Interest free loans
As prescribed in IFRS 9.B5.1.1, a loan payable or receivable that carries no interest should be recognised at fair value measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (currency, term, etc.) with a similar credit rating.
An incremental borrowing rate of the debtor will usually be a great starting point for calculation of the discount rate. Any amount lent/borrowed exceeding the fair value of the loan should be accounted for according to its substance under other applicable IFRS.
This means if a government provides a subsidy that lowered the interest rate from 5% to 3% the difference (through a discount allocation) has to be treated as a government grant as per IAS 20 Accounting for Government Grants and Disclosure of Government Assistance (see example below).
Interest free loan-Application
Entity A runs an oil refinery in Serbia and is majority (51%) government owned.
Entity A is provided with an interest free loan from a third party bank of USD900,000 repayable in 10 annual and equal amounts.
Acquisitions and disposals – IFRS 3 Pharmaceutical and Life Sciences
Contingent consideration arrangements in acquisitions and disposals are common within the Pharmaceutical and Life Sciences industry as they can be a convenient way of validating a company’s value as well as sharing economic risk between the buyer and the seller.
In this industry, many acquisitions and disposals involve compounds or devices that have not yet received regulatory approval, which inherently increases the risk that the degree of commercial success of what is acquired or sold may not be known at the date of acquisition.
For example, a pharmaceutical company may prefer to pay the seller of a biotech company an upfront amount at the acquisition date and then pay an additional amount if one of the compounds acquired receives regulatory approval or reaches a specified sales target.
The acquirer’s accounting for contingent consideration is outlined in the business combination standards (IFRS 3).
The standard defines consideration transferred by the acquirer to include the acquisition date fair value of contingent consideration. Depending on the terms of the contingent consideration, the acquirer either recognises, at the acquisition date, a liability or equity, at fair value.
Contingent
Contingent is a word used regularly in IFRS Standards and it is used in a rather normal way, most of the times a s contingent being dependent on. Here are the IFRS Standards in which contingent is used and in which context.
IFRS 3 Business combinations
Buyer’s accounting for royalties and milestones payable to a seller in a business combination
Acquisitions and divestitures have been headline news in the pharmaceutical and life sciences industry lately. With expiring patents on blockbuster products and downward pricing pressure, many companies have increased their M&A activity and turned to acquisitions to expand research pipelines in order to fuel innovation. In addition, companies have also looked to sell businesses or assets as part of R&D portfolio decisions to streamline operations and focus their efforts on faster growing areas of the business.
A common theme in acquisitions is that part of the purchase consideration may be in the form of future payments, such as royalties (i.e., the buyer has an obligation to make future royalty payments to the seller) or milestones. Payments related to these contingent obligations are often triggered by regulatory approval of in-process research and development (IPR&D) projects, or based on future performance measures, such as a percentage of sales.
Because many acquisitions or licenses of intellectual property, particularly those still in development, include milestone or royalty payments to the seller/licensor, the accounting and valuation of those contingent payments is often complex.
Designated hedged items
This narrative provides an overview of the eligible hedged items that are permitted in IFRS 9.
Definition of hedged item
Under IFRS 9, a hedged item can be a recognised asset or liability, an unrecognised firm commitment, a forecast transaction or a net investment in a foreign operation. The hedged item can be:
- A single item, or
- A group of items.
If the hedged item is a forecast transaction, it must be highly probable.
Risk components of non-financial items
Under IFRS 9, risk components of financial items (such as the SONIA rate (replacement of LIBOR rate) in a loan that bears interest at a floating rate of SONIA plus a spread) could be designated as a hedged item, provided they are separately identifiable and reliably measurable and risk components can be designated for non-financial hedged items, provided the component is separately identifiable and the changes in fair value or cash flows of the item attributable to the risk component are reliably measurable. This requirement could be met where the risk component is either explicitly stated in a contract (contractually specified) or implicit in the fair value or cash flows (non-contractually specified).
Entities that hedge commodity price risk that is only a component of the overall price risk of the item, are likely to welcome the ability to hedge separately identifiable and reliably measurable components of non-financial items.
