The main changes of IAS 40 (2003 revised)

In December 2003, the IASB issued a revised version of IAS 40 Investment Property.

There are several main changes of revised IAS 40 from the previous version as described below (IN4 to IN11 of IAS 40) :

IN5 of IAS 40 states that a property interest that is held by a lessee under an operating lease may be classified and accounted for as investment property provided that :

1. the rest of the definition of investment property is met;
2. the operating lease is accounted for as if it were a finance lease in accordance with IAS 17 Leases; and
3. the lessee uses the fair value model set out in IAS 40 for the asset recognised.

The classification alternative described in paragraph IN5 is available on a property-by-property basis. However, because it is a general requirement of the Standard that all investment property should be consistently accounted for using the fair value or cost model, once this alternative is selected for one such property, all property classified as investment property is to be accounted for consistently on a fair value basis.

The Standard requires an entity to disclose :

1. whether it applies the fair value model or the cost model; and
2. if it applies the fair value model, whether, and in what circumstances, property interests held under operating leases are classified and accounted for as investment property.

Further, it describes that when a valuation obtained for investment property is adjusted significantly for the purpose of the financial statements, a reconciliation is required between the valuation obtained and the valuation included in the financial statements.

The Standard clarifies that if a property interest held under a lease is classified as investment property, the item accounted for at fair value is that interest and not the underlying property.

As stated in IN10 that comparative information is required for all disclosures.

Latest, IN11 of IAS 40 states that some significant changes have been incorporated into the Standard as a result of amendments that the Board made to IAS 16 Property, Plant and Equipment as part of the Improvement projects :

1. to specify what costs are included in the cost of investment property and when replaced items should be derecognised;
2. to specify when exchange transactions (ie. transactions in which investment property is acquired in exchange for non-monetary assets, in whole or in part) have commercial substance and how such transactions, with or without commercial substance, are accounted for; and
3. to specify the accounting for compensation from third parties for investment property that was impaired, lost or given up.

The basic concept of Investment Property

IAS 40 Investment Property shall be applied in the recognition, measurement and disclosure of transactions regarding investment property.

What is the definition of Investment Property ?

Based on Para. 5 of IAS 40, Investment Property is property (land or building – or part of a building – or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for (a) use in the production or supply of goods or services or for administrative purposes; or (b) sale in the ordinary course of business.

Investment Property is the opposite of Owner-occupied property. The Owner-occupied property is property held (by the owner or by the lessee under a finance lease) for use in the production or supply of goods or services or for administrative purposes.

Investment property is held to earn rentals or for capital appreciation or both. Therefore, an investment property generates cash flows largely independently of the other assets held by an entity. This distinguishes investment property from owner-occupied property. The production or supply of goods or services (or the use of property for administrative purposes) generates cash flows that are attributable not only to property, but also to other assets used in the production or supply process. IAS 16 Property, Plant and Equipment applies to owner-occupied property.

In the step of recognition, investment property shall be recognised as an asset when, and only when :

1. it is probable that the future economic benefits that are associated with the investment property will flow to the entity; and
2. the cost of the investment property can be measured reliably.

An investment property shall be measured initially at its cost. Transaction costs shall be included in the initial measurement. The cost of a purchased investment property comprises its purchase price and any directly attributable expenditure which includes, for example, professional fees for legal services, property transfer taxes and other transactions costs. While, the cost of a self-constructed investment property is its cost at the date when the construction or development is complete. Until that date, an entity applies IAS 16. At that date, the property becomes investment property and IAS 40 applies.

After the initial recognition, an entity may choose as its accounting policy measurement of investment property either the fair value model or the cost model, and shall apply that policy to all of its investment property.

If an entity choose the cost model, it shall measure all of its investment property in accordance with IAS 16’s requirements for that model, other than those that meet the criteria to be classified as held for sale (or are included in a disposal group that is classified as held for sale) in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations.

Regarding the depreciation, if an entity choose the cost model as its investment property measurement, it has to depreciate the property in accordance with IAS 16. While the fair value model was chosen, the property shall not be depreciated (Hrd).

What are the threshold of criteria #3 and #4 of IAS 17 have to be met to be classified as a finance lease ?

IAS 17 Leases stipulates that whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract.

Situations that, individually or in combination, would normally lead to a lease being classified as a finance lease are :

1. the lease transfers ownership of the asset to the lessee by the end of the lease term;
2. the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
3. the lease term is for the major part of the economic life of the asset even if title is not transferred;
4. at the inception of the lease the present value of the minimum lease payments amounts  to at least substantially all of the fair value of the leased assets; and
5. the leased assets are of such a specialised nature that only the lessee can use them without major modifications.

Of the third criterion, it may stir a question about the threshold of the ‘major part of the economic life of the asset’. IAS 17 was not clearly explained this definition. But, if we refer to the US GAAP of SFAS 13 Accounting for Leases, in paragraph 7c, the standard stated that the lease term is equal to 75 percent or more of the estimated economic life of the leased property. So, if the lease term met the 75% of the estimated economic life of the leased asset, it fulfilled the third criteria and the lease has to be classified as a finance lease.

Besides, a query may also arise from the fourth criterion that defines what are essentially arrangements to fully compensate the lessor for the entire value of the leased property as financing arrangements. Under IAS 17, such quantitative threshold is not provided. While the US GAAP of SFAS 13 in paragraph 7d states that the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him. So, based on the US GAAP, the threshold of the present value of minimum lease payments amounts must be at least 90% of leased asset fair value to be classified as a finance lease (Hrd).

A Guide through IFRS July 2010

The IFRS Foundation will shortly publish an updated version of "A Guide through IFRSs July 2010".

