P 2 standards 2.docx

7/23/2019 P 2 standards 2.docx

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In line with ACCAs established rule, accounting standards issuedby 1 September in a givenyear are examinable from 1 September in the following year, so IFS 1! will be examinablein "# from the September #$1! session%

Core principle

&he core principle of IFS 1! is that an entity shall recognise revenue from the transfer ofpromised good or services to customers at an amount that reflects the consideration to whichthe entity expects to be entitled in exchange for those goods and services%

&he standard introduces a five'step model for the recognition of revenue%

Limited exceptions

&he five'step model applies to revenue earned from a contract with a customer with limited

exceptions, regardless of the type of revenue transaction or the industry%

Step one-Identification of the contractwith the customer%

Forms

Contracts may be in different forms (written, verbal or implied), but must be enforceable,have commercial substance and be approved by the parties to the contract%

Payment terms

&he model applies once the payment terms for the goods or services are identified and it isprobable that the entity will collect the consideration%

Rights

*ach partys rights in relation to the goods or services have to be capable of identification%

Reassessment

If a contract with a customer does not meet these criteria, the entity can continually reassessthe contract to determine whether it subse+uently meets the criteria%

Combined

&wo or more contracts that are entered into around the same time with the same customermay be combined and accounted for as a single contract, if they meet the specified criteria%


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Modification

A modification may be accounted for as a separate contract or as a modification of the

original contract, depending upon the circumstances of the case%

Step two-identification of the separate performance obligationsin the contract%

eginning

&his is often referred to as unbundling, and is done at the beginning of a contract%

!istincti"eness

&he -ey factor in identifying a separate performance obligation is the distinctiveness of thegood or service, or a bundle of goods or services% A good or service is distinct if the customercan benefit from the good or service on its own or together with other readily availableresources and it is separately identifiable from other elements of the contract%

Single performance obligation

IFS 1! re+uires that a series of distinct goods or services that are substantially the same withthe same pattern of transfer, to be regarded as a single performance obligation%

#ot distinct

A good or service which has been delivered may not be distinct if it cannot be used withoutanother good or service that has not yet been delivered%

Combined

Similarly, goods or services that are not distinct should be combined with other goods orservices until the entity identifies a bundle of goods or services that is distinct%

!etermination

IFS 1! provides indicators rather than criteria to determine when a good or service isdistinct within the context of the contract% &his allows management to apply .udgment todetermine the separate performance obligations that best reflect the economic substance of atransaction%


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Step three'determine the transaction price

$ransaction price

It is the amount of consideration that an entity expects to be entitled to in exchange for thepromised goods or services%

$hird parties

&his amount excludes amounts collected on behalf of a third party / for example,government taxes%

%ariable or contingent consideration

&he transaction price might include variable or contingent consideration%

&stimation

0ariable consideration should be estimated as either the expected value or the most li-elyamount%

&xpected "alue approach

&he expected value approach represents the sum of probability'weighted amounts for variouspossible outcomes% &he most li-ely amount represents the most li-ely amount in a range ofpossible amounts%

Consistency

anagement should use the approach that it expects will best predict the amount ofconsideration and it should be applied consistently throughout the contract%

%ariable consideration

An entity can only include variable consideration in the transaction price to the extent that itis highly probable that a subse+uent change in the estimated variable consideration will notresult in a significant revenue reversal%

Part of the "ariable consideration

If it is not appropriate to include all of the variable consideration in the transaction price, theentity should assess whether it should include part of the variable consideration% 2owever,this latter amount still has to pass the revenue reversal test%

'ider


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0ariable consideration is wider than simply contingent consideration as it includes anyamount that is variable under a contract, such as performance bonuses or penalties%

#on cash consideration

Additionally, an entity should estimate the transaction price, ta-ing into account non'cashconsideration, consideration payable to the customer and the time value of money if asignificant financing component is present%

Less than one year

&he latter is not re+uired if the time period between the transfer of goods or services andpayment is less than one year%

Lower amount

If an entity anticipates that it may ultimately accept an amount lower than that initiallypromised in the contract due to, for example, past experience of discounts given, thenrevenue would be estimated at the lower amount with the collectability of that lower amount

being assessed%

Impairment losses

Subse+uently, if revenue already recognised is not collectable, impairment losses should beta-en to profit or loss%

