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RSM ReportingApril 2015
Paul Druckman, CEO, IIRC
Comments on IFRS and global accounting standards
Joelle Moughanni
Capitalisation of borrowing costs in 20 questions and answers
RSM in the industry
Recognition of deferred tax assets, measuring quoted investments and impairment of investments.
Our experts in... Australia
Jane Meade and Daisy Yang report on the interpretation and application of IFRS 11 - Joint Arrangements
Welcome to the 23rd edition of RSM Reporting — the newsletter from RSM covering technical developments in global accounting and reporting.
It is a widespread concept among users and preparers of financial statements around the world that corporate performance is multifaceted and cannot be reduced to just one measure. Investors benefit from the increasingly global comparability of the accounting data (see our opening issue of this year) but use a wealth of tools that span well beyond purely accounting information, to achieve a more comprehensive analysis of the overall performance of the companies they are considering including in their portfolios. Often, though, investors find that there is an enormous disparity between the accuracy and structure with which accounting data is available and the fragmented and patchy information on all the other aspects of corporate performance that are relevant to their decisions.
Over the past two decades, several attempts have been made at standardising some of the non-accounting information in annual reports e.g. the various corporate governance and stewardship codes proposed in different countries. However, users of financial statements need more complete and reliable sources of this type of information and our guest contributor, Paul Druckman, explains that Integrated Reporting <IR> may constitute that breakthrough which investors are longing for.
Investors and users alike long also long for clarity around the accounting standards, to ensure their effective application and meaningful presentation of accounting data. A case where this clarity is yet to be fully achieved is analysed by Jane Meade and Daisy Yang, who discuss some of the implementation issues identified by preparers of financial statements with regard to IFRS 11 – Joint Arrangements, some of which remain to be resolved to enable a fully effective interpretation of this standard.
The accounting treatment of capitalisation of borrowing costs, instead, is a more mature concept, which Joelle is able to fully clarify in her twenty questions and answers.
The newsletter closes with an update on the developments of technical issues to which RSM has contributed with its comments on exposure drafts on ‘Recognition of Deferred Tax Assets for Unrealised Losses’ and on ‘Measuring Quoted Investments in Subsidiaries, Joint Ventures and Associates at Fair Value’, and with its analysis of a specific case study on ‘Impairment of investments in joint ventures and associates accounted for under the equity method’.
We hope you will find this issue insightful and helpful.
Enjoy your reading!
Marco
Dr Marco Mongiello ACA
Welcome from the Editor,
Marco Mongiello
1RSM Reporting April 2015
PD: Look at the principles for IFRS, how can you have more than three and a half thousand pages worth of principles? I think we have to redefine the term ‘principle’. With <IR> you are talking about an overarching framework more than a ‘principles-based’ approach. We set out to do a framework with ‘concepts’ rather than ‘a method’.
When you prepare an integrated report, the data and information it is based on are comparable, but the way you articulate your strategy does not have to be comparable. Whether the data is greenhouse gases or turnover, they are defined and standardised. When you use them in an integrated report, why should we repeat how to define and standardise them? What we say, instead, is that when you are describing your strategy and you link it to key performance indicators, those key performance indicators must be the generally accepted standards. The way they are used depends on
what is important to the company’s stakeholders. For example, although we all understand that profit is a key driver in companies, the question that <IR> addresses is: ‘What is the business there to do?’ and analysing its profit in isolation does not answer this question.
In the International <IR> Framework we do suggest a method, indicating six capitals and content elements, but we are not dictating it. In fact, there are many companies which do not use the six capitals, but they refer to them and use others. For example, the Sustainability Report 2013 of Prudential Financial Inc.1, the US-based financial services group, refers to four capitals, because these are the ones that count for them2. On another example, Mitsubishi Corporation uses, in its Integrated Report 2014, five capitals as they bring social and human capitals together3. Others do not talk about manufactured capital, because they think
it is part of the financial capital. We are not insisting on one specific format.
MM: So perhaps comparability will come later on, as a consequence, when more common practice is established?
PD: What you say is quite right: it is early days. <IR> is innovation. Let me say that although I do not know what the perfect integrated report is, I think that what it should be is the story of the business along the lines of ‘how the business creates value’. How do you create a template for that? Do we have to have the same structure for different companies to tell their own stories? Not necessarily. As long as the data and information the story is based on is reliable and standardised, then you will have enough comparability.
MM: Often in organisations profit, or at least positive margin, is not the goal, but is a means instrumental to the
The editor’s interview
A conversation with Paul Druckman, CEO of the International Integrated Reporting Council (IIRC)
As Integrated Reporting <IR> is starting to be adopted by an increasing number of companies worldwide, I set out to meet Paul Druckman, the CEO of the International Integrated Reporting Council (IIRC). My aim was to bring an update on <IR> to this newsletter, but I found myself having a much more profound conversation on the role of companies in our society.
My opening question was whether the principles based approach of the International <IR> Framework’s poses any challenge in terms of comparability of integrated reports across companies. However, Paul reset the scenario by raising the question of what ‘principles’ means. Then I knew I was in for a conversation on another level...
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achievement of other goals. It is my understanding that <IR> will help these organisations in expressing this hierarchy of means and goals. However, companies may misuse <IR> and make of it a mere communication tool, i.e. the façade of an empty concept.
PD: I don’t think so. There was a major debate when we created the framework about who should be the target audience of <IR>. With the overriding concept of <IR> about value creation, it was decided in the end that the audience has to be what we call the providers of financial capital; addressing their informational needs is the filter through which the integrated report should be written. It does not mean that many other stakeholders will not be part of the audience, but the focus that drives the writing of the integrated report must be what investors, banks or whoever is investing in the business are interested in.