This 2010 edition is presented in two volume parts (Part A and B), sold together as a set. This new guide will include :

• All IFRSs and IASs as approved by the IASB at 1 July 2010
• The Complete and up-to-date consolidated text, with extensive cross-references and other annotations, of IFRSs, including IASs and IFRIC and SIC Interpretations.
• IASB-issued supporting documents, illustrative examples, implementation guidance.
• Bases for conclusions and dissenting opinions as approved at 1 July 2010.

This edition does not contain documents that are being replaced or superseded but remain applicable of the reporting entity chooses not to adopt the newer version early.

The main changes in this collection, since the 2009 edition, are the inclusion of :

• one new standard – IFRS 9
• one revised standard – IAS 24
• amendments to IFRSs that were issued as separate documents
• amendments to IFRSs issued in the third annual improvements project
• amendments to other IFRSs resulting from those revised or amended standards
• one new Interpretation – IFRIC 19

The arrangement of the contents in this edition differs from that in previous editions. In recognition of the growing size of the contents this edition of the Bound Volume is published in two parts. Part A presents the Framework and the unaccompanied IFRSs and their introductions and explanatory rubrics. Part B contains the accompanying documents, such as bases for conclusions, implementation guidance and illustrative examples. This partition therefore distinguishes the Framework and the requirements of IFRSs (in Part A) from the non-mandatory accompanying material (in Part B), and enables them to be read side by side.

How to purchase this publication ?

A Guide through IFRS July 2010 - (ISBN 978-1-907026-82-9 Set of two volume parts A & B), can be purchased for £90 each set (plus shipping). Discounts are available for bookshops/agents, multiple copies, students/academics and residents of middle and low income countries.
You can find further information about this publication and register your interest at the web shop.

Proposed amendments to IAS 12 Deferred Tax : Recovery of Underlying Assets

On 10 September 2010, the IASB published for public comment an exposure draft (ED) of Deferred Tax : Recovery of Underlying Assets.

The proposal would amend one aspect of IAS 12 Income Taxes. Under IAS 12, the measurement of deferred tax liabilities and deferred tax assets depends on whether an entity expects to recover an asset by using the asset or by selling the asset. In some cases, it is difficult and subjective to assess whether recovery will be through use or through sale.

To provide a practical approach in such cases, the proposed amendments state that, in specified circumstances, the measurement of deferred tax liabilities and deferred tax assets should reflect a rebuttable presumption that the carrying amount of the underlying asset will be recovered entirely by sale.

The specified circumstances are that the deferred tax liability or deferred tax asset arises from :

1. investment property, when an entity applies the fair value model in IAS 40 Investment Property; or
2. property, plant and equipment or intangible assets, when an entity applies the revaluation model in IAS 16 Property, Plant and Equipment or IAS 38 Intangible Assets.

The presumption is rebutted only when an entity has clear evidence that it will consume the asset’s economic benefits throughout its economic life.

Overall, the proposed amendments are intended to provide a practical approach for measuring deferred tax liabilities and deferred tax assets when it would be difficult and subjective to determine the expected manner of recovery.

The ED is open for comment until 9 November 2010.

The Press Release and the Exposure Draft are available from the IASB website : IASB proposes to amend one aspect of accounting for deferred tax

Effect of Operating and Finance Leases on Lessee Financial Statements and Key Financial Ratios

As stated in IAS 17 : Leases, there are two classifications of lease transaction that applicable in the financial statements of the lessee : (1) Operating leases and (2) Finance leases.

Followings are the effect of operating and finance leases on lessee financial statements and key financial ratios which was taken from : International Financial Reporting Standards - A Practical Guide by Hennie van Greuning.

(1) Balance Sheet

Operating Lease - Non effect because no assets or liabilities are created under the operating method

Finance Lease - A leased asset (equipment) and a lease obligation are created when the lease is recorded. Over the life of the lease, both are written off, but the asset is usually written down faster, creating a net liability during the life of the lease

(2) Income Statement

Operating Lease – The lease payment is recorded as an expense. These payments are often constant over the life of the lease.

Finance Lease – Both interest expense and depreciation expense are created. In the early years of the lease, they combine to produce a higher expense than is reported under the operating method. However, over the life of the lease, the interest expense declines, causing the total expense trend to decline. This produces a positive trend in earnings. In the later years, earnings are higher under the finance lease method than under the operating method. Over the entire term of the lease, the total lease expenses are the same under both methods.

(3) Statement of Cash Flows

Operating Lease – The entire cash outflow paid on the lease is recorded as an operating cash outflow

Finance Lease – The cash outflow from the lease payments is allocated partly to an operating or financing cash outflow (interest expense) and partly to a financing cash outflow (repayment of the lease obligation principal). The depreciation of the leased asset is not a cash expense and, therefore, is not a cash flow item.

(4) Profit Margin

Operating Lease – Higher in the early years because the rental expense is normally less than the total expense reported under the finance lease method. However, in later years, it will be lower than under the finance lease method.

Finance Lease – Lower in the early years because the total reported expense under the finance lease method is normally higher than the lease payment. However, the profit margin will rend upward over time, so in the later years it will exceed that of the operating method.

(5) Asset Turnover

Operating Lease – Higher because there are no leased assets recorded under the operating method

Finance Lease – Lower because of the leased asset (equipment) that is created under the finance lease method. The ratio rises over time as the asset is depreciated.

(6) Current Ratio

Operating Lease – Higher because no short-term debt is added to the balance sheet by the operating method.

Finance Lease – Lower because the current portion of the lease obligation created under the finance lease method is a current liability. The current ratio falls farther over time as the current portion of the lease obligation rises.