Step four-allocation of the transaction price to the separate performance obligations%

Standalone selling prices

&he allocation is based on the relative standalone selling prices of the goods or servicespromised and is made at the inception of the contract% It is not ad.usted to reflect subse+uentchanges in the standalone selling prices of those goods or services%

(bser"able price

&he best evidence of standalone selling price is the observable price of a good or servicewhen the entity sells that good or service separately%

3hen a contract contains more than one distinct performance obligation, an entity shouldallocate the transaction price to each distinct performance obligation on the basis of thestandalone selling price%

%ariable amount and discounts


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3here the transaction price includes a variable amount and discounts, it is necessary toestablish whether these amounts relate to all or only some of the performance obligations inthe contract% 4iscounts and variable consideration will typically be allocated proportionatelyto all of the performance obligations in the contract% 2owever, if certain conditions are met,they can be allocated to one or more separate performance obligations%

Separation

&his will be a ma.or practical issue as it may re+uire a separate calculation and allocationexercise to be performed for each contract% For example, a mobile telephone contracttypically bundles together the handset and networ- connection and IFS 1! will re+uire theirseparation%

Step fi"e' re"enue to be recognised as each performance obligation is satisfied %

Control transfer

An entity satisfies a performance obligation by transferring control of a promised good orservice to the customer%

$ime

It could occur over time or at a point in time%

Control defined

&he definition of control includes the ability to prevent others from directing the use of andobtaining the benefits from the asset%

Criteria

A performance obligation is satisfied at a point in time unless it meets one of the followingcriteria, in which case, it is deemed to be satisfied over time5

&he customer simultaneously receives and consumes the benefits provided by the

entitys performance as the entity performs%

&he entitys performance creates or enhances an asset that the customer controls as

the asset is created or enhanced%

&he entitys performance does not create an asset with an alternative use to the entity

and the entity has an enforceable right to payment for performance completed to date%

$ransfer


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evenue is recognised in line with the pattern of transfer% 3hether an entity recognisesrevenue over the period during which it manufactures a product or on delivery to thecustomer will depend on the specific terms of the contract%

Control is passed

If an entity does not satisfy its performance obligation over time, it satisfies it at a point intime and revenue will be recognised when control is passed at that point in time%

Factors

Factors that may indicate the passing of control include the present right to payment for theasset or the customer has legal title to the asset or the entity has transferred physical

possession of the asset%

For exam purposes) you should focus on understanding the principles of the fi"e-step

model so that you can apply them to practical *uestions+

'ritten by a member of the P, examining team

!efinition and nature of a contract

!efinition

A contract exists when an agreement between two or more parties creates enforceable rights

and obligations between those parties%

'riting or not

&he agreement does not need to be in writing to be a contract, but the decision as to whether acontractual right or obligation is enforceable is considered within the context of the relevantlegal framewor- of a .urisdiction%

Criteria

&he first of the criteria is that the parties should ha"e appro"ed the contract and arecommitted to perform their respecti"e obligations%


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Fulfilling

&he parties need not always be committed to fulfilling all of the obligations under a contract%

&"idence

&here needs to be evidence, however, that the parties are substantially committed to thecontract%

#ot recognised

If IFS 1! had re+uired all of the obligations to be fulfilled, there would have beencircumstances, as set out above, where revenue would not have been recognised, even thoughthe parties were substantially committed to the contract%

$he second and third criteria state that it is essential that each partys rights and the

payment terms can be identified regarding the goods or ser"ices to be transferred+

Recognised

If the scope of the wor- has been approved and the entity expects that the price will beapproved, then revenue may be recognised%

$he fourth criteria states that the contract must ha"e commercial substancebeforerevenue can be recognised as without this re+uirement, entities might artificially inflate theirrevenue and it would be +uestionable whether the transaction has economic conse+uences%

Finally) it should be probable that the entity will collect the consideration due under the

contract%

Ris. assessment

An assessment of a customers credit ris- is an important element in deciding whether a

contract has validity%

Consideration

&he consideration may be different to the contract price because of discounts and bonusofferings%

/bility

&he entity should assess the ability of the customer to pay and the customers intention to paythe consideration%


