In line with ACCAs established rule, accounting standards issued by 1 September in a given

year are examinable from 1 September in the following year, so IFRS 15 will be examinable
in P2 from the September 2015 session.
Core principle
The core principle of IFRS 15 is that an entity shall recognise revenue from the transfer of
promised good or services to customers at an amount that reflects the consideration to which
the entity expects to be entitled in exchange for those goods and services.
The standard introduces a five-step model for the recognition of revenue.
Limited exceptions
The five-step model applies to revenue earned from a contract with a customer with limited
exceptions, regardless of the type of revenue transaction or the industry.

Step one-Identification of the contract with the customer.

Forms
Contracts may be in different forms (written, verbal or implied), but must be enforceable,
have commercial substance and be approved by the parties to the contract.
Payment terms
The model applies once the payment terms for the goods or services are identified and it is
probable that the entity will collect the consideration.
Rights
Each partys rights in relation to the goods or services have to be capable of identification.
Reassessment
If a contract with a customer does not meet these criteria, the entity can continually reassess
the contract to determine whether it subsequently meets the criteria.
Combined
Two or more contracts that are entered into around the same time with the same customer
may be combined and accounted for as a single contract, if they meet the specified criteria.

Modification
A modification may be accounted for as a separate contract or as a modification of the
original contract, depending upon the circumstances of the case.

Step two-identification of the separate performance obligations in the contract.

Beginning
This is often referred to as unbundling, and is done at the beginning of a contract.
Distinctiveness
The key factor in identifying a separate performance obligation is the distinctiveness of the
good or service, or a bundle of goods or services. A good or service is distinct if the customer
can benefit from the good or service on its own or together with other readily available
resources and it is separately identifiable from other elements of the contract.
Single performance obligation
IFRS 15 requires that a series of distinct goods or services that are substantially the same with
the same pattern of transfer, to be regarded as a single performance obligation.
Not distinct
A good or service which has been delivered may not be distinct if it cannot be used without
another good or service that has not yet been delivered.
Combined
Similarly, goods or services that are not distinct should be combined with other goods or
services until the entity identifies a bundle of goods or services that is distinct.
Determination
IFRS 15 provides indicators rather than criteria to determine when a good or service is
distinct within the context of the contract. This allows management to apply judgment to
determine the separate performance obligations that best reflect the economic substance of a
transaction.

Step three-determine the transaction price

Transaction price
It is the amount of consideration that an entity expects to be entitled to in exchange for the
promised goods or services.

Third parties
This amount excludes amounts collected on behalf of a third party for example,
government taxes.
Variable or contingent consideration
The transaction price might include variable or contingent consideration.
Estimation
Variable consideration should be estimated as either the expected value or the most likely
amount.
Expected value approach
The expected value approach represents the sum of probability-weighted amounts for various
possible outcomes. The most likely amount represents the most likely amount in a range of
possible amounts.
Consistency
Management should use the approach that it expects will best predict the amount of
consideration and it should be applied consistently throughout the contract.
Variable consideration
An entity can only include variable consideration in the transaction price to the extent that it
is highly probable that a subsequent change in the estimated variable consideration will not
result in a significant revenue reversal.
Part of the variable consideration
If it is not appropriate to include all of the variable consideration in the transaction price, the
entity should assess whether it should include part of the variable consideration. However,
this latter amount still has to pass the revenue reversal test.
Wider

Variable consideration is wider than simply contingent consideration as it includes any

amount that is variable under a contract, such as performance bonuses or penalties.
Non cash consideration
Additionally, an entity should estimate the transaction price, taking into account non-cash
consideration, consideration payable to the customer and the time value of money if a
significant financing component is present.
Less than one year
The latter is not required if the time period between the transfer of goods or services and
payment is less than one year.
Lower amount
If an entity anticipates that it may ultimately accept an amount lower than that initially
promised in the contract due to, for example, past experience of discounts given, then
revenue would be estimated at the lower amount with the collectability of that lower amount
being assessed.
Impairment losses
Subsequently, if revenue already recognised is not collectable, impairment losses should be
taken to profit or loss.

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

Standalone selling prices

The allocation is based on the relative standalone selling prices of the goods or services
promised and is made at the inception of the contract. It is not adjusted to reflect subsequent
changes in the standalone selling prices of those goods or services.
Observable price
The best evidence of standalone selling price is the observable price of a good or service
when the entity sells that good or service separately.
When a contract contains more than one distinct performance obligation, an entity should
allocate the transaction price to each distinct performance obligation on the basis of the
standalone selling price.
Variable amount and discounts

Where the transaction price includes a variable amount and discounts, it is necessary to
establish whether these amounts relate to all or only some of the performance obligations in
the contract. Discounts and variable consideration will typically be allocated proportionately
to all of the performance obligations in the contract. However, if certain conditions are met,
they can be allocated to one or more separate performance obligations.
Separation
This will be a major practical issue as it may require a separate calculation and allocation
exercise to be performed for each contract. For example, a mobile telephone contract
typically bundles together the handset and network connection and IFRS 15 will require their
separation.

Step five - revenue to be recognised as each performance obligation is satisfied.

Control transfer
An entity satisfies a performance obligation by transferring control of a promised good or
service to the customer.
Time
It could occur over time or at a point in time.
Control defined
The definition of control includes the ability to prevent others from directing the use of and
obtaining the benefits from the asset.
Criteria
A performance obligation is satisfied at a point in time unless it meets one of the following
criteria, in which case, it is deemed to be satisfied over time:

The customer simultaneously receives and consumes the benefits provided by the
entitys performance as the entity performs.

The entitys performance creates or enhances an asset that the customer controls as
the asset is created or enhanced.

The entitys performance does not create an asset with an alternative use to the entity
and the entity has an enforceable right to payment for performance completed to date.

Transfer

Revenue is recognised in line with the pattern of transfer. Whether an entity recognises
revenue over the period during which it manufactures a product or on delivery to the
customer will depend on the specific terms of the contract.