I think the overriding point here is that every business has a corporate social responsibility, call it ‘a licence to operate’. What we are looking for in <IR> is to explain what the business is doing to create value and some of that could come from its corporate social responsibility. By way of an example, ITC, the Indian tobacco company, launched the e-Choupal initiative in 2000, when the CEO decided that ITC’s business model was not sustainable. In a nutshell, the initiative meant that the CEO reached out to villages in abject poverty and provided them with a computer that enabled them to access reliable weather forecasts. He also invested in dams, to manage water for small communities. ITC implemented a methodology, through dam committees, which would run and maintain the dams. This resulted in a much more sustainable source of tobacco for ITC. In other terms, ITC invested a huge amount of money, but now it also makes a lot of money. This is a great example of corporate social responsibility, but not purely philanthropic, i.e. what we are looking for
to be included in the integrated report, though this is only part of it.
Another example is given by SAP’s Integrated Report 2013, where the company demonstrated why they spent so much money on their people, by providing training and professional development. They demonstrated that the longer they have people in the development teams and as consultants, the more efficient they are, the more customers are happy and the more money they make! Again, this demonstrates the sort of corporate social responsibility that we are looking for in the integrated report.
Another example is PepsiCo with water4. Why are they investing in clean water, in water conservation, distribution, purification and hygiene for underserved communities in China, India, Mali, Brazil, Colombia and other Latin American countries? The answer is that it is good for business! Also it is good for society and the community. The one should not override the other, but at the end of the day a business cannot just do the community bit, because it would not stay in business!
Although the capitalist system may not be perfect, I cannot think of a better one. Whilst we have a capital market system, we have to embed in it the concept of ‘sustained success through responsible business’. <IR> is not just about ‘responsible’, it is also how the company runs the ‘business’; we have to be careful not to move the conversation completely into the corporate social responsibility debate.
MM: So how can the <IR> bring everything together?
PD: To me the central concept is about connectivity. If you cannot connect what you are doing to value creation, then I would not expect to see it in an integrated report. If I was to take a company in the financial industry that is striving to reduce its carbon emissions,
I would nevertheless question whether it is central to their value creation. Probably it is not and, therefore, this should not be in that company’s integrated report.
MM: This brings in the question of materiality.
PD: Materiality too is an interesting word: to me the real divide between what matters to the business and what would constitute mere propaganda, if reported in the integrated report, is whether or not a decision is part of the strategy of the business. If minimising carbon emissions does not get discussed at the Board of a financial institution, then does it really matter to the business?
MM: Are there lessons that can be learnt from the literature and practice on Balanced Scorecard?
PD: Yes, there are. Kaplan5 told me once that one of his biggest disappointments with the use of Balanced Scorecards is that they are not sufficiently articulated outside of the organisation. A remarkable exception is PepsiCo, where the CEO, Indra Nooyi, has adopted the concept of ‘future-proofing your company’6, articulating the company’s goals in ‘performance with purpose’, which mirrors a Balanced Scorecard approach. This is indeed an example of the evolution that Kaplan envisaged of his original balanced scorecard. The light for me came when I sold my own business for many millions of pounds, even though in the balance sheet we did not have assets for a million! I thought: ‘They are paying X multiple of profit or EBITDA, but why are we not articulating the value instead of saying it is profit times X?’ The <IR> does exactly that.
MM: So you think that <IR> will become part of the Corporate Annual Report?
PD: No. I think that the Annual Report is the integrated report and the rest of the Annual Report should be its schedules. To me the financial statements and the rest of the IFRS
3RSM Reporting April 2015
compliance requirements are schedules to the integrated report. Companies that will produce quality integrated reports will reduce the number of pages of the annual reports, because their integrated reports are their annual reports. On the other hand, you cannot do an integrated report without good financials, without the sustainability piece, without understanding your brand.
What you want to know, if you are a provider of capital or a manager of the business, is how the main assets of the business are managed, but often the main assets are not in the balance sheet!
For example, according to a major brand consultant, at Coca-Cola, 48% of the value of the business is its brand, but you do not see it in their balance sheet. Similarly with Intellectual Property (IP). I know that the former CFO of Microsoft said that 98% of its value is not in the balance sheet. He changed his job, because he thought he was wasting his time!
The balance sheet is valuable, but its job is not about providing the value of the company as any attempt to monetise assets like brand or IP is flawed. It is a mistake to try and obtain information from a system that is not designed to provide it.
MM: You used the concept that <IR> should be market-led. Could you elaborate on that?
PD: When managers realise that <IR> is a managerial tool, then it will really be ‘market-led’. In the UK, the
strategic report is very consistent with the integrated report and I have the feeling that we will see high quality integrated reports, because some of the strategic reports represent already good integrated reports. Yet, we will see in two or three years’ time what the strategic reports will look like. Will you be able to differentiate one strategic report from another? The experience of the 10-K forms in the US is not encouraging: there are a lot of requirements about strategy, but the result is boilerplate. On this note, I did an exercise once: I extracted the strategic reports from the 10-K forms of five companies operating in different industries. I then provided a colleague with both these strategic reports and the list of the companies the reports belonged to. I then asked my colleague to match each strategic report with the name of the company that produced it… he was not able to match them! These strategic reports are more about compliance than providing valuable information.
There is the risk that regulators get involved too much and that <IR> becomes a compliance exercise, until managers realise that <IR> is a managerial tool.
MM: To some extent this is a similar reaction many of us have when reading the accounting policies that companies must provide in the notes to their financial statements.
PD: Yes, correct, why have accounting policies if they are all the same? Companies could make a hyperlink to IFRS and avoid copying them!
<IR>, instead, is the connecting tissue between corporate governance and stewardship. Following suit from the UK, many countries, including the Netherlands, South Africa, Japan and South-East Asian countries are implementing stewardship and corporate governance codes, some of which indicate that <IR> should be adopted as good practice. What we need are codes and laws, not reporting compliance. Let us not forget that it is not about the standard of the data, but it is about reporting where the business creates value.