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In cases where the contract does not meet the criteria for recognition as a contract accordingto IFS 1!, the consideration received should only be recognised as revenue when thecontract is either complete or cancelled, or until the contract meets all of the criteria forrecognition%

'holly unperformed contracts

IFS 1! does not apply to wholly unperformed contracts where all parties have theenforceable right to end the contract without penalty%

Customer defined

&he standard defines the term customer as a party that has contracted with an entity toobtain goods or services that are an output of the entitys ordinary activities in exchange for

consideration%

#on-financial asset

In the case of the transfer of non'financial assets that are not an output of an entitys ordinaryactivities, it is now re+uired that an entity applies IFS 1! in order to determine when toderecognise the asset and to determine the gain or loss on derecognition%

$ransfer of assets

&his is because these transactions are more li-e transfers of assets to customers, rather thanother asset disposals%

Scope) exclusions and interactions with other standards

#on 0monetary exchanges

IFS 1! excludes transactions involving non'monetary exchanges between entities in thesame industry to facilitate sales to customers or to potential customers%

Some contracts with customers will fall partially under IFS 1! and partially under other

standards%

An example of this would be a lease arrangement with a service contract% If other IFSsspecify how to account for the contract, then the entity should first apply those IFSs% &hespecific sub.ect standard would ta-e precedence in accounting for a part of a contract and anyresidual consideration should be accounted for under IFS 1!% *ssentially, the transaction

price will be reduced by the amounts that have been measured by the other standard%

As with all standards examined in "#, you should first aim to understand the principles of thestandard, then ma-e sure that you practice applying these to practical +uestions%

'ritten by a member of the P, examining team


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This article is relevant to Papers F7 and P2

Complex lease terms mean that it is often difficult to determine how they should be

classified+ $his article examines I/S 12 and sheds some light on the matter

6eases are classified currently under IAS 17,Leases, as finance or operating leases atinception, depending on whether substantially all the ris-s and rewards of ownership transferto the lessee% 8nder a finance lease, the lessee has substantially all of the ris-s and reward of

ownership% Situations that would normally lead to a lease being classified as a finance leaseinclude the following5

the lease transfers ownership of the asset to the lessee by the end of the lease term

the lease term is for the ma.or part of the economic life of the asset, even if title is not

transferred

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 asset

the leased assets are of a specialised nature such that only the lessee can use them

without ma.or modifications being made

if the lessee is entitled to cancel the lease, the lessor9s losses associated with the

cancellation are borne by the lessee

gains or losses from fluctuations in the fair value of the residual fall to the lessee

the lessee has the ability to continue to lease for a secondary period at a rent that is

substantially lower than mar-et rent

All other leases are operating leases%

&he lease classification is made at the inception of the lease but a lessee and lessor may agreeto change the provisions of the lease% 2owever, changes in estimates for example, changes inthe residual value of a leased property, or changes in circumstances such as default by thelessee, do not give rise to a new classification of a lease% If the changes would have resultedin a different lease classification, had they been applied originally, then the revised leaseagreement is treated as a new lease over the remaining lease term% &he original accountingentries are not retrospectively amended%


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:ften lease indicators may not always point in the same direction causing lease classificationto be difficult% 6eases of specialised assets will usually be structured as finance leases% If anasset is specialised, then this implies that no other entity has a use for the asset% Conse+uentlythe lessor will only achieve its return on investment through the lease payments and it willstructure the lease as a finance lease accordingly% If a lessor can sell or lease non'specialised

assets to other parties at the end of the lease and is willing to accept the financial ris- on thisthen this could be an indicator of an operating lease% Assets of a non'specialised may becomespecialised% For example, leased plant and e+uipment may be permanently installed in a

building and its removal at the end of the lease may be impractical or too expensive for thelessor% :ften specialised assets may have a significant remaining life at the end of the leaseand sometimes this remaining life may be the ma.or part of the economic life of the asset andtherefore this indicator will point to it being an operating lease% 2owever, it may beappropriate to disregard this indicator% ;ormally for there to be an operating lease with asignificant part of the assets life remaining, there needs to be some realisation of fundsthrough sale or further rentals% 2owever, in the case of a specialised asset this will notnormally occur, because it is of value only to the lessee% In these cases, the asset will

normally transfer to the lessee at the end of the lease for a nil or nominal payment and betreated as a finance lease%

