Lease accountingEmail Print Twitter Facebook Linkedin Add This Related Links Multiple-choice questions Read more articles from Accounting and BusinessAs we wait for a definitive leasing standard, Graham Holt explores the original 2013 exposure draft and the current state of playStudying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.Leasing is an important activity for many organisations with the majority of leases not currently reported on a lessees statement of financial position. The existing accounting models for leases require lessees and lessors to classify their leases as either finance leases or operating leases and to account for those leases differently.The existing standards have been criticised for failing to meet the needs of users of financial statements because they do not always provide a faithful representation of leasing transactions.The exposure draft (ED), Leases (May 2013), attempted to solve the lease accounting problem by requiring an entity to classify leases into two types type A and type B and recognise both types on the statement of financial position. The ED was the result of a joint project by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Boards (FASB) (the boards).This article sets out the current deliberations of the boards as at the end of 2014 and, therefore, as such, the final leasing standard may vary from the discussions below.The ED sets out that type A leases would normally mean that the underlying asset is not property, while type B leases mean that the underlying asset is property. However, the entity classifies a lease other than a property lease as type B if the lease term is for an insignificant part of the total economic life of the asset; or the present value of the lease payments is insignificant relative to the fair value of the underlying asset at the leases commencement date.Conversely, the entity classifies a property lease as type A if the lease term is for the major part of the remaining economic life of the underlying asset; or the present value of the lease payments accounts for substantially all of the fair value of the underlying asset at the commencement date. At this date, the lessee discounts the lease payments using the rate the lessor charges the lessee, or if that rate is unavailable, the lessees incremental borrowing rate.The lessee recognises the present value of lease payments as a liability. At the same time it recognises a right-of-use (ROU) asset equal to the lease liability, plus any lease payments made to the lessor at or before the commencement date, less any lease incentives received from the lessor; and any initial direct costs incurred by the lessee. After the commencement date, the liability is increased by the unwinding of interest and reduced by lease payments made to the lessor.A lessee will recognise in profit or loss, for type A leases, the unwinding of the discount on the lease liability as interest and the amortisation of the ROU asset and, for type B leases, the lease payments will be recognised in profit or loss on a straight-line basis over the lease term and reflected in profit or loss as a single lease cost.Following the feedback received on the ED, the FASB still remains supportive of the dual-model approach to bringing leases on to the statement of financial position.Under this approach, a lessee would account for most existing finance leases as type A leases and most existing operating leases as type B leases. Both type A and B leases result in the lessee recognising a ROU asset and a lease liability. However, the IASB has stated that feedback on the 2013 ED indicates that the dual model is too complex and, therefore, has opted currently for a single lessee model that is easy to understand. The IASB decided on a single approach for lessee accounting where a lessee would account for all leases as type A leases.The boards decided that a lessor should determine lease classification (type A or type B) on the basis of whether the lease is effectively a financing or a sale, rather than an operating lease. A lessor would make that determination by assessing whether the lease transfers substantially all the risks and rewards incidental to ownership of the underlying asset. A lessor will be required to apply an approach substantially equivalent to existing International Financial Reporting Standards (IFRS) finance lease accounting to all type A leases.A lease is currently defined by the boards as a contract that conveys the right to use an asset for a period of time in exchange for consideration. An entity would determine whether a contract contains a lease by assessing whether the use of the asset is either explicitly or implicitly specified and the customer controls the use of the asset. The definition of a lease does not require the customer to have the ability to derive the benefits from directing the use of an asset.The boards have decided that the leases guidance should not include specific requirements on materiality and retain the recognition and measurement exemption for a lessees short-term leases (12 months or less) with the IASB specifically favouring a similar exemption for leases of small assets for lessees.The boards have decided that, when determining the lease term, an entity should consider all relevant factors that may affect the decision to extend, or not to terminate, a lease. The lease term should only be reassessed when a significant event occurs or there is a significant change in circumstances that are within the control of the lessee. A lessor should not be required to reassess the lease term.Only variable lease payments that depend on an index or a rate should be included in the initial measurement of leases and the IASB has determined that reassessment of variable lease payments would only occur when the lessee re-measures the lease liability for other reasons. A lessor will not be required to reassess variable lease payments that depend on an index or a rate.The definition of the discount rate remains unchanged as the rate implicit in the lease, as does the requirement for a lessee to reassess the discount rate only when there is a change to either the lease term or the assessment of whether the lessee is (or is not) reasonably certain to exercise an option to purchase the asset.A lease modification for both a lessee and a lessor should be accounted for as a new lease, separate from the original lease, when:1. the lease grants the lessee an additional right-of-use not included in the original lease, and2. the additional right-of-use is priced commensurate with its standalone price in the context of that particular contract.In terms of the initial direct costs for both lessors and lessees, they should include only incremental costs that would not have incurred if the lease had not been executed. These include commissions or payments made to existing tenants to obtain the lease. A lessor in a type A lease should include initial direct costs in the initial measurement of the lease receivable and they should be taken into account in determining the rate implicit in the lease.A lessor in a type A lease who recognises selling profit at lease commencement should recognise initial direct costs as an expense. A lessor in a type B lease should expense such costs over the lease term on the same basis as lease income. A lessee should include initial direct costs in the initial measurement of the right-of-use asset and amortise those costs over the lease term.The guidance in the ED has been retained for sale and leaseback transactions with a sale having to meet the requirements of a sale as set out in IFRS 15. A buyer-lessor should account for the purchase of the underlying asset consistent with the guidance that would apply to the purchase of any non-financial asset.This article sets out the deliberations of the IASB/FASB as regards lease accounting at the end of December 2014. The IFRS is due for publication in 2015, but it seems that the FASB and IASB will have differing views on several recognition and measurement issues when the IFRS is finally published. There may yet however be further changes of opinion.Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business SchoolThe FASB reThe FASB remains supportive of the dual-model approach to bringing leaseson to the statement of financial position mains supportive of the dual-model approach to bringing leases on to the statement of financial positionAccounting for changesEmail Print Twitter Facebook Linkedin Add This Related Links Multiple-choice questions Read more articles from Accounting and BusinessGraham Holt discusses the IASBs application of effects analysis to new standards and any material changes in existing standardsStudying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.This article was first published in the February 2015 international edition ofAccounting and Businessmagazine.The introduction of a new accounting standard or a change in an accounting standard can have a significant impact on an entity from an internal as well as an external perspective. As a result, the International Accounting Standards Board (IASB) has recently agreed to conduct an effects analysis before publishing any International Financial Reporting Standard (IFRS).When the IASB issues a new or significantly amended IFRS, it changes the way in which financial statements show particular transactions or events. Changes in reporting requirements always come with a cost.The IASB uses discussion papers and the basis for conclusions to explain the steps taken to ensure that a proposed IFRS has taken into account the costs and benefits of the new reporting practice that it introduces.Whats the impact?The IASB considers a variety of matters prior to the issue of a standard. These matters include how the changes improve the comparability of financial information and the assessment of the effect on an entitys future cashflows.Further considerations include whether the changes will result in better economic decision-making, the likely compliance costs for preparers, and the potential cost for users of extracting the data.On application of the new IFRS, investors will be provided with different information on which to base their decisions. Investors assessment of how management has discharged its stewardship responsibilities could be changed as could the cost of the entitys capital. This, in turn, could affect how investors vote at a shareholder meeting or influence their investment decisions. New financial reporting requirements may call for the disclosure of information that is of competitive advantage to third parties, which would be a cost to the entity.A change in an accounting standard could result in some entities no longer investing in certain assets or change how they contract for some activities. For example, the comment letters on the exposure draft on leases suggest that some entities would change their leasing arrangements if operating leases had to be shown on the balance sheet with adverse economic impacts including the loss of thousands of jobs.Further IFRS-based financial statements are used in contracts or regulation. Banking agreements often specify maximum debt levels or financial ratios that refer to figures prepared in accordance with IFRS. New financial reporting requirements can affect those ratios, with potential breach of contracts. Many jurisdictions have regulation that restricts the amount that can be paid out in dividends, by reference to