This is different from ‘market-led’; investors and companies should lead <IR>. In many cultures that is possible, in many others the government will lead, but not necessarily with regulations.
Editor’s note:
This newsletter wants to be at the forefront of the message of success through responsible leadership, which is nurtured by the most reputable accounting bodies and most enlightened business schools worldwide, contributing to the important role of educating current and aspiring accountants, and policymakers the world over. Therefore, reporting on <IR> in this issue is not just timely and appropriate, but also highly inspiring. I feel privileged to be able to share this with you all, and sincerely thanks Paul for his time.
Marco Mongiello Editor
1Prudential Financial Inc.’s Sustainability Report 2013, page 15: “The overall Sustainable Value Creation Model is a reflection of the International Integrated Reporting Committee’s integrated reporting framework.” 2Financial, Intellectual, Human and Social (Prudential Financial Inc.’s Sustainability Report 2013, page 11) 3Financial, Business by Groups, Human Resources & Social Initiatives, Corporate Governance and Sustainability (Mitsubishi Integrated Report 2014). 4For the latest initiative in Colombia see: https://www.youtube.com/watch?v=FFpyMaVqf5Y&feature=youtu.be 5Kaplan and Norton are the two authors of the original Balanced Scorecard and many subsequent articles on its applications and developments. 6PepsiCo Annual report 2013, page 8.
4RSM Reporting April 2015
Our experts in... Australia By Jane Meade and Daisy Yang RSM Bird Cameron
Jane Meade and Daisy Yang report from Australia on the latest developments on interpretation and application of IFRS 11 – Joint Arrangements.
Following the implementation date of IFRS 11 Joint Arrangements (IFRS 11), being 1 January 2013, the IFRS Interpretations Committee received several requests relating to the application of the requirements of that standard. In response, in July 2013, the IFRS Interpretations Committee conducted an outreach to obtain an understanding of the various implementation issues, along with the divergent views on those issues. The issues collected broadly reflected concerns in the following categories:
• Category A1 & A2 – The unclear wording and lack of guidance in IFRS 11 in relation to classifying a joint arrangement, in particular the “other facts and circumstances” assessment;
• Category B – Potential circumstances which may result in changes in the classification of a joint arrangement;
• Category C – Recognition and measurement issues of joint arrangements;
• Category D1 – Recognition and measurement issues in relation to acquiring control over a joint operation;
• Category D2 – Recognition and measurement issues in relation to acquiring an interest whilst obtaining or retaining joint control; and
• Category E – Other issues (e.g. preparation of the separate financial statements of the joint operation).
From the identified issues, the IFRS Interpretations Committee prioritised two issues for further consideration at its November 2013 meeting:
(a) whether the ‘other facts and circumstances’ assessment should consider facts and circumstances that do not involve contractually or legally enforceable terms, which may include matters such as the design and purpose of the joint arrangement, and the entities’ business needs; and
(b) how the parties to a joint operation should recognise assets, liabilities, revenues and expenses, when the parties’ interests in the assets and liabilities differ from their ownership interest in the joint operation.
Issue (a)
The ‘other facts and circumstances’ assessment is made, in classifying a joint arrangement structured through
a separate vehicle, as either a joint operation or joint venture. This follows consideration of the legal form of the separate vehicle and terms of the contractual arrangement. Results of the outreach indicated divergent views as to how that assessment should be conducted.
To address the diversity in practice, the IFRS Interpretations Committee performed an analysis of the IFRS 11 requirements. It noted that the IFRS 11 principle for classifying a joint arrangement is whether the arrangement gives the parties both rights to the assets and obligations for the liabilities. Such rights and obligations are enforceable by nature.
The IFRS Interpretations Committee concluded that the “other facts and circumstances” assessment should focus on identifying the ‘economic substance’ of the joint arrangement, i.e. facts and circumstances that create enforceable rights to the assets and obligations for the liabilities, which override those conferred by the legal form of the separate vehicle. In other words, that assessment should only consider enforceable terms (legal or contractual), regardless of other factors such as how closely entities are involved with the operation of the separate vehicle, the design and purpose of the joint arrangement etc.
5RSM Reporting April 2015
The IFRS Interpretations Committee then sought to further understand how and why particular facts and circumstances create rights and obligations that result in the joint operation classification. In this regard, the IFRS Interpretations Committee firstly performed an analysis of the IFRS 11 requirements, with a view to articulating the principles behind the “other facts and circumstances” assessment, and then applied those principles to an analysis of four specific fact patterns and some common joint arrangement structures.
“Other facts and circumstances” – Analysis of IFRS 11 Requirements
The IFRS Interpretations Committee noted that in order to classify a joint arrangement as a joint operation as a result of “other facts and circumstances” analysis, it is necessary to demonstrate that parties to the joint arrangement have rights to and obligations to acquire substantially all of the economic benefits of assets of the joint arrangement (“rights to assets”). A simple case illustrating this requirement in IFRS 11 is when parties are obligated to purchase all output produced by the entity set up by the joint arrangement.
Furthermore, cash flow provided by the parties to the joint arrangement is required to be sufficient to settle the liabilities of the joint arrangement on a continuous basis (“obligations for liabilities”). The obligation to provide cash flow is enforceable through legal or contractual terms (i.e. mere intention is not enough), and may take forms such as obligations to purchase all output, cash call on demand etc. The cash flow provided must be sufficient to enable settling liabilities on a continuous basis. This, therefore, may exclude some obligations such as providing guarantees for a third-party loan, when cash outflow only occurs when certain conditions are satisfied.
