Introduction to Financial Instruments
- IAS 32 Financial Instruments: Presentation
- IFRS 7 Financial Instruments: Disclosures
- IFRS 9 Financial Instruments
IAS 32 FINANCIAL INSTRUMENTS: PRESENTATION
The stated objective of IAS 32 is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and liabilities.
IAS 32 addresses this in a number of ways:
- clarifying the classification of a financial instrument issued by an entity as a liability or as equity
- prescribing the accounting for treasury shares (an entity’s own repurchased shares)
- prescribing strict conditions under which assets and liabilities may be offset in the balance sheet
- IAS 32 applies in presenting and disclosing information about all types of financial instruments with the exceptions of items under IAS 27, IAS 28, IFRS 11, IAS 19 and IFRS 2 and nonfinancial items which will be settled through physical delivery.
However, IAS 32 applies to:
- The contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument
The following terms are used in this Standard with the meanings specified:
A Financial Instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
A Financial Asset is any asset that is:
- An equity instrument of another entity; (c) A contractual right:
- To receive cash or another financial asset from another entity; or
- To exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or
(d) A contract that will or may be settled in the entity‘s own equity instruments and is:
- A non-derivative for which the entity is or may be obliged to receive a variable number of the entity‘s own equity instruments; or
- A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity‘s own equity instruments.
A Financial Liability is any liability that is:
- A contractual obligation:
- To deliver cash or another financial asset to another entity; or
- To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or
- a contract that will or may be settled in the entity‘s own equity instruments and is:
- a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity‘s own equity instruments; or
- a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity‘s own equity instruments.
An Equity Instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
A Puttable Instrument is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder.
Examples of financial assets include Trade receivables, Options, Shares (when used as an investment).
Examples of financial liabilities include Trade payables, Debenture loans payable, Redeemable preference (non-equity) shares and Forward contracts standing at a loss.
Financial instruments include both of the following.
- Primary instruments: e.g. receivables, payables and equity securities
- Derivative instruments: e.g. financial options, futures and forwards, interest rate swaps and currency swaps, whether recognized or unrecognized
IAS 32 makes it clear that the following items are not financial instruments.
- Physical assets, e.g. inventories, property, plant and equipment, leased assets and intangible assets (patents, trademarks etc).
- Prepaid Expenses, deferred revenue and most warranty obligations.
- Liabilities or assets that is not contractual in nature
- Contractual rights/obligations that do not involve transfer of a financial asset, e.g. commodity futures contracts, operating leases
Compound Financial Instruments
The issuer of a non-derivative financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. Such components shall be classified separately as financial liabilities, financial assets or equity instruments.
An entity recognises separately the components of a financial instrument that:
- creates a financial liability of the entity and
- Grants an option to the holder of the instrument to convert it into an equity instrument of the entity.
If an entity reacquires its own equity instruments, those instruments (‗treasury shares‘) shall be deducted from equity. No gain or loss shall be recognized in profit or loss on the purchase, sale, issue or cancellation of an entity‘s own equity instruments. Consideration paid or received shall be recognized directly in equity.
Interest, Dividends, Losses and Gains
Interest, dividends, gains, and losses relating to an instrument classified as a liability should be reported in profit or loss. This means that dividend payments on preferred shares classified as liabilities are treated as expenses. On the other hand, distributions (such as dividends) to holders of a financial instrument classified as equity should be charged directly against equity, not against earnings.
Transaction costs of an equity transaction are deducted from equity. Transaction costs related to an issue of a compound financial instrument are allocated to the liability and equity components in proportion to the allocation of proceeds.
OFFSETTING FINANCIAL ASSETS AND LIABILITIES
IAS 32 also prescribes rules for the offsetting of financial assets and financial liabilities. It specifies that a financial asset and a financial liability should be offset and the net amount reported when, and only when, an entity:
- Has a legally enforceable right to set off the amounts; and
- Intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.
Financial instruments disclosures are in IFRS 7 Financial Instruments: Disclosures, and no longer in IAS 32.