3here an asset has been leased several times during its economic life, and the lease is the lastlease to ta-e the asset to the end of its life, then many of the indicators may point towards afinance lease% For example, the present value of the minimum lease payments mayapproximate to the fair value of the asset at the inception of the final lease and there isunli-ely to be an option to purchase the asset at fair value or to extend the lease at a mar-etrent because the asset has reached the end of its life% 2owever the asset will obviously benon'specialised and the final lease will not be for the ma.or part of the economic life of theasset% &he lease will be for the entire remaining useful life of the asset but IAS 17, Leases,focuses on economic life as an indicator of a finance lease% &he lessor is recovering theinvestment in the asset through a number of leases and the substance of each of those leaseswill normally be an operating lease% &hus if the final lease were to be classified as a financelease simply because of its position in the chain, this would normally be unacceptable%

3here an asset is leased and rents are nominal rents, the agreement is still a lease under IAS17% &he total value of the rents will fall short of the fair value of the asset, thus indicating anoperating lease% :ften, the rents are low because a premium will have been paid up'frontwhich may be e+uivalent to substantially all of the fair value of the asset% In this case, thelease is probably a finance lease% 3here rents are very low and no premium has been paid,

the lease does not have a commercial basis and it would appear that the lessor is indifferent tothe ris-s and rewards of ownership% 6ease classification, in this case, is better .udged byloo-ing at the substance of the arrangement and the intentions of the lessor in granting a leaseon such terms%

&he presence of an option to extend the lease at substantially less than a mar-et rent impliesthat the lessor expects to achieve its return on investment solely through the lease paymentsand therefore is content to continue the lease for a secondary period at a nominal rental% &hisis an indicator of a finance lease% It is reasonable to assume that the lessee will extend thelease in these circumstances% 2owever, an option to extend it at a mar-et rental may indicatethat the lessor has not achieved its return on investment through the lease rentals and

therefore is relying on a subse+uent lease or sale to do so% &his is an indicator of an operatinglease as there will be no compelling commercial reason why the lessee should extend the


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agreement% &he absence of any option to extend the lease does not provide evidence eitherway as to an operating or a finance lease and other factors will need to be considered todetermine the classification%

In some cases, fluctuations in the fair value of the residual interest in the leased asset are

passed bac- to the lessee% &his indicates that the lessee is bearing the residual value ris-, andthe lessors return on investment is effectively fixed%

&hese indicators provide evidence of a finance lease% If the lease also re+uires the lessee toma-e good to the lessor any shortfall between the sale proceeds and a fixed residualamount, then again this is evidence of the lessors return being fixed% 3here the lessor retainsthe proceeds of the eventual sale of the asset, the lessor is bearing the residual value ris- andwhere the sale proceeds are significant, then this could be evidence of an operating lease%

Issues sometimes arise in lease contracts where an asset is held on a finance lease and then itis all or partially sub' let to another party on identical terms and conditions% &his can occur

where several entities intend to share leased accommodation and arrange for one entity tolease the whole asset and then sub'let the relevant parts to the others% &he issue that ariseshere is whether the lead entity should recognise the finance leases on a gross basis in itsaccounts or whether it should net off the transactions in its accounts%

In this case the entity should currently loo- at the de'recognition re+uirements of IAS


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because of the distinction between finance and operating leases% As a result, many users offinancial statements ad.ust the amounts presented in the statement of financial position toreflect the assets and liabilities arising from operating leases which ma-es the deliberations ofcompanies regarding classification of leases somewhat a futile exercise%

'ritten by a member of the Paper P, examining team

IFRS ,)Share-based Payment) applies when a company ac*uires or recei"es goods and

ser"ices for e*uity-based payment+ $hese goods can include in"entories) property) plant

and e*uipment) intangible assets) and other non-financial assets+ $here are two notable

exceptions3 shares issued in a business combination) which are dealt with under IFRS 4)

Business Combinations5 and contracts for the purchase of goods that are within the

scope of I/S 4, and I/S 46+ In addition) a purchase of treasury shares would not fall

within the scope of IFRS ,) nor would a rights issue where some of the employees are

shareholders+

*xamples of some of the arrangements that would be accounted for under IFS # include call

options, share appreciation rights, share ownership schemes, and payments for services made

to external consultants based on the companys e+uity capital%

RECOGNITION OF SHARE-BASED PAYMENTIFS # re+uires an expense to be recognised for the goods or services received by a company%

