Aircraft Acquisition Costs

Aircraft are initially recorded at cost. Aircraft acquisition costs normally include purchase costs, duties and taxes, foreign exchange gains and losses and borrowing costs. The costs associated with major inspection activities or overhauls that result in future economic benefits should be recognised as a separate “component” and depreciated through the next major maintenance. Similarly, major spare part inventories may be capitalised as Property, Plant and Equipment.

The Component Approach

An aircraft is a complicated and costly asset with numerous components. Under IFRS, each significant component must be depreciated separately. As indicated above, IAS 16 itself indicates that the airframe and engine of an aircraft may be depreciated separately. Choosing components is a management decision, which will have to be done with some technical expertise and judgement.

Measurement

Under IFRS, companies have a choice on how to measure PP&E. They can choose to use either the historical cost method and carry the assets at cost less accumulated depreciation and impairment charges or the revaluation method and revalue the assets regularly to fair value.

For assets carried under the historical cost method or revaluation method, it is important for companies to review the assets' useful life, residual value, and depreciation method.

Residual Values

In normal industries, the residual value of assets is normally determined to be a percentage of the total asset value. However, due to the nature of the assets owned by an airline and the fact that their costs are significant, the residual value could be much higher than in normal industries. Airframes, engines and other assets owned by airlines usually have significant residual values. The residual value and the useful life of an asset under IFRS should be reviewed at least at each financial year-end with the following criteria in mind:

• technological obsolescence,
• operating cycles, and
• repair and maintenance policy.

The financial statements of Lufthansa provide an example of a change in the useful life as well as a change in the residual value.

Lufthansa have stated that repairable spare parts for aircraft are held at continually adjusted prices based on average acquisition costs. For measurement purposes, spare parts are assigned to individual aircraft models and depreciated on a straight-line basis depending on the lifetime of the fleet models for which they can be used.

Classification of Leases

Airlines enter into leases for a variety of assets including aircraft, spare engines, ground support equipment, machinery and facilities, and other equipment and tools. Leases, including those within the scope of IFRIC 4 Determining Whether an Arrangement Contains a Lease, are classified as either operating or finance leases based on the facts and circumstances at their inception.

IAS 17, Leases, defines a finance lease as one that transfers substantially all the risks and rewards incidental to ownership to the lessee. The asset's title may or may not eventually be transferred to the lessee. Operating leases have a negative definition – they are defined as all leases that are not finance leases.

Under IFRS, classification depends on substance rather than legal form, IAS 17 lists the following indicators that individually or in combination would lead to a finance lease:

• The lease transfers ownership of the asset to the lessee.
• The lessee has the option to purchase the asset at below market value so that it is reasonably certain that the lessee will exercise the option.
• The lease term is for the major part of the asset's economic life.
  • The present value of the minimum lease payments is close to the fair value of the leased asset when the lease contract is signed.
  • The leased assets are of a specialised nature so that only the lessee can use them without major modifications.
  • The lessor's losses associated with the cancellation of a lease are borne by the lessee.
• Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee – for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease.
• The lessee extends the lease term at substantially below-market rent.

Determining whether an aircraft lease is an operating or a finance lease involves significant judgement and will have to done very carefully. For instance, use of a wrong discount rate to calculate the present value of the minimum lease payments could change the nature of classification of the Lease.

Sale and Leaseback Transactions

Sale and leaseback transactions are frequently used to raise capital in the airline industry. The transaction involves the sale of an aircraft or other assets and the leaseback of the same assets, usually under a finance lease. The future lease payments and the sale price are often interdependent because they are negotiated as a package.

The accounting treatment of such a transaction, under IFRS, depends on classification of the leaseback as either a finance lease or an operating lease. If the leaseback results in a lease classified as a finance lease, any gain is deferred and amortised to income over the lease term. If the sales proceeds are less than the carrying amount, the loss is also deferred unless there has been an impairment of the asset's value. If the leaseback results in a lease classified as an operating lease, the accounting treatment is more complex because the sale price must be compared with the asset's fair value. If the sale price is at fair value or below fair value, the resulting profit or loss is recognised in the profit or loss account immediately. If the sale price is above fair value, the excess over fair value should be deferred and amortised to adjust the future rent over the period for which the asset is expected to be used.

The proposed revision to IAS 17 Leases would significantly impact the airline industry – this has been discussed in the chapter on future IFRS standards that could impact industries. As the new Standard has radically altered the method of recognising Lease Assets, it is expected that the value of these Assets on the Balance Sheets of airlines would increase. This may improve their financial condition and borrowing capacity – however this could take time since lenders would need to get used to the concept of recognising a Leased Asset as an Asset in the books of the Lessee.

Frequent Flier Accounting

Airlines grant award credits as part of sales transactions, including awards that can be redeemed for goods and services not supplied by the entities, through their customer loyalty programmes. The most common customer loyalty programme in the airline industry is the frequent flier programmes.

IFRS requires that awards, loyalty, or similar programmes, whereby a customer earns credits based on the purchase of goods or services, be accounted for as multi-element arrangements. As such, IFRS requires that the fair value of the award credits (otherwise attributed in accordance with the multiple-element guidance) be deferred and recognised separately upon achieving all applicable criteria for revenue recognition.

The above-outlined guidance applies whether the credits can be redeemed for goods or services supplied by the entity or whether the credits can be redeemed for goods or services supplied by a different entity. In situations where the credits can be redeemed through a different entity, a company should also consider the timing of recognition and appropriate presentation of each portion of the consideration received given the entity's potential role as an agent versus as a principal in each aspect of the transaction.

Joint Ventures

Joint ventures are common in the airline industry because they allow entities to share the risks and capital costs of new aircraft, routes and facilities. The key principle in IFRS 11 Joint Ventures is that parties to a joint arrangement recognise their contractual rights and obligations arising from the arrangement. It focuses on the recognition of assets and liabilities by the parties to the joint arrangement. The proportionate consolidation for a jointly controlled entity has been eliminated – only the equity method can be used. A single joint arrangement may contain more than one type – for example, joint assets and a joint venture. Parties to such a joint arrangement account first for the assets and liabilities of the joint assets arrangements and then use a residual approach to equity accounting for the joint venture part of the joint arrangement.

Provisions

Airlines are exposed to the potential for various claims and litigations related to aircraft damage, personal injury, other property damage, environmental liability and other matters.

The amount recognised as a provision for IFRS is the best estimate of expenditure required to settle the present obligation as of the balance sheet date. The anticipated cash flows are discounted to their present value if the effect of discounting is material.

Onerous Contracts

The industry commonly uses long-term contractual arrangements – for example, codeshare or outsourcing agreements including those with regional airlines. These contracts can become onerous over time if they cannot be cancelled without payment of a significant penalty or other compensation to the counterparty. Management should analyse specific facts and circumstances and, if appropriate, recognise a provision for the expected loss in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. IAS 37 requires a provision for the minimum unavoidable costs of meeting the obligations under a contract where the costs exceed the economic benefits expected to be received under the contract.

The standard also prohibits making a provision for future operating losses.

1. Is it an Agricultural Activity?

The Standard defines Agricultural Activity to mean management by an entity of the biological transformation and harvest of biological assets for sale or for conversion into agricultural produce or into additional biological assets. It also provides a representative list of biological assets, agricultural produce and the post-harvest product that would invariably be accounted for as Inventory.

Entities would need to exercise judgement while ascertaining if the activity falls under IAS 41. For instance, normal activities in a zoo or a gaming sanctuary would not fall under IAS 41, as there is no biological transformation. Similarly, whether stem-cell culture would fall under the ambit of IAS 41 would depend on whether there is a biological transformation.

Some time ago, there was a discussion as to whether bearer plants should be within the scope of IAS 41 or IAS 16. IAS 41 Agriculture currently requires all biological assets related to agricultural activity to be measured at fair value less costs to sell. This is based on the principle that the biological transformation that these assets undergo during their lifespan is best reflected by fair value measurement. However, there is a subset of biological assets, known as bearer plants, which are used solely to grow produce over several periods. At the end of their productive lives they are usually scrapped. Once a bearer plant is mature, apart from bearing produce, its biological transformation is no longer significant in generating future economic benefits. The only significant future economic benefits it generates come from the agricultural produce that it creates.

The IASB decided that bearer plants should be accounted for in the same way as property, plant and equipment in IAS 16 Property, Plant and Equipment, because their operation is similar to that of manufacturing.

2. Measurement and Disclosures

IAS 41 requires biological assets to be measured on initial recognition and at each balance sheet date at their fair value less costs to sell, except in limited circumstances. There are two occasions where the standard permits departure from current fair value:

• at the early stage of an asset's life; and
• when fair value cannot be measured reliably on initial recognition.