IFRS 9 FINANCIAL INSTRUMENTS (REPLACEMENT OF IAS 39)
The objective of this IFRS is to establish principles for the financial reporting of financial assets and financial liabilities that will present relevant and useful information to users of financial statements for their assessment of the amounts, timing and uncertainty of an entity‘s future cash flows.
RECOGNITION AND DERECOGNITION
Financial asset or financial liability should be recognized by an entity in its statement of financial position when the entity becomes party to the contractual provisions of the financial asset or financial liability, even at nil cost.
Effective interest rate method
Total finance cost: $
Interest paid xx
Issuance cost xx
Total finance cost (Allocate over loan xx
term using effective interest rate)
|Years||Opening balance||Finance cost charged||Interest paid||Rollover||Closing balance|
|Y1||xx||Issue cost, discount &
|Nominal value x Par value||Discount, issue cost & premium||Xx|
Calculation of fair value of financial instrument
- Fair value = Present value of future cash flows at current market interest for similar financial instruments
- Use market rate of relevant year or date Future cash flows will be used.
CLASSIFICATION OF FINANCIAL ASSETS
An entity shall classify financial assets as subsequently measured at:
- Amortised cost or
- Fair value through profit or loss (FVTPL)
- Fair value through other comprehensive income (FVTOCI)
A financial asset (debt instrument only) shall be measured at amortised cost if both of the following conditions are met:
- The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows (Solely principal amount and interest).
- The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Interest is compensation for time value of money and credit risk.
- Assess business management model on portfolio level not on individual investment
- Irregular sales of investments do not impact business management model
- Businesses may have different business management models for different investments
Fair Value Designation of Financial Assets
Even if an instrument meets the two amortised cost tests, IFRS 9 contains an option to designate a financial asset as measured at Fair Value Through Profit and Loss if doing so eliminates or significantly reduces a measurement or recognition inconsistency. Fair value through other comprehensive income
The criteria are as follows:
|For investments in equity||For investment in debt|
|Investment in equity not held for trading||Business management model is to hold investment for collection of contractual cash flows and to sell|
|Entity has made an irrevocable election to recognize gain/ (loss) in other comprehensive income||Investment can generate contractual cash flow at specified time, Principal and Interest, where interest is compensation of time value of money & credit risk|
Fair value through profit or loss
The criteria are as follows:
- It is the default category (After not meeting any other category‘s criteria)
- Investments not categorized at amortized cost and FVTOCI will be classified here
MEASUREMENT OF FINANCIAL ASSETS
1) At Amortised cost:
Initial measurement: Fair value (Cash paid) + Transaction cost
Subsequent measurement: At amortised cost using effective interest rate method 2) At FVTOCI:
Initial measurement: Fair value (Cash paid) + Transaction cost
Subsequent measurement: At fair value and gain/loss will be charged to OCI 3) At FVTPL:
Initial measurement: Fair value (Cash paid)
Transaction cost is charged to P&L
Subsequent measurement: At fair value and gain/loss will be charged to P&L
DERECOGNITION OF FINANCIAL ASSETS
Derecognition is the removal of a previously recognised financial instrument from an entity‘s statement of financial position.
An entity should derecognize a financial asset when:
- The contractual rights to the cash flows from the financial asset expire e.g., cash received from receivable, Option exercised, option expired etc. , OR
- The entity transfers substantially all the risks and rewards of ownership of the financial asset to another party.
On derecognition the difference between the carrying amount and consideration received should be recognised in P&L. Reclassify in P&L any accumulated gains or losses already recognised in OCI
Assess risk and rewards of financial asset immediately before and after transfer a) Substantial risk and rewards transferred Derecognize:
Dr. Cash/Asset xx Dr/Cr. (loss)/Profit xx Cr. Financial asset xx
- Unconditional sale of financial asset
- Factoring of receivables (without recourse)
- Sales of asset on repurchase terms where repurchase will be at market price
- Sale of asset with call or put option and option is deep out of money
b) Substantial risks and rewards retained
Continue to recognize the asset
Any cash received would be secured loan
Dr. Cash xx Cr. Loan xx
- Factoring of receivables with recourse
- Sales of asset on repurchase term where repurchase price is already decided
- Sale of asset with call or put option and option is deep in the money
- Sale of asset with return swap contract
Remember always to apply the principle of substance over form.