(7) Debt to Equity Ratio

Operating Lease – Lower because the operating method creates no debt

Finance Lease – Higher because the finance lease method creates a lease obligation liability (which is higher than the leased asset in the early years). However, the debt-to-equity ratio decreases over time as the lease obligation decreases

(8) Return on Assets

Operating Lease – Higher in the early years because profits are higher and assets are lower

Finance Lease – Lower in the early years because earnings are lower and assets are higher. However, the return on asset ratio rises over time because the earnings trend is positive and the assets decline as they are depreciated.

(9) Return on Equity

Operating Lease – Higher in the early years because earnings are higher

Finance Lease – Lower in the early years because earnings are lower. However, the return on equity rises over time because of a positive earnings trend.

(10) Interest Coverage

Operating Lease – Higher because no interest expense occurs under the operating method

Finance Lease – Lower because interest expense is created by the finance lease method. However, the interest coverage ratio rises over time because the interest expense declines over time.

How is the treatment of Land and Buildings lease transaction ?

Formerly, based on IAS 17 Leases (2003 amendment) para. 14, leases of land and buildings are classified as operating or finance leases in the same way as leases of other assets (read also my previous post regarding the criteria which one of them a lease agreement has to meet to be classified as a finance lease in the financial statements of the lessee : The right way to classify a lease). However, a characteristic of land is that normally has an indefinite economic life and, if title is not expected to pass to the lessee by the end of the lease term, the lessee normally does not receive substantially all of the risks and rewards incidental to ownership, in which case the lease of land will be an operating lease. A payment made on entering into or acquiring a leasehold that is accounted for as an operating lease represents prepaid lease payments that are amortised over the lease term in accordance with the pattern of benefits provided.

Para. 15 stated that the land and buildings elements of a lease of land and buildings are considered separately for the purpose of lease classification. if title to both elements is expected to pass to the lessee by the end of the lease term, both elements are classified as a finance lease, whether analysed as one lease or as two leased, unless it is clear from other features that the lease does not transfer substantially all risks and rewards incidental to ownership of one or both elements. When the land has an indefinite economic life, the land element is normally classified as an operating lease unless title is expected to pass to the lessee by the end of the lease term, in accordance with paragraph 14. The buildings element is classified as a finance or operating lease in accordance with paragraphs 7-13.

However, based on IAS 17 Leases (2009 amendment), both para. 14 and para. 15 of IAS 17 (2003 amendment) were eliminated, replaced with para. 15A which states that when a lease includes both land and buildings elements, an entity assesses the classification of each element as a finance or an operating lease separately in accordance with paragraphs 7-13. In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life.

Why para. 14 and para. 15 of IAS 17 (2003 amendment) was eliminated ?

As prescribed in the Basic for Conclusions on IAS 17 Leases, para. BC8A (IFRS 2010 as at 1 Januari 2010 Part B) that as part of its annual improvements project in 2007, the Board reconsidered the decisions it made in 2003, specifically the perceived inconsistency between the general lease classification guidance in para. 7-13 and the specific lease classification guidance in para. 14 and 15 related to long-term leases of land and buildings. The Board concluded that the guidance in para. 14 and 15 might lead to a conclusion on the classification of land leases that does not reflect the substance of the transaction.

For example, consider a 999-year lease of land and buildings. In this situation, significant risks and rewards associated with the land during the lease term would have been transferred to the lessee despite there being  no transfer of title.

The Board noted that the lessee in leases of this type will typically be in a position economically similar to an entity that purchased the land and buildings. The present value of the residual value of the property in a lease with a term of several decades would be negligible. The Board concluded that the accounting for the land element as a finance lease in such circumstances would be consistent with the economic position of the lessee.

Further, as explained in para. BC8D, the Board noted that this amendment reversed the decision it made in amending IAS 17 in December 2003. The Board also noted that the amendment differed from the International Financial Reporting Interpretations Committee's agenda decision in March 2006 based on the IAS 17 guidance that such long-term leases of land would be classified as an operating lease unless title or significant risks and rewards of ownership passed to the lessee, irrespective of the term of the lease. However, the Board believed that this change improves the accounting for leases by removing a rule and an exception to the general principles applicable to the classification of leases.

Some respondents to the exposure draft proposing this amendment agreed with the direction of this proposal but suggested that it should be incorporated into the Board's project on leases. The Board acknowledged that the project on leases is expected to produce a standard in 2011. However, the Board decided to issue the amendment now because of the improvement in accounting for leases that would result and the significance of this issue in countries in which property rights are obtained under long-term leases. Therefore, the Board decided to remove this potential inconsistency by deleting the guidance in paragraphs 14 and 15  (Hrd).

When the entities NEED To and NEED NOT To present Consolidated Financial Statements ?

IAS 27, Consolidated and Separate Financial Statements shall be applied in the preparation and presentation of consolidated financial statements for a group of entities under the control of a parent. This standard shall also be applied in accounting for investments in subsidiaries, jointly controlled entities and associates when an entity elects, or is required by local regulations, to present separate financial statements. But this standard does not deal with methods of accounting for business combinations and their effects on consolidation, including goodwill arising on a business combination (refer to IFRS 3 Business Combinations).

As stated in para. 9 of IAS 27, a parent entity must present consolidated financial statements in which it consolidates its investments in subsidiaries [the standard defines a subsidiary as an entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent)].

Following, para. 10 states that a parent need not present consolidated financial statements if all the following conditions apply :

(a) the parent is itself a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements;

(b) the parent's debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets);

(c) the parent did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and

(d) the ultimate or any intermediate parent of the parent produces consolidated financial statements available for public use that comply with International Financial Reporting Standards.