accounting profit. Further, some governments use IFRS numbers for statistical and economic planning purposes and the data as evidence for constraints on profitability in regulated industries.Taxation is often calculated on the profit measured for financial reporting purposes. Where IFRS is used as the basis for income tax, a change in a standard can affect the tax base. The economic consequences of the link of accounting with tax liabilities can be significant. If the US Financial Accounting Standards Board (FASB) were no longer to permit use of the last-in first-out (LIFO) method, companies using LIFO would have to pay income taxes sooner because of the higher cost of sales under LIFO. The impact has been estimated to be greater than US$80bn if the tax law was not changed. However, neither the FASB nor the IASB base accounting policy decisions on taxconsequences.Some jurisdictions require an impact assessment before a new standard, or an amendment to a standard, is incorporated into the law. Such a review may take into account the increased administrative burden on entities in that country or its consistency with local company law.Financial statementsOn a micro level, where new and revised pronouncements are applied for the first time, there can be an impact on the drafting of the financial statements. The financial statements will need to reflect the new recognition, measurement and disclosure requirements. For example IFRS 10, Consolidated financial statements, was amended for annual periods beginning on or after 1 January 2014. This amendment provides an exemption from consolidation of subsidiaries for entities that meet the definition of an investment entity, such as some investment funds. Instead, such entities measure their investment in certain subsidiaries at fair value through profit or loss in accordance with IFRS 9, Financial instruments, or IAS 39, Financial instruments: recognition and measurement. The consequences of this amendment will be far-reaching for those entities.IAS 8, Accounting policies, changes in accounting estimates and errors, contains a general requirement that changes in accounting policies are fully retrospectively applied. However, this does not apply where there are specific transitional provisions. For example, when first applying IFRS 15, Revenue from contracts with customers, entities should apply the standard in full for the current period, including retrospective application to all contracts that were not yet complete at the beginning of that period.For prior periods, the transition guidance allows entities an option to either:1. apply IFRS 15 in full to prior periods (some limited practical expedients are available)2. retain prior period figures as reported under the previous standards, recognising the cumulative effect of applying IFRS 15 as an adjustment to the opening balance of equity as at the date of the beginning of the current reporting period.Further, IAS 8 requires the disclosure of a number of matters about the new IFRS. These include the title of the IFRS, the nature of the change in accounting policy, a description of the transitional provisions, and the amount of the adjustment for each financial statement line item that is affected.Additionally, IAS 1, Presentation of financial statements, requires a third statement of financial position to be presented if the entity retrospectively applies an accounting policy, restates items or reclassifies items, and those adjustments had a material effect on the information in the statement of financial position at the beginning of the comparative period.IAS 33, Earnings per share, requires basic and diluted earnings per share (EPS) to be adjusted for the impacts of adjustments resulting from changes in accounting policies accounted for retrospectively, and IAS 8 requires the disclosure of the amount of such adjustments. Where there are new accounting policies, the impact on the interim financial statements will not be as great as on the year-end accounts. However, IAS 34, Interim financial reporting, requires disclosure of the nature and effect of any change in accounting policies and methods of computation.Entity assessmentThe entity itself should prepare an impact assessment relating to the introduction of any new IFRS. There may be significant changes to processes, systems and controls, and management should communicate the impact to investors and other stakeholders. This would include plans for disclosing the effects of new accounting standards that are issued but not yet effective, as required by IAS 8. Audit committees have an important role in overseeing implementation of any new standard in theirorganisations.For example, under IFRS 15, an entity may need to evaluate its relationships with contract counterparties to determine whether a vendor-customer relationship exists. Existing revenue recognition policies will also need to be evaluated to determine whether any contracts within the scope of IFRS 15 will be affected by the new requirements.Where a new standard requires significantly more disclosures than current IFRS, the entity may want to understand whether it has sufficient information to satisfy the new disclosure requirements or whether new systems, processes and controls must be implemented to gather such information and ensure its accuracy. The entity should choose a path to implementation and establish responsibilities and deadlines. This may help to determine the accountability of the implementation team and allow management to identify gaps in resources.For example, IFRS 15 requires entities that select the full retrospective approach to apply the standard to each year presented in the financial statements. This will require entities to begin tracking revenue using the new standard from the current period to the effective date of 1 January 2017.Implementation timeA key thing about recent standards is that the IASB has given entities a reasonable amount of time to plan implementation. For example IFRS 9, Financial instruments, hasan effective date of 1January 2018. However, insurance companies will need this time to plan theirimplementation.The new IFRS 9 standard includes revised guidance about the classification and measurement of financial assets, including a new expected credit loss model for calculating impairment. It also supplements the new general hedge accounting requirements that were published in2013.Insurance companies will be greatly affected as they plan to adopt new standards on financial instruments and insurance contracts. However, before insurers reach conclusions about how they apply IFRS 9, they will want to consider its interaction with the forthcoming standard on insurance contracts.Accounting standards have economic effects, which can be beneficial for some entities and detrimental to others. The IASBs evaluation of costs and benefits are by nature qualitative. The quantitative effects should be anticipated by entities as they are the ones that will feel them.Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business SchoGetting the priorities rightEmail Print Twitter Facebook Linkedin Add This Related Links Multiple-choice questionsGraham Holt explores the ESMAs common enforcement priorities for 2014 financial statementsStudying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.The European Securities and Markets Authority (ESMA) has published the European common enforcement priorities 2014 that represent the key focus for examinations of the financial statements of listed companies by ESMA and European national enforcers.The common enforcement priorities for 2014 financial statements are: preparation and presentation of consolidated financial statements and related disclosures financial reporting by entities with joint arrangements and related disclosures recognition and measurement of deferred tax assets.These topics have been highlighted because of significant changes to accounting practices as a result of new standards, such as IFRS 10, Consolidated Financial Statements, IFRS 11, Joint Arrangements, and IFRS 12, Disclosure of Interests in Other Entities, and the challenges faced by issuers as a result of the current economc environment.The latter refers to the difficulty of forecasting future taxable profits for the purpose of determining deferred tax assets when there is a period of low economic growth. The priorities were identified after discussions with European national enforcers with a view to further increasing transparency in financial reports.National enforcers might also set additional enforcement priorities. ESMA will report on its priorities in 2015 and will review priorities identified in previous years. These include requirements related to the impairment of financial and non-financial assets, fair value measurement and disclosures on risks arising from financial instruments. In particular, ESMA reminds issuers of the specific requirements related to using cashflow projections and the disclosure of key assumptions when performing impairment tests of non-financial assets.ESMA pointed out that its 2013 report on comparability of institutions financial statements remains relevant to the 2014 financial statements. This report found that the required disclosures under International Financial Reporting Standards (IFRS) were generally observed, but also identified broad variations in the quality of the information provided. ESMA defines the European common enforcement priorities in order to promote consistent application of IFRS.ESMA still feels that financial statements are cluttered with excessive disclosure due to their general rather than entity-specific nature, or because they refer to transactions that are not relevant for the issuer. Its aim is not necessarily a decrease in the number of items disclosed, but rather clear and complete disclosures which are specific to an entity and necessary to understand its financial position. Entities should avoid too much aggregation and allow users to understand the consequences of economic events that affect the entity.The requirements of IFRS 10, IFRS 11, IFRS 12, amended IAS 27, Separate Financial Statements, and IAS 28, Investments in Associates and Joint Ventures, became mandatory in the EU for periods starting on or after 1 January 2014.IFRS 10 defines control as the situation when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. The principles relating to control are set out in IFRS 10 and the application guidance. ESMA feels both the standard and the application guidance should be considered when determining if control exists. This may require significant judgment to be made and issuers should carefully explain the judgments made in complex situations as required by IFRS 12.IFRS 12 requires disclosures to enable users to understand the nature of the non-controlling interests (NCI) in the groups activities and cashflows. Disclosures are expected to be sufficient which includes disclosure of the operating segments material NCIs have been allocated to.ESMA stresses the importance of the materiality assessment as well as the issuers judgment in determining the presentation of information. When a group presents a significant amount of NCIs, none of which are individually significant, ESMA encourages issuers to disclose and explain this. Issuers should disclose the nature and extent of any significant restrictions on their ability to access assets and settle liabilities. The amount of significant cash and