Control is passed
If an entity does not satisfy its performance obligation over time, it satisfies it at a point in
time and revenue will be recognised when control is passed at that point in time.
Factors
Factors that may indicate the passing of control include the present right to payment for the
asset or the customer has legal title to the asset or the entity has transferred physical
possession of the asset.

For exam purposes, you should focus on understanding the principles of the five-step
model so that you can apply them to practical questions.

Written by a member of the P2 examining team

Definition and nature of a contract

Definition
A contract exists when an agreement between two or more parties creates enforceable rights
and obligations between those parties.
Writing or not
The agreement does not need to be in writing to be a contract, but the decision as to whether a
contractual right or obligation is enforceable is considered within the context of the relevant
legal framework of a jurisdiction.
Criteria
The first of the criteria is that the parties should have approved the contract and are
committed to perform their respective obligations.

Fulfilling
The parties need not always be committed to fulfilling all of the obligations under a contract.

Evidence
There needs to be evidence, however, that the parties are substantially committed to the
contract.
Not recognised
If IFRS 15 had required all of the obligations to be fulfilled, there would have been
circumstances, as set out above, where revenue would not have been recognised, even though
the parties were substantially committed to the contract.
The second and third criteria state that it is essential that each partys rights and the
payment terms can be identified regarding the goods or services to be transferred.

Recognised
If the scope of the work has been approved and the entity expects that the price will be
approved, then revenue may be recognised.
The fourth criteria states that the contract must have commercial substance before
revenue can be recognised as without this requirement, entities might artificially inflate their
revenue and it would be questionable whether the transaction has economic consequences.
Finally, it should be probable that the entity will collect the consideration due under the
contract.
Risk assessment
An assessment of a customers credit risk is an important element in deciding whether a
contract has validity.
Consideration
The consideration may be different to the contract price because of discounts and bonus
offerings.
Ability
The entity should assess the ability of the customer to pay and the customers intention to pay
the consideration.

In cases where the contract does not meet the criteria for recognition as a contract according
to IFRS 15, the consideration received should only be recognised as revenue when the
contract is either complete or cancelled, or until the contract meets all of the criteria for
recognition.

Wholly unperformed contracts

IFRS 15 does not apply to wholly unperformed contracts where all parties have the
enforceable right to end the contract without penalty.
Customer defined
The standard defines the term customer as a party that has contracted with an entity to
obtain goods or services that are an output of the entitys ordinary activities in exchange for
consideration.
Non-financial asset
In the case of the transfer of non-financial assets that are not an output of an entitys ordinary
activities, it is now required that an entity applies IFRS 15 in order to determine when to
derecognise the asset and to determine the gain or loss on derecognition.
Transfer of assets
This is because these transactions are more like transfers of assets to customers, rather than
other asset disposals.

Scope, exclusions and interactions with other standards

Non monetary exchanges
IFRS 15 excludes transactions involving non-monetary exchanges between entities in the
same industry to facilitate sales to customers or to potential customers.
Some contracts with customers will fall partially under IFRS 15 and partially under other
standards.
An example of this would be a lease arrangement with a service contract. If other IFRSs
specify how to account for the contract, then the entity should first apply those IFRSs. The
specific subject standard would take precedence in accounting for a part of a contract and any
residual consideration should be accounted for under IFRS 15. Essentially, the transaction
price will be reduced by the amounts that have been measured by the other standard.
As with all standards examined in P2, you should first aim to understand the principles of the
standard, then make sure that you practice applying these to practical questions.
Written by a member of the P2 examining team

This article is relevant to Papers F7 and P2

Complex lease terms mean that it is often difficult to determine how they should be
classified. This article examines IAS 17 and sheds some light on the matter
Leases are classified currently under IAS 17, Leases, as finance or operating leases at
inception, depending on whether substantially all the risks and rewards of ownership transfer
to the lessee. Under a finance lease, the lessee has substantially all of the risks and reward of
ownership. Situations that would normally lead to a lease being classified as a finance lease
include the following:

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

the lease term is for the major part of the economic life of the asset, even if title is not
transferred

at the inception of the lease, the present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset

the leased assets are of a specialised nature such that only the lessee can use them
without major modifications being made

if the lessee is entitled to cancel the lease, the lessor's losses associated with the
cancellation are borne by the lessee

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

the lessee has the ability to continue to lease for a secondary period at a rent that is
substantially lower than market rent

All other leases are operating leases.

The lease classification is made at the inception of the lease but a lessee and lessor may agree
to change the provisions of the lease. However, changes in estimates for example, changes in
the residual value of a leased property, or changes in circumstances such as default by the
lessee, do not give rise to a new classification of a lease. If the changes would have resulted
in a different lease classification, had they been applied originally, then the revised lease
agreement is treated as a new lease over the remaining lease term. The original accounting
entries are not retrospectively amended.