The IFRS Interpretations Committee also consulted the IASB on this matter, and the IASB members consulted
generally concurred with the IFRS Interpretations Committee’s view on the principles behind the “other facts and circumstances” assessment.
“Other facts and circumstances” – Application to Specific Fact Patterns
The IFRS Interpretations Committee considered how particular features of some fact patterns would affect the classification of the joint arrangement, when assessing other facts and circumstances. The results of their analysis are summarised as follows:
• Output sold from the joint arrangement to the parties at a market price – This is not a determinative factor for classifying the joint arrangement. Instead the focus is on whether cash flow provided through the parties’ purchase of output at market price would be sufficient to enable settling the joint arrangement’s liabilities on a continuous basis.
• Financing from a third party – This factor alone would not affect the classification, if parties to the joint arrangement have obligations to fund the repayment of the external financing.
• Nature of output – This is not a determinative factor for classifying the joint arrangement. Instead the focus is on assessing the cash flows between the parties and the joint arrangement, regardless of whether the output is replaceable or custom made.
• Whether “substantially all of the output” is assessed in terms of volumes, or monetary values – The assessment should be based on the monetary value of output, instead of physical quantities, because the economic benefits of the assets of the joint arrangement would relate to the cash flows arising from the parties’ rights and obligations for the assets.
The IFRS Interpretations Committee also considered the classification of some common joint arrangements. It noted, in particular, constituents’ concern that two joint arrangements with similar features would be classified differently, when one is structured through a separate vehicle and the other is not. This is because a joint arrangement that is not structured through a separate vehicle is automatically classified as a joint operation per IFRS 11.
The IFRS Interpretations Committee noted that the legal form of the separate vehicle does affect the rights and obligations of the parties to the joint arrangement, hence its role in affecting the classification is justified. For example, the legal personality would be crucial in determining whether parties have rights to “gross” economic benefits (i.e. substantially all economic benefits of the joint arrangement), or only a portion of those arising from net assets (after deducting the obligations) of the separate vehicle.
In summary, the IFRS Interpretations Committee concluded that sufficient guidance exists in IFRS 11 for conducting the “other facts and circumstances” assessment. However, judgement is required in relation to specific contractual terms, and a full analysis of all features of a joint arrangement is required.
Issue (b)
The IFRS Interpretations Committee specifically discussed the accounting when the joint operator’s share of the output purchased differs from its share of ownership interest in the joint operation. It noted that there might be other elements in the contractual arrangement that could explain why there is a difference between the percentage share of ownership and the percentage share of output.
Identification of those elements may assist in determining how to account for the difference between the two. Take two
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joint operators (A and B), for example. The fact that A’s share of output exceeds its share of ownership may be explained by A’s other commitments to B, as provided for in the contract. That element is required to be reflected in the appropriate accounting for the difference.
Separate Financial Statements for Joint Operators and Joint Operations
Concurrently with discussing issues (a) & (b), the IFRS Interpretations Committee also considered the implications for accounting within separate financial statements for joint operators and a joint operation structured through a separate vehicle. It noted that IFRS 11 requires a joint operator to account for its rights (share of the assets) and obligations (share of the liabilities) in relation to the joint operation. Therefore, the joint operator would not additionally account for its shareholding in the separate vehicle. It also noted that the same accounting applies to both consolidated and separate financial statements of the joint operator.
However, the IFRS Interpretations Committee noted that IFRS 11 does not apply to the separate financial statements of a joint operation, which shall be prepared in accordance with other applicable IFRS Standards. Some constituents raised the concern of whether it is appropriate to report the same financial statement items in the separate financial statements of both the joint operators and the joint operation. The IFRS Interpretations Committee consulted with the IASB on this matter: both agree that it is appropriate to report the same financial statement items in both sets of financial statements. However, it will also be important to reflect the effects of the joint operators’ rights and obligations in accounting for the joint operation’s assets and liabilities.
Recognition of Revenue by a Joint Operator
In addition, the IFRS Interpretations Committee discussed whether a joint operator should recognise its share of revenue when the joint operation sells its output to parties to the joint arrangement. It noted that a joint operation classification means that ultimately the parties take all the output of the joint arrangement; and in that case, they would recognise their revenue only when output is sold to third parties. Accordingly, it concluded that when a joint operator accounts for its share of revenue from the sale of output by the joint operation, that sale should be directed to external third parties only, which excludes sales to other parties to the joint operation.
Current Stage
As a result of its analysis of various implementation issues and consultations with the IASB, the IFRS Interpretations Committee did not add to its agenda any issue relating to IFRS 11. Instead, its conclusions and observations are documented in the November 2014 issue of IFRIC Update, in the form of a series of tentative agenda decisions.
Have all Concerns been Addressed?
The IFRS Interpretations Committee have specifically responded to most issues raised in terms of the unclear wording and lack of guidance in relation to the “other facts and circumstances” assessment. In particular, it articulated the principles behind the “other facts and circumstances” assessment, with a view that the principles should be capable of being applied to analysing joint arrangements of various features.
