International Financial Reporting Standards (IFRS) are detailed and extensive. In our Bitesize IFRS Knowledge Library we highlight the key issues for your financial reporting team to consider.
IAS 2 Inventory
IAS 2 defines inventory as assets which are:
- held for sale in the ordinary course of business;
- in the process of production for a sale;
- in the form of materials or supplies consumed in the production process.
Common examples include the items for sale in a retail store; raw material held in a manufacturing business and items still in production at the reporting date that will be sold once completed.
Inventories are held at the lower of cost and net realisible value.
The cost of inventories includes not only the purchase price but also transport, handling and other costs directly attributable to the acquisition of finished goods or materials.
In the example of a company manufacturing a product, these ‘other costs’ will include both variable and fixed production overheads, such as the costs of staff working on the production process and depreciation of the machinery used. The standard prescribes the method by which costs should be attributed to the cost of inventories.
Items held in inventory which are not interchangable, such as a specific model at a car dealership, should be measured at the cost of that particular asset. Where there are a large number of interchangeable items, such as tins of beans in a supermarket, then either the “first in, first out”, or “weighted average” method of costing should be applied.
In most cases, the cost of inventories will be held on the Statement of Financial Position until they are sold, at which point the cost is recorded in Profit or Loss. Any impairments are recognised immediately in Profit or Loss.
Saffery Champness regularly advises clients on inventory recognition issues across a wide range of sectors including retail, manufacturing, property, mining, pharmaceuticals and agriculture.
IAS 7 Cash flow statements
IAS 7 requires the inclusion of a cash flow statement as a primary financial statement.
IFRS itself does not permit any exemptions from preparing a cash flow statement.
Cash flows are classified into operating, investing and financing activities.
Operating activities are the core revenue-producing activities of the entity, as well as any activities not falling under the definition of financing or investing activities.
Examples include cash receipts associated with the entity’s trading activities and payments to suppliers and employees.
Taxes are typically reflected as an operating cash flow unless they can be identified as being associated with investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments not defined as cash.
All investing activities must result in the recognition of an asset in the Statement of Financial Position, such as machinery, licences or shareholdings in other entities.
Financing activities are activities that result in changes in the size and composition of equity and borrowings.
Common examples include the proceeds on issue of new shares, loans received, and repayment of lease liabilities.
What are ‘cash and cash equivalents’?
IAS 7 defines cash and cash equivalents as investments that are:
- held for meeting short-term cash commitments rather than for investment or other purposes;
- highly liquid;
- readily convertible to fixed amounts of cash; and – subject to an insignificant risk of changes in value.
In most cases, “cash and cash equivalents” will be assessed as cash balances held in instant-access currency accounts, and short-term deposit accounts of up to 3 months.
IAS 20 Government grants
IAS 20 describes the accounting treatment for government grants. This includes assistance from international, national and local governments, as well as bodies acting on behalf of governments.
Government grants commonly take the form of a cash transfer to the entity (including forgivable or low-interest loans), a reduction in costs that otherwise would have been incurred (such as a waiver of fees or taxes) or a straight transfer of assets (such as the transfer of land for specific development purposes).
Government grants are recognised when there is reasonable assurance that the entity will comply with the conditions attached to them, and that the grants will be received.
When a grant represents compensation for costs already incurred (such as furloughed staff) the value of the grant is recorded immediately in Profit or Loss. Where the grant compensates for cash outflows over multiple periods, it needs to be recognised on a systematic basis over those periods.
For grants to assist with the purchase of capital equipment, the benefit will be spread over the life of the acquired asset. This can done via a reduction in the initial cost, or presented as deferred income that unwinds against depreciation associated with that asset.
Grants related to expenditure can be shown as “other income”, or deducted from the expense line in question.
IAS 40 Investment Property
Investment property is land or a building (or both) held to earn rentals or for capital appreciation, rather than for use in the production or supply of goods, or for administrative purposes, by the entity which owns it.
In a group scenario where one group entity leases property to another, the same property may be investment property in the separate accounts of the lessor, but not from a group perspective, where it will be recorded as property, plant and equipment.
Where any element of the property is occupied by its owner, it is not investment property, unless the proportion is insignificant.
Investment properties are initially measured at cost. Subsequently, they are measured at either fair value or cost. Once an accounting policy has been decided, it must be applied to all investment property held.
Under the fair value model, changes in property valuation are recorded immediately in Profit or Loss and should be remeasured at each reporting period.
Where the cost model is applied, the fair value of the property still requires disclosure by way of note.