Under the provisions of IAS 27, when the above conditions are all satisfied and as a consequence the parent entity chooses not to present consolidated financial statements, but to instead present separate financial statements, then all investments in its subsidiaries, jointly controlled entities and associates that are consolidated, proportionally consolidated or accounted for under the equity method in consolidated financial statements prepared in accordance with the requirements of IAS 27 or in financial statements prepared in accordance with the requirements of IAS 31 Interest in Joint Ventures or IAS 28 Investments in Associates, must be accounted for either at cost, or as available-for-sale financial assets in accordance with IAS 39 Financial Instruments : Recognition and Measurement. The same method must be applied for each category of investments. In other words, if consolidated financial reporting if foregone, then equity method accounting or proportional consolidation is also precluded.

As stated in para. 38 of IAS 27, when an entity prepares separate financial statements, it shall account for investments in subsidiaries, jointly controlled entities and associates either : (a) at cost, or (b) in accordance with IFRS 9 Financial Instruments and IAS 39 Financial Instruments : Recognition and Measurement.

Further, it states that the entity shall apply the same accounting for each category of investments. Investments accounted for at cost shall be accounted for in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations when they are classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with IFRS 5. The accounting for investments in accordance with IFRS 9 and IAS 39 is not changed in such circumstances (HRD).

The shocking overhaul lease accounting standard

As I mentioned before in here : Exposure Draft of IAS 17 Leases, a new approach to lease accounting, on 17 August 2010, the global accounting standard-setter of IASB and the U.S accounting standard-setter of FASB have published for public comment a joint proposal to improve the financial reporting of lease contracts.

Soon after the publication, such ED becomes a hot topic of discussion and commenting amongst the accounting practices.

The proposal would require that all lease obligations be recorded on the balance sheet at the present value of the expected lease payment, along with an asset representing the right to use the leased asset. While the current accounting standard recognizes the capital (which places the lessee's asset and liability on the balance sheet) and operating lease (which goes off the balance sheet) method.

Before the publication of such ED, Reuters on August 15, 2010 published an article titled “Rulemakers plan global overhaul of lease accounting.” 

"Operating leases have long been considered one of the major off-balance sheet obligations, so there was this view that in an operating lease, the lessee has incurred an obligation and that it should be reflected on the balance sheet," said JanetPegg, an accounting analyst at UBS Investment Bank as reported by Reuter in the article.

Further, it reported that "while some investors may welcome the change to lease accounting because it will provide more clarity, many companies are fearful that the change will force their balance sheets to balloon overnight, and change all sorts of leverage and debt ratios, forcing them to renegotiate covenants with their lenders."

The Economist on August 19, 2010 in an article titled ”Shocking new accounting rules - You gonna buy that?” reported among others that "today, companies can opt either for a “capital lease”, which goes on the balance-sheet, or an “operating lease”, which does not. This distinction makes a certain sense. But the IASB and FASB think it is open to abuse. By labeling leases as “operating”, firms can appear less indebted than they really are. The new rules would put the right to use the leased item in the assets column. The obligation to pay for it would go in the debit column."

Leslie Seidman, FASB board member told WebCPA as reported in the article “Accounting Boards Propose Leasing Standards”  published on August 17, 2010 that "This proposal would put an asset on the books and amortize it, sort of like a depreciation expense, and then put a liability up and record interest expense related to it. First you’ve changed what you’re calling these P&L items, and then you’re changing the pattern of it because the asset will be amortized ratably and then interest expense will be recognized based on a declining liability amount. The pattern is just different from before, but again it’s intended to simulate the accounting if you were to buy it and finance it.”

Another related articles :

1. New lease accounting standard criticised for complexity (Accountancy Magazine)
2. New Accounting Rules Will Shatter The High Corporate Cash Mirage (Business Insider)
3. IASB and FASB propose to overhaul lease accounting
4. New leasing rules could hit bank lending (AccountancyAge)
5. Businesses await new standard for lease accounting (AccountingWeb)
6. FASB, IASB Ink Proposal to Put Leases on Balance Sheets (ComplianceWeek)

Exposure Draft of IAS 17 Leases, a new approach to lease accounting

On 17 August 2010, The IASB and US FASB published for public comment joint proposals to improve the financial reporting of lease contracts. As mentioned in the press release, the proposals are one of the main project included in the board's MoU. The proposals, if adopted, will greatly improve the financial reporting information available to investors about the financial effects of lease contracts. The proposed requirements would supersede IAS 17 Leases in IFRSs and the guidance in Topic 840 on leases in US GAAP.

The exposure draft (ED) is open for public comment until 15 December 2010.

In the ED, the boards propose to define a lease as a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration. In the boards' view, this definition retains the principle in the definition of a lease in both IFRSs and US GAAP.

Current IAS 17 Leases defines a lease as an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for a agreed period of time. A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. An operating lease is a lease other than a finance lease.

IFRSs and US GAAP classify leases into two categories : finance leases (called capital leases under US GAAP) and operating leases. Categorisation is based on various factors. If a lease is classified as a finance lease, assets and liabilities are shown on the lessee's balance sheet. However, for an operating lease the lessee does not show any assets or liabilities on the balance sheet. The lessee simply accounts for the lease payments as an expense over the lease term. Hence, investors have to estimate the effect of operating leases on financial leverage and earnings, and routinely have to adjust the financial statements of lessees for the effects of operating leases. Such adjustments are either arbitrary or based on estimates.

As the solution, the proposed model of lease accounting would reflect assets and liabilities arising from all lease contracts. All leases have to be recorded on the balance sheet. So, investors would no longer need to adjust the amounts presented in the balance sheet and the income statement to reflect the assets, liabilities and finance costs arising from lessees' operating leases.