Arriving at an appropriate Fair Value for biological assets as per the requirements of IFRS 13 could pose some challenges. Quoted prices in an active market may not be available and observable inputs could be minimal. In such instances, reliance on unobservable inputs would be high. Another factor, which would impact the appropriate fair valuation of biological assets, would be the fact that some biological assets are seasonal. What discount factor would an entity give to a biological asset that is classified as Inventory in the month of June but is sold in the month of December?

An entity that is new to IFRS and has to follow IAS 41 could find the disclosure requirements pretty intense as compared to their erstwhile disclosures.

3. Impairment of Assets

IAS 36 Impairment of Assets is another Standard that would impact Agriculture. Most Agricultural activities depend on the weather, rains, temperature and other such natural resources for their growth and development. If there is too little rain, crops don't grow and if there is too much rain, crops get destroyed. There would be very clear internal as well as external indicators of impairment. Most Biological Assets are meant to be consumed within a particular time frame failing which their value could be eroded. It would appear that tests of Impairment would need to be much quicker for biological assets in the IFRS regime.

Master Supply Agreements

However, car factories of the future are not expected to be located in huge, sprawling complexes. This is because car companies have discovered the art of outsourcing manufacture of various components of a car to different suppliers. Only a small portion of the actual car manufacturing process, if any at all, takes place in the factory. The car manufacturer and the supplier enter into Master Supply Agreements (MSA).

MSAs can bring in some complications in accounting for Property, Plant and Equipment. For instance, the car manufacturer could supply some tools to the component supplier which were capitalised in the books. The tools may never come back from the supplier as they are being used to manufacture a car component. The car manufacturer would have to go back to the Framework to test whether the tool meets the definition of an Asset.

Intangible Assets

Due to the very nature of the car industry, there is a need to invest in Research and Development to bring out new models of cars or to alter known defects in existing models. IAS 38 provides guidance on capitalising Research and Development costs and reflecting them as Intangible Assets. Research costs (original investigation undertaken to gain new knowledge) are expensed as incurred. Development costs (application of research to new or substantially improved products) are capitalised provided that they meet specific criteria. Car factories would need to be extremely careful in applying this judgement.

Revenue Recognition

As per the mandate of IAS 18, revenue from the sale of products is recognised when substantially all risks and rewards from ownership of the goods are transferred to the customer. In the normal course, revenue would be recognised when the vehicle is handed over to the customer since it is generally felt that physical delivery is the best example of transfer of risks and rewards. However, the concept of risks and rewards could change if the vehicle is sold to/by a manufacturer, wholesaler or retailer. The terms of the contract would need to be looked in detail to determine recognition of revenue. This could prove to be a bit complicated due to aggressive selling tactics by dealers and sales dumping by manufacturers.

Multiple-Component Arrangements

It is normal for car companies to provide a certain number of free services and warranties. IAS 18 states that when the selling price of a product includes an identifiable amount for subsequent servicing, that amount is deferred and recognised as revenue over the period during which the service is performed. Conversely, the recognition criteria are applied to two or more transactions together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. For example, an entity may sell goods and, at the same time, enter into a separate agreement to repurchase the goods at a later date, thus negating the substantive effect of the transaction; in such a case, the two transactions are dealt with together.

Car manufacturers would need to closely look at both their contracts with suppliers and customers as well as the provisions of IFRS 15 to ascertain when and how much revenue they would need to recognise on the sale of a car to a customer with services bundled in.

Discount Arrangements and Incentives

An automotive entity may provide incentives to a customer as part of an arrangement. Examples of sales incentives offered by a seller include cash incentives, discounts and volume rebates, free/discounted goods or services and vouchers. In many cases the arrangement or incentive may need to be identified as a separate component of the transaction, with revenue being attributed and accounted for separately; in other cases it may be appropriate to deduct the amount of the incentive from revenue.

Leased Assets

It is normal for car manufacturing companies to have separate finance arms to provide finance to customers to purchase the cars they sell. Normally, the agreements with the customers are operating leases for the car manufacturer who would also have to look into the provisions of IAS 18 to recognise interest income and any fees that it receives for the financing transaction. The accounting for these would become relevant to the car manufacturer since the financing company would invariably be a subsidiary and hence would need to be consolidated as per the requirements of IFRS 10.

Financing being a risk-based business, there will be an impact of customers not paying up for which a provision would need to be made.

Decommissioning and Restoration Liabilities Under IFRS – Contractual and Constructive

Car factories are normally set up on land acquired from the Government. In many instances, the Government may insist that the car manufacturer return the lands to the Government at the end of a specified period in “broom-clean” condition. This would entail the car manufacturer incurring significant costs to decommission the Plant and restore the land to “broom-clean” condition. The car manufacturer would need to account for both a liability as well as an Asset for the amount of Decommissioning and Restoration Costs. They would also need to take into account the provisions of IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities.

As per IAS 37 Provisions, Contingent Liabilities and Contingent Assets, entities recognise obligations, both contractual and constructive, as part of the carrying amount of an asset. Liabilities for automotive entities often include a significant environmental component from storage tanks and chemicals used in the manufacturing process. An accurate estimate of the liability needs to be done.

Recall of Vehicles

It is the norm these days for automotive manufacturers to recall vehicles to rectify some defect in the vehicles. This would involve some costs. Automotive companies need to estimate if they would need to make a provision for these costs are per IAS 37. They key would be to determine the timing of when the current obligation from past events occurs and create a provision for possible expenses accordingly. Automotive companies should be aware of the fact that creating a general provision for possible expenses on recall of vehicles would impact their credibility and thereby possible future sales.

Financial Instruments

To the treasury function of a bank or a financial institution, financial instruments are almost like inventories.

Financial instruments are initially measured at fair value, which most often, but not always, is the transaction price. After initial recognition they are measured at fair value, amortised cost, or cost. “Amortised cost” is a concept similar to cost, but involves adjusting the balance sheet amount for the effect of calculating the yield on certain financial instruments by spreading fees, transaction costs and discounts or premiums over the lives of those instruments.

The types of financial assets that can be accounted for under amortised cost are mostly limited to debt instruments held to maturity and those not quoted in an active market. Financial assets that do not meet the amortised cost criteria are accounted for at fair value with gains and losses recognised either in profit or loss or in other comprehensive income.

Derivatives are generally accounted for at fair value with gains and losses generally recognised in profit or loss. If derivatives are “embedded” in other contracts (those contracts may or may not be financial instruments) they may have to be separated and accounted for separately from the host contract, at fair value, with gains and losses recognised in profit or loss.

Equity investments are generally accounted for at fair value. There is a limited exemption for unlisted equity investments when fair value cannot be reliably measured, which are accounted for at cost less impairment.

Impact of IFRS 9

The standard removes the “cost” accounting category for investments in equity instruments and introduces new classification criteria. Under its requirements, financial assets are eligible for accounting at amortised cost only if they are held within a business model whose objective is to collect contractual cash flows and their contractual terms give rise to cash flows that are solely payments of principal and interest.

Financial assets that do not meet the criteria for amortised cost accounting are measured at fair value with gains and losses recognised in profit or loss. For equity investments, an election can be made to recognise gains and losses in other comprehensive income. Accounting for financial liabilities remains similar to that in IAS 39 except that the effect of changes in credit risk on financial liabilities designated as at fair value is generally recognised in other comprehensive income. Requirements relating to derecognition of financial instruments are complex, requiring a comprehensive analysis of the transaction. The requirements are a mixture of “risk and rewards” and “control” models.

Impairment of Assets

The impairment of financial assets is currently measured on an “incurred loss” basis. This means that no impairment allowance can be established at initial recognition of a financial asset. Impairment is recognised if objective evidence indicates that an asset is impaired due to events occurring after initial recognition. An impairment loss is measured differently for financial assets accounted for at amortised cost than those accounted for at fair value with gains and losses recognised in other comprehensive income (the latter measurement category is called Available for Sale, or AFS). For financial assets measured at amortised cost, the impairment loss is measured as the difference between an asset's carrying amount and the present value of the estimated future cash flows, discounted at the asset's original rate of return. For AFS assets impairment is measured as the difference between acquisition cost and fair value.

Expected Losses Model

As a part of the amendments to IFRS 9, the IASB has replaced the incurred loss approach with an approach based on expected losses (i.e. expected cash flow approach). Under this model the initial estimate of credit losses would be spread over the expected lives of the financial assets as part of the recognition of return from those assets. Any subsequent changes to the initial estimate would be recognised immediately in profit or loss. Extensive additional disclosures are also proposed. The proposals are likely to be very challenging for banks to implement. Unlike IAS 39, the new IFRS 9 will only require an impairment assessment on assets measured at amortised cost; therefore, the expected cash flow model would become the single impairment model for financial assets.

Banks normally have their own robust internal mechanisms to estimate credit losses. A very basic example of the differences between the expected losses approach and the incurred loss approach is given below.