In terms of recognition and measurement, issues that have been addressed include the accounting applied by a joint operator when its share of output differs from its ownership interest, and the preparation of separate
financial statements by joint operators and the joint operation. In addition, the accounting for acquiring interests in a joint operation whilst obtaining or retaining joint control (Category D2) has been addressed by an amendment to IFRS 11 issued in May 2014 (applicable from 1 January 2016), i.e. by applying the business combination accounting in IFRS 3 for both initial and additional interests obtained. However, we noted that the following issues raised in the initial outreach appear to remain outstanding:
• How a party to a joint arrangement should measure a joint arrangement when there is a change in classification of a joint arrangement (Category C)
• The recognition and measurement of its interests when an investor obtains control over a joint operation through step-acquisition or single purchase (Category D1)
• Whether the capitalisation of borrowing costs incurred for equity-accounted investments should be allowed (Category E)
• When changing from proportionate consolidation to equity method – whether alternative methodology for allocating goodwill can be explored, whether transition guidance in IFRS 11 (using carrying value as ‘costs basis’) supersedes IAS 28 when conflict arises, and whether a first-time adopter can recognise a reversal of impairment for its investment (Category E)
Jane Meade Partner - National Technical
RSM Bird Cameron [email protected]
Daisy Yang National Technical Advisor
RSM Bird Cameron [email protected]
7RSM Reporting April 2015
Capitalisation of borrowing costs in 20 questions and answers
By Joelle Moughanni - Technical Consultant at RSM
IAS 23 Borrowing Costs requires borrowing costs incurred to finance construction of qualifying assets to be capitalised (the option of immediate recognition of borrowing costs as an expense was eliminated in March 2007 with the issue of the revised Standard).
Although quite straightforward at first sight, the requirement’s practical implementation gives rise to a few challenges – often due to the mixed principles-based and rules-based character of IAS 23’s requirements – some of which are discussed in this article. In practice, IAS 23 proves to be a good illustration of the idiom ‘the devil is in the detail’.
1. As a brief reminder, what is the core principle of IAS 23?
Borrowing costs are costs that an entity incurs in connection with the borrowing of funds; they include interest expense (calculated using IAS 39 effective interest method), finance charges related to finance leases (under IAS 17) and exchange differences arising from foreign currency borrowings (to the extent that they are regarded as an adjustment to interest costs).
Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset – i.e. those that would have been avoided if the expenditure on the qualifying asset had not been made – form part of the cost of that asset (other borrowing costs are recognised as an expense).
When an asset is acquired, management should assess whether, at the date of acquisition, it is ‘ready for its intended use or sale’. Depending on how management intends to use the asset, it may be a qualifying asset under IAS 23. For example, when an acquired asset can only be used in combination with a larger group of fixed assets or was acquired specifically for the construction of one specific qualifying asset, the assessment of whether the acquired asset is a qualifying asset is made on a combined basis.
For all the situations where the standard does not provide guidance, it is important not to lose sight of the basic principle that requires capitalisation only of the amount of borrowing costs that would have been avoided had the expenditure on a qualifying asset not been made.
2. A qualifying asset is defined as an asset that necessarily takes a substantial period of time to get ready for its intended use or sale. Is there a quantitative definition of ‘substantial period of time’?
No, as IAS 23 does not provide any bright line or guidance on what constitutes a substantial period of time. Therefore, management should exercise judgement based on specific facts and circumstances when determining which assets are qualifying assets. For example, an asset that normally takes more than a year to be ready for its intended use is usually a qualifying asset.
Management’s intention is taken into account to assess the asset’s ‘substantial period of time to get ready for its intended use or sale’. Depending on how management intends to use the asset, it may be a qualifying asset under IAS 23.
3. Can an intangible asset be a qualifying asset under IAS 23?
Yes, as long as the intangible asset takes a substantial period of time to get ready for its intended use or sale. This would be the case, for example, for an internally developed software during its development phase when it takes a substantial period of time to complete. The interest capitalisation rate is applied only to those costs that themselves have been capitalised.
4. Would borrowing costs incurred to finance the production of an entity’s wine inventories be capitalised?
Yes. Although an entity is normally exempted from the requirement to capitalise borrowing costs incurred to manufacture inventories in large quantities on a repetitive basis, it can choose to do so, given that the exemption (or scope exclusion) in IAS 23 is optional and not mandatory.
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Accordingly, interest capitalisation is allowed as long as the production cycle takes a substantial period of time, as is usually the case with wine. The election to capitalise borrowing costs on those inventories is an accounting policy choice (implying consistent application, disclosure etc.).
5. Should borrowing costs incurred on the acquisition of a 4G licence that the entity intends to use in developing and operating a wireless network be capitalised?
Yes, since the licence has been exclusively acquired with the intention of using it to operate the wireless network (even if the licence could be sold or licensed to a third party). The acquisition of the licence is part of the network development, which meets the definition of a qualifying asset under IAS 23 (see also Q&A 2).
6. Can borrowing costs related to investment property under development measured at fair value be capitalised?
Yes, although capitalisation of borrowing costs for assets measured at fair value is not required by IAS 23 as, on a net basis, the measurement of the asset would not be affected. If an entity chooses, (as an accounting policy) to capitalise those borrowing costs, it should reduce its interest expense incurred during the period by the amount of borrowing costs capitalised and adjust the carrying amount of the investment property accordingly. Re-measurement of the investment property to fair value has a direct effect on the gain or loss arising from a change in the fair value of investment property recorded in profit or loss for the period. In fact, only presentation of borrowing costs and fair value movements within profit or loss and other comprehensive income are affected, whilst the asset’s carrying amount remains the same (i.e. at fair value).
7. Could an entity with no borrowings that uses its own cash resources to finance the construction of a qualifying asset capitalise notional borrowing costs?
No, because IAS 23 clearly limits the amount that can be capitalised to the actual borrowing costs incurred. Notional interest expenses representing the opportunity cost of the cash employed in financing the asset’s construction (which could have been otherwise used to earn interest) cannot be capitalised because the amount of borrowing costs capitalised would then exceed the amount of borrowing costs actually incurred.
8. A subsidiary finances a qualifying asset with a loan provided by its parent company. How is this treated in the respective financial statements?
In its financial statements, the subsidiary capitalises the borrowing costs incurred on the inter-company loan. If the financing was through a capital increase, no borrowing costs would be capitalised, as IAS 23 does not deal with actual or imputed cost of equity (see also Q&A 7).
In its separate financial statements, the parent cannot capitalise borrowing costs because they relate to its investment in a subsidiary (i.e. a financial asset) which is not a qualifying asset.