In the ED, the boards also proposing a 'right-of-use' model in accounting for all leases (including leases of right-of-use assets in a sublease) where both lessees and lessors record assets and liabilities arising from lease contract. The assets and liabilities are recorded at the present value of the lease payments, and subsequently measured using a cost-based method.

In conjunction with revaluation issue, the ED proposes the approaches to the revaluation of right-of-use assets as follows :

(a) lessees using IFRSs would have the option to revalue right-of-use assets

(b) lessees using US GAAP would not be permitted to revalue right-of-use assets unless required to do so to recognise an impairment loss.

The ED proposes that if an entity applying IFRSs revalues a right-of-use asset, it should revalue the entire class of asset (ie the entire class of assets comprising all owned and leased assets) to which the underlying asset belongs.

The IASB Press Release and Exposure Draft are available to download in here : Exposure Draft and Comment Letter

Read also (updated December 2, 2010) :

1. Proposal Would Require Most Leases to Appear on the Balance Sheet (Journal of Accountancy)
2. Taking the "Ease" Out of "Lease"?

Changes to the Presentation of Other Comprehensive Income

At present, entities have an option in IAS 1 Presentation of Financial Statements to present either a statement of comprehensive income or two separate statements of profit or loss and other comprehensive income.

As prescribes in para. 81 of IAS 1 : an entity shall present all items of income and expense recognised in a period : (a) in a single statement of comprehensive income, or (b) in two statements : a statement displaying components of profit or loss (separate income statement) and a second statement beginning with profit or loss and displaying components of other comprehensive income (statement of comprehensive income).

On 27 May 2010, the International Accounting Standards Board (IASB) published for public comment proposals to improve the consistency of how items of Other Comprehensive Income (OCI) are presented.

This exposure draft proposes to require a statement of profit or loss and OCI containing two distinct sections - profit or loss and other comprehensive income.

It also proposes a new presentation approach for items of OCI. With recent decisions in other projects, more items will be presented in OCI. IFRS 9 and the proposed amendments to IAS 19 have introduced new items that will be presented in OCI.

The IASB is proposing to require that items that will never be recognised in profit or loss should be presented separately from those that are subject to subsequent reclassification (recycling).

The Board invites comments on the proposals in this ED, particularly on the questions set out in the ED. For instance, in Question 1 : the board proposes to change the title of the statement of comprehensive income to 'statement of profit or loss and other comprehensive income' when referred to in IFRSs and its other publications. Do you agree ? Why or why not ? What alternative do you propose ?

The exposure draft is open for comment until 30 September 2010.

Link to the IASB publications :

1. Presentation of Items of Other Comprehensive Income
2. IASB proposes improvements to the presentation of items of Other Comprehensive Income

Computer Software Cost, Capitalized or Expensed ?

Based on IAS 38 Intangible Assets, paragraph 4 which explains that some intangible assets may be contained in or on a physical substance such as a compact disc (in the case of computer software), legal documentation (in the case of license or patent) or film. In determining whether an asset that incorporates both intangible and tangible elements should be treated under IAS 16 Property, Plant and Equipment or as an intangible asset under IAS 38, an entity uses judgment to assess which element is more significant.

For example, computer software for a computer-controlled machine tool that cannot operate without that specific software is an integral part of the related hardware and it is treated as property, plant and equipment. The same applies to the operating system of a computer. When the software is not an integral part of the related hardware, computer software is treated as an intangible asset.

In connection with the accounting approach for the recognition of computer software costs, several questions may come up :

1. In the case of a company developing software programs for sale, should the costs incurred in developing the software be expensed, or should the costs be capitalized and amortized ?
2. If the developing software programs to be used for in-house applications only, how is the treatment ?
3. In the case of purchased software, should the cost of the software be capitalized as a tangible asset or as an intangible asset, or should it be expensed fully and immediately ?

Referring to the provision of IAS 38, the above questions can be clarified as follows :

(1) In the case of a software-developing company, the costs incurred in the development of software programs are research and development costs. Accordingly, as regulates in para. 54 of IAS 38, all expenses incurred in the research phase would be expensed. That is, all expenses incurred before technological feasibility for the product has been established should be expensed. The reporting entity would have to demonstrate both technological feasibility and a probability of its commercial success.

Technological feasibility would be established if the entity has completed a detailed program design or working model. The entity should have completed the planning, designing, coding, and testing activities and established that the product can be successfully produced.

Apart from being capable of production, the entity should demonstrate that it has the intention and ability to use or sell the program. Action taken to obtain control over the program in the form of copyrights or patents would support capitalization of these costs. At this stage the software program would be able to meet the criteria of identifiability, control, and future economic benefits, and can thus be capitalized and amortized as an intangible asset.

(2) In the case of software internally developed for in-house use – for example, a computerized payroll program developed by the reporting entity itself – the accounting approach would be different. While the program developed may have some utility to the entity itself, it would be difficult to demonstrate how the program would generate future economic benefits to the entity. Also, in the absence of any legal rights to control the program or to prevent others from using it, the recognition criteria would not be met. Further, the cost proposed to be capitalized should be recoverable. In view of the impairment test prescribed by the standard, the carrying amount of the asset may not be recoverable and would accordingly have to be adjusted. Considering the above facts, such costs may need to be expensed.