Assume that a finance company has a portfolio of $500,000 of Receivables. The ageing schedule of the receivables is provided in the example. Out of these, the company has subsequently come to know that one debtor A who is in the >365 days bracket has filed for bankruptcy. Another debtor B who is in the >300 days bracket is due $50,000 but has agreed to pay $25,000 in full and final settlement to which the finance company has agreed.

The company has made its own estimates of the expected losses from receivables. The differences between IAS 39 and IFRS 9 is captured below:

Disclosures

IFRS 7 Financial Instruments: Disclosures requires extensive qualitative and quantitative information explaining the significance of financial instruments to an entity's financial statements, its exposure to risk and how this exposure is managed. The financial crisis has had a significant impact on the banking sector, and there is considerable demand from financial statement users to improve the quality of the disclosures, including explanation of significant management judgement and sensitivity analysis, a move away from so-called “Boiler Plate” compliance with the standard. Some of the information required by IFRS 7 may not be readily available and new systems, processes and internal controls may need to be put in place to collect it.

Hedge Accounting

Hedge accounting is often used to minimise profit or loss fluctuation arising due to volatility in foreign exchange, interest rates, and other changes in fair values of certain financial instruments and other non-financial items. As under IFRS generally all derivatives have to be accounted for at fair value, with gains and losses recognised in profit or loss, hedge accounting aims to mitigate profit or loss impact in respect of the portion of the hedge that is effective.

There are three types of hedging relationships under IAS 39: fair value hedges, cash flow hedges and hedges of a net investment in a foreign operation. Accounting implications of each are as follows:

For fair value hedges, the gains and losses relating to both the hedged item and the hedging instrument are recognised in profit or loss.

For cash flows hedges and hedges of a net investment in foreign operation, the gains and losses on the hedging item are recognised in other comprehensive income.

In addition, IFRS specifically allows some types of portfolio hedges in which many derivatives can be used to hedge many assets/liabilities in a single relationship. This so-called “macro-hedging” can be very useful in minimising documentation requirements.

A hedging relationship only qualifies for hedge accounting if certain criteria are met, including formal designation and documentation of the hedging relationship at inception of the hedge. It should also be demonstrated, both at the outset and throughout the existence that the hedge is expected to be and has been highly effective, that is, remaining within the 80–125 per cent range. The initial documentation and subsequent effectiveness testing can be time consuming and systems-based solutions may be helpful in monitoring the effectiveness of the hedging relationships.

Hedge accounting requirements are detailed and prescriptive. They define the items that can be hedged (including components and risks) and the allowed hedging instruments. Care needs to be taken to ensure that hedge relationships are identified in a manner that meets the requirements of the standard and, in particular, that the effectiveness tests are designed in a way that minimises the risk of future hedge relationships failure.

Consolidated Financial Statements

Consolidated financial statements should include all subsidiaries of the parent company. The definition of a subsidiary focuses on the concept of control, which is defined in IFRS 10 as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.

IFRS contains specific guidance on the application of the control concept to SPEs, as many SPEs have pre-determined objectives and so it is more difficult to determine who controls them. An SPE is defined as an entity created to accomplish a narrow and well-defined objective (e.g. securitisation of receivables). In practice, judgement is often needed to conclude whether an entity should be regarded as an SPE.

Presentation: Debt vs. Equity

IAS 32 Financial Instruments: Presentation addresses the liability or equity classification of financial instruments. The classification is dependent on the substance of the contractual arrangements rather than legal form.

In general, an instrument is classified as a financial liability if it contains a contractual obligation to transfer cash or another financial asset, or if it may be settled in a variable number of the entity's own equity instruments. An obligation to transfer cash may arise from a requirement to repay principal or to pay interest or dividends. An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

An exception to the rules are puttable instruments, which give the holder the right to put the instruments back to the issuer for cash or another financial asset or instruments imposing an obligation on an entity only in liquidation. If certain criteria are met, then such instruments are classified as equity.

Some contracts may contain both equity and liability components, which may have to be accounted for separately. An example is a convertible bond that comprises a debt instrument and an equity conversion option. The equity conversion option would require analysis to determine whether it meets the definition of equity.

This is an example of another area that requires contract-by-contract analysis during the IFRS conversion process.

In general, an instrument is classified as a financial liability if it contains a contractual obligation to transfer cash or another financial asset, or if it may be settled in a variable number of the entity's own equity instruments. An obligation to transfer cash may arise from a requirement to repay principal to pay interest or dividends. An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

An exception to the rule is puttable instruments, which gives the holder the right to put the instruments back to the issuer for cash or another financial asset.

Product Classification and Significant Risks

IFRS 4 is the first Standard from the International Accounting Standards Board (IASB) on insurance contracts. The Standard is designed to make limited improvements to accounting practices and to provide users with an insight into the key areas that relate to accounting for insurance contracts. All entities that issue policies that meet the definition of an insurance contract under IFRS 4 have to apply this Standard. The Standard does not apply to other assets and liabilities of the insurance companies, such as financial assets and financial liabilities, which fall within the scope of IAS 39.

Classification of products into insurance products and other than insurance products is thus a pre-requisite for applying IFRS 4.

Basis of Classification of Insurance Contract

The conceptual basis of an insurance contract is the presence of significant insurance risk and insurance risk is defined as a transferred risk other than financial risk.

Various aspects viz. financial risk, insurance risk, transferred risk, significance of insurance risk and uncertainty of future event, need to be considered while determining whether a contract or product would classify as Insurance contract. There could be some contracts that do not meet the definition of an insurance contract. IFRS 4 requires that the insurable interest is embodied in the contract as a precondition for providing benefits. IFRS 4 also clarifies that survival risk, which reflects uncertainty about the required overall cost of living, qualifies as insurance risk.

Contracts issued that do not meet the definition of an insurance contract contained in IFRS 4 (also referred to as investment contracts) will be accounted for as financial instruments under IAS 39. Such contracts would be accounted at fair value or on amortised cost basis, based on classification of such contracts done by the company.

Accounting for Insurance Contracts Under IFRS

IFRS 4 permits the company to continue with its existing accounting policies on Insurance contracts except for the following:

1. measuring insurance liabilities on an undiscounted basis;
2. measuring contractual rights to future investment management fees at an amount that exceeds their fair value as implied by a comparison with current fees charged by other market participants for similar services;
3. using non-uniform accounting policies for the insurance liabilities of subsidiaries.

It further,

1. prohibits provisions for possible claims under contracts that are not in existence at the reporting date (such as catastrophe and equalisation provisions);
2. requires a test for the adequacy of recognised insurance liabilities and an impairment test for reinsurance assets;
3. requires an insurer to keep insurance liabilities in its balance sheet until they are discharged or cancelled, or expire, and to present insurance liabilities without offsetting them against related reinsurance assets.

Further the standard requires deposit element (if any) inherent in the insurance contract to be separated (unbundled) in case certain conditions are satisfied, as failure to separately account for the deposit element inherent in an insurance contract may result in material liabilities and assets not being fully recognised on the balance sheet of an entity, under the existing accounting policies which continue to apply in terms of IFRS 4.

Unbundling of deposit component is mandated if:

• the deposit component can be measured separately and the insurer's accounting policies do not otherwise require recognition of all obligations and rights arising from the deposit component;
• it is permitted but not required, if the deposit component can be measured separately and the insurer's accounting policies require recognition of all obligations and rights arising from the deposit component;
• it is prohibited if the deposit component cannot be measured separately.

If unbundled, the insurance component is accounted for under IFRS 4 and the deposit component under IAS 39 Financial instruments: recognition and measurement. The impact of unbundling would mean that only the net revenue for the company being recognised as top line (premium income) thereby eroding the top line to the extent of unbundling.

Recognition

IAS 38 states that an intangible asset is to be recognised if, and only if, the following criteria are met:

• it is probable that future economic benefits from the asset will flow to the entity; and
• the cost of the asset can be reliably measured.

The above recognition criteria look straightforward enough, but in reality it can prove to be very difficult to assess whether or not these have been met. In order to make the recognition of internally-generated intangibles more clear-cut, IAS 38 separates an R&D project into a research phase and a development phase.

Research Phase

It is impossible to demonstrate whether or not a product or service at the research stage will generate any probable future economic benefit. As a result, IAS 38 states that all expenditure incurred at the research stage should be written off to the income statement as an expense when incurred, and will never be capitalised as an intangible asset.

Development Phase

Under IAS 38, an intangible asset arising from development must be capitalised if an entity can demonstrate all of the following criteria:

• the technical feasibility of completing the intangible asset (so that it will be available for use or sale),
• intention to complete and use or sell the asset,
• ability to use or sell the asset,
• existence of a market or, if to be used internally, the usefulness of the asset,
• availability of adequate technical, financial, and other resources to complete the asset, and
• the cost of the asset can be measured reliably.