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In practice An example of a contractually specified risk component that exists in practice is a contract to purchase a product (such as aluminium cans), in which a metal (such as aluminium) is used in the production process. Contracts to purchase aluminium cans are commonly priced by market participants based on a building block approach, as follows:
Many entities may want to use aluminium LME futures or forwards to hedge their price exposure to aluminium. However, IAS 39 did not allow just the LME component of the price to be the hedged item in a hedge relationship. All of the pricing elements had to be designated as being hedged by the LME future. This caused ineffectiveness, which was recorded within P&L; and, in some cases, it caused sensible risk management strategies to fail to qualify for hedge accounting. By contrast, IFRS 9 allows entities to designate the LME price as the hedged risk, provided it is separately identifiable and reliably measurable. |
Designated hedging instruments
Most derivative financial instruments can be designated as hedging instruments, provided they are entered into with an external party. Intra-group derivatives or other balances do not qualify as hedging instruments in consolidated financial statements irrespective of whether a proposed hedging instrument, such as an intercompany borrowing, will affect consolidated profit or loss. But they might qualify in the separate financial statements of individual entities in the group.
The main changes to hedging instruments in IFRS 9 are: how to account for the time value of options; the interest element of forward contracts; and the currency basis of cross-currency swaps when used as hedging instruments.
Derivative financial instruments
IFRS 9 contains no restrictions regarding the circumstances in which a derivative can be designated as a hedging instrument (provided the hedge accounting criteria are met), except for some written options.
– Non-derivative financial instruments measured at fair value through P&L
Under IFRS 9, non-derivative financial instruments are allowed as hedging instruments of foreign currency risk provided that such non-derivative financial instruments are not investments in equity instruments for which the entity has elected to present the changes in fair value in OCI.
Fair Value Hedges
In short – A fair value hedge is a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or components of any such item, that is attributable to a particular risk and could affect profit or loss.
Fair value hedges recognize the change in fair value of the hedged item in the current reporting period to offset the change in the related hedging instrument. Therefore, there is earlier recognition of the fair value change in the hedged item than if hedge accounting was not applied.
For example, inventory is ordinarily measured at the lower of net realizable value and cost. A farming company with cattle inventory could seek to hedge its commodity price risk with a forward contract for the sale of its cattle. This derivative would be measured at FVPL. Any increase in the market price of the cattle would result in a loss on the derivative.
However, without applying hedge accounting, the increase in the fair value of the cattle inventory would not be recognized until the physical inventory is sold. Conversely, designation of a fair value hedging relationship would allow the Company to record the impact of the change in market prices for the cattle in profit or loss on both the derivative and its physical inventory to accurately reflect the company’s risk management practices.
Cash Flow Hedges
In short – A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognized asset or liability or a highly probable forecast transaction, and could affect profit or loss.
Without hedge accounting, there is a mismatch in the timing of when the gains or losses arising from the change in cash flows of the hedging instrument and hedged item are reflected in profit or loss. The change in the cash flows of the hedging instrument is recognized prior to that for the hedged item. With hedge accounting, the gains or losses arising from the change in cash flows of the hedging instrument are accumulated and held in a separate component of equity until the hedged item is recognized. Therefore, a cash flow hedge delays the recognition of the change in cash flows related to the hedging instrument.
Example of a Cash Flow Hedge |
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ABC Credit Union provides member loans bearing interest at variable rates. The variable-rate member loans are Assessment: In effect, the Credit Union has converted the variable rate loan assets into fixed rate loan assets and hedged their exposure to changes in market interest rates. If hedge accounting is not applied, a decrease in market interest rates would result in a gain on the swap which is recognized in profit or loss because the swap is a derivative. Since the member loans are measured at amortized cost there would be no change in their stated value. Accordingly, an earnings mismatch results. It is this mismatch that cash flow hedge accounting aims to address by recognizing the effective portion of the change in the swap in a separate cash flow hedge reserve in equity until the actual cash flows of the loan assets affects profit or loss. |
When cash flow hedge accounting is applied, the effective portion of the gains or losses on the hedging instrument is recognized in Other comprehensive income (‘OCI’). These gains or losses are accumulated in a separate component of equity known as the cash flow hedge reserve. The ineffective portion of the gains or losses on the hedging instrument is recognized in profit or loss.