&he corresponding entry in the accounting records will either be a liability or an increase in

the e+uity of the company, depending on whether the transaction is to be settled in cash or in

e+uity shares% @oods or services ac+uired in a share'based payment transaction should be

recognised when they are received% In the case of goods, this is obviously the date when this

occurs% 2owever, it is often more difficult to determine when services are received% If shares

are issued that vest immediately, then it can be assumed that these are in consideration of past

services% As a result, the expense should be recognised immediately%

Alternatively, if the share options vest in the future, then it is assumed that the e+uity

instruments relate to future services and recognition is therefore spread over that period%

EQUITY-SETTLED TRANSACTIONS

*+uity'settled transactions with employees and directors would normally be expensed and

would be based on their fair value at the grant date% Fair value should be based on mar-et

price wherever this is possible% any shares and share options will not be traded on an active

mar-et% If this is the case then valuation techni+ues, such as the option pricing model, would

be used% IFS # does not set out which pricing model should be used, but describes thefactors that should be ta-en into account% It says that intrinsic value should only be used


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where the fair value cannot be reliably estimated% Intrinsic value is the difference between the

fair value of the shares and the price that is to be paid for the shares by the counterparty%

&he ob.ective of IFS # is to determine and recognise the compensation costs over the period

in which the services are rendered% For example, if a company grants share options to

employees that vest in the future only if they are still employed, then the accounting process

is as follows5

The fair value of the options will be calculated at the date the options aregranted.

This fair value will be charged to prot or loss equally over the vestingperiod, with adjustments made at each accounting date to reect the bestestimate of the number of options that will eventually vest.

Shareholders equity will be increased by an amount equal to the charge inprot or loss. The charge in the income statement reects the number ofoptions vested. f employees decide not to e!ercise their options, becausethe share price is lower than the e!ercise price, then no adjustment ismade to prot or loss. "n early settlement of an award withoutreplacement, a company should charge the balance that would have beencharged over the remaining period.

&7/MPL& 1

A company issued share options on 1 une #$B to pay for the purchase of inventory% &he

inventory is eventually sold on


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&7/MPL& ,

A company grants #,$$$ share options to each of its three directors on 1 anuary #$B,

sub.ect to the directors being employed on


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/nswer

# years H E=$$,$$$

DEFERRED TAX IMPLICATIONS

In some .urisdictions, a tax allowance is often available for share'based transactions% It is

unli-ely that the amount of tax deducted will e+ual the amount charged to profit or loss under

the standard% :ften, the tax deduction is based on the options intrinsic value, which is the

difference between the fair value and exercise price of the share% A deferred tax asset will

therefore arise which represents the difference between a tax base of the employees services

received to date and the carrying amount, which will effectively normally be Jero% A deferred

tax asset will be recognised if the company has sufficient future taxable profits against which

it can be offset%

For cash settled share'based payment transactions, the standard re+uires the estimated taxdeduction to be based on the current share price% As a result, all tax benefits received (or

expected to be received) are recognised in the profit or loss%

&7/MPL& 8

A company operates in a country where it receives a tax deduction e+ual to the intrinsic value

of the share options at the exercise date% &he company grants share options to its employees

with a fair value of EG%Dm at the grant date% &he company receives a tax allowance based on

the intrinsic value of the options which is EG%#m% &he tax rate applicable to the company is


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nformation that allows users of nancial statements to understand thee$ect of e!penses, which have arisen from share#based paymenttransactions, on the entitys prot or loss in the period.