(3) In the case of purchased software, the treatment could differ and would need to be evaluated on a case-by-case basis. Software purchased for sale would be treated as inventory. However, software held for licensing or rental to others should be recognized as an intangible asset. On the other hand, cost of software purchased by an entity for its own use and which is integral to the hardware (because without that software the equipment cannot operate), would be treated as part of cost of the hardware and capitalized as property, plant, or equipment. Thus, the cost of an operating system purchased for an in-house computer, or cost of software purchased for computer-controlled machine tool, are treated as part of the related hardware.

The cost of other software programs should be treated as intangible assets (as opposed to being capitalized along with the related hardware), as they are not an integral part of the hardware. For example, the cost of payroll or inventory software (purchased) may be treated as an intangible asset provided it meets the capitalization criteria under IAS 38.

Source : IAS 38 Intangible Assets and Wiley – Interpretation and Application of IFRS, Barry J. Epstein and Eva K. Jermakowicz

The Death of LIFO Accounting ?

IAS 2 Inventories does not permit the use of the last-in, first-out (LIFO) formula to measure the cost of inventories of a company. This regulation has left the first-in, first-out (FIFO) and the weighted-average methods as the only two acceptable costing methods under IFRS.

In connection with the prohibition of LIFO formula, CFO.com on July 15, 2010 published an article titled “Sucking the LIFO Out of Inventory”. Written by Marie Leone, Senior Editor of CFO.com, this article described why companies still prefer LIFO method to measure the cost of inventories.

Here is the quotation from the article,

LIFO allows companies to calculate the cost of goods sold based on the price of the most recently purchased (“last-in”) inventory, rather than inventory that was purchased more cheaply in the past and has been sitting on the shelf. That boosts the cost of goods sold, which lowers profits – and, thus, taxable income. LIFO is particularly important to companies that have slow-moving inventory. Read further

The LIFO method has long been acceptable in the US for tax purposes, and, within the condition of rising prices, LIFO costing method resulted in lower reportable income and therefore in lower taxes.

Read also : Method of Inventory Costing under IAS 2

Guidance on Amortization of Intangible Assets

The accounting for an intangible asset is based on its useful life. An intangible asset with a finite useful life is amortised, and an intangible asset with an indefinite useful life is not.

What is the definition of Amortization ?

Amortization is the systematic allocation of the depreciable amount of an intangible asset over its useful life.

IAS 38 para. 97-106 rules the amortization of finite useful lives of intangible assets.

Paragraph 97 of IAS 38 states that the depreciable amount of an intangible asset with a finite useful life shall be allocated on a systematic basis over its useful life. Amortization shall begin when the asset is available for use, ie when it is in the location and condition necessary for it to be capable of operating in the manner intended by management.

Amortization shall cease at the earlier of the date that the asset is classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with IFRS 5 and the date that the asset is derecognized.

The amortization method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. If that pattern cannot be determined reliably, the straight-line method shall be used.

The amortization charge for each period shall be recognized in profit or loss unless this or another Standard permits or requires it to be included in the carrying amount of another asset.

According to Para. 98, a variety of amortization methods can be used to allocate the depreciable amount of an asset on a systematic basis over its useful life. These methods include the straight-line method, the diminishing balance method and the unit of production method. The method used is selected on the basis of the expected pattern of consumption of the expected future economic benefits embodied in the asset and is applied consistently from period to period, unless there is a change in the expected pattern of consumption of those future economic benefits.

Further, para. 99 of IAS 38 states that amortization is usually recognized in profit or loss. However, sometimes the future economic benefits embodied in an asset are absorbed in producing other assets. In this case, the amortization charge constitutes part of the cost of the other asset and is included in its carrying amount. For example, the amortization of intangible assets used in a production process is included in the carrying amount of inventories.

While para. 104 requires an entity to review the amortization period and method at least at each financial year-end.

If the expected useful life of the asset is different from previous estimates, the amortization period shall be changed accordingly. If there has been a change in the expected pattern of consumption of the future economic benefits embodied in the asset, the amortization method shall be changed to reflect the changed pattern. Such changes shall be accounted for as changes in accounting estimates in accordance with IAS 8.

During the life of an intangible asset, it may become apparent that the estimate of its useful life is inappropriate. For example, the recognition of an impairment loss may indicate that the amortization period needs to be changed.

Over time, the pattern of future economic benefits expected to flow to an entity from an intangible asset may change. For example, it may become apparent that a diminishing balance method or amortization is appropriate rather than a straight-line method. Another example is if use of the rights represented by a license is deferred pending action on other components of the business plan. In this case, economic benefits that flow from the asset may not be received until later periods (Hrd).

Source : IFRS as issued at 1 January 2010

Methods of adjusting ACCUMULATED DEPRECIATION at the date of REVALUATION

When an item of Property, Plant and Equipment is REVALUED, any accumulated depreciation at the date of the revaluation is treated in one of the following ways : (1) Restate accumulated depreciation proportionately with the change in the gross carrying amount of the asset (so that the carrying amount of the asset after revaluation equals its revalued amount); or (2) Eliminate the accumulated depreciation against the gross carrying amount of the asset (IAS 16 par. 35).

Example, Konin Corporation (KC) own buildings with a cost of USD200,000 and estimated useful life of five years. Accordingly, depreciation of USD40,000 per year is anticipated. After two years, KC obtains market information suggesting that a current fair value of the buildings is USD 300,000 and decided to write the building up to a fair value of USD300,000. There are two approaches to apply the revaluation model in IAS 38; the asset and accumulated depreciation can be “grossed up” to reflect the new fair value information, or the asset can be restated on a “net” basis. These two approaches are illustrated below. For both illustrations, the net carrying amount (book value or depreciated cost) immediately prior to the revaluation is USD120,000 (USD 200,000 - (2XUSD40,000)). The net upward revaluation is given by the difference between the fair value and net carrying value, or USD300,000 – USD120,000 = USD180,000.