Our Real Estate Practice Group advises our property clients across a range of scenarios including property investment funds, developers, residential property portfolios, student accommodation and others.
IFRS 1 First time adoption of IFRS Standards
For privately-owned UK companies, IFRS is likely to have been adopted voluntarily.
IFRS 1 describes the process for the transition from another set of accounting standards, which most commonly will be FRS 102 (UK GAAP).
An entity’s first set of IFRS financial statements is the first set that contains an explicit and unreserved statement of compliance with IFRS, even if previous accounts were prepared under IFRS principles but did not contain such a statement.
A first time adopter must present an opening IFRS Statement of Financial Position at the date of transition to IFRS. This is generally the first day of the preceding accounting period. Therefore 3 Statements of Financial Position will be required.
The same accounting policies must be applied throughout all periods presented, and these will be based on those standards in force at the first reporting date. It is therefore important to understand the key differences between the previous GAAP and IFRS for the entity in question. The adoption of IFRS could affect key metrics such as EBITDA, interest cover, gearing and so on.
For many entities this transition will result in the restatement of results as previously reported under another GAAP. Such adjustments are typically recorded in the opening retained earnings.
The first set of IFRS financial statements will also require a reconciliation of equity reported under previous GAAP to IFRS standards, as well as a reconciliation of profit on the same basis.
We have advised clients wishing to transition to IFRS for a range of purposes; including entities preparing to list on a stock exchange, those recently acquired by an international group and entities newly required to report under IFRS for investors or lenders.
IFRS 2 Share based payment
Share based payment transactions are those in which a third party is entitled to receive equity instruments of the entity, or cash amounts based on the value of such equity instruments, in exchange for goods or services.
IFRS 2 also applies where the entity ultimately issuing equity instruments is a related entity of the party receiving the goods or services, for example a parent company issuing shares of behalf of a subsidiary.
Most share based payments take the form of share options, which is where employees have the option to purchase shares subject to meeting certain vesting conditions.
In a cash settled scheme, the employee receives a cash amount based on the performance of the company’s share price. These schemes might be set up as Share Appreciation Rights schemes or “growth share” schemes, for example.
Equity settled share options
Employees may receive share options which entitle them, at a future date, to buy shares at a fixed price. This might be as a reward, or as an incentive to remain in the job and to hit growth targets, for example. In these cases, it is difficult to assess the value of the employee’s services which are being compensated. Therefore a share option valuation methodology is typically applied, such as the Black-Scholes model.
The value of the options is calculated at the date the options are granted, and that value is recognised over the period in which the options vest. For example, where the only condition associated with the option is that the employee remains in employment for 3 years, the value of the option will be recorded in Profit or Loss over 3 years. The corresponding credit is recorded within equity.
Where vesting conditions are not met, or options lapse because the employee leaves, any expense recorded is written back in Profit or Loss such that no expense has been recorded on a cumulative basis.
Once options have vested (ie the option becomes exercisible), the fair value of options is never written back to Profit or Loss.
Entities need to apply judgement in estimating the number of options that will vest at each reporting period. However, the fair value of the options is never reassessed unless the conditions of the option are revised.
Cash settled share based payments
In this case, the employee will be entitled to a cash payment based on the value of the entity’s shares at a future date. Instead of reflecting a charge within equity, a liability is recorded and revised at each reporting date to reflect the fair value of the expected future payout.
There can be significant complexity involved in the accounting for share based payments. Our expert IFRS financial reporting team has advised on a wide range of share option schemes and also provide share option valuation services, as well as taxation advice on various option schemes.
IFRS 3 Business combinations
Acquiring another business is likely to be a significant event so care should be taken when preparing the appropriate accounting entries.
In a parent company’s own financial statements, the acquisition of a controlling interest of shares in another company will be presented as an investment in subsidiary. This is normally carried at cost, although other options are available.
At group level, the accounting treatment requires a range of judgements and the entries can be complex.
The first question is whether the acquired company is in substance a ‘business’. Acquiring the shares of another company does not necessarily constitute a business combination. For example, if the acquired company simply holds an asset which is currently inactive, it may be that the transaction is in effect the purchase of an asset.
Conversely, a business can be acquired without purchasing shares, for example in the case where ‘trade and assets’ are acquired.
Having established that a business combination has occurred, the next step is to evaluate the fair values of both the consideration given to the seller (such as cash, shares and deferred/contingent payments) and the net assets acquired.
This fair valuation exercise may require significant judgement, as fair values of certain assets may not be readily apparent.
