that a significant reversal will not occur.
• Significant financing component: If payment timing differs significantly from delivery, adjust for the time value of money (unless the period is one year or less — practical expedient).
• Non-cash consideration: Measured at fair value.
• Consideration payable to a customer: Usually reduces the transaction price (e.g., coupons, rebates).

Step 4: Allocate the transaction price to performance obligations

If there are multiple performance obligations, allocate the total transaction price to each in proportion to their relative stand-alone selling prices. If a stand-alone selling price is not directly observable, estimate it.

Step 5: Recognise revenue when (or as) each performance obligation is satisfied

A performance obligation is satisfied when (or as) the customer obtains control of the promised good or service. Control can transfer:

• At a point in time: Revenue recognised at the moment control transfers (e.g., delivery of goods). Indicators: entity has a present right to payment, customer has legal title, physical possession has transferred, customer has significant risks and rewards, customer has accepted the asset.
• Over time: Revenue recognised progressively as the performance obligation is satisfied. This applies when:
  • The customer simultaneously receives and consumes the benefits (e.g., cleaning services), OR
  • The entity's performance creates or enhances an asset that the customer controls as it is created (e.g., constructing a building on customer's land), OR
  • The entity's performance does not create an asset with alternative use to the entity AND the entity has an enforceable right to payment for performance completed to date

For over-time recognition, measure progress using input methods (e.g., costs incurred relative to total expected costs) or output methods (e.g., units delivered, milestones reached).

A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Control exists when the lessee has both:

• The right to obtain substantially all the economic benefits from use of the asset, AND
• The right to direct the use of the asset (i.e., direct how and for what purpose it is used)

Lease liability: Measured at the present value of future lease payments not yet paid, discounted at the interest rate implicit in the lease. If that rate cannot be readily determined, use the lessee's incremental borrowing rate.

Lease payments included in the measurement:

• Fixed payments (less any lease incentives receivable)
• Variable lease payments that depend on an index or rate (e.g., CPI-linked)
• Amounts expected to be payable under residual value guarantees
• Exercise price of a purchase option if the lessee is reasonably certain to exercise it
• Payments of penalties for terminating the lease if the lease term reflects exercise of a termination option

Right-of-use (ROU) asset: Initially measured at:

• The amount of the lease liability (as calculated above)
• Plus: any lease payments made at or before commencement (prepaid rent)
• Plus: initial direct costs incurred by the lessee (e.g., legal fees, commissions)
• Plus: an estimate of costs to dismantle/restore the asset (if obligated)
• Less: any lease incentives received

Lease liability:

• Increased by interest each period: Dr Finance cost / Cr Lease liability (interest = opening liability × discount rate)
• Reduced by lease payments made: Dr Lease liability / Cr Cash
• The interest element of each payment is a finance cost in the SoPL; the capital (principal) element reduces the liability

Right-of-use asset:

• Depreciated over the shorter of the lease term and the useful life of the underlying asset
• Exception: if ownership transfers to the lessee at the end of the lease, or the lessee is reasonably certain to exercise a purchase option, depreciate over the useful life of the asset
• Can use the cost model (most common) or revaluation model (IAS 16)
• Subject to impairment testing under IAS 36

SoPL impact compared to old operating lease treatment:

IFRS 16 provides two optional exemptions where a lessee can choose not to recognise an ROU asset and lease liability:

1. Short-term leases: Leases with a lease term of 12 months or less at commencement (with no purchase option). The lessee recognises the lease payments as an expense on a straight-line basis (or another systematic basis). The exemption is made by class of underlying asset.

2. Leases of low-value assets: Leases where the underlying asset has a low value when new (IASB guidance suggests approximately US$5,000 or less). Examples: tablets, personal computers, small office furniture, phones. The exemption is made on a lease-by-lease basis. Note: the value is assessed based on the value of the asset when new, regardless of its age when leased.

Under both exemptions, the accounting is similar to the old operating lease treatment — straight-line expense, no balance sheet recognition.