Deferred tax and business combinations
Deferred tax and consolidated accounts
Business combinations offer an added level of complexity to the reporting of deferred taxes. This section considers a number of practical issues that can arise, specifically:
- whether deferred tax should be recognised on intangible assets acquired in a business combination
- when deferred tax arises on assets acquired in a business combination, whether the tax rate to be applied is that of the acquiree or acquirer
- when deferred tax is recognised in a business combination, whether this leads to an immediate impairment of goodwill
- the provision of deferred tax on unrealised intra-group profits eliminated on consolidation.
Intangible assets arising on a business combination
IFRS 3 (Revised 2008) requires intangible assets acquired in a business combination to be recognised at their fair value in the consolidated statement of financial position. Tax rules on intangible assets vary from jurisdiction to jurisdiction.
Understanding these rules is necessary to identify the tax bases of intangible assets and, accordingly, any temporary difference that may arise. For example, in certain jurisdictions tax is calculated using the separate financial statements of the members of the group, and not the consolidated accounts.
Hence, if an asset arises only on consolidation, its tax base will be nil. This is because, the income earned whilst the asset is used will be taxable and there will be no tax deductions available against that income from the use of the asset. Equally, if such an asset were sold, there would be usually no tax deduction on disposal.
This results in a temporary difference equal to the carrying value of the asset on initial recognition in the consolidated accounts. As the intangible asset and the related deferred tax arise on a business combination, the other side of the entry is to goodwill under IAS 12.66, see Deferred tax allocated to business combinations in Allocating the deferred tax charge or credit.
Allocating deferred tax charge or credit
This narrative summarises the approach to allocating the deferred tax charge or credit for the year to the various components of the financial statements. Similar principles apply to the allocation of current tax.
IAS 12 requires that the deferred tax effects of a transaction or other event are consistent with the accounting for the transaction or event itself (IAS 12.57). The deferred tax charge or credit for the year can arise from a number of sources and therefore may need to be allocated to:
- continuing operations within profit or loss
- discontinued operations within profit or loss
- other comprehensive income (OCI) or equity
- goodwill
in order to comply with this basic principle.
Flowchart for allocating the deferred tax charge or credit
IAS 12.58 requires that deferred tax should be recognised as income or an expense and included in profit or loss for the period, except to the extent that the tax arises from:
- a transaction or event which is recognised, in the same or a different period, outside profit or loss, either in other comprehensive income (OCI) or directly in equity or
- a business combination.
The flowchart below summarises this requirement diagrammatically. It shows the steps needed to allocate the deferred tax charge or credit to the various components of the financial statements.
Step 1 – Recognition of deferred tax in OCI or equity
Deferred taxes and Share-based payments
This narrative looks at two particular issues that arise in accounting for deferred tax arising on share-based payments, specifically:
- how to calculate the amount to be recognised in other comprehensive income / equity and the amount to be recognised in profit or loss
- how to account for deferred tax on share based payments not caught by the measurement provisions of IFRS 2 ‘Share-based Payment’.
Calculating the credit to equity
IAS 12 requires a deferred tax asset to be recognised for deductible temporary differences associated with equity-settled share-based payments. In certain jurisdictions, tax law provides for a deduction against corporation tax when share options are exercised. The deduction can be equal to the intrinsic value (market price less exercise price) of the share options at the date they are exercised or computed on another basis specified by the tax law.
IAS 12.68C requires any deferred tax credit arising on equity-settled share-based payments to be allocated between profit or loss and equity.
What amount should be credited in profit or loss?
Simple case – Tax credit in profit or loss |
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On 1 January 20X1, Company A issued share options to its employees with a one year vesting period. At 31 December 20X1, an IFRS 2 charge of CU15,000 had been recognised. At 31 December 20X1, the share options expected to be exercised had a total intrinsic value of CU25,000. In the year, a deferred tax credit of CU5,750 should be recognised, based on a tax rate of 23% (assumed tax rate) (CU25,000 × 23%). At 31 December 20X1, the expected tax deduction of CU25,000 exceeds the cumulative IFRS 2 charge recognised to date of CU15,000 by CU10,000. Therefore, of the tax credit of CU5,750, CU3,450 should be recognised in profit or loss (CU15,000 × 23%) and CU2,300 should be recognised directly in equity (CU10,000 × 23%). |
In the above simple case, the amount of the deferred tax credit to be taken to profit or loss was simply the current year’s share-based payment charge multiplied by the effective tax rate. However, this will not always be the case. Whether any amount should be taken to equity in a given year depends on whether or not there is an ‘excess tax deduction’.