CLASSIFICATION OF FINANCIAL LIABILITIES
Financial liabilities are either classified as:
- Financial liabilities at amortised cost; or
- Financial liabilities as at fair value through profit or loss (FVTPL).
Financial liabilities are measured at amortised cost unless either:
- The financial liability is held for trading and is therefore required to be measured at FVTPL (e.g.
derivatives not designated in a hedging relationship), or
- The entity elects to measure the financial liability at FVTPL (using the fair value option).
MEASUREMENT OF FINANCIAL LIABILITIES
- At Amortised cost:
Initial measurement: Fair value (Cash received) – Issue cost
Subsequent measurement: At amortised cost using effective interest rate method
Examples of items at amortised cost are Trade payables, Loan payables, Bank borrowings
- At Fair value option:
Fair value Gain/Loss will be split
- Gain/Loss due to own credit risk will be charged to OCI
- Gain/Loss due to other credit risk will be charged to P&L
- At FVTPL:
Initial measurement: Fair value (Cash received)
Transaction cost is charged to P&L
- Fair value will be calculated by PV(FCF) by using current market interest rate
- Any Gain or loss will be charged to P&L
Examples of items at FVTPL are Held for trading liability, Derivatives standing at loss, Contingent liability arising at business combination
RECLASSIFICATION OF FINANCIAL INSTRUMENTS
For financial assets, reclassification is required between FVTPL and amortised cost, or vice versa, if and only if the entity’s business model objective for its financial assets changes so its previous model assessment would no longer apply.
If reclassification is appropriate, it must be done prospectively from the reclassification date. An entity does not restate any previously recognised gains, losses, or interest.
IFRS 9 does not allow reclassification where:
- Financial assets have been classified as equity instruments, or
- The fair value option has been exercised in any circumstance for a financial assets or financial liability.
DERECOGNITION OF FINANCIAL LIABILITIES
An entity shall remove a financial liability (or a part of a financial liability) from its statement of financial position when, and only when, it is extinguished – i.e. when the obligation specified in the contract is discharged or cancelled or expires.
The difference between the carrying amount of a financial liability (or part of a financial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, shall be recognised in profit or loss.
IMPAIRMENT OF FINANCIAL INSTRUMENTS
The impairment requirements are applied to:
- Financial assets measured at amortised cost (incl. trade receivables)
- Financial assets measured at fair value through OCI
- Loan commitments and financial guarantees contracts where losses are currently accounted for under IAS 37 Provisions, Contingent Liabilities and Contingent Assets Lease receivables.
The impairment model follows a three-stage approach based on changes in expected credit losses of a financial instrument that determine
- The recognition of impairment, and
- The recognition of interest revenue.
At initial recognition of the financial asset an entity recognises a loss allowance equal to 12 months expected credit losses which consist of expected credit losses from default events possible within 12 months from the entity‘s reporting date. An exception is purchased or originated credit impaired financial assets.
|Impairment||12 month expected credit loss||Lifetime expected credit loss|
|Interest||Effective interest on the gross carrying amount (before deducting expected losses)
|fective interest on the net (carrying) amount|
THREE STAGE APPROACH
12 month expected credit losses (gross interest)
- Applicable when no significant increase in credit risk
- Entities continue to recognise 12 month expected losses that are updated at each reporting date Presentation of interest on gross basis
Lifetime expected credit losses (gross interest)
- Applicable in case of significant increase in credit risk
- Recognition of lifetime expected losses
- Presentation of interest on gross basis
Lifetime expected credit losses (net interest)
- Applicable in case of credit impairment
- Recognition of lifetime expected losses
- Presentation of interest on a net basis
30 days past due rebuttable presumption
- Rebuttable presumption that credit risk has increased significantly when contractual payments are more than 30 days past due
- When payments are 30 days past due, a financial asset is considered to be in stage 2 and lifetime expected credit losses would be recognised
- An entity can rebut this presumption when it has reasonable and supportable information available that demonstrates that even if payments are 30 days or more past due, it does not represent a significant increase in the credit risk of a financial instrument.