Often lease indicators may not always point in the same direction causing lease classification
to be difficult. Leases of specialised assets will usually be structured as finance leases. If an
asset is specialised, then this implies that no other entity has a use for the asset. Consequently
the lessor will only achieve its return on investment through the lease payments and it will
structure the lease as a finance lease accordingly. If a lessor can sell or lease non-specialised
assets to other parties at the end of the lease and is willing to accept the financial risk on this
then this could be an indicator of an operating lease. Assets of a non-specialised may become
specialised. For example, leased plant and equipment may be permanently installed in a
building and its removal at the end of the lease may be impractical or too expensive for the
lessor. Often specialised assets may have a significant remaining life at the end of the lease
and sometimes this remaining life may be the major part of the economic life of the asset and
therefore this indicator will point to it being an operating lease. However, it may be
appropriate to disregard this indicator. Normally for there to be an operating lease with a
significant part of the assets life remaining, there needs to be some realisation of funds
through sale or further rentals. However, in the case of a specialised asset this will not
normally occur, because it is of value only to the lessee. In these cases, the asset will
normally transfer to the lessee at the end of the lease for a nil or nominal payment and be
treated as a finance lease.
Where an asset has been leased several times during its economic life, and the lease is the last
lease to take the asset to the end of its life, then many of the indicators may point towards a
finance lease. For example, the present value of the minimum lease payments may
approximate to the fair value of the asset at the inception of the final lease and there is
unlikely to be an option to purchase the asset at fair value or to extend the lease at a market
rent because the asset has reached the end of its life. However the asset will obviously be
non-specialised and the final lease will not be for the major part of the economic life of the
asset. The lease will be for the entire remaining useful life of the asset but IAS 17, Leases,
focuses on economic life as an indicator of a finance lease. The lessor is recovering the
investment in the asset through a number of leases and the substance of each of those leases
will normally be an operating lease. Thus if the final lease were to be classified as a finance
lease simply because of its position in the chain, this would normally be unacceptable.
Where an asset is leased and rents are nominal rents, the agreement is still a lease under IAS
17. The total value of the rents will fall short of the fair value of the asset, thus indicating an
operating lease. Often, the rents are low because a premium will have been paid up-front
which may be equivalent to substantially all of the fair value of the asset. In this case, the
lease is probably a finance lease. Where rents are very low and no premium has been paid,
the lease does not have a commercial basis and it would appear that the lessor is indifferent to
the risks and rewards of ownership. Lease classification, in this case, is better judged by
looking at the substance of the arrangement and the intentions of the lessor in granting a lease
on such terms.
The presence of an option to extend the lease at substantially less than a market rent implies
that the lessor expects to achieve its return on investment solely through the lease payments
and therefore is content to continue the lease for a secondary period at a nominal rental. This
is an indicator of a finance lease. It is reasonable to assume that the lessee will extend the
lease in these circumstances. However, an option to extend it at a market rental may indicate
that the lessor has not achieved its return on investment through the lease rentals and
therefore is relying on a subsequent lease or sale to do so. This is an indicator of an operating
lease as there will be no compelling commercial reason why the lessee should extend the

agreement. The absence of any option to extend the lease does not provide evidence either
way as to an operating or a finance lease and other factors will need to be considered to
determine the classification.
In some cases, fluctuations in the fair value of the residual interest in the leased asset are
passed back to the lessee. This indicates that the lessee is bearing the residual value risk, and
the lessors return on investment is effectively fixed.
These indicators provide evidence of a finance lease. If the lease also requires the lessee to
make good to the lessor any shortfall between the sale proceeds and a fixed residual
amount, then again this is evidence of the lessors return being fixed. Where the lessor retains
the proceeds of the eventual sale of the asset, the lessor is bearing the residual value risk and
where the sale proceeds are significant, then this could be evidence of an operating lease.
Issues sometimes arise in lease contracts where an asset is held on a finance lease and then it
is all or partially sub- let to another party on identical terms and conditions. This can occur
where several entities intend to share leased accommodation and arrange for one entity to
lease the whole asset and then sub-let the relevant parts to the others. The issue that arises
here is whether the lead entity should recognise the finance leases on a gross basis in its
accounts or whether it should net off the transactions in its accounts.
In this case the entity should currently look at the de-recognition requirements of IAS 39,
Financial Instruments: Recognition and Measurement. The treatment will depend on the
terms of the individual transaction. If the two transactions are separate to the extent that the
lead entity is liable to pay its rentals under the head-lease regardless of whether it actually
receives its sub-lease rentals, then the de-recognition requirements will not be met and it will
need to account for the two leases on a gross basis.
A contingent rent is such amount that is paid as part of lease payments but is not fixed or
agreed in advance at the inception of lease rather the amount to be paid is dependent on some
future event. However, it is not an interest payment as it is not connected with the passage of
time therefore time value of money is not an issue. Contingent rent is commonly connected
with an increase or decrease in future sales by the lessee or increase or decrease in the use of
asset or inflation or deflation. Under IAS 17, contingent rents are excluded from minimum
lease payments and are accounted as expense/income in the period in which they are
incurred/earned.
If a lease contains a clean break clause, where the lessee is free to walk away from the lease
agreement after a certain time without penalty, then the lease term for accounting purposes
will normally be the period between the commencement of the lease and the earliest point at
which the break option is exercisable by the lessee. If a lease contains an early termination
clause that requires the lessee to make a termination payment to compensate the lessor such
that the recovery of the lessors remaining investment in the lease was assured, then the
termination clause would normally be disregarded in determining the lease term. Similarly
the same principle applies, if the lease agreement states that the lease can only be terminated
in remote circumstances, with the permission of the lessor or on entering a new lease
agreement for the same or equivalent asset.
The IASB is preparing a standard that may clarify and change some of the above aspects of
lease accounting. The current models lead to a lack of comparability and undue complexity

because of the distinction between finance and operating leases. As a result, many users of
financial statements adjust the amounts presented in the statement of financial position to
reflect the assets and liabilities arising from operating leases which makes the deliberations of
companies regarding classification of leases somewhat a futile exercise.
Written by a member of the Paper P2 examining team

IFRS 2, Share-based Payment, applies when a company acquires or receives goods and
services for equity-based payment. These goods can include inventories, property, plant
and equipment, intangible assets, and other non-financial assets. There are two notable
exceptions: shares issued in a business combination, which are dealt with under IFRS 3,
Business Combinations; and contracts for the purchase of goods that are within the
scope of IAS 32 and IAS 39. In addition, a purchase of treasury shares would not fall
within the scope of IFRS 2, nor would a rights issue where some of the employees are
shareholders.
Examples of some of the arrangements that would be accounted for under IFRS 2 include call
options, share appreciation rights, share ownership schemes, and payments for services made
to external consultants based on the companys equity capital.

RECOGNITION OF SHARE-BASED PAYMENT

IFRS 2 requires an expense to be recognised for the goods or services received by a company.
The corresponding entry in the accounting records will either be a liability or an increase in
the equity of the company, depending on whether the transaction is to be settled in cash or in
equity shares. Goods or services acquired in a share-based payment transaction should be
recognised when they are received. In the case of goods, this is obviously the date when this
occurs. However, it is often more difficult to determine when services are received. If shares
are issued that vest immediately, then it can be assumed that these are in consideration of past
services. As a result, the expense should be recognised immediately.
Alternatively, if the share options vest in the future, then it is assumed that the equity
instruments relate to future services and recognition is therefore spread over that period.