Option 1. Applying the “gross up” approach, since the fair value after two years of the five-year useful life have already elapsed is found to be USD300,000, the gross fair value (gross carrying amount) must be 5/3 X USD300,000 = USD500,000. In order to have the net carrying value equal to the fair value after two years, the balance in accumulated depreciation needs to be USD200,000. Consequently, the buildings and accumulated depreciation accounts need to be restated upward as follows : buildings up USD300,000 (USD500,000 – USD200,000) and accumulated depreciation USD120,000 (USD200,000 – USD80,000). Alternatively, this revaluation could be accomplished by restating the buildings account and the accumulated depreciation account so that the ratio of net carrying amount to gross carrying amount is 60% (USD120,000/USD200.000) and the net carrying amount is USD300,000. New gross carrying amount is calculated USD300,000/60%=USD500,000.

The following journal entry illustrate the restatement of the accounts :

Buildings	300,000
Accumulated Depreciation		120,000
Other comprehensive income – gain on revaluation		180,000

And the following table illustrate the restatement of the accounts :

	Original cost		Revaluation		Total	%
Gross carrying amount	USD200,000	+	USD300,000	=	USD500,000	100
Accumulated Depreciation	80,000	+	120,000	=	200,000	40
Net carrying amount	USD120,000	+	USD180,000	=	USD300,000	60

After the revaluation, the carrying value of the building is USD300,000 (=USD500,000 – 200,000) and the ratio of net carrying amount to gross carrying amount is 60% (=USD300,000/USD500,000).

This method is often used when an asset is revalued by means of applying an index to determine its depreciated replacement cost.

Option 2. Applying the “netting” approach, KC would eliminate accumulated depreciation of USD80,000 and then increase the building account by USD180,000 so the net carrying amount is USD300,000 (=USD200,000 – USD80,000 + USD180,000). The journal entry as follow :

Acc. Depreciation	80,000
Buildings		80,000
Buildings	180,000
Other comprehensive income – gain on revaluation		180,000

This method is often used for buildings. In terms of total assets reported in the statement of financial position, option 2 has exactly the same effect as option 1.

However, many users of financial statements, including credit grantors and prospective investors, pay heed to the ratio of net property and equipment as a fraction of the related gross amounts. This is done to assess the relative age of the entity’s productive assets and, indirectly, to estimate the timing and amounts of cash needed for asset replacements. There is a significant diminution of information under the second method. Accordingly, the first approach described above, preserving the relationship between gross and net asset amounts after the revaluation, is recommended as the preferable alternative is the goal is meaningful financial reporting.

Source : WILEY – 2010 Interpretation and Application of IFRS, Barry J. Epstein and Eva K. Jermakowicz

Identifying the condition to recognise “Events after the Reporting Period”

IAS 10 Events after the Reporting Period replaces IAS 10 Events After the Balance Sheet Date (revised in 1999) and should be applied for annual periods beginning on or after 1 January 2005.

The main change from the previous version of IAS 10 was a limited clarification of par. 12 and 13. As revised, those paragraphs state that if an entity declares dividends after the reporting period, the entity shall not recognise those dividends as a liability at the end of the reporting period.

When an entity should recognise “Events after the Reporting Period” in the financial statements ?

IAS 10 par. 3 – 7 underlines several guidances regarding above question.

Par. 3 defines “Events after the Reporting Period” as those events, favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue. Two types of events can be identified :

1. those that provide evidence of conditions that existed at the end of the reporting period (adjusting events after the reporting period); and
2. 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 will vary depending upon 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 been issued. In such cases, the financial statements are authorised for issue on the date of issue, not the date when shareholders approve the financial statements.

Example, the management of an entity completes draft financial statements for the year to 31 December 20X1 on 28 February 20X2. On 18 March 20X2, 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 20X2. The financial statements are made available to shareholders and others on 1 April 20X2. The shareholders approve the financial statements at their annual meeting on 15 May 20X2 and the approved financial statements are then filed with a regulatory body on 17 May 20X2.

In this condition, the financial statements are authorised for issue on 18 March 20X2 (date of board authorisation for issue).

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, on 18 March 20X2, 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 interests. The supervisory board approves the financial statements on 26 March 20X2. The financial statements are made available to shareholders and others on 1 April 20X2. The shareholders approve the financial statements at their annual meeting on 15 May 20X2 and the financial statements are then filed with a regulatory body on 17 May 20X2.

In this condition, the financial statements are authorised for issue on 18 March 20X2 (date of management authorisation for issue to the supervisory board).

Events after the reporting period include all events up to the date when the financial statements are authorised for issue, even if those events occur after the public announcement of profit or of other selected financial information (Hrd). ***

Several main features of IAS 27 - Consolidated and Separate Financial Statements

The objective of IAS 27 is to enhance the relevance, reliability and comparability of the information that a parent entity provides in its separate financial statements and in its consolidated financial statements for a group of entities under its control.

The Standard specifies :

1. the circumstances in which an entity must consolidate the financial statements of another entity (being a subsidiary);
2. the accounting for changes in the level of ownership interest in a subsidiary;
3. the accounting for the loss of control of a subsidiary; and
4. the information that an entity must disclose to enable users of the financial statements to evaluate the nature of the relationship between the entity and its subsidiaries

Presentation of consolidated financial statements. A parent must consolidate its investments in subsidiaries. There is a limited exception available to some non-public entities. However, that exception does not relieve venture capital organisations, mutual funds, unit trusts and similar entities from consolidating their subsidiaries.