If any of the recognition criteria are not met then the expenditure must be charged to the income statement as incurred. Note that if the recognition criteria have been met, capitalisation must take place.

Treatment of Capitalised Development Costs

Once development costs have been capitalised, the asset should be amortised in accordance with the accruals concept over its finite life. Amortisation must only begin when commercial production has commenced (hence matching the income and expenditure to the period in which it relates). Each development project must be reviewed at the end of each accounting period to ensure that the recognition criteria are still met. If the criteria are no longer met, then the previously capitalised costs must be written off to the income statement immediately.

In view of the above, pharmaceutical companies would need to be extremely careful in segregating their costs into research costs and development costs. There can be no single formula to do this segregation and it would depend on a case to case basis. The trigger point to decide whether to stop expensing costs and capitalising them would be when the entity is certain that there are future economic benefits available.

There could also be some issues related to what type of expenditure can be capitalised in case the expenditure meets the definition of an Intangible Asset. If the Asset meets the definition of a Qualifying Asset detailed in IAS 23, borrowing costs can be capitalised. Patent protection costs that are specific to the drug being developed can also be capitalised as there would be future economic benefits. As a general rule, advertisement and promotional expenditure would be expensed unless the future economic benefit test can be satisfied for it to meet the definition of an asset.

Once recognised as an Intangible Asset, the next step would be to identify its useful life. Unlike other products, certain drugs may not have limited shelf-lives. Since IFRS necessitates doing a useful life test every year besides mandating an Impairment Test, initial estimates of useful lives made by pharmaceutical companies can be trued up every year.

Provisions, Contingent Liabilities and Contingent Assets

It is probably impossible to find a pharmaceutical company that has not been fined by the Food and Drug Administration ( FDA) in the United States. This is due to the strict quality control measures and policing that the FDA exercises over pharmaceutical companies. The fines have been levied for an eclectic variety of reasons:

• misbranding the painkiller … with “the intent to defraud or mislead”, promoting the drug to treat acute pain at dosages the FDA had previously deemed dangerously high;
• illegal promotion of the painkiller .. which was withdrawn from the market in 2004 after studies found the drug increased the risk of heart attacks;
• misbranding the drug …. for treating depression in patients under 18, even though the drug had never been approved for that age group;
• the company gave doctors free units of an injection to relieve knee pain to encourage those doctors to buy their product. They lowered the effective price by promising these free samples to doctors, but at the same time got inflated prices from government programmes by submitting false price reports;
• promoted these drugs for uses not approved as safe and effective by the FDA, targeted elderly dementia patients in nursing homes, and paid kickbacks to physicians and to the nation's largest long-term care pharmacy provider; and
• the drug was approved for treating schizophrenia and later for bipolar mania, but the government alleged that the company promoted the drug or a variety of unapproved uses, such as aggression, sleeplessness, anxiety, and depression.

It can be observed from the above that it is possible for pharmaceutical companies to pay fines to the FDA and other regulators for a wide variety of reasons. It is obvious that a pharma company will not provide for these fines in the normal course unless there is a triggering event. The triggering event could be a notice of demand from the FDA or an inspection by the FDA of the manufacturing facilities of the company. The time-line between the discovery of an infraction by a company and the ultimate penalty imposed could spread over a couple of years. Thus, it is possible that the company initially discloses this amount as a Contingent Liability and moves it to a Liability in the books on crystallisation of the liability.

Patent Protection Costs

Patents guarantee the protection of intellectual property. In the event of successful commercialisation, profits can be invested to enable continued, sustainable research and development. Due to the long period of time between the patent application and the market launch of a product, companies generally have only a few years in which to earn an adequate return on its intellectual property. This makes effective and reliable patent protection all the more important. Generic manufacturers and others attempt to contest patents prior to their expiration. Sometimes a generic version of a product may even be launched “at-risk” prior to the issuance of a final patent decision. This could result in legal proceedings. When a patent defense is unsuccessful, or it expires, prices are likely to come under pressure because of increased competition from generic products entering the market. Legal action by third parties for alleged infringement of patent or proprietary rights may impede or even halt the development or manufacturing of certain products or require payment of monetary damages or royalties to third parties. Large pharmaceutical companies have patent departments that keep themselves up to date with the developments.

Finance would need to interact with Patents Department to ascertain if either a Contingent Liability or Contingent Asset should be disclosed or a Liability provided for.

Consolidated Financial Statements

It is often felt that private equity funds control the entities they invest in. This would depend on the facts and circumstances of each case. IFRS 10 mandates consolidation of all subsidiaries that are controlled by the entity but provides an exemption to investment entities.

IFRS 10 states that an investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. An investment entity has been defined by IFRS 10 to mean an entity that:

1. obtains funds from one or more investors for the purpose of providing those investor(s) with investment management services,
2. commits to its investor(s) that its business purpose is to invest funds solely for returns from capital appreciation, investment income, or both, and
3. measures and evaluates the performance of substantially all of its investments on a fair value basis.

Most private equity funds would meet all the three requirements to qualify as an investment entity. It is advisable however to maintain adequate and sufficient documentation in support of these.

Often it is seen that private equity firms “demonstrate” that they have power over the investee. Often, this is achieved through the PE firms removing the Chief Executive Officer and/or the key management of the investee. In such situations where control has been demonstrated, the decision whether to consolidate the investee or not could prove to be tricky. The solution probably lies in the PE firm proving that the control that they demonstrated was with the sole intention of improving the capital appreciation for the ultimate investors. This could be proved by tangible evidence such as performance metrics and intangible parameters such as a “good feeling” about the change.

Special Purpose Entities

Enron showed the world what not to do with Special Purpose entities. IFRS 10 consolidates all the requirements of Consolidation including SIC 12 Special Purpose Entities. PE Investors normally set up various SPE's for tax and other purposes. They should carefully evaluate whether they meet the definition of an investment entity as mentioned in IFRS 10 or whether they control the SPE. The results of this evaluation will drive the accounting for these investments.

Financial Instruments

IFRS 10 states that if it were proved that an entity is an investment management entity, then IAS39/IFRS 9 would apply.

Financial instruments are recognised on the statement of financial position when the entity becomes party to the contractual provisions of the instrument.

All financial instruments are measured initially at fair value, directly attributable transaction costs are added to or deducted from the carrying value of those financial instruments that are not subsequently measured at fair value through profit or loss. Subsequent Measurement would depend on the category in which the Financial Instrument is classified:

• Fair Value through Profit and Loss Account
• Held to Maturity (HTM)
• Available for Sale (AFS)
• Loans and Receivables.

The HTM and the Loans and Receivables category can be ruled out due to the nature of the investment of the PE firm. As the Available for Sale category is a residual category, PE firms should probably classify the investment in the first category – Fair Value through Profit and Loss Account. This would appear to meet one of the requirements of IFRS 10 to determine investment management entity – measures and evaluates the performance of substantially all its returns on a Fair Value basis.

The financial instrument is measured at Fair Value. All gains and losses would be recognised in Profit or Loss Account.

Investment Property

This is likely to be the most significant item in the statement of financial position of entities in the real estate sector. IAS 40 Investment Property is a distinct standard addressing investment property, (e.g. land held for long-term capital appreciation and not for short-term sale in the ordinary course of business) and it allows the choice of using either the fair-value model or the cost model to account for such properties. Investment Property and PPE held for sale represents property that management intends to sell, but, unlike inventory, the sale of such property is not in the ordinary course of business.

Properties under construction (for sale): real estate companies sometimes sell properties e.g. houses and units apartments while they are under construction or development. The point is that IFRS principles treat sale of apartment and properties as a sale of a product (inventory) that is arguably also the underlying substance of such transactions, as against contracts for provision of construction services.

However, where there is an agreement to provide construction services, the real estate company is in the position of a contractor engaged in contracting activities. Hence, property being constructed on behalf of third parties is within the scope of IAS 11 Construction Contracts which deals with the accounting for construction contracts in the financial statements of contractors.

If IAS 11 Applies, What is the Accounting?

If IAS 11 applies, revenue is recognised on a percentage-of-completion basis provided that reliable estimates of construction progress and future costs can be made.

If IAS 18 Applies, Service or Goods?

Even if IAS 18 applies, the agreement may be to provide construction services rather than goods. This would likely be the case, for instance, if the entity is not required to acquire and supply construction materials. If the entity is required to provide services together with construction materials in order to perform its contractual obligation to deliver real estate to the buyer, the agreement is accounted for as the sale of goods under IAS 18.

Costs and Disclosures

New judgements will be required when accounting for contract costs, as the new standard replaces existing cost guidance in IAS 11 Construction Contracts with limited new guidance on the costs of obtaining and fulfilling a contract. This will directly affect profit recognition, especially when revenue is recognised over time. You will need to evaluate the impact of the new guidance on the costs to be capitalised and also consider the period over which they can be amortised.