EQUITY-SETTLED TRANSACTIONS

Equity-settled transactions with employees and directors would normally be expensed and
would be based on their fair value at the grant date. Fair value should be based on market
price wherever this is possible. Many shares and share options will not be traded on an active
market. If this is the case then valuation techniques, such as the option pricing model, would
be used. IFRS 2 does not set out which pricing model should be used, but describes the
factors that should be taken into account. It says that intrinsic value should only be used

where the fair value cannot be reliably estimated. Intrinsic value is the difference between the
fair value of the shares and the price that is to be paid for the shares by the counterparty.
The objective of IFRS 2 is to determine and recognise the compensation costs over the period
in which the services are rendered. For example, if a company grants share options to
employees that vest in the future only if they are still employed, then the accounting process
is as follows:

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

This fair value will be charged to profit or loss equally over the vesting
period, with adjustments made at each accounting date to reflect the best
estimate of the number of options that will eventually vest.

Shareholders equity will be increased by an amount equal to the charge in

profit or loss. The charge in the income statement reflects the number of
options vested. If employees decide not to exercise their options, because
the share price is lower than the exercise price, then no adjustment is
made to profit or loss. On early settlement of an award without
replacement, a company should charge the balance that would have been
charged over the remaining period.

EXAMPLE 1
A company issued share options on 1 June 20X6 to pay for the purchase of inventory. The
inventory is eventually sold on 31 December 20X8. The value of the inventory on 1 June
20X6 was $6m and this value was unchanged up to the date of sale. The sale proceeds were
$8m. The shares issued have a market value of $6.3m.
How will this transaction be dealt with in the financial statements?
Answer
IFRS 2 states that the fair value of the goods and services received should be used to value
the share options unless the fair value of the goods cannot be measured reliably. Thus equity
would be increased by $6m and inventory increased by $6m. The inventory value will be
expensed on sale.

PERFORMANCE CONDITIONS

Schemes often contain conditions which must be met before there is entitlement to the shares.
These are called vesting conditions. If the conditions are specifically related to the market
price of the companys shares then such conditions are ignored for the purposes of estimating
the number of equity shares that will vest. The thinking behind this is that these conditions
have already been taken into account when fair valuing the shares. If the vesting or
performance conditions are based on, for example, the growth in profit or earnings per share,
then it will have to be taken into account in estimating the fair value of the option at the grant
date.

EXAMPLE 2
A company grants 2,000 share options to each of its three directors on 1 January 20X6,
subject to the directors being employed on 31 December 20X8. The options vest on 31
December 20X8. The fair value of each option on 1 January 20X6 is $10, and it is anticipated
that on 1 January 20X6 all of the share options will vest on 30 December 20X8. The options
will only vest if the companys share price reaches $14 per share.
The share price at 31 December 20X6 is $8 and it is not anticipated that it will rise over the
next two years. It is anticipated that on 31 December 20X6 only two directors will be
employed on 31 December 20X8.
How will the share options be treated in the financial statements for the year ended 31
December 20X6?
Answer
The market-based condition (ie the increase in the share price) can be ignored for the purpose
of the calculation. However the employment condition must be taken into account. The
options will be treated as follows:
2,000 options x 2 directors x $10 x 1 year / 3 years = $13,333
Equity will be increased by this amount and an expense shown in profit or loss for the year
ended 31 December 20X6.

CASH SETTLED TRANSACTIONS

Cash settled share-based payment transactions occur where goods or services are paid for at
amounts that are based on the price of the companys equity instruments. The expense for
cash settled transactions is the cash paid by the company.
As an example, share appreciation rights entitle employees to cash payments equal to the
increase in the share price of a given number of the companys shares over a given period.
This creates a liability, and the recognised cost is based on the fair value of the instrument at
the reporting date. The fair value of the liability is re-measured at each reporting date until
settlement.
EXAMPLE 3
Jay, a public limited company, has granted 300 share appreciation rights to each of its 500
employees on 1 July 20X5. The management feel that as at 31 July 20X6, the year end of Jay,
80% of the awards will vest on 31 July 20X7. The fair value of each share appreciation right
on 31 July 20X6 is $15.
What is the fair value of the liability to be recorded in the financial statements for the year
ended 31 July 20X6?

Answer
300 rights x 500 employees x 80% x $15 x 1 year / 2 years = $900,000

DEFERRED TAX IMPLICATIONS

In some jurisdictions, a tax allowance is often available for share-based transactions. It is

unlikely that the amount of tax deducted will equal the amount charged to profit or loss under
the standard. Often, the tax deduction is based on the options intrinsic value, which is the
difference between the fair value and exercise price of the share. A deferred tax asset will
therefore arise which represents the difference between a tax base of the employees services
received to date and the carrying amount, which will effectively normally be zero. A deferred
tax asset will be recognised if the company has sufficient future taxable profits against which
it can be offset.
For cash settled share-based payment transactions, the standard requires the estimated tax
deduction to be based on the current share price. As a result, all tax benefits received (or
expected to be received) are recognised in the profit or loss.
EXAMPLE 4
A company operates in a country where it receives a tax deduction equal to the intrinsic value
of the share options at the exercise date. The company grants share options to its employees
with a fair value of $4.8m at the grant date. The company receives a tax allowance based on
the intrinsic value of the options which is $4.2m. The tax rate applicable to the company is
30% and the share options vest in three-years time.
Answer
A deferred tax asset would be recognised of:
$4.2m @ 30% tax rate x 1 year / 3 years = $420,000
The deferred tax will only be recognised if there are sufficient future taxable profits available.

DISCLOSURE

IFRS 2 requires extensive disclosures under three main headings:

Information that enables users of financial statements to understand the

nature and extent of the share-based payment transactions that existed
during the period.