&he standard is applicable to e+uity instruments granted after 7 ;ovember #$$# but not yetvested on the effective date of the standard, which is 1 anuary #$$!% IFS # applies to

liabilities arising from cash'settled transactions that existed at 1 anuary #$$!%

MULTIPLE-CHOICE QUESTIONS

1% 3hich of the following do not come within the definition of a share'based payment under

IFS #

/employee share purchase plans

employee share option plansCshare appreciation rights

!a rights issue that includes some shareholder employees

#% A company issues fully paid shares to !$$ employees on


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CIncrease liability E7,!$$L increase in expense profit or loss E7,!$$

!Increase liability EG!,$$$L increase in current assets EG!,$$$

G% A public limited company has granted 7$$ share appreciation rights (SAs) to each of its

G$$ employees on 1 anuary #$B% &he rights are due to vest on


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Basic principls !" #$%in%

Are you ris- adverse I thin- I am% For example, as a property owner I have an insurance

policy to protect me from the ris- of incurring a loss if my house were to burn down%

Companies will face many ris-s and if they see- to cover these ris-s then they are said to be

hedging% 2edging therefore is a ris- management process whereby ris- adverse companies

firstly identify and +uantify that they have a ris- and secondly see- to cover that ris-%

T# #$%$ i&'

is-s come in many forms for companies% For example there is a ris- that the fair value of

assets and liabilities that they hold might increase or decrease, that in future the price of the

goods they buy or sell might change, that interest rates on their borrowings or deposits might

change, and that foreign exchange rates may move% A hedged item is defined as an item that

exposes the entity to ris- of changes in fair value or future cash flows and is designated asbeing hedged%

T# #$%in% ins&r('n&

In order to protect themselves from losses on hedged items companies enter into contracts to

cover any loss arising% &hese contracts often not only eliminate the ris- but also eliminate any

potential gain% &hese contracts are termed the hedging instrument% A hedging instrument is

defined as a contract whose fair value or cash flows are expected to offset changes in the fair

value or cash flows of a designated hedged item% 2edging instruments are normally a type of

financial instrument -nown as a derivative%

I have written about the accounting for financial instruments (see 9elated lin-s9)% &o recap, a

financial instrument is a contract that gives rise to a financial asset of one entity and a

financial liability or e+uity instrument of another entity% A derivative is so called because its

value changes in response to the change in an underlying variable such as an interest rate, a

commodity, a security price, or an index% 4erivatives often re+uire no initial investment, or

one that is smaller than would be re+uired for a contract with similar response to changes in

mar-et factorsL and are settled at a future date%

An example of a derivative is a forward contract% Forward contracts are contracts to purchase

or sell a specific +uantity of something, eg a commodity, or a foreign currency at a specified

price determined at the outset, with delivery or settlement at a specified future date% For

example a farmer may enter into a forward contract with a supermar-et to sell in 1# months a

specific amount of crop at a certain price% In this way the producer (the farmer) is protected

from the ris- of falling prices, and the consumer (the supermar-et) is protected from the ris-

of rising prices% It therefore provides certainty%

Another example of a derivative is a futures contract% &hese contracts are similar to forwards

but whereas forward contracts are individually tailored, futures are generic and are tradable ina mar-et% Futures are generally settled through an offsetting (reversing) trade, whereas


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forwards are generally settled by the actual delivery of the underlying item or cash

settlement%

If a derivative is held by a company and it is not designated as a hedging instrument then it is

deemed to be held for speculation, ie for trading purposes% All derivatives must be recognised

at fair value on the statement of financial of position / this is sometimes referred as being

mar-ed to mar-et% As the value of derivatives can be very unstable and so can generate

large gains and losses in a short period, derivatives cannot be carried at historic cost (which is

often nil anyway) as this would result in large gains and losses being unreported% If the

derivative is not designated as a hedging instrument then any gains or losses arising are

recognised in the statement of profit of loss% &his is fair enough as the rightful place for

trading profits and losses is the statement of profit or loss%

Basic principls #$% acc!(n&in% an$ )c&i*nssIn essence the principle of hedge accounting is that it see-s to reflect the substance of why

the hedging instrument (the derivative) has been entered into% &o that end hedge accounting is

trying to match any loss (or gain) on the hedged item with the gain (or loss) on the hedging

instrument% In a perfect world hedging would wor- so that no net gain or loss arose% For

example if the hedged item created a loss of say E!$$m it would then be matched by a gain

on the hedging instrument of E!$$m% &his would be a perfect hedge, a hedge with 1$$

effectiveness% 2owever we do not live in a perfect world so a 1$$ effective hedge is highly

unli-ely% So if the hedged item created a loss of E!$$m and the hedging instrument a gain of

EG!$m then the hedge would said to be =$ effective (G!$>!$$ H =$)%

IAS +, c(rrn& r%(la&i!n

IAS


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a portfolio hedge of interest rate ris0 13acro 4edge2 only

a portion of the portfolio of nancial assets or nancial liabilities that sharethe ris0 being hedged.

