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Vietnamese Every year, the IFRS experts at accounting firm Grant Thornton International publish what they call the “IFRS Top 20 Tracker.” It contains the 20 disclosure and accounting issues they think will pose potential challenges to IFRS preparers for the year.
“The IFRS Top 20 Tracker is not of course intended to be a comprehensive list of issues that companies may face during this financial reporting season,” they make clear. “It is intended to highlight areas that we expect to be particularly significant for many Grant Thornton clients, and in turn to assist management in prioritisation and review.”
For 2012, the Tracker focused on the following themes, keyed to existing and newly issued standards on or after 1 January 2011:
- the need for a company’s management commentary and financial statements to complement and be consistent with each other
- the effect that adverse economic conditions may have on a company’s financial statements, with particular emphasis on issues related to the Eurozone sovereign debt crisis
- key areas of interest for regulators
- challenging areas of accounting
- recent and forthcoming changes in financial reporting
CFO Innovation highlights three of the 20 IFRS issues singled out by Grant Thornton that we think are particularly applicable to Asia. These issues revolve around revenue recognition, statement of cash flows and business combinations
Revenue recognition
Grant Thornton notes that the most important accounting policy in the financial statements is the one on revenue recognition. But IFRS preparers sometimes fail to make clear what the company’s revenue recognition policy is, prompting regulators to raise questions about the financial statements.
The traps to watch out for include the following:
- failure to set out the accounting policy in sufficient detail
- lack of clarity on how the company determined the stage of completion of sales of services
- failure to describe the policies applied to the different revenue streams
- failure to explain areas of significant judgement
Grant Thornton advises IFRS preparers to make clear exactly how they have applied the principles of IAS 18 (Revenue) “to the specific business and its significant revenue streams.” They must also clearly note the point where revenue is recognised and the basis for measuring the revenue, especially in cases where the stage of completion has to be identified.
What are some of the red flags that would lead regulators to challenge the revenue recognition policy? The Tracker gives three examples:
- the accounting policy seems to allow the recognition of revenue before the qualifying criteria have been met, resulting in overstatement of income
- the accounting policy appears to suggest that revenue is recognised on product delivery without reference to customer acceptance or returns
- the accounting policy is unclear on how the various components in the sale of both goods and services have been accounted for
Regulators have also challenged companies that devised detailed accounting policies to cover apparently immaterial revenue streams, Grant Thornton notes. A good set of financial statements should not contain such “unnecessary clutter.”
Consistency is important. For example, if the company makes a reference to income streams in the management commentary section or segmental disclosures, the accounting policies on revenues should address each of those income streams. “Failure to do so is very likely to lead to questions from regulators,” the Tracker warns.
IAS 18 also requires specific disclosures that companies need to make. In practice, however, these requirements are easily overlooked. The IFRS preparer may also wrongly assume that the disclosures made to satisfy other standards already comply with the requirements of IAS 18.
Statement of cash flows
Grant Thornton observes that compliance with IAS 7 (Statement of Cash Flows) is coming under increased regulatory scrutiny these days, possibly because of economic problems in Europe that could affect the company’s ability to generate cash.
Cash and cash equivalents. Regulators have raised questions about cash and cash equivalents. For example, they would scrutinise the inclusion of bank overdrafts in cash and cash equivalents, if the company’s bank balance often moves from positive balance to overdraft position and back. This is taken as evidence that the bank overdraft is integral to the business’s cash management.
But regulators have challenged the inclusion of longer term borrowings (such as bank loans) and long-term deposits in cash and cash equivalents. This is because including them is seen as having the effect of obscuring the company’s true short-term position.
Classification of cash flows. Regulators have also challenged financial statements that have misclassified the three types of cash flows:
- cash flows from operating activities
- cash flows from investing activities
- cash flows from financing activities
Grant Thornton reminds IFRS preparers that cash flows generated by operating activities may be presented using the direct method, which requires disclosure of the major classes of cash receipts and cash payments.
The alternative is to present these cash flows using the indirect method, where profit or loss is adjusted for non-cash items, movements in working capital and any income or expense associated with investing and financing cash flows. This is done to reconcile the total cash flows from operating activities.
Cash flows generated by investing activities include the acquisition and disposal of long-term assets such as property, plant and equipment, and the acquisition and disposal of investments not included in cash equivalents.
The rule is that only expenditure that results in a recognised asset in the statement of financial position can be categorised as cash flow from investing activities. This means that cash flows in training or research, which may be broadly considered as investments, are not “investing activities” as contemplated by IAS 7 because costs associated with training and research must be expensed under IFRS.
Examples of cash flows from financing activities include the repayment of borrowings and the money raised from the issue of shares. Changes in ownership interests in subsidiaries that generate cash flows are also classified as financing activities, even though the parent company retains control of the subsidiary. This also applies to cases where the parent buys a non-controlling interest in a subsidiary.
Foreign exchange differences. Regulators have also challenged companies that report foreign exchange differences in reconciling ‘profit or loss’ and ‘cash flows from operating activities.’ The foreign exchange differences may be an indication that the reconciliation has not been done properly.
In cases where cash flows arise in a foreign currency, these should be recorded in the company’s functional currency by translating each cash flow at the exchange rate on the date the cash flow occurred. An average rate for the period may be used, but this rate should approximate the value of the actual rates.