Information that allows users of financial statements to understand how

the fair value of the goods or services received, or the fair value of the
equity instruments which have been granted during the period, was
determined.

Information that allows users of financial statements to understand the

effect of expenses, which have arisen from share-based payment
transactions, on the entitys profit or loss in the period.

The standard is applicable to equity instruments granted after 7 November 2002 but not yet
vested on the effective date of the standard, which is 1 January 2005. IFRS 2 applies to
liabilities arising from cash-settled transactions that existed at 1 January 2005.
MULTIPLE-CHOICE QUESTIONS

1. Which of the following do not come within the definition of a share-based payment under
IFRS 2?
A employee share purchase plans
B employee share option plans
C share appreciation rights
D a rights issue that includes some shareholder employees

2. A company issues fully paid shares to 500 employees on 31 July 20X8. Shares issued to
employees normally have vesting conditions attached to them and vest over a three-year
period, at the end of which the employees have to be in the companys employment. These
shares have been given to the employees because of the performance of the company during
the year. The shares have a market value of $2m on 31 July 20X8 and an average fair value
for the year of $3m. It is anticipated that in three-years time there will be 400 employees at
the company.
What amount would be expensed to profit or loss for the above share issue?
A $3m
B $2m
C $1m
D $666,667

3. A company grants 750 share options to each of its six directors on 1 May 20X7. The
options vest on 30 April 20X9. The fair value of each option on 1 May 20X7 is $15 and their
intrinsic value is $10 per share. It is anticipated that all of the share options will vest on 30
April 20X9. What will be the accounting entry in the financial statements for the year ended
30 April 20X8?
A Increase equity $33,750; increase in expense in profit or loss $33,750
B Increase equity $22,500; increase in expense in profit or loss $22,500

C Increase liability $67,500; increase in expense profit or loss $67,500

D Increase liability $45,000; increase in current assets $45,000

4. A public limited company has granted 700 share appreciation rights (SARs) to each of its
400 employees on 1 January 20X6. The rights are due to vest on 31 December 20X8 with
payment being made on 31 December 20X9. During 20X6, 50 employees leave, and it is
anticipated that a further 50 employees will leave during the vesting period. Fair values of the
SARs are as follows:
$
1 January 20X6

15

31 December 20X6

18

31 December 20X7

20

What liability will be recorded on 31 December 20X6 for the share appreciation rights?
A $1,260,000
B $1,680,000
C $2,520,000
D $3,780,000

ANSWERS
1 (d).
2 (b). $2m. The issue of fully paid shares is deemed to relate to past service and should be
expensed to profit or loss at 31 July 20X8.
3 (a). 750 x 6 (directors) x $15 / 2 years = $33,750
4 (a). 700 x (400 100) x $18 x 1/3 = $1,260,000
Written by a member of the Paper P2 examining team

The article explains the basic principles of hedging and the current accounting regulations as
set out in IAS 39, Financial Instruments: Recognition and Measurement (IAS 39). The article
concludes by considering the weaknesses of IAS 39 and how those weaknesses are addressed
by the proposed changes issued by the IASB in September 2012.

Basic principles of hedging

Are you risk adverse? I think I am. For example, as a property owner I have an insurance
policy to protect me from the risk of incurring a loss if my house were to burn down.
Companies will face many risks and if they seek to cover these risks then they are said to be
hedging. Hedging therefore is a risk management process whereby risk adverse companies
firstly identify and quantify that they have a risk and secondly seek to cover that risk.

The hedged item

Risks come in many forms for companies. For example there is a risk that the fair value of
assets and liabilities that they hold might increase or decrease, that in future the price of the
goods they buy or sell might change, that interest rates on their borrowings or deposits might
change, and that foreign exchange rates may move. A hedged item is defined as an item that
exposes the entity to risk of changes in fair value or future cash flows and is designated as
being hedged.

The hedging instrument

In order to protect themselves from losses on hedged items companies enter into contracts to
cover any loss arising. These contracts often not only eliminate the risk but also eliminate any
potential gain. These contracts are termed the hedging instrument. A hedging instrument is
defined as a contract whose fair value or cash flows are expected to offset changes in the fair
value or cash flows of a designated hedged item. Hedging instruments are normally a type of
financial instrument known as a derivative.
I have written about the accounting for financial instruments (see 'Related links'). To recap, a
financial instrument is a contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity. A derivative is so called because its
value changes in response to the change in an underlying variable such as an interest rate, a
commodity, a security price, or an index. Derivatives often require no initial investment, or
one that is smaller than would be required for a contract with similar response to changes in
market factors; and are settled at a future date.
An example of a derivative is a forward contract. Forward contracts are contracts to purchase
or sell a specific quantity of something, eg a commodity, or a foreign currency at a specified
price determined at the outset, with delivery or settlement at a specified future date. For
example a farmer may enter into a forward contract with a supermarket to sell in 12 months a
specific amount of crop at a certain price. In this way the producer (the farmer) is protected
from the risk of falling prices, and the consumer (the supermarket) is protected from the risk
of rising prices. It therefore provides certainty.
Another example of a derivative is a futures contract. These contracts are similar to forwards
but whereas forward contracts are individually tailored, futures are generic and are tradable in
a market. Futures are generally settled through an offsetting (reversing) trade, whereas

forwards are generally settled by the actual delivery of the underlying item or cash
settlement.
If a derivative is held by a company and it is not designated as a hedging instrument then it is
deemed to be held for speculation, ie for trading purposes. All derivatives must be recognised
at fair value on the statement of financial of position this is sometimes referred as being
marked to market. As the value of derivatives can be very unstable and so can generate
large gains and losses in a short period, derivatives cannot be carried at historic cost (which is
often nil anyway) as this would result in large gains and losses being unreported. If the
derivative is not designated as a hedging instrument then any gains or losses arising are
recognised in the statement of profit of loss. This is fair enough as the rightful place for
trading profits and losses is the statement of profit or loss.