The standard includes extensive new disclosure requirements. You may have to redesign, and in many cases significantly expand, the information captured about unfulfilled performance obligations in order to draft the notes to the financial statements dealing with revenue. The new disclosures could convey important additional information about business practices and prospects to investors and competitors. No exemptions have been provided for commercially sensitive information.

Accounting – Financial Asset Model

The operator recognises a financial asset to the extent that it has an unconditional contractual right to receive cash or another financial asset from or at the direction of the grantor for the construction services. The operator has an unconditional right to receive cash if the grantor contractually guarantees to pay the operator:

1. specified or determinable amounts, or
2. the shortfall, if any, between amounts received from users of the public service and specified or determinable amounts, even if payment is contingent on the operator ensuring that the infrastructure meets specified quality or efficiency requirements.

The operator measures the financial asset at fair value.

Accounting – Intangible Asset Model

The operator recognises an intangible asset to the extent that it receives a right (a licence) to charge users of the public service. A right to charge users of the public service is not an unconditional right to receive cash because the amounts are contingent on the extent that the public uses the service.

The operator measures the intangible asset at fair value.

Operating revenue

The operator of a service concession arrangement recognises and measures revenue in accordance with IASs 11 and 18 for the services it performs.

Presented below is how Aberdis reflected the impact of IFRIC 12 in their financial statements:

Exploration and Evaluation Expenditure/Assets

IFRS 6 deals only with Exploration and Evaluation Expenditure. IFRS 6 is a temporary Standard as the IASB is working on a larger project on extractive activities. Prior to IFRS 6, mining entities used to follow different methods in treating exploration and evaluation expenditure – some used to expense it, some used to capitalise it while some used to do a bit of both depending on the type of expenditure.

IFRS 6 can be summarised as follows:

• It permits an entity to develop an accounting policy for exploration and evaluation assets without specifically considering the requirements of paragraphs 11 and 12 of IAS 8. Thus, an entity adopting IFRS 6 may continue to use the accounting policies applied immediately before adopting the IFRS. This includes continuing to use recognition and measurement practices that are part of those accounting policies.
• It requires entities recognising exploration and evaluation assets to perform an impairment test on those assets when facts and circumstances suggest that the carrying amount of the assets may exceed their recoverable amount.
• It varies the recognition of impairment from that in IAS 36 but measures the impairment in accordance with that Standard once the impairment is identified.

However, IFRS 6 states that an entity shall not apply the IFRS to expenditures incurred:

• before the exploration for and evaluation of mineral resources, such as expenditures incurred before the entity has obtained the legal rights to explore a specific area; and
• after the technical feasibility and commercial viability of extracting a mineral resource has been demonstrated.

Para 9 of IFRS 6 provides the following indicative list of expenditures that might be included in the initial measurement of exploration and evaluation assets:

1. acquisition of rights to explore;
2. topographical, geological, geochemical and geophysical studies;
3. exploratory drilling;
4. trenching;
5. sampling; and
6. activities in relation to evaluating the technical feasibility and commercial viability of extracting a mineral resource.

It is common practice for entities in the Oil and Gas Industry to use the “successful efforts” method of accounting for exploration and development (E&D) expenditure. Under this method, the costs associated with locating, purchasing, and developing reserves are capitalised on a field-by-field basis. Once the reserves are proven, the capitalised costs can be assigned to the discovery; if discovery is not attained, then the expenditures are charged as an expense.

However, “successful efforts” is by no means a universal method. In its place, a number of upstream companies employ the full cost method of accounting for E&D expenditure. In contrast to the field-by-field approach of successful efforts, full cost is based on the aggregation of fields around geographic cost centers, typically organised on a country or regional basis.

Under IFRS, the proper application of full cost remains unsettled. IFRS 6 Exploration for and Evaluation of Mineral Assets allows for the use of full cost only for exploration and evaluation. After this phase, companies must switch to the successful efforts method.

Presented below is an extract from the financial statements of British Petroleum. It is interesting to note that instead of a generic statement of significant estimate or judgement at the beginning of the Statement of Accounting Policies, BP has chosen to give statements of significant estimate or judgement in their disclosures of every significant accounting policy.

De-Commissioning Costs

The accounting for Decommissioning is well covered by the scope of IAS 37 Provisions, Contingent Liabilities and Contingent Assets and management will need to apply care and judgment in applying this standard. The objective of IAS 37 “is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and to ensure that sufficient information is disclosed in the notes to enable users to understand their nature, timing and amount”. Decommissioning obligations have a financial impact as they necessitate cash costs in the future IAS 37 requires recognition of a provision when there is: a present obligation (legal or constructive) as a result of a past event; it is probable that an outflow will occur; and a reliable estimate can be made. The “present obligation as a result of a past event” criterion means that only infrastructure that is currently in place will result in a provision. The liability will therefore exclude decommissioning costs of facilities yet to be installed. For an event to be an obligating event, it is necessary that the entity has no realistic alternative to settling the obligation created by the event. This is the case only when: the settlement of the obligation can be enforced by law, or in the case of a constructive obligation where the event creates valid expectations in other parties that the entity will discharge the obligation.

With respect to the initial recognition of decommissioning liabilities, provisions should only be recognised if the obligation arises from past events existing independently of an entity's future actions; thus, if an entity can avoid an obligation by its future actions, no provision is required. The cost of dismantling and removing an asset associated with the construction of the asset should be apportioned in the original cost of the asset. Obligations to decommission an asset should be recognised during the exploration and evaluation and development or production phases, as appropriate, rather than at the time the asset begins commercial production. This is an important consideration for an asset that takes a substantial period of time to prepare for its intended use.

Decommissioning liabilities and the related capitalised costs are measured at the best estimate of the costs required to settle the decommissioning liability or to transfer to third party. Decommissioning liability provisions are discounted using pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability.

The standard requires that, in the event the time value of money is significant, the amount of a provision should be the present value of the expected expenditures necessary to discharge the obligation. It will be important for entities to be consistent in the choice and application of a discount rate, not only from period to period but also to situations in which discounting is required, e.g., impairment tests, cash flows from reserves, etc. IAS 37 explicitly prescribes that:

• the amount of the provision is the present value of the expenditure expected to be required to settle the obligation;
• the discount rate applied is a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability; and
• the discount rate should not reflect risks for which future cash flow estimates have been adjusted.

The Decommissioning Asset is depleted (depreciated), in the same way as the other oil and gas assets, using the unit of production (UOP) basis. This means that the cost of decommissioning is expensed to profit and loss over the life of the field, rather than in one big hit after the field has stopped producing. The Decommissioning Provision is increased over time as it is unwound, which adjusts for the year's worth of discount risk. The key idea is that by the time the field dries up, asset is down to 0 and provision is up to the full cost of decommissioning, in the money of the day when this takes place.

Costs estimates are based upon a number of assumptions and as a result changes in these estimates are almost inevitable over the life of a field, which will result in a change in the decommissioning asset and decommissioning provision. The decommissioning provision must be reviewed at each reporting date and adjusted to reflect management's current best estimates. In addition, at each reporting date the decommissioning provision is to be recalculated for changes in the estimated timing or amount of future cash outflows.

Accounting for changes in provisions is outlined in IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities and is applicable to decommissioning liabilities that have been both included in PP&E as part of an asset measured under IAS 16 and measured as a liability under IAS 37. It deals with the effect of the following three changes:

1. a change in the estimated timing of outflow of resources necessary to discharge the decommission obligation,
2. a change in the current market based discount rate (changes in the time value of money and risks specific to the liability), and
3. an increase that reflects the passage of time (also referred to as the unwinding of the discount or accretion of the discount).

For changes caused by items 1 and 2, the change is added to or deducted from the capitalised decommission cost of the asset to which it relates and the adjusted amount is amortised prospectively over the estimated life of the asset. A downward adjustment to the decommissioning and restoration asset cannot exceed the current carrying amount of the asset. Any excess should be recognised in the income statement in the current period.

The unwinding of the discount (item 3) arising from the passage of time is recognised as a financing cost in the income statement. It is not a borrowing cost as defined in IAS 23 Borrowing Costs and cannot be capitalised.

Rights of Return

For publishing and music companies converting to IFRSs, a key issue likely is determining an appropriate accounting policy for the rights of return. The nature of different arrangements with customers such as book and music stores will determine whether it is appropriate to recognise revenue under a consignment sale model, i.e. only as the book or music store sells the goods to the end customer, or whether it is appropriate to recognise revenue in full at the date of shipment to the book or music stores less a provision for expected returns.

Online Downloads and e-Books

It is now a norm to purchase media goods through online downloads, whereby the customer pays a fee to download content, such as books (e-books) and music, over the internet onto portable devices.