cash equivalent balances held by the entity but not available for use by the group should also be disclosed.ESMA draws issuers attention to specific disclosure requirements with respect to the nature of, and changes in, the risks associated with their interests in consolidated and unconsolidated structured entities. IFRS 12 defines a structured entity as having been set up so that any voting or similar rights are not the dominant factor in deciding who controls the entity. For example, when voting rights relate only to administrative tasks and the relevant activities are directed by contractual arrangements. A structured entity often has some or all of the following features:1. restricted activities2. a narrow and well-defined objective3. insufficient equity to permit the entity to finance its activities without subordinated financial support4. financing in the form of multiple contractually linked instruments to investors that create concentrations of credit or other risks (tranches).The principal uses of structured entities are to provide clients with access to specific portfolios of assets and to provide market liquidity for clients through securitising financial assets. Structured entities may be established as corporations, trusts or partnerships. They generally finance the purchase of assets by issuing debt and equity securities that are collateralised by and/or indexed to the assets held by the structured entities.The debt and equity securities issued by structured entities may include varying levels of subordination. Structured entities are consolidated when the substance of the relationship between a group and the structured entities indicate that the entities are controlled by the group. The disclosures for these entities are wider and deeper than for unstructured ones.IFRS 11 sets out criteria which determines the classification of joint arrangements as either joint operations or joint ventures. The basis of the classification is the rights and obligations of the parties to the arrangement, rather than, as previously, the legal form. This requires consideration of the structure, terms, conditions and the legal form of the arrangement, and other facts and circumstances.When assessing other facts and circumstances, the focus should be on whether they create rights to the assets and obligations for the liabilities. It is possible for two joint arrangements with similar characteristics to be classified differently depending on their structure.The IFRS Interpretations Committee has considered various issues arising from the implementation of IFRS 11, and ESMA has recommended that issuers review the findings of these discussions when preparing their 2014 financial statements. ESMA expects issuers to provide disclosures about significant judgments and assumptions regarding the joint arrangement and information relating to the nature, extent and financial effects of its interests in joint arrangements.The first-time adoption of IFRS 10 and IFRS 11 might change the assessment as to whether to consolidate an investee. This could be the case where a different conclusion is reached over whether control is achieved by an investor holding less than a majority of voting rights in an investee. If this is the case, the factors that led to the change should be disclosed and the changes dealt with in accordance with IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors.IAS 31 allowed the use of proportionate consolidation, outlawed by IFRS 11. A change of accounting policy may occur as a result of joint ventures now being accounted for using the equity method. IFRS 10 introduces an exception to the consolidation requirement for investment entities. Issuers are expected to be very specific about how they arrived at any judgment not to consolidate.The current economic climate could result in the recognition of tax losses or the existence of deductible temporary differences where perhaps impairments are not yet deductible for tax purposes. The recognition of deferred tax assets requires detailed consideration of the carry forward of unused tax losses, whether future taxable profits exist, and the need for disclosing judgments made in these circumstances.IAS 12, Income Taxes, limits the recognition of a deferred tax asset to the extent that future taxable profits will probably be available against which the deductible temporary difference can be utilised. IAS 12 says the existence of unused tax losses is strong evidence that future taxable profit might not be available. Therefore, recent losses make the recognition of deferred tax assets conditional on the existence of convincing other evidence.The probability that future taxable profit will be available to utilise the unused tax losses will need to be reviewed and if convincing evidence is available, there should be disclosure of the amount of a deferred tax asset and the nature of the evidence. ESMA feels it is particularly relevant to disclose the period used for the assessment of the recovery of a deferred tax asset as well as the judgments made. ESMA also expects issuers to disclose their accounting policy relating to material uncertain tax positions.As well as ESMA, national enforcers will continue to focus on material issues in the financial statements and will take corrective actions if material misstatements are identified.Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business SchoolIFRS 9 - the final versionEmail Print Twitter Facebook Linkedin Add This Related Links Multiple-choice questionsPutting the IFRS 9 requirements which will affect all sectors, but mostly banks into practice will be a challenge, says Graham HoltStudying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.In July, the International Accounting Standards Board (IASB) completed its response to the financial crisis by issuing the final version of IFRS 9, Financial Instruments. IFRS 9 sets out a model for classification and measurement, an expected loss impairment model and a transformed approach to hedge accounting. The IASB had previously issued versions of IFRS 9 that introduced new classification and measurement requirements in 2009 and 2010 and a new hedge accounting model in 2013. The latest publication consolidates the previous versions of the standard, and replaces IAS 39, Financial Instruments: Recognition and Measurement.It also changes some of therequirements of the previous publications. IFRS 9 is effective for annual periods beginning on or after1 January 2018.Classification determines how financial assets and financial liabilities are accounted for and measured in financial statements. The requirements for impairment and hedge accounting are based upon the instruments classification.The standard introduces a principle-based system for the classification and measurement of financial assets, which depends upon the entitys business model for managing the financial asset and the financial assets contractual cashflow characteristics.IFRS 9 utilises a single classification approach for all types of financial assets, which includes those that contain embedded derivative features. Financial assets are now not subject to complicated bifurcation requirements.The business model approach refers to how an entity manages its financial assets in order to generate cashflows either by collecting contractual cashflows, selling financial assets or both. Financial assets are measured at amortised cost, where the business models objective is to hold assets in order to collect contractual cashflows. The new standard clarifies the existing guidance on the collection of the assets contractual cashflows.When determining the applicability of this business model, an entity should consider past and future sales information.If an entity holds financial assets for sale, then it will fail the business model test for accounting for the financial assets at amortised cost. However, sales activity is not necessarily inconsistent with the business model if they are infrequent and insignificant in value but, where these sales are frequent and significant in value, an entity needs to assess whether such sales are consistent with an objective of collecting contractual cashflows.The sales may be consistent with that objective if they are made close to the maturity of the financial assets and the proceeds from the sales approximate the collection of the remaining contractual cashflows.For many entities, the assessment will be relatively straightforward, as their financial assets may be simply trade receivables and bank deposits for which the amortised cost criteria are likely to be met. For those entities with a broader range of financial assets such as investors in debt securities, and insurance companies, the motivations behind the disposal of the assets will have to be considered.IFRS 9 includes a new measurement category whereby financial assets are measured at fair value through other comprehensive income (FVTOCI).This category is used when financial assets are held in a business model whose objective is both collecting contractual cashflows and selling financial assets. Unlike the available-for-sale criteria in IAS 39, the criteria for measuring at FVTOCI are based on the financial assets cashflow characteristics and the entitys business model.This business model will involve a greater frequency and volume of sales with the possible objectives of managing liquidity or matching the duration of financial liabilities to the duration of the assets they are funding.This category was introduced because of the concerns raised by preparers who sold financial assets in greater volume than was consistent with the previous business model and would, without this category, have to record such assets at fair value through profit or loss. (FVTPL).Financial assets may qualify for amortised cost or FVOCI only if they give rise to solely payments of principal and interest (SPPI) under the contractual cashflows characteristics test. Many instruments have features that are not in line with the SPPI condition. IFRS 9 makes it clear that such features are disregarded if they are non-genuine or de minimis.IFRS 9 now provides more guidance on SPPI. For contractual cashflows to be SPPI, they must include returns that are consistent with the return on a basic lending arrangement to the holder, which generally includes consideration for the time value of money, credit risk, liquidity risk, a profit margin and consideration for costs associated with holding the financial asset over time such as servicing costs. Thus if the contractual arrangement includes a return for equity price risk, then this would be inconsistent with SPPI.IFRS 9 introduces guidance on how the contractual cashflows characteristics assessment applies to debt instruments that may contain a modified time value element; for example, those instruments that may contain a variable interest rate.These characteristics will result in an instrument failing the contractual cashflow characteristics test if the resulting undiscounted contractual cashflows could be significantly different from the undiscounted cashflows of a benchmark instrument that does not have such features.Interest rates set by a government or a regulatory authority are accepted as a proxy for the consideration for the time value of money if those rates provide consideration that is broadly consistent with consideration for the passage of time. Such cashflows are considered SPPI as long as they do not