Basic principles hedge accounting and effectiveness

In essence the principle of hedge accounting is that it seeks to reflect the substance of why
the hedging instrument (the derivative) has been entered into. To that end hedge accounting is
trying to match any loss (or gain) on the hedged item with the gain (or loss) on the hedging
instrument. In a perfect world hedging would work so that no net gain or loss arose. For
example if the hedged item created a loss of say $500m it would then be matched by a gain
on the hedging instrument of $500m. This would be a perfect hedge, a hedge with 100%
effectiveness. However we do not live in a perfect world so a 100% effective hedge is highly
unlikely. So if the hedged item created a loss of $500m and the hedging instrument a gain of
$450m then the hedge would said to be 90% effective (450/500 = 90%).

IAS 39 the current regulation

IAS 39 regulates what can be designated a hedged item, a hedging instrument, when a
hedging relationship exists and also how to account for the gains and losses on certain types
of hedging relationships.
IAS 39 regulates that a hedged item can be:

a single recognised asset or liability, firm commitment, or a highly

probable transaction

a group of assets, liabilities, firm commitments, or highly probable forecast

transactions

an investment for foreign currency or credit risk (but not for interest risk or
prepayment risk)

a portion of the cash flows or fair value of a financial asset or financial

liability

a non-financial item for foreign currency risk only for all risks of the entire
item

a portfolio hedge of interest rate risk (Macro Hedge) only

a portion of the portfolio of financial assets or financial liabilities that share

the risk being hedged.

IAS 39 regulates that hedging instruments can be derivative contracts with an external
counterparty, except for some written options. However a non-derivative financial asset or
liability may not be designated as a hedging instrument except as a hedge of foreign currency
risk. (This is quite a rule-based approach!)
IAS 39 permits hedge accounting under certain circumstances provided that the hedging
relationship is:

formally designated and documented at inception, including the entity's

risk management objective and strategy for undertaking the hedge,
identification of the hedging instrument, the hedged item, the nature of
the risk being hedged, and how the entity will assess the hedging
instrument's effectiveness, and

expected to be highly effective in achieving offsetting changes in fair

value or cash flows attributable to the hedged risk as designated and
documented, and effectiveness can be reliably measured, and

assessed on an ongoing basis and determined to have been highly

effective.

Effectiveness is the extent to which the instrument offsets changes in fair value or cash flows
attributable to the hedged risk. A hedge is highly effective if that offset falls within a 80
125% window. Hedge effectiveness has to be assessed both prospectively and retrospectively.
All hedge ineffectiveness is recognised immediately in the statement of profit or loss
(including ineffectiveness within the 80% to 125% window).
While IAS 39 recognises three categories of hedge, only two are examinable in Paper P2,
Corporate Reporting. These are fair value hedges and cash flow hedges.

Fair value hedge

A fair value hedge is defined as a hedge of the exposure to changes in fair value of a
recognised asset or liability. For example, if a company has an asset that it is concerned will
fall in value it can designate this as a hedged item and enter into a derivative that is designed
to match any change in the fair value of the asset, and this derivative is then designated as a
hedging instrument.
The accounting for a fair value hedge is that the gain (or loss) from the change in fair value of
the hedging instrument is recognised immediately in the statement of profit or loss. At the

same time the carrying amount of the hedged item is adjusted for the corresponding loss (or
gain) with respect to the hedged risk, which is also recognised immediately in the statement
of profit or loss. This is instant hedge accounting as the gains and losses offset in the
statement of profit or loss. A fair value hedge is taken to the statement of profit or loss.

Example of a fair value hedge

For example a company has an asset with a current fair value of $200m that it is concerned
will fall in value, so designates this to be a hedged item and enters into a derivative
designated as a hedging instrument. This is a fair value hedge. Let us suppose at the next
reporting date the fair value of the hedged item has fallen to $160m thus creating a loss of
$40m. However, because it is a hedged item the hedging instrument (the derivative) should
create a gain. If the gain on the hedging instrument is $45m, then the hedge is assessed as
being 112.5% effective (45/40 = 112.5%). This is within the permitted band of 80% 125%.
As a result of applying fair value hedge accounting and matching the loss on the hedged item
with the gain on the hedging instrument, the loss of $40m and the gain of $45m will offset to
report a net gain of $5m in the statement of profit or loss.

Cash flow hedge

A cash flow hedge is defined as a hedge of the exposure to variability in cash flows that is
attributable to a particular risk associated with a recognised asset or liability (such as all or
some future interest payments on variable rate debt) or a highly probable forecast transaction
and could affect profit or loss. For example, if a company is concerned that the price it will
have to pay for next year's raw materials will rise it can designate this as a hedged item and
enter into a derivative (eg a futures contract designed to cover any price rise) which it
designates as a hedging instrument. Similarly, if a company is concerned that interest rates
will rise on its debt finance, then it could designate this as a hedged item and enter into a
derivative (eg an interest rate swap) which it designates as a hedging instrument.
The portion of the gain or loss on the hedging instrument that is determined to be an effective
cash flow hedge is recognised in other comprehensive income and creates a reserve in equity.
If a hedge of a forecast transaction subsequently results in the recognition of a financial asset
or a financial liability, any gain or loss on the hedging instrument that was previously
recognised directly in equity is recycled from reserves into the statement of profit or loss in
the same period(s) in which the financial asset or liability affects profit or loss.
If a hedge of a forecast transaction subsequently results in the recognition of a non-financial
asset, then the entity has an accounting policy option that must be applied to all such hedges
of forecast transactions. One policy is to apply the same accounting as for recognition of a
financial asset or financial liability, in that any gain or loss on the hedging instrument that
was previously recognised in other comprehensive income is recycled from reserves into the
statement of profit or loss in the same period(s) in which the non-financial asset or liability
affects profit or loss. The other policy is to make an adjustment on the acquired non-financial

asset so that the gain or loss on the hedging instrument that was previously recognised in
other comprehensive income is removed from reserves and is included in the initial
measurement of the acquired non-financial asset.