If the group has a foreign subsidiary, the cash flows of that subsidiary should be converted into the group’s presentation currency by using the actual exchange rates on the dates when the cash flows occurred. An average rate may be used as well, but again this should approximate the actual rates.
Changes in exchange rates may generate unrealised gains, but these gains should not be categorised as cash flows. However, if changes in exchange rates have an effect on cash and cash equivalents denominated in a foreign currency, that effect needs to be reported in the statement of cash flows in order to reconcile the opening and closing balances of cash and cash equivalents.
The amount is presented separately from the three categories of cash flows (operating, investing and financing), typically at the foot of the statement of cash flows.
Business combinations
The revised IFRS 3 (Business Combinations) became effective for business combinations that occurred in annual periods starting on or after 1 July 2009. The areas that are causing practical problems for IFRS preparers, or which they overlook, are now becoming apparent.
These key areas include the following:
- identifying a business
- identifying the acquirer
- intangible assets acquired
- contingent consideration
Identifying a business. Under IFRS 3, a business is defined as “an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.”
The most common application of IFRS 3 involves a situation where one entity acquires another, notes Grant Thornton. However, the definition makes clear that a business is not necessarily always an entity. A collection of assets and activities can also be considered as a business. From the definition, this collection of assets and activities does not need to provide returns at this moment, but it must have the ability to do so in the future.
Regulators have challenged companies that treated a transaction as a purchase of group of assets, rather than as a business combination. How would an IFRS preparer know whether the accounting treatment should be a purchase of assets or business combination?
“An example of an indicator that a group of assets is a business is that employees are transferred with the acquired assets,” says Grant Thornton. “Alternatively, it may be the types of assets acquired that give rise to questions, for example, assets arising from research and development.”
Identifying the acquirer. In all business combinations under the purview of IFRS 3, one of the combining entities must be identified as the acquirer, defined as the entity that takes control of the acquiree.
How do you identify the acquirer? “The acquirer is usually the entity that transfers cash or other assets or incurs liabilities, or that issues equity instruments to effect the business combination,” notes Grant Thornton.
The relevant factors that determine who the acquirer is include the following:
- the relative voting rights in the combined entity after the business combination
- the existence of a large minority voting interest in the combined entity if no other owner or organised group of owners has a significant voting interest
- the composition of the governing body of the combined entity
- the composition of the senior management of the combined entity
- the terms of exchange of equity interests
Regulators have asked for clarifications from companies in cases where it appears the business combination is a reverse acquisition, but has not been accounted for as such. In a reverse acquisition, the issuing entity (the legal parent) is the acquiree for accounting purposes (that is, the accounting acquiree), even though it is the party that issues equity shares to the owners of the other entity (the accounting acquirer).
To account for a business combination that is in the form of a reverse takeover, the value of the consideration transferred must be determined based on what the accounting acquirer would have paid to complete the same business combination.
“Consolidated financial statements issued following a reverse acquisition will be in the name of the legal parent (the accounting acquiree), but are presented as a continuation of the legal subsidiary (the accounting acquirer),” says Grant Thornton.
However, the financial statements, including the comparatives, should reflect the legal share capital and share premium of the legal parent. The calculation of the consideration and the presentation of the consolidated financial statements following a reverse acquisition are set out in Appendix B of IFRS 3.
Intangible assets acquired. In a business combination, IFRS 3 requires that the acquired identifiable assets and liabilities be recognised at their acquisition date fair values. This requirement also covers the identifiable intangible assets of the acquiree, regardless of whether or not the acquiree has recognised these intangible assets in its own accounts.
“IFRS 3 is also clear that all identifiable intangible assets acquired in a business combination should be capable of reliable measurement,” notes Grant Thornton.
Regulators have observed inconsistencies between the management commentary and the disclosures, in cases where the company discussed the expected benefits of the acquisition, such as the use of brand names and access to customer relationships. They conclude from this that not all acquired intangibles have been identified and thus are likely to question the company.
What if the acquirer does not intend to utilise an intangible asset acquired in a business combination? This may be the case with a brand name that the acquirer plans to discontinue, for example. Under IFRS 3, the acquirer must still recognise the asset at fair value.
Contingent consideration. It is common in acquisitions to include a clause that calls for payment to be made to the owners of the acquiree contingent upon the occurrence of a future event. The amount of the consideration may also be linked to the acquiree’s level of future profits, for example.
IFRS preparers must make sure that any contingent consideration in a business combination is included, at fair value, in the consideration transferred at the acquisition date.
If the contingent consideration results in a financial asset or liability under IAS 39 (Financial Instruments: Recognition and Measurement), any change in fair value after the acquisition should be recognised in “profit or loss” or in “other comprehensive income” in accordance with IAS 39.
No subsequent re-measurement is required if the contingent consideration meets the definition of equity under IAS 32 (Financial Instruments: Presentation).
The key here is adequate disclosure in the presentation of accounting policies or in the notes that explain how contingent consideration has been accounted for. According to Grant Thornton, regulators have been known to challenge companies that recognised contingent consideration liabilities, but did not explain how those liabilities were measured.
Source: CFOInnovation
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