Low credit risk instruments
- Instruments that have a low risk of default and the counterparties have a strong capacity to repay (e.g. financial instruments that are of investment grade)
- Instruments would remain in stage 1, and only 12 month expected credit losses would be provided.
Short term trade receivables
- Recognition of only ‗lifetime expected credit losses‘ (i.e. stage 2)
- Expected credit losses on trade receivables can be calculated using provision matrix (e.g.
geographical region, product type, customer rating, collateral or trade credit insurance, or type of customer)
- Entities will need to adjust the historical provision rates to reflect relevant information about current conditions and reasonable and supportable forecasts about future expectations. Long term trade receivables and lease receivables Entities have a choice to either apply:
- the three-stage expected credit loss model; or
- The ‗simplified approach‘ where only lifetime expected credit losses are recognised.
LOAN COMMITMENTS AND FINANCIAL GUARANTEES
- The three-stage expected credit loss model also applies to these off balance sheet financial commitments
- An entity considers the expected portion of a loan commitment that will be drawn down within the next 12 months when estimating 12 month expected credit losses (stage 1), and the expected portion of the loan commitment that will be drawn down over the remaining life the loan commitment (stage 2)
- For loan commitments that are managed on a collective basis an entity estimates expected credit losses over the period until the entity has the practical ability to withdraw the loan commitment.
Purchased or originated credit-impaired financial assets
Purchased or originated credit-impaired financial assets are treated differently because the asset is creditimpaired at initial recognition. For these assets, an entity would recognise changes in lifetime expected losses since initial recognition as a loss allowance with any changes recognised in profit or loss. Under the requirements, any favourable changes for such assets are an impairment gain even if the resulting expected cash flows of a financial asset exceed the estimated cash flows on initial recognition.
Hedging, for accounting purposes, means designating one or more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item.
Hedging instruments: A hedging instrument is a designated derivative or (in limited
circumstances) another financial asset or liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.
A hedged item is an asset, liability, firm commitment, or forecasted future transaction that:
(a) exposes the entity to risk of changes in fair value or changes in future cash flows, and that (b) is designated as being hedged
Hedge accounting recognises the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item.
Hedging relationships are of three types:
- Fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss.
- Cash flow hedge: a hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk 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 (ii) could affect profit or loss.
- Hedge of a net investment in a foreign operation as defined in IAS 21.
Designation and Documentation
Must be formalised at the inception of the hedging relationship:
- The hedging relationship
- Risk management strategy and objective for undertaking the hedge The hedged item and hedging instrument How hedge effectiveness will be assessed.
All three hedge effectiveness requirements met
(a) An economic relationship exists between the hedged item and hedging instrument (b) Credit risk does not dominate changes in value (c) The hedge ratio is the is the same for both the:
- Hedging relationship
- Quantity of the hedged item actually hedged, and the quantity of the hedging instrument used to hedge it.
Types of Hedging
1. Fair value hedge
It is the exposure to changes in fair value of recognized asset or liabilities
- Hedge Instrument:
Hedge instrument gain/loss will be charged to P&L (unless hedge item is equity instrument measured at FVTOCI).