Example of a cash flow hedge

For example during year 1, a company is planning to buy an asset in the next accounting
period at a an estimated cost of $100m but it is concerned that the cost of buying the asset
will rise. The company can designate the risk of the future cash out flows rising as a hedged
item and enter into a derivative, the hedging instrument to cover this risk. This is a cash flow
hedge. Let us suppose at the year 1 reporting date the estimated cost of the asset had risen to
$120m and the hedging instrument was reporting a gain of $19m then the hedge is 95%
effective (19/20 = 95%) and so within the 80%125% rule. The gain of $19m that has arisen
in respect of the derivative has to be recognised, and as it is the hedging instrument of a cash
flow hedge, it is recognised in other comprehensive income and creates a reserve (often
called other components of equity). The gain (or loss) on a derivative that is designated as a
cash flow hedge is in effect carried forward and is delayed being recognised in the statement
of profit of loss. There can be no offset in the current accounting period as the potential extra
cost of $20m of buying the assets is a notional number and not one that is yet recognised in
the financial statements, as after all the asset has yet to be bought.
As an aside, sticking with the example that the hedging instrument reports a gain of $19m if
we were to assume that the cost of the asset had only risen by $9.5m then the cash flow hedge
would be 200% effective (19/9.5 = 200%) and therefore outside of the 80125%
effectiveness rule. The hedging relationship is not highly effective and therefore hedge
accounting is not permitted. The whole $19m gain on the hedging instrument must therefore
be recognised in the statement of profit or loss.
However, assuming as we did in the first place, that the hedge was effective at the reporting
date and we then jump forward a few months into the middle of year 2 and further assume
that the asset is indeed bought for $120m and is a financial asset, then the previously
recognised gain of $19m on the hedging instrument sitting in reserves is recycled from equity
and recognised in the statement of profit or loss. Recycling has meant that this gain of $19m
has appeared within the statement of comprehensive income in two consecutive years, firstly
in other comprehensive income and secondly in the statement of profit or loss. Many argue
that recycling is double counting and therefore inappropriate. This is one of the few
remaining situations of recycling being permitted by reporting standards. For example IAS
16, Property, Plant and Equipment clearly prohibits the recycling of previously recognised
gains on the disposal of revalued property. The other comprehensive statement must clearly
distinguish between those gains and losses which may or may not be recycled to the
statement of profit or loss in future periods.
If the asset is a non-financial asset for example, inventory that is sold in the accounting
period then the previously recognised gain of $19m on the hedging instrument can be

recycled from its reserve in equity and recognised in the statement of profit or loss. However,
if the asset is property, plant and equipment, then the reserve would be recycled over the
useful life of the property, plant and equipment.

Issues with IAS 39 and how the proposals address them

IAS 39 takes a rules-based approach to hedge accounting and these rules are often complex
and sometimes contradictory. An example of this is the quantitative effectiveness rule of
80%125%. These are arbitrary numbers. It has also been argued that requirements to
perform quantitative effectiveness tests are onerous and that there is insufficient guidance on
how to actually quantify hedge effectiveness.
Under the new proposals the assessment of hedge effectiveness will only be required on a
prospective basis and the 80%125% test for hedge effectiveness testing will be dropped. The
hedge effectiveness will assessed by a review of the risk management strategy with a
requirement that no systematic under or over hedging is expected. Under the proposals a
hedging relationship must comply with the following to qualify for hedge accounting:

there should be an economic relationship between the hedging instrument

and the hedged item

the effect of credit risk should not dominate the value changes that result
from that economic relationship, and

the hedge ratio should reflect the actual quantity of hedging instrument
used to hedge the actual quantity of hedge item.

In other words this is a more principles-based approach.

IAS 39 requires a different accounting treatment depending on whether the hedge is classified
as a fair value hedge or a cash flow hedge. With a fair value hedge the gain or loss on the
hedging instrument is recognised in the statement of profit or loss whilst with the cash flow
hedge the gain or loss on the hedging instrument is initially recognised in the other
comprehensive income with the potential for it being recycled to the statement of profit or
loss at a later date. Accordingly similar items are being treated in an inconsistent manner,
which is not ideal. Further it can be difficult to distinguish between a fair value hedge and a
cash flow hedge.
IAS 39 allows hedge accounting to be optional. Therefore, even if a company does actually
hedge and complies with the current rules they do not need to apply hedge accounting. The
rules-based approach to hedge accounting also results in some companies who do hedge not
being able to apply hedge accounting because they fall foul of the rules. An example of this is
the inability to apply hedge accounting for specific components of non-financial items. For
example an airline wishing to protect itself from changes in aircraft fuel prices can in reality
do so by entering into forward crude oil contracts. This is because crude oil is a major

component of aircraft fuel and the price of aircraft fuel will be closely correlated to crude oil
prices. However, this is not considered a valid hedge under IAS 39 as the company can only
account for a hedge of either the foreign currency risk, or the entire non-financial item (the
purchase price of the aircraft fuel).
Under the new proposals hedging by risk components will be permitted for both financial and
non-financial items, if separately identifiable and measurable. In addition, hedging
instruments can include non-derivatives and there are significant new disclosure
requirements.

Conclusion

IAS 39s restrictive rules have resulted in some companies not applying hedge accounting or
changing their risk management approach to become eligible to apply hedge accounting. The
proposed revision of the restrictions should cause changes in the risk management approach
and more application of hedge accounting.
Tom Clendon FCCA, Kaplan Financial

The IASB is proposing new regulations for the impairment of financial assets. This is a
current issue that is examinable in Paper P2, Corporate Reporting.