introduce risk or volatility, which is inconsistent with a basic lending arrangement.Any financial assets not held in one of the two business models above are measured at FVTPL, which is essentially a residual category. Also included in this category are financial assets that are held for trading and those managed on a fair-value basis. Financial assets are reclassified when the entitys business model for managing them changes. This is not expected to occur frequently and it ensures that users of financial statements are provided with information on the realisation of cashflows.IAS 39 was felt to work well as regards the accounting for financial liabilities; therefore the IASB felt there was little need for change. Thus most financial liabilities will continue to be measured at amortised cost. IAS 39 also permitted entities to elect to measure financial liabilities at fair value through profit or loss (fair-value option).The changes introduced by IFRS 9 are restricted to those liabilities designated at FVTPL using the fair-value option. Fair-value changes of these financial liabilities are presented in other comprehensive income to the extent that they are attributable to the change in the entitys own credit risk. If this would cause an accounting mismatch, then the total fair-value change is presented in profit or loss.This change is designed to eliminate volatility in profit or loss caused by changes in the credit risk of financial liabilities that an entity has elected to measure at fair value.IFRS 9 introduces an impairment model for financial assets that is based on expected losses rather than incurred losses. It applies to amortised-cost financial assets and those categorised as FVTOCI. It also applies to certain loan commitments, financial guarantees, lease receivables and contract assets. An entity recognises expected credit losses at all times and updates the assessment at each reporting date to reflect any changes in the credit risk. It is no longer necessary for there to be a trigger event for credit losses to be recognised and the same impairment model is used for all financial instruments that are impairment tested.Other than purchased or originated credit-impaired financial assets, IFRS 9 requires entities to measure expected credit losses by recognising a loss allowance equal to either:1. 12-month expected credit losses. This measurement is required if the credit risk is low at the reporting date or the credit risk has not increased significantly since initial recognition.2. Full lifetime expected credit losses. This measurement is required if the credit risk has risen significantly since recognition and the resulting credit quality is not considered to be low credit risk. Entities can elect for an accounting policy of always recognising full lifetime expected losses for contract assets, trade receivables, and lease receivables. When measuring expected credit losses, an entity should consider the probability-weighted outcome, the time value of money and information that is available without undue cost or effort.IFRS 9 introduces a reformed model for hedge accounting with enhanced disclosures about risk management activity. Under IFRS 9, a hedging relationship qualifies for hedge accounting only if all of these criteria are met: the hedging relationship consists only of eligible hedging instruments and eligible hedged items at its inception there is formal designation and documentation of the hedging relationship and the entitys risk management objective and strategy for undertaking the hedge the relationship meets all of the hedge effectiveness requirements. The hedge relationship must meet the effectiveness criteria at the beginning of each hedged period to qualify for hedge accounting there is an economic relationship between the hedged item and the hedging instrument the effect of credit risk does not dominate the value changes that result from that relationship the hedge ratio of the hedging relationship is the same as that used in the economic hedge.IFRS 9 will affect all sectors through the introduction of an expected loss model for loan loss provisioning, but will impact mostly on banks. It should give investors better insight into the credit quality of all financial assets.Putting the new requirements into practice by the effective date, however, will be quite a challenge.

Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business SchoolWhat is fair value?Email Print Twitter Facebook Linkedin Add This Related Links Multiple-choice questionsAn overview of the key concepts and practical guidance for SFRS 113 Fair Value Measurement including valuation techniquesStudying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.For many years, preparers of financial statements have grappled with the issues associated with measuring fair value because several financial reporting standards require (or permit) reporting entities to measure (or disclose) assets or liabilities at fair value. Singapore FRS 113 Fair Value Measurement (SFRS 113) was issued to provide guidance about how to measure fair value and information to be disclosed.As this standard is to be applied prospectively for annual periods on or after 1 January 2013, Singapore entities presenting financial statements from 2014 onwards will be affected.SFRS 113 establishes how to measure fair value. It does not address which assets or liabilities to measure at fair value, or when it must be performed. The reporting entity must look to other financial standards in this regard.This article is not intended to address comprehensively all of the detailed requirements of this standard, but rather toprovide an overview of the key concepts and practical guidance.ScopeSFRS 113 applies whenever another financial reporting standard requires (or permits) the measurement of fair value, including ameasure that is based on fair value, i.e. fair value lesscost.For example, SFRS 103 Business Combinations requires identifiable assets acquired and liabilities assumed to be measured at fair value for purchase price allocation. Investment properties areto be measured at fair value ateach reporting date under SFRS 40 Investment Property.However, this standard does not apply to share-based payment and leasing transactions. Also, measurements that are similar to fair value, but are not fair value (such as net realisable value in SFRS 2 Inventories or value in use in SFRS 36 Impairment of Assets) are not applicable.The term fair value isused throughout FRS. Given that there are few scope exclusions, this standard ispervasive.Definition of fair valueFair value is defined 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.Fair value is a current exit price, not an entry price (see diagram, above). The exit price for an asset (or liability) is conceptually different from its transaction price (or entry price). While the exit and entry price may be identical in many situations, the transaction price is not presumed to represent fair value. For example, the last transacted price for a thinly traded quoted investment may not reflect fair value.The exit price objective of a fair value measurement applies regardless of the reporting entitys intent and/or ability to sell the asset (or transfer the liability). Fair value is the exit price in the principal market, or in the absence, the most advantageous market.Fair value is not based on how much an entity has to pay to settle a liability. Instead, it should be based on how much the reporting entity has to pay a market participant who is willing to take over the liability.The transaction to sell the asset (or transfer the liability) is assumed to be orderly between market participants under normal current market conditions. Information that becomes known after measurement date is not normally taken into account.Market participants are buyers and sellers in the principal (or most advantageous) market whoare: (i) independent of each other; (ii) knowledgeable about the asset or liability; and (iii) able and willing to enter intoa transaction for the asset or liability.In other words, fair value is a market-based measurement, not an entity-specific measurement. For example, synergies available to a specific buyer are not considered in the valuation of an interest in an unquoted investment.Fair value frameworkMany of the key components used in the fair value framework are interrelated and their interaction should be considered holistically. The overall process for determining fair value under SFRS 113 may be illustrated by the diagram above.In practice, navigating thefair value framework may be more straightforward for certain types of assets (e.g. quoted investments) than for others (e.g. intangible assets).The unit of account defines what is being measured for financial reporting and this is normally determined by the applicable financial reporting standard. Fair value may need to be measured for either a standalone asset (orliability) or a group of assets (or liabilities), i.e. acash-generating unit.For example, a reporting entity that manages a group of financial assets and financial liabilities with offsetting risks on the basis of its net exposure to market may elect to measure the group based on the price that would bereceived to sell its net long position.The principal market is the market for the asset (or liability) that has the greatest volume or level of activity. To determine the principal market, management needs to evaluate the level of activity in various markets. The market in which an entity normally transacts ispresumed to be the principal market.In the absence of a principal market, management needs to identity the most advantageous market, which is one that maximises the amount that would be received to sell the asset, after taking into account transaction costs and transport costs.The standard is clear that, if there is a principal market for the asset (or liability), the price in that market represents fair value. The standard prohibits adjusting fair value for transaction costs incurred, but it does require such transaction costs to be considered in determining the most advantageous market. For example, agents commission, legal fees and stamp duty are not deducted from the price used to fair value realestate.There may be no known or observable market for an asset or liability. For example, there may be no specific market for the sale of a CGU or intangible asset. In such cases, management needs to develop a hypothetical market and identify potential market participants.The concepts of highest and best use and valuation premise are only applicable when determining the fair value of non-financial assetse.g. property, plant and equipment.The fair value hierarchy categorises the inputs used into three levels. A reporting entity is required to maximise the use of Level 1 inputs (i.e. unadjusted prices in active markets, like stock price quoted on SGX) and minimise the use of Level 3 inputs (i.e. unobservable assumptions like projected cashflows). The best indication of fair value is a quoted price in an active market. This categorisation is relevant fordisclosure purposes.While the availability of inputs might affect the valuation techniques selected to measure fair value, the standard does not prioritise the use of onevaluation approach overanother.Valuation techniquesThree valuation approaches are widely used to measure fair value, namely the market approach, the income approach and thecost approach.