IAS


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same time the carrying amount of the hedged item is ad.usted for the corresponding loss (or

gain) with respect to the hedged ris-, which is also recognised immediately in the statement

of profit or loss% &his is instant hedge accounting as the gains and losses offset in the

statement of profit or loss% A fair value hedge is ta-en to the statement of profit or loss%

E.a'pl !" a "air *al( #$%

For example a company has an asset with a current fair value of E#$$m that it is concerned

will fall in value, so designates this to be a hedged item and enters into a derivative

designated as a hedging instrument% &his is a fair value hedge% 6et us suppose at the next

reporting date the fair value of the hedged item has fallen to E1$m thus creating a loss of

EG$m% 2owever, because it is a hedged item the hedging instrument (the derivative) should

create a gain% If the gain on the hedging instrument is EG!m, then the hedge is assessed as

being 11#%! effective (G!>G$ H 11#%!)% &his is within the permitted band of D$ / 1#!%

As a result of applying fair value hedge accounting and matching the loss on the hedged itemwith the gain on the hedging instrument, the loss of EG$m and the gain of EG!m will offset to

report a net gain of E!m in the statement of profit or loss%

Cas# /!0 #$%

A cash flow hedge is defined as a hedge of the exposure to variability in cash flows that is

attributable to a particular ris- associated with a recognised asset or liability (such as all or

some future interest payments on variable rate debt) or a highly probable forecast transaction

and could affect profit or loss% For example, if a company is concerned that the price it will

have to pay for next year9s raw materials will rise it can designate this as a hedged item and

enter into a derivative (eg a futures contract designed to cover any price rise) which it

designates as a hedging instrument% Similarly, if a company is concerned that interest rates

will rise on its debt finance, then it could designate this as a hedged item and enter into a

derivative (eg an interest rate swap) which it designates as a hedging instrument%

&he portion of the gain or loss on the hedging instrument that is determined to be an effective

cash flow hedge is recognised in other comprehensive income and creates a reserve in e+uity%

If a hedge of a forecast transaction subse+uently results in the recognition of a financial asset

or a financial liability, any gain or loss on the hedging instrument that was previouslyrecognised directly in e+uity is recycled from reserves into the statement of profit or loss in

the same period(s) in which the financial asset or liability affects profit or loss%

If a hedge of a forecast transaction subse+uently results in the recognition of a non'financial

asset, then the entity has an accounting policy option that must be applied to all such hedges

of forecast transactions% :ne policy is to apply the same accounting as for recognition of a

financial asset or financial liability, in that any gain or loss on the hedging instrument that

was previously recognised in other comprehensive income is recycled from reserves into the

statement of profit or loss in the same period(s) in which the non'financial asset or liability

affects profit or loss% &he other policy is to ma-e an ad.ustment on the ac+uired non'financial


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asset so that the gain or loss on the hedging instrument that was previously recognised in

other comprehensive income is removed from reserves and is included in the initial

measurement of the ac+uired non'financial asset%

E.a'pl !" a cas# /!0 #$%

For example during year 1, a company is planning to buy an asset in the next accounting

period at a an estimated cost of E1$$m but it is concerned that the cost of buying the asset

will rise% &he company can designate the ris- of the future cash out flows rising as a hedged

item and enter into a derivative, the hedging instrument to cover this ris-% &his is a cash flow

hedge% 6et us suppose at the year 1 reporting date the estimated cost of the asset had risen to

E1#$m and the hedging instrument was reporting a gain of E1=m then the hedge is =!

effective (1=>#$ H =!) and so within the D$/1#! rule% &he gain of E1=m that has arisen

in respect of the derivative has to be recognised, and as it is the hedging instrument of a cash

flow hedge, it is recognised in other comprehensive income and creates a reserve (oftencalled other components of e+uity)% &he gain (or loss) on a derivative that is designated as a

cash flow hedge is in effect carried forward and is delayed being recognised in the statement

of profit of loss% &here can be no offset in the current accounting period as the potential extra

cost of E#$m of buying the assets is a notional number and not one that is yet recognised in

the financial statements, as after all the asset has yet to be bought%

As an aside, stic-ing with the example that the hedging instrument reports a gain of E1=m if

we were to assume that the cost of the asset had only risen by E=%!m then the cash flow hedge

would be #$$ effective (1=>=%! H #$$) and therefore outside of the D$/1#!