Current regulation on the impairment of financial assets the incurred

loss approach

IAS 39, Financial Instruments: Recognition and Measurement (IAS 39), does not require
financial assets classified at fair value through profit or loss (FVTP&L) and fair value
through other comprehensive income (FVTOCI) to be subject to impairment reviews.
Therefore impairment reviews are only required in respect of financial assets that are
classified as amortised cost for example, loans, debt securities and trade receivables. Please
see 'Related links' for the articles that I have previously written explaining these terms and the
basic principles of accounting for financial instruments.
IAS 39 states that a financial asset is impaired and impairment losses are incurred only if a
loss event has occurred and this loss event had a reliably measurable impact on the future
cash flows. This is often called the 'incurred loss' approach.
The incurred loss approach has the advantage of being fairly objective there has to have
been a past event for example, an actual default or a breach of a debt covenant. This
objectivity reduces the risk of profit smoothing by companies are they are unable to estimate
anticipated future losses. However, the incurred loss model has attracted criticism because it
can result in the overstatement of both assets and profits. Arguably the incurred loss approach
was a contributory factor in the credit crunch.

Proposed regulation on the impairment of financial assets the

expected loss approach

The IASB has proposed a model where credit losses on financial assets are no longer
recognised when incurred but rather, are recognised on the basis of expected credit losses.
This is often called the 'expected loss' approach.
The expected loss approach is likely to result in earlier recognition of credit losses, which
includes not only losses that have already been incurred but also expected future losses.
Arguably this method will be more prudent as both assets and profits will be reduced. It is
however open to the criticism that allowing the judgment of what future losses might be
incurred it will allow some companies to engage in profit smoothing.
Expected credit losses are defined as the expected shortfall in contractual cash flows. The
estimation of expected credit losses should consider past events, current conditions and
reasonable and supportable forecasts.

Example of the expected loss approach

The Bale company has a portfolio of $50,000 financial assets (debt instruments) that have
two years to maturity and are correctly accounted for at amortised cost. Each asset has a
coupon rate of 10% as well as an effective rate of 10%. No previous impairment loss has
been recognised. At the year-end information has emerged that the sector in which the
borrowers operate is experiencing tough economic conditions. It is now felt that a proportion
of loans will default over the remaining loan period. After considering a range of possible
outcomes, the overall rate of return from the portfolio is expected to be approximately 6% per
annum for each of the next two years.
Required:
Calculate the expected credit losses on a life time basis.
Answer
The lender was expecting an annual return of $5,000 a year ($50,000 10%) but is now only
expecting an annual return of $3,000 a year ($50,000 6%). There is therefore a shortfall ie
an expected credit loss shortfall of $2,000 per year. An allowance should be calculated at the
present value of the shortfalls over the remaining life of the asset.
The discount rate used should be between the risk-free rate and the effective rate of the asset.
In the absence of further information, the effective rate of 10% has been used in the
calculations below:
Discount
rate

Contractual cash
flow shortfall
$

Present value

Contractual cash
flow shortfall

Discount
rate

Present value

Year 1

2,000

0.909

1,818

Year 2

2,000

0.8264

1,653
3,471

Thus, the expected credit loss is $3,471. This is recognised as the impairment loss thus
creating an expense to be charged to profit or loss and offset against the carrying value of the
financial asset on the statement of financial position.

Background to the proposals

In 2009, the IASB published an exposure draft (ED) that proposed adjusting for expected
impairment losses through adjusting the effective interest rate of a financial instrument. The
basis for this model was that expected credit losses are usually priced into the interest rate to
be charged and should be reflected in the yield on the financial asset. Changes in credit loss
expectations were to be recognised as incurred as these changes would not have been priced
into the asset. This works conceptually but is a little impracticable. In 2011, the IASB
proposed removing interest adjustment from the recognition of impairment losses and
adopting expected credit losses and this is the basis of the current ED issued in March 2013.
The ED applies to financial assets measured at amortised cost and at fair value through other
comprehensive income. This includes debt instruments such as loans, debt securities and
trade receivables. Additionally it applies to irrevocable loan commitments and financial
guarantee contracts that are not accounted for at fair value through profit or loss under IFRS 9
and also lease receivables. This is a wider scope than at present.
The principle behind the ED is that financial statements should reflect the general pattern of
deterioration or improvement in the credit quality of financial assets within the scope of the
ED. The IASB new proposals require the recognition of expected credit losses for certain
financial assets by creating an allowance/provision based on either 12-month or lifetime
expected credit losses. For financial assets, entities would recognise a loss allowance whereas
for commitments to extend credit, a provision would be set up to recognise expected credit
losses.
On initial recognition, an entity would create a credit loss allowance/provision equal to 12months' expected credit losses. In subsequent years, if the credit risk increased significantly
since initial recognition, this amount would be replaced by an estimate of the lifetime

expected credit losses. Financial assets with a low credit risk would not meet the lifetime
expected credit losses criterion. An entity does not recognise lifetime expected credit losses
for financial assets that are equivalent to 'investment grade', which means that the asset has a
low risk of default. Under the proposed model, there is a rebuttable presumption that lifetime
expected losses should be provided for if contractual cash flows are 30 days overdue. If the
credit quality subsequently improves and the lifetime expected credit losses criterion is no
longer met, the credit loss reverts back to a 12-month expected credit loss basis. The entity
can apply the ED on a collective basis, rather than on an individual basis, if the financial
instruments share the same risk characteristics.

Two stage approach

On initial recognition
On the initial recognition of a financial asset an entity would recognise an impairment loss
based on the 12-months' expected credit losses.
On subsequent review
Financial assets whose credit quality has not significantly deteriorated since their initial
recognition; then the impairment loss is based on 12 months of expected credit losses.
Financial assets whose credit quality has significantly deteriorated since their initial
recognition, then the impairment loss is based on a lifetime of expected credit losses.
Financial assets for which there is objective evidence of an impairment as at the reporting
date, then the impairment loss is based on a lifetime of expected credit losses.

Simplified approach

For trade receivables there is a simplified procedure in that no credit loss allowance is
recognised on initial recognition. Any impairment loss will be the present value of the
expected cash flow shortfalls over the remaining life of the receivables.

Conclusion

The proposed change from the incurred loss model to an expected credit loss model will
require more judgment as the carrying value of financial assets will be dependent on
considering more forward-looking information which means that any losses would be
accounted for earlier than happens under the current rules.
Tom Clendon, FTMS