- Hedge Item:
Hedge item gain/loss will be charged to P&L (unless hedge item is equity instrument at
FVTOCI, then recognize in OCI)
2. Cash flow hedge
It is a hedge of the exposure to variability in cash flows that:
- Attributable to particular risk associated with recognized asset or liability or a high probable forecast transaction
- Could affect profit or loss Accounting treatment Hedge Instrument:
- Gain or loss on hedge instrument that‘s determined to be an effective hedge must be recognized in OCI (will become spate reserve in SOCIE) and ineffective portion will be charged to P&L , and effective portion (separate reserve) will be reclassified to P&L when cash flows expected to effect P&L
- If non-financial asset recognized due to hedge item then reserve can be adjusted in initial cost of non-financial asset
Any contract , that have three features:
- Its initial cost is zero or nominal as compared to other contracts that has similar response to changes in market value
- It will be settled in future
- Its value is dependent on certain underlying item
Types of derivative contract are as follows:
- Future contract
- Forward contract
- Swap contract
- Fair value through profit and loss
- Initial measurement: Fair Value
- Subsequent measurement: Fair value and gain/(loss) will be charged to P&L
- Derivative Standing at gain; Financial Asset
- Derivative Standing at loss; Financial Liability
An embedded derivative is a component of a hybrid contract that also includes a non-derivative host— with the effect that some of the cash flows of the combined instrument vary in a way similar to a standalone derivative.
Host contracts are the contracts in which derivative contracts are embedded.
- A lease
- A debt or equity instrument
- An insurance contract
- A sale or purchase contract
- A construction contract
A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty, is not an embedded derivative, but a separate financial instrument.
Hybrid contracts with financial asset hosts
If a hybrid contract contains a host that is an asset within the scope of this IFRS, an entity shall apply the measurement rules to the entire hybrid contract (recognized at FVTPL). E.g. Investment in convertible loan, Investment in bond where interest rate vary with gold prices
Other hybrid contracts
If host contact is a financial liability or non-financial contracts E.g. Issue of convertible loan, lease/construction contract in foreign currency
Criteria: (if met separation required)
- Economic characteristic should be different (host contract and derivative)
- Host contract should not be measured at FVTPL
- Embedded derivatives should meet the definition of ―stand alone derivative‖
IFRS 7 FINANCIAL INSTRUMENT DISCLOSURES
IFRS 7 requires entities to provide disclosures in their financial statements that enable users to evaluate:
- The significance of financial instruments for the entity‘s financial position and performance; and
- The nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the reporting date, and how the entity manages those risks.
Classes of financial instruments and level of disclosures
IFRS 7 requires that certain disclosures should be given by class of financial instruments. The classes of financial instruments that will be disclosed should be appropriate to the nature of the information disclosed and should take into account the characteristics of those financial instruments. An entity should provide sufficient information to permit reconciliation to the line items presented in the statement of financial position.
Statement of financial position:
- Financial assets measured at fair value through profit and loss, showing separately those held for trading and those designated at initial recognition
- Special disclosures about financial assets and financial liabilities designated to be Measured at fair value through profit and loss, including disclosures about credit risk and market risk, changes in fair values attributable to these risks and the methods of measurement.
- Reclassifications of financial instruments from one category to another (e.g. from fair value to amortised cost or vice versa)
- information about financial assets pledged as collateral and about financial or non- financial assets held as collateral
- Reconciliation of the allowance account for credit losses (bad debts) by class of financial Assets.
- Information about compound financial instruments with multiple embedded derivatives
- Breaches of terms of loan agreements
Statement of profit or loss and other comprehensive income
- Items of income, expense, gains, and losses, with separate disclosure of gains and losses from financial assets measured at fair value through profit and loss, showing separately those held for trading and those designated at initial recognition
- total interest income and total interest expense for those financial instruments that are not measured at fair value through profit and loss
- fee income and expense
- amount of impairment losses by class of financial assets
- interest income on impaired financial assets
IFRS 10 – CONSOLIDATED FINANCIAL STATEMENTS
A group is formed when one company, known as the parent, acquires control over another company, known as its subsidiary.
The subsidiary and the holding company are considered separate legal entities. Group accounts are presented as if the parent company and its subsidiary were one single entity – an application of the substance over form concept.
Group of Companies arises when one company (Parent) takes control of another company (subsidiary).
Subsidiary is a company controlled by another company.
Parent is a company that controls one or more subsidiaries.
Non-Controlling Interestis a collective representation of the shareholders that normally own 49% or less of equity.
Consolidated Financial Statements means F/S of whole Group presented as a single set of accounts.
According to IFRS 10 Consolidated
Financial Statements an investor controls investee when it 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.