Market approach: The market approach is a widelyused valuation technique and is defined as uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.Valuation techniques consistent with the market approach use prices from observed transactions for the same or similar assets e.g. P/E and P/EBIDTA multiples. Another example of a market approach is matrix pricing, which is normally used to value certain types of financial instruments e.g. debt securities estimated using transaction prices and other relevant market information like coupon, maturity and credit rating.

Income approach: The income approach converts future cashflows or income and expenses to a discounted amount. A fair value using this approach will reflect current market expectations about future cashflows or income and expenses.Valuation techniques include: Present value techniques e.g. discount rate adjustment rate technique and expected present value technique Options pricing models e.g. Black-Scholes-Merton Multi-period excess earnings method Relief from royalties methodThe standard does not limit the valuation techniques that are consistent with the income approaches. It provides some application guidance, but only in relation to present value techniques.

Cost approach: The cost approach reflects the amount that would be required currently to replace the service capacity of an asset. This approach is often referred to as current replacement cost and is typically used to measure the fair value of tangible assets such as plant and equipment.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.Obsolescence is broader than depreciation and encompasses: Physical deterioration Functional/technological obsolescence Economic obsolescenceThese three approaches are consistent with generally accepted valuation methodologies used outside financial reporting.The determination of the appropriate technique(s) to be applied requires significant judgment, sufficient knowledge of the asset (or liability) and an adequate level of expertise regarding valuation techniques. Within a given approach, there may be a number of possible valuation methods.For instance, there are a number of different methods used to value intangible assets under the income approach, namely the multi-period excess earnings method and the relief from royalty method, depending on the nature of the asset.Selection, application and evaluation of the valuation techniques can be complex. As such, the reporting entity may need assistance from valuation professionals.Regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same, that is, an exit price under current market conditions from the perspectives of market participants.Premiums and discountsIn certain instances, selection of inputs could result in a premium or discount being incorporated into the fair value measurement. The standard distinguishes between premiums or discounts that reflect size as a characteristic (especially blockage factor), control premium/discount for minority interest and discount for lack of marketability.The standard explicitly prohibits the consideration of blockage discounts in fair value measurement. Blockage discount is an adjustment to the quoted price of an asset because the markets normal trading volume is not sufficient to absorb the quantity held by a reporting entity.When measuring the fair value of interest in private business, control premium/discount for minority interest and discount for lack of marketability can be taken into consideration.Fair value of a liabilitySFRS 113 applies to liabilities, both financial (e.g. debt obligation) and non-financial (e.g. decommissioning liability), whenever a standard requires those instruments to be measured at fair value.For example, in accordance with FRS 103 Business Combination, management needs to determine the fair value ofliabilities assumed whencontemplating a purchase price allocation.The fair value measurement of a liability contemplates the transfer of the liability to a market participant at the measurement date. The liability is assumed to continue (i.e. it is not settled or extinguished), and the market participant to whom the liability is transferred would be required to fulfil the obligation.The fair value of a liability also reflects the effect of non-performance risk. Non-performance risk is the risk that an obligation will not be fulfilled and includes the reporting entitys own credit risk and other risks such as settlement risk.For example, there is no observable price available for a decommissioning liability. Hence, the reporting entity might consider the future cash outflows that a market participant would expect to incur in fulfilling the obligation, discounted at arate, which reflects the risk-free rate and risk premium to reflect its creditrisk, i.e. a present value technique.Concluding thoughtsSFRS 113 provides a framework to estimating fair value. It is intended toreduce inconsistencies and increase comparability in fair value measurements used in financial reporting. However, it does not provide specific rules or detailed how to guidance. Hence, judgment is involved in estimating fair value.The effect of applying this standard is likely to vary from entity to entity. Inmost cases, it will lead to a refinement of previous practice. However, in some cases, the change may be more significant. For example, if a reporting entity did not consider the highest and best use when revaluing its plant and equipment, adopting this standard could result in a higher fair value than it would have previously determined.

