Accounting news 06 US GAAP. 02 Czech Accounting 03 IFRS. Have you considered all the options well?

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1 Have you considered all the options well? Accounting news Czech Accounting, IFRS and US GAAP June 2013, Deloitte Czech Republic 02 Czech Accounting Interpretations of the National Accounting Council in IFRS Current/non-current distinction of liabilities IFRS EU Endorsement Process 06 US GAAP Exit Plans and Restructuring: Contract Termination Costs

2 Czech Accounting Interpretations of the National Accounting Council in 2013 What is the National Accounting Council? The National Accounting Council is an independent professional institution for the support of professional competencies and professional ethics in the development of accounting professions in the area of accounting and financing methodology. The council members are representatives of significant professional organisations (Chamber of Auditors of the Czech Republic, Chamber of Tax Advisers of the Czech Republic, the Union of Accountants) and academics (the Prague School of Economics). The Council s key mission involves cooperation with the Ministry of Finance and other governmental, legislative and other institutions in the preparation of legislative and related norms focusing on accounting, and the preparation, updating, issuance and distribution of Czech Accounting Standards and Interpretations of the National Accounting Council. Interpretations of the National Accounting Council The interpretations express the National Accounting Council s professional opinion on the practical application of Czech accounting rules. The interpretations are not legally binding. Their aim is to contribute to the formulation of optimal and unified procedures in accounting and financial reporting. Principally, the interpretations focus on issues and questions that are not tackled by Czech accounting regulations or are tackled insufficiently, and on areas for which no unified guidance in accounting practice exists. In our Accounting Bulletin for March 2012 we informed you of three interpretations approved by the National Accounting Council in While no additional interpretations were approved in 2012, two new interpretations were approved in March Specifically, this includes interpretations Nos. I 24 and I 25. I 24 Post-Balance Sheet Events The interpretation tackles the following questions: 1. Can the state of affairs existing at the end of the balance sheet date (hereinafter at the balance sheet date ) be described using the information obtained subsequent to the balance sheet date, including information resulting from events that occurred no sooner than subsequent to the balance sheet date? If so, up to which date subsequent to the balance sheet date does this new information need to be taken into consideration? In preparing the financial statements, it is necessary to pay attention to all information known to the reporting entity up to the balance sheet date. Specifically, this also includes information on the circumstances and events that occurred no sooner than subsequent to the end of the reporting period for which the financial statements are prepared. These circumstances and events arising in a period between the balance sheet date and the preparation date of the financial statements, regardless of whether they have a positive or negative impact on the reporting entity, are called post-balance sheet events for the purposes of the interpretation. The impact of post-balance sheet events on the information presented in the financial statements differs according to the nature of the information, which may be of two kinds: a. Events that refer to the state of affairs existing at the balance sheet date for the purposes of the interpretation, these post-balance sheet events are called adjusting events. Adjusting events are reflected in the relevant financial statements prepared at the balance sheet date, except for cases that may lead to the reporting of unrealised profit (refer to Section 25 (3) of the Accounting Act). By presenting the adjusting events in the financial statements, the reporting entity does not free itself from its obligation to disclose these events also in the notes to the financial statements, as stipulated by Section 19 (5) of the Accounting Act. In identifying the adjusting events, the crucial point is the reporting entity s ability to prove the state of affairs existing already at the balance sheet date. For instance, the sale of inventory in the following reporting period at a price that is lower than the inventory s net book value is a transaction related to the following reporting period. Nevertheless, from this sale the value of inventory at the balance sheet date may already be arrived at. Therefore, such sale may be assessed as an adjusting event having an impact on the valuation reported in the financial statements prepared at the balance sheet date. b. Events evidencing the state of affairs that occurred no sooner than subsequent to the balance sheet date for the purposes of the interpretation, these post-balance sheet events are called non-adjusting events. In preparing the financial statements at the relevant balance sheet date, non-adjusting events are not presented in the relevant financial statements. However, should their non-presentation in the financial statements cause the financial statements to be misleading in any way, the reporting entity shall disclose these events in the notes to the financial statements in line with Section 19 (5) of the Accounting Act. The preparation date of the financial statements is to be presented in the financial statements in line with Section 18 (2) (f) of the Accounting Act. The preparation date of the financial statements is the date of affixing a signature to the financial statements. Any adjusting and non-adjusting events occurring or identified subsequent to this date are not presented in the financial statements (including the notes to the financial statements). Nevertheless, it is necessary to take into account the requirement under Section 21 (2) (a) of the Accounting Act to present such material information in the annual report, in the event that the reporting entity identifies the information prior to the annual report s issuance date. In the event that the financial statements are adjusted subsequent to their preparation date (eg in line with Section 17 (4) of the Accounting Act), these relevant financial statements are deemed new financial statements with a new preparation date. Therefore, it is necessary to take into account all known post- -balance sheet events occurring up to the preparation date of the new financial statements. I 25 Post-Predecessor Valuation In circumstances where companies acquire assets through transactions such as mergers and non-cash investments (generally all cases in which Section 24 (3) (a) of the Accounting Act is applied), the treatment in practice significantly differs in terms of how the valuation at the acquiring reporting entity follows up on the valuation applied by the preceding reporting entity. The accounting regulations do not provide any specific guidance to be followed in revaluation or how to continue the valuation that was applied by the preceding reporting entity.. continues on next page