Existence of parent subsidiary relationship
Parent subsidiary relationship exists when:
- The parent holds more than one half of the voting power of the entity
- The parent has power over more than one half of the voting rights by virtue of an agreement with other investors (common control)
- The parent has the power to govern the financial and operating policies of the entity under the articles of association of the entity
- The parent has the power to appoint or remove a majority of the board of directors
- The parent has the power to cast the majority of votes at meetings of the board
EXEMPTION FROM PREPARING GROUP ACCOUNTS
A parent need not present consolidated financial statements if the following stipulations hold:
- The parent itself is a wholly-owned subsidiary or it is a partially owned subsidiary of another entity Its securities are not publicly traded
- The parent‘s debt or equity instruments are not traded in a public market
- The parent did not file its financial statements with a securities commission or other regulatory organisation
- The ultimate parent publishes consolidated financial statements that comply with International Financial Reporting Standards.
CONDITIONS – DIRECTORS MAY NOT WISH TO CONSOLIDATE A SUBSIDIARY
The directors of a parent company may not wish to consolidate some subsidiaries due to:
- Control is temporary as the subsidiary was purchased for re-sale
- Unsatisfactory performance and weak financial position of the subsidiary
- Differing activities (nature) of the subsidiary from the rest of the group
- Reduction of apparent gearing by avoiding consolidation of subsidiary‘s loan Legal conditions restricting the parent‘s ability to run the subsidiary.
Apart from legal restriction, these reasons are not permitted according to IFRSs and consolidated financial statements should be prepared including all these subsidiaries.
IFRS 3 requires exclusion from consolidation only if the parent has lost control over its investment. This could occur in cases where control over a subsidiary is lost because of a restriction from government, a regulator, a court of law, or as a result of a contractual agreement.
- Same accounting policies should be used for both the holding company and the subsidiaries. Adjustments must be made where there is a difference
- The reporting dates of parent and subsidiary will be the same in most cases. In case of difference, the subsidiary will be allowed to prepare another set of accounts for consolidation purposes (if the difference is of more than three months).
Accounting for subsidiaries in separate financial statements of the holding company
The holding company will usually produce its own separate financial statements. Investments in subsidiaries and associates have to be accounted for at cost or in accordance with IFRS 9. Where subsidiaries are classified as held for sale then the provisions of IFRS 5 have to be complied with.
In accordance with IFRS 3, because acquisition-related costs are not part of the exchange transaction between the acquirer and the acquiree (or its former owners), they are not considered part of the business combination.
Costs of issuing debt or equity instruments are accounted for under IAS 32 Financial Instruments: Presentation and IFRS 9 Financial Instruments. All other costs associated with an acquisition must be expensed, including reimbursements to the acquiree for bearing some of the acquisition costs. Therefore, transaction costs no longer form a part of the acquisition price; they are expensed as incurred. Transaction costs are not deemed to be part of what is paid to the seller of a business. They are also not deemed to be assets of the purchased business that should be recognised on acquisition. The standard requires entities to disclose the amount of transaction costs that have been incurred.
Examples of costs to be expensed include finder’s fees; advisory, legal, accounting, valuation and other professional or consulting fees; and general administrative costs, including the costs of maintaining an internal acquisitions department.
ACQUIRED ASSETS AND LIABILITIES
IFRS 3 establishes the following principles in relation to the recognition and measurement of items arising in a business combination:
- Recognition principle. Identifiable assets acquired, liabilities assumed, and non-controlling interests in the acquiree, are recognised separately from goodwill
- Measurement principle. All assets acquired and liabilities assumed in a business combination are measured at acquisition-date fair value.
IFRS 3 (Revised) has introduced some changes to the assets and liabilities recognised in the acquisition statement of financial position. The existing requirement to recognise all of the identifiable assets and liabilities of the acquiree is retained. Most assets are recognised at fair value, with exceptions for certain items such as deferred tax and pension obligations.
Acquired intangible assets must be recognised and measured at fair value in accordance with the principles if it is separable or arises from other contractual rights, irrespective of whether the acquiree had recognised the asset prior to the business combination occurring. This is because there is always sufficient information to reliably measure the fair value of these assets.