A further complication arises, as the acquirer also needs to consider whether it has acquired any assets that were not previously reported in the acquiree’s financial statements. Examples include brands, customer contracts, and previously expensed development assets.
If, after assessment of the above, the consideration is greater than the identified net assets, the balance is recorded as goodwill.
Goodwill is not amortised, but tested for impairment annually.
There are some complex judgements involved in this process. Our IFRS team has assisted clients across a range of scenarios with their business combination accounting as well as preparing valuations of acquired assets and advising on related tax issues.
IFRS 15 Revenue from Contracts with Customers
IFRS 15 is a recent Standard which describes how and when revenue should be recognised.
It sets out a 5-step model which reporters should follow as part of their financial reporting process.
We have advised a range of clients on revenue recognition issues, which can also involve implementation of suitable reporting systems and processes.
Step 1 – Identify the contract
This may seem to be the easiest step, although it’s not necessarily clear if a contract has been agreed.
Contracts can be written, spoken, or implied by customary business practices.
Importantly, it must be probable that consideration will be received, which requires the customer to be able and willing to pay.
Step 2 – Identify the performance obligations
This step requires particular attention. IFRS 15 matches the recognition of revenue against the satisfaction of ‘performance obligations’.
These are distinct promises that the seller makes to the buyer. Examples are a dealer selling a car, or a recruiter placing a candidate.
Sometimes a single contract contains multiple performance conditions, so these need to be identified and separated.
Step 3 – Determine the transaction price
The transaction price is the amount of revenue that the seller expects to be entitled to, in exchange for fulfilling the performance obligations.
This is potentially complex, for example in the case of volume discounts, or arrangements where payment is not a fixed amount of cash received within normal trading terms.
Significantly deferred payments terms may indicate a ‘financing component’ within the contract, which will be recorded separately from revenue.
Step 4 – Allocate the transaction price
The transaction price needs to be allocated to performance obligations.
It may be that a single price is paid in exchange for the performance of multiple performance obligations. In such a case, the price is allocated based on a weighting of ‘standalone’ selling prices.
Where standalone prices are not readily available, they can be estimated.
Step 5 – Recognise revenue as performance obligations are satisfied
Performance obligations are satisfied either at a point in time, or over time.
The sale of a car from a dealership has a single point of time at which the sale occurs, whereas the construction of a building takes place over a period of time, and perhaps multiple accounting periods.
Where revenue is recorded over time, it is measured in a way that depicts the performance, for example by reference to output (project progress) or input (costs incurred to date) methods.
IFRS 15 contains a wide range of application guidance and examples.
The impact of IFRS 15 is an important consideration for reporters transitioning to IFRS, as reported revenue may be different to the previous GAAP measure.
For transition, implementation or wider IFRS 15 assistance please contact a Saffery IFRS specialist partner.
IFRS 16 Leases
The recent introduction of IFRS 16 marked a significant change to financial reporting in the UK.
The impact of the Standard is to bring most operating leases onto the balance sheet by recognising assets and associated liabilities.
For many IFRS reporters, this creates additional complexity in the financial reporting process.
A lease is a contract that conveys the right to use an asset for a period of time in exchange for consideration. The Standard doesn’t apply to leases which have a term of less than 12 months from inception, or for low value assets (eg telephones).
Our IFRS team has advised on a wide range of lease scenarios, including leases of property, machinery, vehicles and telecomms facilities.
The lease asset is recognised at cost, comprising the amount of the lease liability, any lease payments made at inception, initial direct costs and an estimate of dismantling or restoration costs.
The asset is then depreciated over the shorter of the lease term and the useful life of the asset.
At the commencement date, the lessee recognises a lease liability reflecting the outstanding lease payments, discounted at the rate implicit in the lease. In many cases, this is not readily available and so the company’s rate of borrowing for loans with similar characteristics is used.
The principal component of the lease liability is the fixed payments set out in the lease. More complex leases may contain other contractual payments to be reflected in the liability.
Where there are variable lease payments related to trading performance, such as turnover-based rent for retailers, such payments are not included in the lease liability and are instead recorded in profit or loss as incurred.
The lease liability is subsequently measured using the amortised cost basis; whereby effective interest payments will be larger in earlier periods.
Companies moving from FRS 102 to IFRS should consider the potential impact of IFRS 16 on EBITDA or other critical metrics, since the profit or loss impact of leases will move from an operating expense to a combination of depreciation and finance costs.
IFRS 16 also provides guidance for lessors, as well as more complex scenarios such as sale and leaseback arrangements.
Please speak to one of our expert IFRS partners for further assistance.