For music, risks and rewards generally are transferred upon the payment of fees and download of the file by the customer, and revenue would be recognised at that point.

Publishers selling e-books will require careful analysis of contractual terms of the arrangement prior to recognising revenue in order to reflect the substance of the arrangement. Two models are possible:

• the purchase model, whereby content is transferred to the customer in exchange for an upfront price. In this case, revenue is recognised upon download; or
• the licensing model, whereby the customer is offered access to individual e-books or a series of titles during the licence period. Typically in that case revenue is recognised over the period of access.

Bundled Arrangements

Some publishing companies often sell both print and online products for a single price, such as in the case of educational or professional products. While print products have a fixed edition status at the time of sale, the online product often includes regular updates to the information contained in the printed product for a certain period of time. A key practice issue is determining when to separate the various components in a bundled arrangement.

Under IFRSs, if it is determined that (1) the component has stand-alone value to the customer; and (2) its fair value can be measured reliably, then generally the component is accounted for separately. In our experience, a large number of these transactions will be separated into individual components under IFRSs, with only the attributable revenue recognised as each component is delivered.

Once the individual components have been identified, the next step is to allocate the consideration among these components. IFRSs allow the relative fair value method or the fair value of the undelivered components (residual method) as a basis for allocating revenues to the separable components.

The detailed requirements of IFRS 15 would need to be considered for bundled contracts.

Sales Incentives

Publishing and music companies often provide sales incentives such as cash discounts, volume rebates, free/discounted goods or services and vouchers to customers directly or through third parties. When an incentive programme is based on the volume or price of the products sold, the cost of these programmes generally is deducted from revenue when the corresponding sales are recorded.

Presented below are extracts from the Annual Report of the Guardian Media Group.

Purchased Rights

Generally, publishing, title and distribution rights are acquired either separately or through a business combination. The costs incurred to acquire these rights are capitalised as intangible assets, provided that they meet the definition thereof as well as the recognition criteria under IAS 38 Intangible Assets.

Internally Developed Rights

Publishing companies often incur significant expenditure on internally generated intangible assets such as developing publishing rights and publishing titles. IFRSs include specific requirements in respect of such costs, and companies will need to carefully review their internal capitalisation policies on converting to IFRSs.

The internal cost of developing an intangible asset is classified into the research phase and the development phase. Only directly attributable costs incurred during the development phase are capitalised from the date that the publishing company can demonstrate that certain criteria are met. In our experience, the key criteria for publishing companies are: (1) the ability to demonstrate the probability of generating future economic benefits; and (2) the ability to reliably measure the expenditure incurred. Capitalising costs incurred during the development phase is not optional.

IFRSs specifically prohibit capitalising expenditure on internally generated intangible assets such as internally generated brands, mastheads, publishing titles and customer lists. This is because such expenditure cannot be distinguished from the costs of developing the business as a whole. Publishing companies often develop and publish magazines and incur significant costs in their research and development. These costs are not capitalised under IFRSs, since in practice publishing companies find it difficult to determine future economic benefits that will accrue on its sale. Publishing companies on converting to IFRSs should carefully review their internal capitalisation policies.

Development of Database Content

Developing content for a database and then selling the related access rights often is the main business for publishers, especially those in the business of developing and publishing professional and scientific material. Developing this content is similar to internally developed rights, and costs that are directly attributable to the development of the database content typically are capitalised as an intangible asset.

Amortisation

IFRSs do not require a specific method of amortisation, and publishing and music companies can choose between the straight-line, diminishing balance, unit-of-production method, or another method that appropriately reflects the pattern of consumption of the asset's economic benefits.

Impairment of Non-Financial Assets

Under IAS 36 Impairment of Assets, publishing and music companies are required to assess at the end of each reporting period whether there are any indicators, external or internal, that an asset is impaired. In our experience, some of the indicators that publishing and music companies should consider include:

• the unexpected release of rival publications or albums;
• changes in the requirements within the advertising environment affecting publications that rely heavily on advertising;
• the adaptation of publications or music records to reflect the wishes of target groups;
• substantial differences between the quantities originally planned and those actually sold; and
• expected losses on a project as a whole.

Impairment of Exploration and Evaluation Assets

IFRS 6 effectively modifies the application of IAS 36 Impairment of Assets to exploration and evaluation assets recognised by an entity under its accounting policy. Specifically:

• entities recognising exploration and evaluation assets are required to perform an impairment test on those assets when specific facts and circumstances outlined in the standard indicate an impairment test is required. The facts and circumstances outlined in IFRS 6 are non-exhaustive, and are applied instead of the “indicators of impairment” in IAS 36;
• entities are permitted to determine an accounting policy for allocating exploration and evaluation assets to cash-generating units or groups of CGUs. This accounting policy may result in a different allocation than might otherwise arise on applying the requirements of IAS 36; and
• if an impairment test is required, any impairment loss is measured, presented and disclosed in accordance with IAS 36.

(a) Revenue

Revenue recognition issues in the retail industry could involve timing of the revenue recognition. The main questions that would need to be answered here are:

1. When does the margin/commission of the retailer accrue?
2. What is the process to be followed by the retailer to account for incentives/rebates given by the manufacturer?
3. How does the retailer account for Barter transactions?

(b) Rebates

Under IFRS, non-cash rebates (e.g., free gift with purchase or buy one get one free) are generally treated as a reduction in revenues. This may not be the case in other GAAP requirements.

(c) Layaway Sales

Under IAS 18 layaway sales would generally be recognised when the goods are delivered. Under IFRS revenue could also be recognised when a significant deposit is received, provided that the goods are on hand, identified, and ready for delivery to the buyer. Because “significant” is not defined under IFRS, one will have to carefully apply judgment upon determining when to recognise revenue.

4.16.2.1 IAS 18/IFRS 15

Telecoms face challenges when applying the revenue recognition requirements under IFRS. International Accounting Standard (IAS) 18 Revenue and related International Financial Reporting Interpretations Committee (IFRIC) interpretations are principle – based rather than sector-specific, which has resulted in a degree of inconsistency in the recognition of revenues by telecoms.

When faced with arrangements such as bundled products, free handsets, broadband connectivity and television and installation fees, telecoms reporting under IFRS must assess whether the risks and rewards of ownership have been transferred in order to determine when to recognise revenue. Accordingly, the individual facts and circumstances always will need careful consideration as they may vary between entities and also between different contracts within the same entity.

Separating arrangements into the underlying multiple deliverables, including customer loyalty programmes. Are you able to separate equipment sales from service arrangements? Can broadband installation or mobile activation fees be separated from the ongoing network provision? Such examples require a careful analysis of the entire revenue arrangement, rather than the constituent parts of the contract. Under IAS 18, two or more transactions are considered a single arrangement when they are “linked” in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. This will usually revolve around the nature of the components of the transaction and the stand-alone value of those components.

In today's era of fierce competition and bundled pricing, “free” products, such as free handsets, modems or set-top boxes, are offered to customers by telecoms on subscribing to their wireless or fixed-line services.

In basic terms, if it is determined that (1) the component has stand-alone value to the customer and (2) its fair value can be measured reliably, then the component should be accounted for separately.

We would expect large numbers of these transactions to be separated into individual components under IFRS, with only the attributable revenue recognised as each component is delivered. The separation guidance equally applies to customer loyalty programmes, which are required to be accounted for as separate revenue-generating deliverables rather than as cost deferrals. The accounting for customer loyalty programmes will be a significant change for many telecoms.

4.16.2.2 Gross Revenue Reporting versus Net Revenue Reporting

IFRS have specific guidance on determining whether an entity is acting as principal (indicative of reporting a transaction on a gross basis) or agent (indicative of reporting a transaction on a net basis) in a transaction. The issue is of particular importance to telecoms when it comes to mobile content downloads, premium rate services and call transmission such as international calls.

4.16.2.3 Intangible Assets

Spectrum or wireless licences, software (both acquired and internally developed) and goodwill are significant to the statement of financial position of telecoms and to the decision maker in any acquisition.

Spectrum licences are either acquired through government auctions or as part of an acquisition of another telecom, i.e., a business combination. The measurement of cost when purchased as part of a government auction includes the purchase price and any directly attributable costs such as borrowing costs, legal and professional fees. Alternatively, when such licences are acquired as part of a business combination, they are measured at fair value.

An internally generated intangible asset, such as billing software, is measured based on the direct costs incurred in preparing the asset for its intended use. Internal costs relating to the research phase of research and development (R&D) are generally expensed. However, development costs are capitalised if certain criteria are met. This requirement for an entity to define the criteria for research separately from development may affect telecoms who define R&D by reference to the criteria of other GAAPs.