Acquirers are required to recognise brands, licences and customer relationships, and other intangible assets.
Contingent assets are not recognised, and contingent liabilities are measured at fair value.
Until a contingent liability is settled, cancelled or expired, a contingent liability that was recognised in the initial accounting for a business combination is measured at the higher of the amount the liability would be recognised under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, and the amount less accumulated amortization (amount under the relevant standard).
The acquirer can seldom recognise a reorganisation provision at the date of the business combination. There is no change from the previous guidance in the new standard: the ability of an acquirer to recognise a liability for terminating or reducing the activities of the acquiree is severely restricted. A restructuring provision can be recognised in a business combination only when the acquiree has, at the acquisition date, an existing liability for which there are detailed conditions in IAS 37, but these conditions are unlikely to exist at the acquisition date in most business combinations.
Timeline for acquisition accounting
An acquirer has a maximum period of 12 months from the date of acquisition to finalise the acquisition accounting. The adjustment period ends when the acquirer has gathered all the necessary information, subject to the 12-month maximum. There is no exemption from the 12-month rule for deferred tax assets or changes in the amount of contingent consideration. The revised standard will only allow adjustments against goodwill within this one-year period.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
At the date of acquisition, the investment by the parent company in the subsidiary company is cancelled of against the equity (share capital, state premium, retained earnings of subsidiary company. Any excess remaining is known as goodwill.
All assets and liabilities of subsidiary company are than added on a line by line basis with the assets and liabilities of the parent company.
In the consolidated statement of financial position, the share capital and share premium will ALWAYS be of Parent Co. only.
If the parent contacts less than 100% of a subsidiary, the remaining investment is known as noncontrolling interest and a portion of equity shall now be attributable to NCI.
Types of consideration
There are five different ways in which consideration may be paid at the acquisition of subsidiary co. A sum of all of these is called the COST OF INVESTMENT.
Consideration might be paid in the following ways:
- By cash
- By share for share exchange
- By deferred consideration
- By contingent consideration
- By loan notes
- By Cash
The consideration is calculated by multiplying the number of shares acquired with per share cash paid i.e. Total no. of shares of subsidiary co. x % holding x cash paid per share.
- By Share for share exchange
The consideration is calculated by multiplying the number of shares issued by Parent Co. with per share price of Parent Co. at the date of acquisition. i.e. No. of shares issued by Parent co. x Parent co. per share price
- By Deferred consideration: Deferred consideration is recorded at present value at the date of acquisition.
Dr. Cost of investment
Cr. Provision for deferred consideration
Subsequent recognition Unwinding of discount
Dr. Consolidates retained earnings
Cr. Provision for deferred consideration
- Contingent consideration: At times, the parent Co. agrees to pay the consideration only if some specified conditions are met such conditions are contingent events and IFRS 3 requires to measure such consideration at fair value. Initial recognition:
Dr. Cost of investment
Cr. Provision for contingent consideration
Fair value of contingent considered is re-assessed at every subsequent reporting date. Increase/ Decrease in fair value is charged to consolidated retained earnings.
In case of increase in fair value, following double entry will be passed.
Dr. Consolidates retained earnings
Cr. Provision for contingent consideration
- By loan notes
The consideration is calculated by recording the loan notes issued to shareholders of subsidiary co. at the date of acquisition.
The loan notes are issued to shareholders of subsidiary co. so these are NOT subsequently adjusted as inter company loan.
Fair Value Adjustment
All items in subsidiary co. financial statements are brought at their fair value at the date of acquisition for a valid calculation of goodwill. Gain or loss on fair value adjustment is included in the calculation of goodwill.
Additional depreciation due to fair value adjustment is deducted from retained earnings.