Ong Woon Pheng is a partner at CAS Consultants Pte Ltd heading the financial advisory servicesdepartmentAll changeEmail Print Twitter Facebook Linkedin Add This Related Links Multiple-choice questionsDont be fooled; changes to IAS 16, IAS 38 and IFRS 11 will have a profound effect on some entities, explains Graham HoltStudying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.This article was first published in the July/August 2014 UK edition of Accounting and Business magazine.In May 2014, the International Accounting Standards Board (IASB) issued two amendments to standards, entitled Clarification of Acceptable Methods of Depreciation and Amortisation (Amendments to IAS 16 and IAS 38) and Accounting for Acquisitions of Interests in Joint Operations (Amendments to IFRS 11). At first sight, these amendments may not seem to be of significance; however, to some entities they will have a profoundeffect.A variety of depreciation methods are used to allocate the depreciable amount of an asset over its useful life. These methods include the straight-line method, the diminishing balance method and the units of production method. The method used is selected on the basis of the expected pattern of consumption of the expected future economic benefits and is applied consistently, unless there is a change in the expected pattern of consumption.The IASB decided to amend IAS 16, Property, Plant and Equipment, to address issues that had arisen over the use of a revenue-based method for depreciating an asset. This is a method that is based on revenues generated in an accounting period as a proportion of the total revenues expected to be generated over the assets useful economic life.ClarificationThe total revenue takes into account any anticipated changes due to price inflation but the IASB felt that inflation has no bearing on the way in which an asset is consumed. The amendment came as a result of a request to clarify the meaning of consumption of the expected future economic benefits embodied in the asset when deciding on the amortisation method to be used for intangible assets of service concession arrangements. IAS 16 requires the depreciation method to reflect the pattern in which the assets future economic benefits are expected to be consumed by the entity.Revenue may be a measurement of the output generated by the asset, but does not represent the way in which an item of PPE is used. Such methods reflect a pattern of generation of economic benefits that arise from the operation of the business of which an asset is part, rather than the pattern of consumption of an assets expected future economic benefits.The IASB concluded that a method of depreciation that is based on revenue generated from an activity that includes the use of an asset is not appropriate, but that the diminishing balance method is an accepted depreciation method. This has the capability of reflecting accelerated consumption of the future economic benefits in the asset.This latter conclusion regarding the diminishing balance method was a clarification due to concerns raised by Committee members who questioned whether the proposed amendment, given the influence of a pricing factor, would limit the ability to apply a diminishing balance depreciation method to manufacturing equipment.The original exposure draft proposed that there might be circumstances in which a revenue-based method gave the same result as a units-of-production method. This statement was thought to contradict the proposed amendments and so wasdropped.The principle in IAS 38, Intangible Assets, is that an amortisation method should reflect the pattern of consumption of the expected future economic benefits and not the pattern of generation of expected future economic benefits. IAS 38 is therefore amended to introduce a rebuttable presumption that a revenue-based amortisation method for intangible assets is inappropriate for the same reasons as in IAS 16. However, there are limited circumstances when this presumption can be overturned. They are where the intangible asset is expressed as a measurement of revenue and where it can be demonstrated that revenue and the consumption of the intangible asset is directly linked to the revenue generated from the asset.Both standards now contain an explanation that expected future reductions in selling prices might be indicative of an increased rate of consumption of the future economic benefits of that asset. The amendments are effective for annual periods beginning on or after 1 January 2016 with earlier application permitted. Full retrospective application of the amendments would have been too onerous for some entities.Outstanding issuesIn 2011, the IASB issued IFRS 11, Joint Arrangements, which introduced several changes. Principally, there are now only two types of joint arrangements, which are joint ventures and joint operations.Further, proportionate consolidation is no longer permitted for arrangements classified as joint ventures, as equity accounting has to be applied. Although the standard deals with most issues arising out of the accounting for joint operations, there are certain matters that it does not address. A key issue is accounting for the acquisition of an interest in a joint operation, which represents a business. As both IFRS 11 and its predecessor, IAS 31, Joint Ventures, did not deal with the issue, significant diversity in practice has occurred. The approaches used in practice in accounting for a joint operation, which constituted a business, were as follows:1. IFRS 3, Business Combinations, approach: identifiable assets and liabilities were normally measured at fair value and goodwill recognised. Additionally, transaction costs were not capitalised and deferred taxes were recognised on initial recognition of assets and liabilities. The guidance in IFRS 3 was not followed where it was not appropriate; for example, in this situation there would not be non-controlling interests.2. Cost approach: the total cost of acquiring the interest in the joint operation was allocated to the individual identifiable assets on the basis of their relative fair values. The premium paid, if any, was allocated to the identifiable assets and not recognised as goodwill. Transaction costs were capitalised and deferred taxes were not recognised as per the exception in IAS 12, Income Taxes.3. Hybrid approach: preparers in this group applied IFRS 3 and other IFRSs selectively with the result that mainly identifiable assets and liabilities were measured at fair value and goodwill was recognised.Transaction costs were capitalised with contingent liabilities and deferred taxes generally not recognised.This diversity has led to different treatments of any premium paid on acquisition, recognition or non-recognition of any deferred taxes arising on acquisition and acquisition costs being capitalised orexpensed.As a result of the above diversity, the IFRS Interpretations Committee was asked to clarify whether the acquirer of such interests in joint operations should apply the principles in IFRS 3 or whether the acquirer should account for it as a group of assets. The committee referred the matter to the IASB, suggesting that the most appropriate approach was to apply the relevant principles for business combinations in IFRS 3 and other IFRSs.Defining a businessOne of the key judgments is whether the activities of the joint operation, or the set of activities and assets contributed to the joint operation on its formation, represent a business as defined by IFRS 3.IFRS 3 defines a business as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.Further guidance explains that a business is a series of inputs and processes applied to those inputs that have the ability to create outputs. However, outputs are not required for the activities to qualify as a business. An output should have the ability to provide a return in the form of dividends, lower costs or other economic benefits to owners.The assessment of whether a set of activities and assets represent a business is still extremely judgmental.As a result of the IASBs deliberations, an amendment to IFRS 11 has been made. Accounting for Acquisitions of Interests in Joint Operations (Amendments to IFRS 11) requires that the acquirer of an interest in a joint operation which constitutes a business, as defined in IFRS 3, is required to apply all of the principles in IFRS 3 and other IFRSs with the exception of those principles that conflict with the guidance in IFRS 11. As a result, a joint operator that has acquired such an interest has to: measure most identifiable assets and liabilities at fair valueexpense acquisition-related costs (other thandebt or equity issuance costs) recognise deferred taxes recognise any goodwill or bargain purchase gain perform impairment tests for the cash-generating units to which goodwill has been allocated disclose information required relevant for business combinations.The amendments apply to the acquisition of an interest in an existing joint operation and also to the acquisition of an interest when a joint operation is formed. IFRS 1, First-time Adoption of International Financial Reporting Standards, has also been amended to extend the business combination exemptions. The amendments are effective for annual periods beginning on or after 1 January 2016 and apply prospectively.For some companies, the amendment will represent a significant change to current practice and will present a number of challenges as a result of having to apply business combinations accounting, while others relate to the nature of the proposed amendment itself. For example, joint arrangements are common in the mining and metals sector; therefore any changes in the accounting can have wide-ranging implications. Some key implications for those companies are the increased time, cost and effort needed to determine fair values for the identifiable assets acquired and liabilities assumed. This in turn will lead to changes in the profiles of the financial statements and the need for more detailed recordkeeping.Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business SchoolCatering to user demandsEmail Print Twitter Facebook Linkedin Add This Related Links Multiple-choice questionsThere are some significant changes to previous ASB proposals in the standards bodys latest plans to reshape financial reporting in the UK and Ireland, says Graham Holt Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.This article was first published in the June 2014 UK edition of Accounting and Business magazine.For many years, regulators and standard-setters have grappled with the issue of how entities should best present financial performance and not mislead the user. Many jurisdictions have enforced a standard format for performance reporting, with no additional analysis permitted on the face of the income statement. Others have allowed entities to adopt various methods of conveying the nature of underlying or sustainable earnings.Although financial statements are prepared in accordance with applicable financial reporting standards, users are demanding more information and issuers seem willing to give users their understanding of the financial information. This information varies from the disclosure of additional key performance indicators of the business to providing more information on individual items within the financial statements. These additional performance measures (APMs) can assist users in making investment decisions, but they dohave limitations.Common practiceIt is common practice for entities to present APMs, such as normalised profit, earnings before interest and tax (EBIT) and earnings before interest, tax, depreciation and amortisation (EBITDA). These alternative profit figures can appear in various communications, including company media releases and analyst briefings. Alternative profit calculations normally exclude particular income and expense items from the profit figure reported in the financial statements. Also, there could be the exclusion of income or expenses that are considered irrelevant from the viewpoint of the impact on this years performance or when considering the expected impact on future performance.An example of the latter has been gains or losses from changes in the fair value of financial instruments. The exclusion of interest and tax helps to distinguish between the results of the entitys operations and the impact of financing and taxation.These APMs can help enhance users understanding of the companys results and can be important in assisting users in making investment decisions, as they allow them to gain a better understanding of an entitys financial statements and evaluate the entity through the eyes of the management. They can also be an important instrument for easier comparison of entities in the same sector, market or economic area.However, they can be misleading due to bias in calculation, inconsistency in the basis of calculation from year to year, inaccurate classification of items and, as a result, a lack of transparency. Often there is little information provided on how the alternative profit figure has been calculated or how it reconciles with the profit reported in the financial statements.The APMs are also often described in terms which are neither defined by issuers nor included in professional literature and thus cannot be easily recognised by users.APMs include: all measures of financial performance not specifically defined by the applicable financial reporting framework all measures designed to illustrate the physical performance of the activity of an issuers business all measures disclosed to fulfil other disclosure requirements included in public documents containing regulated information.An example demonstrating the use of APMs is the financial statements of Telecom Italia Group for the year ended 31 December 2011. These contained a variety of APMs as well as the conventional financial performance measures laid down by International Financial Reporting Standards. The non-IFRS APMs used in the Telecom Italia statements were:EBITDA. Used by Telecom Italia as the financial target in its internal presentations (business plans) and in its external presentations (to analysts and investors). The entity regarded EBITDA as a useful unit of measurement for evaluating the operating performance of the group and the parent.Organic change in revenues, EBITDA and EBIT. These measures express changes in revenues, EBITDA and EBIT, excluding the effects of the change in the scope of consolidation, exchange differences and non-organic components constituted by non-recurring items and other non-organic income and expenses. The organic change in revenues, EBITDA and EBIT is also used in presentations to analysts and investors.Net financial debt. Telecom Italia saw net financial debt as an accurate indicator of its ability to meet its financial obligations. It is represented by gross financial debt less cash and cash equivalents and other financial assets. The report on operations includes two tables showing the amounts taken from the statement of financial position and used to calculate the net financial debt of the group and parent.Adjusted net financial debt. A new measure introduced by Telecom Italia to exclude effects that are purely accounting in nature resulting from the fair value measurement of derivatives and related financial assets and liabilities.Evaluating APMsThe International Accounting Standards Board (IASB) is undertaking an initiative to explore how disclosures in IFRS financial reporting can be improved. The project has started to look at possible ways to address the issues arising from the use of APMs. This initiative is made up of a number of projects. It will consider such things as adding an explanation in IAS 1 that too much detail can obscure useful information and adding more explanations, with examples, of how IAS 1 requirements are designed to shape financial statements instead of specifying precise terms that must be used. This includes whether subtotals of IFRS numbers such as EBIT and EBITDA should be acknowledged in IAS 1.In the UK, the Financial Reporting Council supports the inclusion of APMs when users are provided with additional useful, relevant information. In contrast, the Australian Financial Reporting Council feels that such measures are outside the scope of the financial statements. In 2012, the Financial Markets Authority (FMA) in the UK issued a guidance note on disclosing APMs and other types of non-GAAP financial information, such as underlying profits, EBIT and EBITDA.APMs appear to be used by some issuers to present a confusing or optimistic picture of their performance by removing negative aspects. There seems to be a strong demand for guidance in this area, but there needs to be a balance between providing enough flexibility, while ensuring users have the necessary information to judge the usefulness of the APMs.To this end, the European Securities and Markets Authority (ESMA) has launched a consultation on APMs. The aim is to improve the transparency and comparability of financial information while reducing information asymmetry among the users of financial statements. ESMA also wishes to improve coherency in APM use and presentation and restore confidence in the accuracy and usefulness of financial information.ESMA has therefore developed draft guidelines that address the concept and description of APMs, guidance for the presentation of APMs and consistency in using APMs. The main requirements are: Issuers should define the APM used, the basis of calculation and give it a meaningful label andcontext. APMs should be reconciled to the financial statements. APMs that are presented outside financial statements should be displayed with less prominence. An issuer should provide comparatives for APMs and the definition and calculation of the APM should be consistent over time. If an APM ceases to be used, the issuer should explain its removal and the reasons for the newly defined APM.However, these guidelines may not be practicable when the cost of providing this information outweighs the benefit obtained or the information provided may not be useful to users. Issuers will most likely incur both implementation costs and ongoing costs. Most of the information required by the guidelines is already collected for internal management purposes, but may not be in the format needed to satisfy the disclosure principles.ESMA believes that the costs will not be significant because APMs should generally not change over periods. Therefore, ongoing costs will relate almost exclusively to updating information for every reporting period. ESMA believes that the application of these guidelines will improve the understandability, relevance and comparability of APMs.Application of the guidelines will enable users to understand the adjustments made by management to figures presented in the financial statements. ESMA believes that this information will help users to make better-grounded projections and estimates of future cashflows and assist in equity analysis and valuations. The information provided by issuers in complying with these guidelines will increase the level of disclosures, but should lead issuers to provide more qualitative information. The national competent authorities will have to implement these guidelines as part of their supervisory activities and provide a framework against which they can require issuers to provide information about APMs.Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business SchoolAdding valueEmail Print Twitter Facebook Linkedin Add This Related Links Multiple-choice questionsThe IASBs practice statement on management commentary and the MASBs SOP 3 provide a framework, explains Ramesh Ruben LouisStudying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.This article was first published in the June 2014 Malaysia edition of Accounting and Business magazine. The users of financial information come in all shapes and sizes, with distinct needs and expectations. Many generally look for information that enables them to better understand what has taken place in the organisation, as well as to get a sneak peak at its potential, prospects and future plans.With this in mind, the International Accounting Standards Board (IASB) issued a practice statement on Management Commentary on 8 December 2010, thereafter issued in Malaysia by the Malaysian Accounting Standards Board (MASB) as Statement of Principles 3 Management Commentary (SOP 3) on 28 February 2013, which is equivalent to the IASBs International Financial Reporting Standard (IFRS) practice statement.BackgroundIt is important to note that the practice statement/SOP 3 is not a financial reporting standard but instead provides a broad, non-binding framework for the presentation of management commentary to accompany financial statements prepared usingIFRS/MFRS, which may also be applied bynon-listed entities that prepare IFRS financial statements that include management commentary.A management commentary is a narrative report that provides information to interpret the financial position, financial performance and cashflows of an entity. It also provides management with an opportunity to explain its objectives and its strategies for achieving those objectives. Users routinely use the type of information provided in management commentary to help them evaluate an entitys prospects and its general risks, as well as the success of managements strategies for achieving its stated objectives.The underlying principle of management commentary is to provide managements view of the entitys performance, position and progress; and to supplement and complement information presented in the financial statements. This is best achieved when the commentary is forward looking and provides qualitative characteristics that supplement and complement information contained in the financial statements providing additional explanations of amounts presented in the financial statements and including information that is not presented there. Ultimately, the information should be useful for decisionmaking.Management commentary should be clearly identified and distinguished from other information (say, in theannual report) and should incorporate a statement on the extent of compliance with the practice statement/SOP 3.The practice statement/SOP 3 sets out five key elements that are regarded as crucial information for the understanding of the users.Presentation of management commentaryWhile the practice statement/SOP 3 sets out the principles, qualitative characteristics and elements that are essential in providing users of financial reports with useful information, the form and content of management commentary may vary by entity, depending on the particular circumstances of their