4.16.2.4 Amortisation of Intangible Assets

Intangible assets are classified into those with a finite life, which are subject to amortisation, and those with an indefinite life including goodwill, which are not amortised but are subject to annual impairment testing.

The method of amortisation for an intangible asset with a finite useful life should reflect the pattern of consumption of the economic benefits. This should be consistent with management's assumptions in their budgeting, with amortisation beginning at the earliest point at which economic benefits are received from the intangible asset. Under IFRS, difficulties in determining useful life do not imply that an intangible asset has an indefinite useful life. This may cause issues for example, with spectrum licences in which it is likely that technology will eventually render a licence obsolete.

4.16.2.5 Property, Plant and Equipment

Telecoms are faced with the challenging task of reviewing capitalisation policies, detailed asset tracking and component depreciation.

4.16.2.6 Costs Eligible for Capitalisation

All costs such as material costs, labour and related benefits, installation costs, cost relating to network testing activities, site preparatory costs, among others, that are directly attributable to bringing an asset to the present condition and location necessary for intended use are eligible for capitalisation. However, all non-directly attributable costs such as allocations of general overhead including training costs may not be capitalised under IFRS. Telecoms, on conversion to IFRS, therefore will need to carefully review their asset capitalisation policies.

4.16.2.7 Component and Depreciation Methods

A telecom is required to allocate the initial amount relating to an item of property, plant and equipment into its significant parts or “components” and depreciate each part separately. This may involve significant judgement on part of the telecom.

When an item of property, plant and equipment comprises significant individual components for which different depreciation methods or rates are appropriate, each component is depreciated separately. A separate component may be either a physical component or a non-physical component that represents a major inspection or overhaul. An item of property, plant and equipment should be separated into components when those parts are significant in relation to the total cost of the item. Component accounting is compulsory when it would be applicable. However, this does not mean that an entity should split its assets into an infinite number of components if the effect on the financial statements would be immaterial.

IFRS do not specify one particular method of depreciation as preferable. Telecoms have the option to use the straight-line method, the diminishing or reducing balance method or the units-of-production method, as long as it reflects the pattern in which the economic benefits associated with the asset are consumed.

4.16.2.8 Asset Retirement Obligations or “Decommissioning Liabilities” Under IFRS – Contractual and Constructive Obligations

Under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, telecoms recognise obligations, both contractual and constructive, as part of the carrying amount of an asset. However, there are often differences in practice relating to recognition where rectification obligations may exist but they are not enforced. For example, obligations in respect of cables laid in international waters on the seabed or on coastal “landing stations” may be unclear and inconsistently accounted for between telecoms. Some telecoms may consider that removing the original cables may cause more environmental damage than leaving them in place. In our experience, judgment is required in the area of recognition and measurement of such provisions.

4.16.2.9 Impairment of Non-Financial Assets

A one-step approach requiring impairment losses to be recorded in the event the carrying amount of an asset exceeds its recoverable value. Consideration of the time value of money (i.e., discounting) is required.

4.16.2.10 Long-Lived Assets Other than Goodwill

Under IAS 36 Impairment of Assets, entities assess at the end of each reporting period whether there are any indicators, external or internal, that an asset is impaired. An impairment loss is recognised and measured for an individual asset, other than goodwill, at an amount by which its carrying amount exceeds its “recoverable amount.” If the recoverable amount cannot be determined for the individual asset, because the asset does not generate independent cash inflows separate from those of other assets, then the impairment loss is recognised and measured based on the cash-generating unit (“CGU”) to which the asset belongs.

4.16.2.11 Cash-Generating Units

A CGU is defined as the smallest group of assets that generates cash inflows from continuing use that are largely independent of the cash inflows from other assets or group of assets of the telecom.

Identifying CGUs can become more complex in the telecoms sector because of multiple products across different networks, especially if a telecom has operations in various countries. Further, certain telecoms may have their operating segments based on “type of customers” (e.g., residential or commercial), or “type of network” (e.g., fixed-line or wireless).

Telecoms are also faced with the challenge of allocating revenues from bundled products and services to the various networks in the current environment. This may be difficult when a customer is typically offered fixed-line calls, wireless, broadband and TV bundled as one service, while individual products are declining or rising in volume (e.g., fixed-line calls versus broadband line rentals).

4.16.2.12 Indicators of Impairment

Some examples of indicators of impairment are outlined below:

• Market value has declined significantly or the entity has operating or cash losses. For example, the migration of customers from fixed-line to wireless services may result in operating cash losses in the fixed-line business and result in a trigger for impairment.
• Technological obsolescence. For example, the technology shift from copper-based network to fibre-based network may be an indicator of impairment for the copper-based network.
• Competition. For example, the saturation of the mobile market intensifies competition for customers, which may reduce revenues and operating profits, thereby indicating potential impairment.
• Market capitalisation. For example, the carrying amount of the telecom's net assets exceeds its market capitalisation.
• Significant regulatory changes. For example, regulation of roaming charges in the European Union.
• Physical damage to the asset.
• Significant adverse effect on the entity that will change the way the asset is used or expected to be used. For example, the impact of sharing networks with other telecoms or exchanging network capacity, which may lead to stranded network assets that may be impaired.
• Goodwill. Under IFRS, telecoms are required to test goodwill (and intangible assets with indefinite lives) for the purposes of impairment at least annually irrespective of whether indicators of impairment exist and more frequently at interim periods if impairment indicators are present. Goodwill by itself does not generate cash inflows independently of other assets or group of assets and therefore is not tested for the impairment separately. Instead, it should be allocated to the acquirer's CGUs that are expected to benefit from the synergies of the business combination from which goodwill arose, irrespective of whether other assets or liabilities of the acquiree are assigned to those units. Goodwill is allocated to a CGU which represents: (1) the lowest level within the entity at which the goodwill is monitored for internal management purposes and (2) cannot be larger than an operating segment as defined in IFRS 8 Operating Segments. An impairment loss is recognised and measured at an amount by which the CGU's carrying amount, including goodwill, exceeds its recoverable amount.
• Impairment reversals. Impairment losses related to goodwill cannot be reversed. However, other impairment losses are reversed, subject to certain restrictions, if the recoverable amount has increased. However, as networks become more sophisticated, such a reversal of value in the assets used in legacy technology areas is perhaps unlikely in the telecoms sector.

4.16.2.13 Leases

Considering the operating costs required by telecoms and the changing face of the sector, lease accounting is gaining attention. IAS 17 Leases instead looks to the substance of the transaction to determine which party has the risks and rewards of ownership of a leased asset. This may affect those telecoms who adjust accounting models to come close to the bright-line benchmarks that keep assets off-balance sheet as operating leases, when the substance of the arrangement is that the telecom obtains substantially all of the risks and rewards incidental to ownership of the asset.

4.16.2.14 Financial Instruments

Significant changes in accounting for financial instruments.

Telecoms generally have financial instrument accounting issues owing to the treasury structures used to assist material network infrastructure build.

As it currently stands, IAS 39 Financial Instruments: Recognition and Measurement requires financial assets to be classified into one of four categories (financial assets at fair value through profit and loss, loans and receivables, held-to-maturity or available-for-sale) and financial liabilities are categorised as either financial liabilities at fair value through profit and loss or other liabilities.

Financial assets and financial liabilities are initially measured at fair value. After initial recognition, loans and receivables and held-to-maturity investments are measured at amortised cost. All derivative instruments are measured at fair value with gains and losses recorded in profit and loss except when they qualify as hedging instruments in a cash flow hedge.

A financial asset is derecognised only when the contractual rights to cash flows from that particular asset expire or when substantially all risk and rewards of ownership of the asset are transferred. A financial liability is derecognised when it is extinguished or when the terms are modified substantially.

4.16.2.15 Provisions and Contingencies

IFRS generally will result in earlier recognition of provisions.

Various types of provisions that affect telecoms include, but are not limited to warranties, environmental liabilities, decommissioning liabilities, disputes and legal claims which are covered under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The standard requires the recognition of a present obligation as a provision based on the probability of occurrence of outflow of resources, in which “probable” is defined as “more likely than not.” This may result in the recognition of additional amounts or earlier recognition of such amounts in the financial statements, as compared to the existing standards currently applied by telecoms.

Management is required to recognise a provision for its best estimate of the expenditure to be incurred at the end of the reporting period. The time value of money is considered, if material. For single obligations (e.g., lawsuits) a provision may be measured based on the most likely outcome. For a large population of possible amounts (e.g., product warranties), a provision is measured at its expected value which is a probability-weighted approach. In the event there is a continuous range of possible outcomes and no one amount is considered to be equally likely, then management is required to consider the mid-point of the range as an estimate of the amount of provision.