Goodwill in consolidated Statement of Financial Position:
Acquisition-date fair value of consideration transferred by parent X
Plus: Fair (or full) value of the N-CI at date of acquisition X
Less: Fair value of subsidiary’s identifiable net assets at date of acquisition (X)
Equals: Total Goodwill X
Format for detailed working of Full Goodwill calculation
|Cost of investment by Parent Co.||X|
|Fair value of NCI at the date of acquisition||X||XX|
|Fair value of net assets of subsidiary co.|
|Pre-acquisition retained earnings||X|
|Pre-acquisition revaluation reserve||X|
|Fair value adjustment||X/(X)||(XX)|
Negative goodwill is called Bargain Purchase Gain. It is charged to current year statement of profit or loss as income.
Impairment Of Goodwill
Under this approach the goodwill appearing in the consolidated Statement of Financial Position is the total goodwill. The accounting treatment will be:
Dr Group retained Earnings X
Dr Non-controlling interest X
Cr Goodwill X
Intra-group balances shall be removed from consolidated statement of financial position (CSOFP) only if the balances reconcile.
If balances do not reconcile then there can be two possible reasons for it. It is either due to cash in transit or goods in transit.
Make the adjustments for in transit items to bring their values at the same level in parent and subsidiary co.
- Cash in transit
- Goods in transit
Intra-Group unrealized profits
These are the profits on inventory arising as a result of inter company/intra group sale and the goods are still unsold at the year end.
Downstream transactions: If P Co has sold goods to S Co and these goods remain the in inventory at the year end, the profit recognized by the parent Co. Shall be eliminated (No impact on NCI)
Dr. Consolidated Reserves
Upstream transaction: If the S Co. has sold goods to the P.Co. the profits have been earned by the S.Co. and shall be eliminated not only from group reserve but also from NCI
Dr. Consolidated Reserves
Intra-group loans: The portion of loan given by the P.Co to its subsidiary is an intra-group receivable, payable and shall be eliminated as such.
Dr. Loan liability Cr. Loan Asset Any interest receivable payable on such loans shall also be eliminated but only to the extent related to the parent
Dr. Interest payable
Cr. Interest receivable
If the P.Co has not recorded interest receivable on loans given to the sub Co. the first treatment is to record the interest receivable.
Dr. Interest receivable
Cr. Consolidated reserves
After this an intra-group interest receivable payables exists which shall be eliminated
Dr. Interest payable
Cr. Interest receivable
If P.Co. has recorded the receivable but subsidiary company has not included a payable in its own financial statements, first treatment is to record the interest payable.
After this an intra-group interest receivable, payable asset which shall be eliminated.
Intra-group dividends: If the parent Co has not recorded the dividend recoverable the first treatment is to record the receivables.
Dr. Dividend receivable
Cr. Consolidated reserve
After this an intra-group, dividends receivable/payable exists which shall be eliminated:
Dr. Consolidated reserves
Cr. Dividend payable
Redeemable Preference Shares: Treat like any other long-term loans i.e. eliminate as an intercompany loan and adjust for any interest accrual.
Full or fair value of NCI: IFRS-3, allows/requires goodwill to be stated at full value i.e. a part of goodwill shall now be attributable to NCI.
Now goodwill impairment shall be charged not only to be parent company but also to NCI
Dr. Consolidated Reserves Cr. Goodwill
FORMAT FOR CALCULATION OF NCI
Fair value of NCI at the date of acquisition* X
Subsidiary Co. share of post-acquisition retained earnings X Share of post-acquisition revaluation reserve X
Unrealised profit (Upstream transaction) (X) Impairment of Goodwill (Share) (X)
Additional depreciation on fair value adjustment (X)
Non- controlling Interest XX
*If fair value of NCI is not available in question, it can be calculated by multiplying NCI no. of shares with Subsidiary Co. per share price at the date of acquisition
CONSOLIDATD RETAINED EARNINGS
Format for calculation of consolidated retained earnings
|Parent Co. total retained earnings||X|
|Subsidiary Co. share of post-acquisition retained earnings||X|
|Impairment of Goodwill (Share)||(X)|
|Additional depreciation on fair value adjustment||(X)|
|Unwinding of present value of deferred consideration||(X)|
|Increase/ Decrease in fair value of contingent consideration||(X)/X|
|Any other adjustment as per question||(X)/X|
|Consolidated Retained Earnings||XX|