effectiveness rule% &he hedging relationship is not highly effective and therefore hedge

accounting is not permitted% &he whole E1=m gain on the hedging instrument must therefore

be recognised in the statement of profit or loss%

2owever, assuming as we did in the first place, that the hedge was effective at the reporting

date and we then .ump forward a few months into the middle of year # and further assume

that the asset is indeed bought for E1#$m and is a financial asset, then the previously

recognised gain of E1=m on the hedging instrument sitting in reserves is recycled from e+uity

and recognised in the statement of profit or loss% ecycling has meant that this gain of E1=m

has appeared within the statement of comprehensive income in two consecutive years, firstlyin other comprehensive income and secondly in the statement of profit or loss% any argue

that recycling is double counting and therefore inappropriate% &his is one of the few

remaining situations of recycling being permitted by reporting standards% For example IAS

1,Property, Plant and Equipmentclearly prohibits the recycling of previously recognised

gains on the disposal of revalued property% &he other comprehensive statement must clearly

distinguish between those gains and losses which may or may not be recycled to the

statement of profit or loss in future periods%

If the asset is a non'financial asset / for example, inventory that is sold in the accounting

period / then the previously recognised gain of E1=m on the hedging instrument can be


23/27

recycled from its reserve in e+uity and recognised in the statement of profit or loss% 2owever,

if the asset is property, plant and e+uipment, then the reserve would be recycled over the

useful life of the property, plant and e+uipment%

Iss(s 0i IAS +, an$ #!0 pr!p!sals a$$rss '

IAS


24/27

component of aircraft fuel and the price of aircraft fuel will be closely correlated to crude oil

prices% 2owever, this is not considered a valid hedge under IAS


25/27

Pr!p!s$ r%(la&i!n !n i'pair'n& !" 1nancial ass&s

.pc&$ l!ss appr!ac#

&he IAS? has proposed a model where credit losses on financial assets are no longer

recognised when incurred but rather, are recognised on the basis of expected credit losses%

&his is often called the 9expected loss9 approach%

&he expected loss approach is li-ely to result in earlier recognition of credit losses, which

includes not only losses that have already been incurred but also expected future losses%

Arguably this method will be more prudent as both assets and profits will be reduced% It is

however open to the criticism that allowing the .udgment of what future losses might be

incurred it will allow some companies to engage in profit smoothing%

*xpected credit losses are defined as the expected shortfall in contractual cash flows% &he

estimation of expected credit losses should consider past events, current conditions andreasonable and supportable forecasts%

E.a'pl !" .pc&$ l!ss appr!ac#

&he ?ale company has a portfolio of E!$,$$$ financial assets (debt instruments) that have

two years to maturity and are correctly accounted for at amortised cost% *ach asset has a

coupon rate of 1$ as well as an effective rate of 1$% ;o previous impairment loss has

been recognised% At the year'end information has emerged that the sector in which the

borrowers operate is experiencing tough economic conditions% It is now felt that a proportion

of loans will default over the remaining loan period% After considering a range of possibleoutcomes, the overall rate of return from the portfolio is expected to be approximately per

annum for each of the next two years%

Re*uired3

Calculate the expected credit losses on a life time basis+

/nswer

&he lender was expecting an annual return of E!,$$$ a year (E!$,$$$ O 1$) but is now only

expecting an annual return of E


26/27

Contractual cash

fow shortall

!iscount

rate

Present "alue

7ear % #,$$$ (.8(8 1,D1D

7ear ' #,$$$ $%D#G 1,!<


27/27

expected credit losses% Financial assets with a low credit ris- would not meet the lifetime

expected credit losses criterion% An entity does not recognise lifetime expected credit losses

for financial assets that are e+uivalent to 9investment grade9, which means that the asset has a

low ris- of default% 8nder the proposed model, there is a rebuttable presumption that lifetime

expected losses should be provided for if contractual cash flows are

P 2 standards 2.docx

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