business, including the legal and economic circumstances of individual jurisdictions. This flexible approach is envisaged to generate more meaningful disclosure relating to matters that are most relevant to their individual circumstances.Whatever the form chosen, the management commentary should: address the principles and five key elements set out in the practice statement/SOP 3 be consistent with its related financial statements. For example, if the financial statements include segment information, the information presented in the management commentary should reflect that segmentation avoid duplication of disclosures made in the notes to its financial statements in its management commentary avoid generic disclosures that do not relate to the practices and circumstances of theentity and insignificant disclosures.Nature of businessUsually set forth as a starting point for users to assess and understand an entitys performance, strategic options and prospects, this element encompasses a description of the business to help users of the financial reports gain an understanding of the entity and the external environment in which it operates. Among others, this would entail a discussion of macro-level information such as:1. the industries in which the entity operates2. the entitys main markets and competitive position within those markets3. significant features of the legal, regulatory and macroeconomic environments that influence the entity and the markets in which the entity operates, and micro-level information4. the entitys main products, services, business processes and distribution methods5. the entitys structure and how it creates value.Managements objectives and strategiesUnder this element, management should disclose information to enable users to assess the strategies adopted by the entity and the likelihood that those strategies will be successful in meeting managements stated objectives, including action to be undertaken and resources that must be managed to deliver results. For example, information about how management of a mobile phone company intends to address new technology, rapid consumer behaviour and expectations, and its related threats and opportunities, provides users of financial reports with insight that can help in their assessment of the entitys future performance. Managements measurement of success and time frame to achieve those objective and strategies should also bediscussed.Management should discuss significant changes in an entitys objectives and strategies from the previous period or periods. Discussion of the relationship between objectives, strategy, management actions and executive remuneration is also helpful.The discussion in this section will likely not be lengthy as many entities would consider that a detailed discussion would risk divulging commercially sensitive information andgive away competitiveadvantage.Resources, risks and relationshipsAn entitys value has a direct correlation to how it manages its resources, risksand relationships. Therefore, information in these three areas would provide users with a better appreciation of the entitys management capabilities.Management should set out critical financial and non-financial resources (such as its employees) available to the entity and how they are used in meeting managements stated objectives as well as its long-term sustainability. Analysis of the adequacy of the entitys capital structure, financial arrangements (whether or not recognised in the statement of financial position), liquidity and cashflows, and human and intellectual capital resources, as well as plansto address any surplusresources or identified and expected inadequacies, are examples of disclosures that can provide useful information.In terms of risks and disclosures about the entitys principal risk exposures (and changes), coupled with its risk-mitigating strategy and how effective those are, would form the crux of the discussion. This information is crucial to assess the risks faced by the entity and possible/potential uncertainties. The key risks that should be included in the analysis would be strategic, commercial, operational and financial, and should be discussed not only from the perspective of adverse consequences but also in light of potential opportunities to the entity, if managed properly. It would be imperative that the discussion on risks (and risk management) be aligned with the entitys objectives and strategies.Under this element, management should also identify significant relationships that the entity has with its stakeholders, how these relationships are managed and how they are likely to affect the performance and value of the entity.Results of operations and performanceFor many, this may likely be the highlight and focal point of the management commentary. It is undeniable that many usersof financial information look for supplementary and complementary analysis that will enable them to make better sense of the main financial statements, especially in terms of whether the entity has delivered results in line with expectations and, implicitly, how well management has understood the entitys market, executed its strategy and managed the entitys resources, risks andrelationships.It is quite common that the following information, where presented and discussed for the current and prior periods, will equip users to meet those needs and concerns: operating results and profitability liquidity shareholders value orreturns net worth and market values debt management.Many entities usually providethis information as financial highlights in their annual reports.Management should provide an analysis of the prospects of the entity, which may include targets for financial and non-financial measures and, where quantified, the risks and assumptions used.Critical performance measures/indicatorsUsers of financial information are more familiar with performance-related information that is used and monitored by management to enable them to assess and evaluate the entitys performance against stated objectives and strategies. To address this need, management should disclose performance measures and indicators (both financial and non-financial) that are used by management to assess progress against its stated objectives.Some key pointers to take note of when discussing performance measures and indicators include: comparability with industry and/or ingeneral if there are changes from prior period, an explanation of why and how it has changed any adjustments or variations from that presented in the main financial statements definition and explanation of measures and indicators not defined or required by IFRS/MFRS, including its relevance to users reconciliation of measures and indicators with those that are presented in the main financial statements.Conclusion and outlookManagement commentary is a component of a more coherent and integrated form of reporting that sets out a context for better understanding and usefulness of financial information, especially the financial statements. When prepared with the needs and concerns of the users in mind, management commentaries will certainly add value to the financial statements. With the issuance of MASBs SOP3 in 2013, it is hoped that the full benefits of financial reporting will be further enhanced in Malaysia in the coming years.Ramesh Ruben Louis is a professional trainer and consultant in audit and assurance, risk management and corporate governance, corporate finance and public practice advisoryProfit, loss and OCIEmail Print Twitter Facebook Linkedin Add This Related Links Multiple-choice questionsGraham Holt explains what differentiates profit or loss from other comprehensive income and where items should be presentedStudying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.The purpose of the statement of profit or loss and other comprehensive income (OCI) is to show an entity's financial performance in a way that is useful to a wide range of users so they may attempt to assess the future net cash inflows of an entity. The statement should be classified and aggregated in a manner that makes it understandable and comparable.International Financial Reporting Standards (IFRS) currently require that the statement be presented as either one statement, being a combined statement of profit or loss and other comprehensive income, or two statements, being the statement of profit or loss and the statement of other comprehensive income. An entity has to show separately in OCI, those items which would be reclassified (recycled) to profit or loss and those items which would never be reclassified (recycled) to profit or loss. The related tax effects have to be allocated to these sections.Profit or loss includes all items of income or expense (including reclassification adjustments) except those items of income or expense that are recognised in OCI as required or permitted by IFRS.Reclassification adjustments are amounts recycled to profit or loss in the current period that were recognised in OCI in the current or previous periods. An example of items recognised in OCI that may be reclassified to profit or loss are foreign currency gains on the disposal of a foreign operation and realised gains or losses on cashflow hedges. Those items that may not be reclassified are changes in a revaluation surplus under IAS 16, Property, Plant and Equipment, and actuarial gains and losses on a defined benefit plan under IAS 19, Employee Benefits.However, there is a general lack of agreement about which items should be presented in profit or loss and in OCI. The interaction between profit or loss and OCI is unclear, especially the notion of reclassification and when or which OCI items should be reclassified.A common misunderstanding is that the distinction is based on realised versus unrealised gains. This lack of a consistent basis for determining how items should be presented has led to an inconsistent use of OCI in IFRS. It may be difficult to deal with OCI on a conceptual level since the International Accounting Standards Board (IASB) is finding it difficult to find a sound conceptual basis.However, there is urgent need for some guidance around this issue.Opinions vary, but there is a feeling that OCI has become a 'dumping ground' for anything controversial because of a lack of clear definition of what should be included in the statement. Many users are thought to ignore OCI as the changes reported are not caused by the operating flows used for predictive purposes.Financial performance is not defined in the Conceptual Framework, but could be viewed as reflecting the value the entity has generated in the period and this can be assessed from other elements of the financial statements and not just the statement of comprehensive income. Examples would be the statement of cashflows and disclosures relating to operating segments. The presentation in profit or loss and OCI should allow a user to depict financial performance, including the amount, timing and uncertainty of the entity's future net cash inflows and how efficiently and effectively the entity's management have discharged their duties regarding the resources of the entity.There are several arguments for and against reclassification. If reclassification ceased, there would be no need to define profit or loss, or any other total or subtotal in profit or loss, and any presentation decisions can be left to specific IFRSs. It is ar