In the consolidated financial statements, capitalisation of borrowing costs reflecting how the qualifying asset was financed from the perspective of the group as a whole is required. Thus, the borrowing costs capitalised by the subsidiary are adjusted:
• If the capitalisation rate at the group level is different from the rate used by the subsidiary, when the group uses external general borrowings
• If the borrowing costs on the external borrowings vary from the amount of borrowings costs capitalised by the subsidiary, when the group uses specific external borrowings
Borrowing costs calculated and capitalised in accordance with IAS 23 cannot exceed the amount of borrowing costs incurred at the group level. Therefore, if the parent company does not have any external borrowings, the borrowing costs capitalised by the subsidiary are eliminated, as there are no borrowing costs incurred from the perspective of the group.
9. Is investment income on excess funds from general borrowings deducted from the borrowing costs eligible for capitalisation?
No, because it cannot be demonstrated that the income is earned from the general borrowings, rather than from other sources (such as equity or cash generated from operating activities). Whilst IAS 23 is relatively clear on specific borrowing costs, it does not provide guidance on general borrowing costs, but the Standard’s basic principles still apply.
10. How are borrowing costs eligible for capitalisation determined when a qualifying asset is financed by a combination of specific and general borrowings?
The amount of borrowing costs eligible for capitalisation is determined as follows:
• First, net expenditure on the qualifying asset (after deducting any pre-sale deposits, progress payments or grants received) is allocated to the borrowing costs incurred on the funds specifically borrowed for the purpose of acquiring, constructing or producing the qualifying asset
• Then, once specific borrowings are fully utilised, the entity applies its capitalisation rate from general borrowings to the remainder of net expenditures
11. If an entity’s cash flows from the operating activities would be sufficient to finance the expenditures incurred on qualifying assets during the period, can management claim that the entity’s general borrowings are used to finance working capital and other transactions and thus not capitalise borrowing costs?
Although this question is not dealt with by IAS 23, it is commonly presumed that any general borrowings in the first instance are used to finance the qualifying assets (after using any funds specific to the qualifying asset). This is the case even where the cash flows from operating activities are sufficient to finance the entity’s capital expenditures, because it could be argued that borrowing costs could have been avoided if the expenditure on the qualifying asset had not been made (using the operating cash to finance working capital).
However, IAS 23.14 refers to ‘the extent that an entity borrows funds generally and uses them for the purpose of obtaining a qualifying asset’. Therefore, to the extent that the qualifying asset is demonstrably not paid for out of general borrowings (e.g. with cash proceeds of an equity issue, or borrowings are specific to non-qualifying assets such as the acquisition of a business), it should be acceptable not to capitalise a deemed interest cost (although not supported by IAS 23).
9RSM Reporting April 2015
12. Does IAS 23 apply to preference shares classified as financial liabilities?
Yes. IAS 23 states that it does not deal with the actual or imputed cost of equity, ‘including preferred capital not classified as a liability’. Consequently, the Standard does apply to costs associated with preference shares and similar financial instruments that are classified as liabilities under IAS 32 (e.g. preference shares that are redeemable at the option of the holder). Also, IAS 32.36 states that ‘dividend payments on shares wholly recognised as liabilities are recognised as expenses in the same way as interest on a bond’. Thus, the costs of servicing those shares (e.g. dividends) fall within the definition of borrowing costs.
13. Is interest expense in relation to the liability component of a convertible bond eligible for capitalisation?
Yes. In accordance with IAS 32, the liability component of a convertible debt instrument is presented on an amortised cost basis using the coupon rate for an equivalent non-convertible debt. The imputed interest is recognised in profit or loss using the IAS 39 effective interest method. Therefore, it is appropriate for the imputed interest expense in relation to the liability component of the convertible bond to be included in borrowing costs eligible for capitalisation.
14. Are the effects of a cash flow or fair value hedging relationship on interest for a specific borrowing capitalised?
Yes, although neither IAS 39 nor IAS 23 provide guidance in this respect. However, this would be consistent with the purpose of an IAS 39 hedging relationship which is to modify the borrowing costs of the entity related to a specific debt. Therefore, entities should capitalise interest on borrowings in an IAS 39 designated hedging relationship after taking into account the effects of hedge accounting. The entity capitalises borrowing costs at the synthetic rate achieved as a result of entering into the effective hedge accounting relationship. Any ineffectiveness is recognised in profit or loss.
Similarly, where an entity borrows funds not related to specific projects, the capitalisation rate is calculated after taking into account effective hedging relationships designated under IAS 39 for all outstanding borrowings other than those borrowings made specifically for the purpose of obtaining a qualifying asset. Ineffectiveness of such hedging relationships should continue to be recognised in profit or loss.
15. When the construction of a qualifying asset is performed by a third party, are borrowing costs capitalised on the prepayments made to the third party?
Yes. Borrowing costs incurred by an entity to finance prepayments on a qualifying asset are capitalised on the same basis as the borrowing costs incurred on self-constructed assets.
The capitalisation starts when all three conditions are met: expenditures are incurred, borrowing costs are incurred, and the activities necessary to prepare the asset for its intended use or sale are in progress.
Expenditures on the asset are incurred when the prepayments are made. Borrowing costs are incurred when borrowing is obtained. The last condition – the activities necessary to prepare the asset for its intended use or sale are in progress – can vary depending on facts and circumstances. When the construction process by the third party does not start at the prepayment
date, management assesses whether it is appropriate to start capitalisation from this date or whether it should be deferred to a later date.