4.16.2.16 Tower Companies

The key issues in question are whether communication towers should be classified as investment property or as property plant and equipment (PPE). An understanding of both the physical structure as well as the ownership and usage of these towers is crucial in order to correctly account for them under IFRS. The IFRS Interpretations Committee (IFRIC) had earlier expressed support for broadening the scope of IAS 40 by focussing on the way the asset is used rather than on the physical characteristics of the structure.

4.17.3 IAS 18/IFRS 15

Entities in the Service Industry have different methods of invoicing customers for the services rendered.

4.17.2.2 IAS 19 Employee Benefits

Employees form the crux of a service organisation. Due to the need to keep employees engaged and happy, entities need to tailor their benefit schemes to attract talent. In addition to high wages, bonuses and other short-term benefits, these organisations also have defined contribution and defined benefit plans for employees. All these benefits would come under the scope of IAS 19 Employee Benefits.

IAS 19 outlines the accounting requirements for employee benefits, including short-term benefits (e.g. wages and salaries, annual leave), post-employment benefits such as retirement benefits, other long-term benefits (e.g. long service leave) and termination benefits. The standard establishes the principle that the cost of providing employee benefits should be recognised in the period in which the benefit is earned by the employee, rather than when it is paid or payable, and outlines how each category of employee benefits are measured, providing detailed guidance in particular about post-employment benefits.

Due to the criticality given to Employee Benefits in service entities, many organisations in this sector have their own retirement plans managed through trusts. IAS 26 Accounting and Reporting by Retirement Benefit Plans would be applicable here. IAS 26 Accounting and Reporting by Retirement Benefit Plans outlines the requirements for the preparation of financial statements of retirement benefit plans. It outlines the financial statements required and discusses the measurement of various line items, particularly the actuarial present value of promised retirement benefits for defined benefit plans.

4.17.2.3 IFRS 2 Share-based Payment

In addition to the employee benefits described above, large service organisations provide stock options, share appreciation rights and other such share-based payments to employees with a view to motivate them to stay with the company for some time and to get rewarded for that.

The issuance of shares or rights to shares requires an increase in a component of equity. IFRS 2 requires the offsetting debit entry to be expensed when the payment for goods or services does not represent an asset. The expense should be recognised as the goods or services are consumed. For example, the issuance of shares or rights to shares to purchase inventory would be presented as an increase in inventory and would be expensed only once the inventory is sold or impaired.

The issuance of fully vested shares, or rights to shares, is presumed to relate to past service, requiring the full amount of the grant-date fair value to be expensed immediately. The issuance of shares to employees with, say, a three-year vesting period is considered to relate to services over the vesting period. Therefore, the fair value of the share-based payment, determined at the grant date, should be expensed over the vesting period.

As a general principle, the total expense related to equity-settled share-based payments will equal the multiple of the total instruments that vest and the grant-date fair value of those instruments. In short, there is truing up to reflect what happens during the vesting period. However, if the equity-settled share-based payment has a market related performance condition, the expense would still be recognised even if all other vesting conditions were met.

In addition to the recognition and measurement requirements, IFRS 2 details a number of disclosures that need to be made by entities that issue share-based payments. IFRS 2 mandates the following disclosures.

1. A description of each type of share-based payment arrangement that existed at any time during the period, including the general terms and conditions of each arrangement, such as vesting requirements, the maximum term of options granted, and the method of settlement (e.g. whether in cash or equity).
2. The number and weighted average exercise prices of share options for each of the following groups of options:
   1. outstanding at the beginning of the period;
   2. granted during the period;
   3. forfeited during the period;
   4. exercised during the period;
   5. expired during the period;
   6. outstanding at the end of the period; and
   7. exercisable at the end of the period.
3. For share options exercised during the period, the weighted average share price at the date of exercise. If options were exercised on a regular basis throughout the period, the entity may instead disclose the weighted average share price during the period.
4. For share options outstanding at the end of the period, the range of exercise prices and weighted average remaining contractual life. If the range of exercise prices is wide, the outstanding options shall be divided into ranges that are meaningful for assessing the number and timing of additional shares that may be issued and the cash that may be received upon exercise of those options.

If the entity has measured the fair value of goods or services received as consideration for equity instruments of the entity indirectly, by reference to the fair value of the equity instruments granted, to give effect to the principle in paragraph 46, the entity shall disclose at least the following.

1. For share options granted during the period, the weighted average fair value of those options at the measurement date and information on how that fair value was measured, including:
   1. the option pricing model used and the inputs to that model, including the weighted average share price, exercise price, expected volatility, option life, expected dividends, the risk-free interest rate and any other inputs to the model, including the method used and the assumptions made to incorporate the effects of expected early exercise;
   2. how expected volatility was determined, including an explanation of the extent to which expected volatility was based on historical volatility; and
   3. whether and how any other features of the option grant were incorporated into the measurement of fair value, such as a market condition.
2. For other equity instruments granted during the period (ie other than share options), the number and weighted average fair value of those equity instruments at the measurement date, and information on how that fair value was measured, including:
   1. if fair value was not measured on the basis of an observable market price, how it was determined;
   2. whether and how expected dividends were incorporated into the measurement of fair value; and
   3. whether and how any other features of the equity instruments granted were incorporated into the measurement of fair value.
3. For share-based payment arrangements that were modified during the period:
   1. an explanation of those modifications;
   2. the incremental fair value granted (as a result of those modifications); and
   3. information on how the incremental fair value granted was measured, consistently with the requirements set out in (a) and (b) above, where applicable.

If the entity has measured directly the fair value of goods or services received during the period, the entity shall disclose how that fair value was determined, e.g. whether fair value was measured at a market price for those goods or services.

The following would also need to be disclosed:

1. The total expense recognised for the period arising from share-based payment transactions in which the goods or services received did not qualify for recognition as assets and hence were recognised immediately as an expense, including separate disclosure of that portion of the total expense that arises from transactions accounted for as equity-settled share-based payment transactions.
2. For liabilities arising from share-based payment transactions:
   1. the total carrying amount at the end of the period; and
   2. the total intrinsic value at the end of the period of liabilities for which the counterparty's right to cash or other assets had vested by the end of the period (e.g. vested share appreciation rights).

As indicated in the Preface, there is a school of thought that so much of what disclosures provide is merely ready fodder for competition to benchmark their compensation schemes or, in some instances, to poach employees since there is so much information available on Employee Benefits.

4.18.2.1 IAS 16 Property, Plant and Equipment

A ship takes a long time to build. A ship is normally built in what is known as a yard. In accordance with IAS 16, all costs necessary to bring the ship to a seaworthy state would be capitalised – these could include charges incurred at the yard in addition to the contract price.

Non-specific or operating costs are expensed as incurred, including costs associated with crew training.

4.18.2.2 IAS 36 Impairment of Assets

IAS 36 provides a number of example indicators of possible impairment, such as:

• a significant adverse change in the market and economic environment in which a company operates or to which an asset is dedicated; and
• evidence being available from internal reporting that indicates economic performance of an asset is worse than expected.

Practical triggers therefore include:

• general downturn in global economy;
• depressed freight rates;
• vessels being laid up;
• higher than normal scrapping rates;
• substantial physical damage to the vessel;
• technological obsolescence (e.g. driven by regulatory change); and
• operating losses.

4.20.2.1 IAS 18/IFRS 15 Revenue/Revenue from Contracts with Customers

4.20.3.1 IFRS 3 Business Combinations

Business Combinations are a norm in the technology industry. Many companies have internal teams to identify potential targets. As per IFRS 3, the purchase method of accounting has to be followed in which acquisition date fair values are assigned to all assets acquired and liabilities assumed. If it is not possible to determine accurate fair values on the acquisition date, IFRS 3 provides a period of one year from the acquisition date as measurement period to ascertain the accurate fair values and true up the values. Previously unrecognised Intangible Assets can be recognised in a Business Combination. Goodwill and other Intangible Assets are tested for Impairment every year and IFRS 3 has detailed methods to account for Contingent Consideration. As per IFRS 3, the net impact of a Bargain Purchase is reflected in the Profit and Loss Account.

The impact of IFRS 3 on technology companies is expected to increase in the future with the recent trend of technology companies displaying a penchant to acquire start-ups that have created an impact. Technologies change and start-up emerge and are acquired at the blink of an eye.

4.20.3.2 Intangible Assets and their Impairment

Entities in the technology industry create, acquire and possess Intangible Assets such as specific software, intellectual property rights, patents and trademarks and specific customer rights. In some instances, valuing Intangible Assets acquired could possess a challenge due to the lack of adequate information as the Assets could be so unique. An erroneous value at the time of initial recognition could pose complications later on since the initial base has been over estimated.

In the software and technology industries, technologies change at the blink of an eyelid. Entities in the industry would need to be particularly vigilant of impairment triggers. Accounting for an impairment loss is ultimately a matter of calculation but the critical aspect would be recognising the correct moment in time when the impairment was triggered.