Consolidation procedures. A group must use uniform accounting policies for reporting like transactions and other events in similar circumstances. The consequences of transactions, and balances, between entities within the group must be eliminated.

Non-controlling interests. Non-controlling interests must be presented in the consolidated statement of financial position within equity, separately from the equity of the owners of the parent. Total comprehensive income must be attributed to the owners of the parent and to the non-controlling interests even if the results in the non-controlling interests having a deficit balance.

Changes in the ownership interests. Changes in a parent’s ownership interest in a subsidiary that do not result in the loss of control are accounted for within equity.

When an entity loses control of a subsidiary, it derecognises the assets and liabilities and related equity components of the former subsidiary. Any gain or loss is recognised in profit or loss. Any investment retained in the former subsidiary is measured at its fair value at the date when control is lost.

Separate financial statements. When an entity elects, or is required by local regulations, to present separate financial statements, investments in subsidiaries. jointly controlled entities and associates must be accounted for at cost or in accordance with IAS 39 Financial Instruments : Recognition and Measurement.

Disclosure. An entity must disclose information about the nature of the relationship between the parent entity and its subsidiaries (Hrd) ***

The Right Way to Classify A Lease

Definitions

A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred.

An operating lease is a lease other than a finance lease.

Classification of Leases

The classification of a lease as either a finance lease or an operating lease is critical as significantly different accounting treatments are required for the different types of lease. The classification is based on the extent to which risks and rewards of ownership of the leased asset are transferred to the lessee or remain with the lessor. Risks include technological obsolescence, loss from idle capacity, and variations in return. Rewards include rights to sell the asset and gain from its capital value.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards of ownership to the lessee. If it does not, then it is an operating lease. When classifying a lease, it is important to recognize the substance of the agreement and not just its legal form. The commercial reality is important. Conditions in the lease may indicate that an entity has only a limited exposure to the risks and benefits of the leased asset. However, the substance of the agreement may indicate otherwise. Situations that, individually or in combination, would usually lead to a lease being a finance lease include :

• transfer of ownership to the lessee by the end of the lease term
• the lessee has the option to purchase the asset at a price that is expected to be lower than its fair value such that the option is likely to be exercised
• the lease term is for a major part of the economic life of the asset, even if title to the asset is not transferred
• the present value of the minimum lease payments is equal to the substantially all of the fair value of the asset
• the leased assets are of a specialized nature such that only the lessee can use them without significant modification

Situations that, individually or in combination, could lead to a lease being a finance lease include :

• if the lessee can cancel the lease, and the lessor’s losses associated with cancellation are borne by the lessee
• gains or losses from changes in the fair value of the residual value of the asset accrue to the lessee
• the lessee has the option to continue the lease for a secondary term at substantially below market rent

It is evident from the descriptions that a large degree of judgment has to be exercised in classifying lease; many lease agreements are likely to demonstrate only a few of the situations listed, some of which are more persuasive that others. In all cases, the substance of the transaction needs to be properly analyzed and understood. Emphasis is placed on the risks that the lessor retains more than the benefits of ownership of the asset. If there is little or no related risk, then the agreement is likely to be a finance lease. If the lessor suffers the risk associated with a movement in the market price of the asset or the use of the asset, then the lease is usually an operating lease.

The purpose of the lease agreement may help the classification. If there is an option to cancel, and the lessee is likely to exercise such an option, then the lease is likely to be an operating lease (Hrd).

Source : IFRS Practical Implementation Guide and Workbook (2nd Edition) - Abbas Ali Mirza, Magnus Orrell & Graham J. Holt

Starting 1 July 2010, IASC Foundation will be known as IFRS Foundation

On 1 July 2010 the IASC Foundation will formally change its name to the IFRS Foundation. The change represents the next step in a process to simplify the names in use across the organisation announced following the conclusion of the Constitutional Review in 2010. The International Financial Reporting Interpretations Committee (IFRIC) and the Standards Advisory Council (SAC) have already been renamed as the IFRS Interpretations Committee and the IFRS Advisory Council, respectively.

The name of the International Accounting Standards Board (IASB) will remain unchanged.

Beyond the change in name, there are no other changes affecting the legal status of the Foundation, its structure or its operating terms and conditions.

Source : www.iasb.org

IASB proposes the ED of Measurement Uncertainty Analysis Disclosure for Fair Value Measurements

The International Accounting Standards Board (IASB) today (29 June 2010) published for public comment further enhancements to a disclosure proposal on Level 3 fair value measurements that formed part of the IASB’s exposure draft Fair Value Measurement published in May 2009.

In that exposure draft, the IASB proposed a three-level fair value hierarchy that categorises observable and non-observable market data used as inputs for fair value measurements. According to that hierarchy, Level 3 inputs are ‘unobservable inputs’ used for the fair value measurement of assets or liabilities for which market data are not available.

In response to comments received, the IASB proposes to enhance its original proposal by requiring the measurement uncertainty analysis disclosure to reflect the interdependencies between unobservable inputs used to measure fair value in Level 3. Users of financial statements commented that this information would allow them to assess the effect that the use of different unobservable inputs would have had on the fair value measurement.

The exposure draft Measurement Uncertainty Analysis Disclosure for Fair Value Measurements is open for comment until 7 September 2010.

T he FASB is publishing the proposals in the exposure draft Amendments for Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. Both boards will consider the comments received on the exposure drafts jointly as they continue their discussions about fair value measurement.

The IASB exposure draft can be accessed on http://go.iasb.org/open+to+comment from today. The FASB exposure draft can be accessed on www.fasb.org.

The IASB will publish in due course on its website a comprehensive summary on the progress of its fair value measurement project, of which these proposals form part.

Source : www.iasb.org