16. How should an entity determine the amount of foreign exchange differences to be capitalised?
IAS 23 requires capitalisation of foreign exchange differences relating to borrowings to the extent that they are regarded as an adjustment to interest costs. The gains and losses that are an adjustment to interest costs include the interest rate differential between borrowing costs that would be incurred if the entity borrowed funds in its functional currency, and borrowing costs actually incurred on foreign currency borrowings. Other differences that are not adjustments to interest costs may include, for example, increases or decreases in the foreign currency rates as a result of changes in other economic indicators such as inflation, employment or productivity, or a change in government.
IAS 23 does not provide guidance on which foreign exchange differences may be regarded as adjustments to interest costs for the purpose of including them in borrowing costs. Consequently, how an entity applies IAS 23 to foreign currency borrowings is a matter of accounting policy requiring the exercise of judgement.
17. Is an investment in a separate vehicle that is established for the purpose of constructing a qualifying asset itself a qualifying asset for the investor?
It is argued that, from the investor’s perspective and in substance, the amount of borrowing costs capitalised should not be different simply because construction of the qualifying asset is through a separate investee vehicle, rather than by the investing entity itself. However, the accounting for the investor’s interest in the vehicle will determine whether or not there is a qualifying asset:
• If the investment is accounted for using the equity method (i.e. an associate or a joint venture), the interest is a financial asset, and capitalisation of borrowing costs is not permitted under IAS 23
• If the investment is classified as a joint operation (in accordance with IFRS 11), the entity should then recognise its share of the assets and liabilities, and capitalisation of borrowing costs is required to the extent that any of the assets are qualifying assets
18. Are borrowing costs incurred on a deposit paid to a supplier when placing the order for the acquisition of an asset that will not be received for a substantial period of time eligible for capitalisation?
In determining whether any borrowing costs incurred are eligible for capitalisation, an assessment is required of all the facts and circumstances and the nature of the deposit paid by the entity.
For example, if the deposit represents a payment on account under a construction contract whereby the supplier builds a property for the entity on the entity’s land and in accordance with the entity’s specifications, borrowing costs incurred on such deposit should be capitalised as part of the cost of the qualifying asset (i.e. the property under construction).
However, if the deposit represents a payment to secure the entity’s place in a waiting list to acquire standard goods (e.g. the next generation of mobile phones), borrowing costs incurred on such deposit must not be capitalised as they do not arise
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in relation to a qualifying asset (because when acquired, the mobile phones will be ready for their intended use or sale).
19. When does capitalisation cease if the qualifying asset is completed in stages?
If each stage can be sold or used individually whilst construction of the other parts continues, capitalisation of the borrowing costs related to the completed stage ceases when this phase is ready for its intended use or sale (e.g. a development programme comprising several buildings or units, each of which can be used or sold individually). Each subsequent phase will give rise to capitalisation of borrowing costs over its own construction period.
However, for an asset that must be completed in its entirety before any part of it can be used as intended, the borrowing costs should be capitalised until all the activities necessary to prepare the whole asset for its intended use or sale are substantially complete (e.g. a manufacturing facility involving a sequence of processes, where production cannot begin until all the processes are in place).
20. Does capitalisation of borrowing costs continue when the completion of a qualifying asset is delayed for the purpose of obtaining regulatory clearance?
When a delay in obtaining regulatory consents (e.g. health and safety clearance) that are sometimes required before an asset is permitted to be brought into use could have been avoided by the entity, this should be seen as abnormal and similar in effect to a suspension of development, so that capitalisation of borrowing costs should cease. However, when it is not possible to avoid a delay between physical completion and obtaining such consents (e.g. when it is not possible to apply for consents until after physical completion), capitalisation of borrowing costs will continue to be appropriate until the consents are obtained, i.e. until the asset is ready for its intended use.
When the completion of an asset is intentionally delayed, continued capitalisation of borrowing costs is not permitted. For example, in the case of property development, it is customary for the developer to defer installation of certain fixtures and fittings and the decoration work until units are sold, so that purchasers may choose their own specifications. Such delays relate more to the marketing of units than to the asset construction process.
Under IAS 23, it is clear that capitalisation should cease when substantially all of the activities necessary to prepare the qualifying asset for its intended sale or use are complete. An asset is normally ready for its intended use or sale when the physical construction of the asset is complete even though routine administrative work might still continue. If only minor modifications, such as the decoration of a property to the purchaser’s or user’s specification, are all that is outstanding, then substantially all of the activities are deemed complete.
Joelle Moughanni Technical Consultant
RSM International [email protected]
11RSM Reporting April 2015
We commented on…
…(i) Recognition of Deferred Tax Assets for Unrealised Losses (ii) Measuring Quoted Investments in Subsidiaries, Joint Ventures and Associates at Fair Value
The exposure draft ED/2014/3 Recognition of Deferred Tax Assets for Unrealised Losses (Proposed amendments to IAS 12) (“the ED”), issued on 20 August 2014, aims at clarifying how to account for deferred tax assets related to debt instruments measured at fair value. In particular, unrealised losses on such instruments that are measured at cost for tax purposes would give rise to deductible temporary differences regardless of whether the debt instrument’s holder expects to recover the debt instrument’s carrying amount by sale or by collecting the contractual cash flows.
Comments were requested by 18 December 2014 and redeliberations are expected to take place in the first half of 2015.
The exposure draft ED/2014/4 Measuring Quoted Investments in Subsidiaries, Joint Ventures and Associates at Fair Value (Proposed amendments to IFRS 10, IFRS 12, IAS 27, IAS 28 and IAS 36 and Illustrative Examples for IFRS 13) (“the ED”), issued on 16 September 2014, aims at clarifying the unit of account for fair value measurement. In particular, the fair value of quoted investments in subsidiaries, joint ventures and associates and of quoted cash-generating units should be measured as the product of the quoted price for the individual financial instruments that make up the investments and the quantity of financial instruments. Also, an Illustrative Example would be added to IFRS 13 to clarify application to the ‘portfolio exception’.
Comments were requested by 16 January 2015 and redeliberations are expected to start in the first half of 2015.
RSM in the industry...
Reporting issues & comment letters
Although we welcome the IASB’s initiative to clarify the application of some of the principles of IAS 12 Income Taxes , in particular in accounting for deferred tax, in our view the Standard is quite clear with respect to the issues discussed in the ED, in particular, that determining temporary differences and estimating future taxable profits are two separate steps, and that the carrying amount of an asset should not be considered as the limit of the estimated future taxable profits. Paragraphs 20 and 26(d) of IAS 12 already specify that a difference between the carrying amount of an asset measured at fair value and its higher tax base gives rise to a deductible temporary difference.
We believe that IAS 12 should not be amended as proposed in the ED; any reported diversity in practice would be best dealt with by issuing guidance (such as an addendum to the Illustrative Examples accompanying IAS 12).
If the Board decides though to proceed with the ED proposals, overall we agree with them as they are mere clarifications that do not introduce changes to the requirements and their implementation.
View the full comment letter: http://bit.ly/1xE8oXE
Although we agree with the conclusion reached by the Board that the unit of account for investments in subsidiaries, joint ventures and associates is the investment as a whole, we disagree with the proposal that the fair value measurement of quoted investments in subsidiaries, joint ventures and associates should be the product of the quoted price (P) multiplied by the quantity of financial instruments held (Q), or P × Q, without adjustments. In our view, this proposal contradicts the above conclusion and is not consistent with other requirements in IFRS (e.g. IFRS 3 Business Combinations).
We share the view that there is no Level 1 input for the investment as a whole (being the unit of account). Consequently, the investment’s fair value should be measured using a valuation technique or by adjusting the Level 1 price to reflect differences between the investment and the underlying individual financial instruments. We are concerned that the proposals will result in information that may not be the most relevant in that it ignores market price adjustments that take into account the nature of the investment as a whole; the price paid for an investment at acquisition includes premiums or discounts and consequently differs from the mathematical product P × Q.
Therefore, we fully agree with the Board member’s dissenting opinion in the ED. View the full comment letter: http://bit.ly/16FtdrV
What is the current status of the project? What is the current status of the project?
What did RSM say on the ED?
What did RSM say on the ED?
(i) (ii)
12RSM Reporting April 2015
We focused on…
… impairment of investments in joint ventures and associates accounted for under the equity method
In its consolidated financial statements, Company XYZ accounts for its investments in associates and joint ventures using the equity method.
However, Company XYZ is not sure about the guidance to apply for the impairment of such investments, in particular, where some of them include goodwill in their equity carrying amount - IAS 36 Impairment of Assets; IAS 39 Financial Instruments: Recognition and Measurement, or; IAS 28 Investments in Associates and Joint Ventures?
XYZ needs to refer to all three Standards as described below.
After application of the equity method for each associate and joint venture at reporting date, including recognising the associate’s or joint venture’s losses, XYZ should apply the requirements of IAS 39 to determine whether it is necessary to recognise any additional impairment loss with respect to its net investment in the associate or joint venture (IAS 28.40).
Under IAS 39, XYZ’s associates and joint ventures should be assessed at the end of each reporting period to determine whether there is any objective evidence that they are impaired. The following factors are a few examples of evidence as to whether an investment in an associate or a joint venture might be impaired: going concern issue raised in the auditor’s report of the investee; bad financial performance and projections of the investee; significant adverse changes in the technological, market, economic or legal environment in which the investee operates; a significant or prolonged decline in the fair value of the investee below its cost etc. The loss event giving rise to this evidence must have occurred after the interest in the associate or joint venture was recognised; loss events that are likely but have not yet occurred are ignored.
Whenever application of IAS 39’s requirements indicates that the interest in an associate or a joint venture may be impaired, the entire carrying amount of the investment, including goodwill, is tested for impairment as a single asset under IAS 36. The investment’s recoverable amount (i.e. the higher of its value in use and fair value less costs of disposal) is thus compared to its carrying amount.
In fact, since goodwill relating to an associate or a joint venture is included in its carrying amount, it is not disclosed separately and not regarded as a separate asset. Consequently, there are no requirements to allocate any resulting impairment loss against the goodwill and share of net assets included in the carrying amount of the investment, or to carry out an annual impairment test under IAS 36. The investment as a whole is impaired and not the underlying assets.
IAS 28 requires that any reversal of impairment loss is recognised in accordance with IAS 36. Consequently, any subsequent increase in the recoverable amount of the investment is recognised in full.
For example, if the equity carrying amount of an associate of XYZ included CU100 goodwill and an impairment loss of CU150 was recognised, the goodwill effectively has been eliminated. If the recoverable amount subsequently increases to its original value, the entire impairment loss of CU150 is reversed (i.e. reversal is not restricted to CU50 as would have been the case for the goodwill under IAS 36).
What is the issue?
What is the proposed solution?
The publication is not intended to provide specific business or investment advice. No responsibility for any errors or omissions nor loss occasioned to any person or organisation acting or refraining from acting as a result of any material in this publication can be accepted by the authors or RSM International. All opinions expressed are those of the authors and not necessarily that of RSM International. You should take specific independent advice before making any business or investment decision.
RSM is the brand used by a network of independent accounting and advisory firms each of which practices in its own right. The network is not itself a separate legal entity of any description in any jurisdiction. The network is administered by RSM International Limited, a company registered in England and Wales (company number 4040598) whose registered office is at 11 Old Jewry, London EC2R 8DU. The brand and trademark RSM and other intellectual property rights used by members of the network are owned by RSM International Association, an association governed by article 60 et seq of the Civil Code of Switzerland whose seat is in Zug.
© RSM International Association, 2015
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