3 Czech Accounting IFRS The purpose of the interpretation is not to suggest whether it is more suitable for the acquirer to base the valuation of assets on the assets original net book value or on their fair value. What the interpretation tackles is the issues related to the implementation of the relevant decision. The interpretation highlights the following conclusions: 1. Except for the cases outlined in Point 2, reporting entities applying the valuation of assets under Section 24 (3) (a) of the Accounting Act and: a. Following Point 1 of the above-named provision (hereinafter valuation at net book value as reported by the predecessor ), in determining the gross value of assets, these reporting entities apply the net book value of the assets as reported by the predecessor; and b. Following Point 2 of the above-named provision (hereinafter valuation at fair value ), in determining the gross value of assets, these reporting entities apply the fair value of the relevant assets. As such, both under the valuation at net book values reported by the predecessor and under the valuation at fair value, accumulated depreciation/ amortisation and provisions have a zero value. 2. In cases where the control over the relevant assets has not actually changed, ie the transactions during which the valued assets are acquired are solely a result of the formal reorganisation of related parties (eg mergers of fellow-subsidiaries) and if the valuation at net book values reported by the predecessor is selected, it is alternatively possible to assume all components of this relevant net book valuation, ie the original gross value including accumulated depreciation/amortisation and provisions. 3. If depreciated/amortised assets are assumed, it is necessary that the assuming reporting entity re-assess its original depreciation plans so that they comply with the selected valuation method and correspond with the planned purpose of using the assets. 4. The reporting entity shall disclose in the notes to the financial statements how the post-predecessor revaluation was dealt with. For the whole text of the Interpretations, go to the website of the National Accounting Council: Current/non-current distinction of liabilities This issue of the Accounting News includes an article on how to distinguish between current and non-current items on the liability side as in practice, there are many uncertainties in this area. Individual requirements of IAS 1 Presentation of Financial Statements providing guidance on this issue in paragraphs 60 to 76 will be illustrated on practical examples. Current and non-current liabilities are presented as separate classifications in the statement of financial position. Current liabilities According to IAS 1.69 an entity shall classify a liability as current when: a. it expects to settle the liability in its normal operating cycle; b. it holds the liability primarily for the purpose of trading; c. the liability is due to be settled within twelve months after the reporting period. (According to IAS 1.71 examples are some financial liabilities classified as held for trading in accordance with IAS 39, bank overdrafts, and the current portion of non-current financial liabilities, dividends payable, income taxes and other non-trade payables.) ; or d. it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. An entity shall classify all other liabilities as non-current. We will demonstrate the application of the requirements of IAS 1.69 on the following four examples. Example 1 - Classification of refundable deposit A company provides services. Contractual arrangements with customers include a security deposit (provided by a customer to the company), which is refundable within four months after the termination of the contract with the customer. The company is able to prove that the average term of the contractual relationship with a customer is four years. Should the deposits be classified as current or non-current liabilities? The deposits should be classified as current liabilities. Despite the historical evidence that indicates that the majority of the deposits are only repaid after the four-year period, the deposits are repayable on four-month notice. IAS 1.69(d) states that a liability should be classified as current when the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. It may be appropriate to disclose why the amounts are presented as current liabilities. Example 2 - Current/Non current presentation of non- derivative financial liabilities An entity issues a 6 per cent CZK100 million bond at par on 30 June The bond is repayable at par 10 years after issuance on 30 June Interest of CZK6 million is paid annually. There are no issue costs. The liability is measured at amortised cost using an effective interest rate of 6 per cent. For illustrative purposes only, assume that the amortised cost of the bond is CZK103 million on 31 December Source: 03 continues on next page

4 IFRS How should the entity present the carrying amount of the bond in its statement of financial position at 31 December 2012? Specifically, how is the presentation of the bond in the financial statements affected by IAS 1.71, which refers to the inclusion of the current portion of non-current financial liabilities in current liabilities? Two methods of classification are acceptable under IFRSs. An entity should adopt one of these methods as an accounting policy choice and should apply it consistently in accordance with paragraph 13 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. One approach is to present the entire amortised cost carrying amount of CZK103 million in non-current liabilities. IAS 1.69 supports this classification because: the liability is not expected to be settled in the entity's normal operating cycle; the liability is not held primarily for the purpose of trading; the liability is not due until 2022 (i.e. the principal is not expected to be settled within 12 months of the end of the reporting period); and the entity has the unconditional right to defer settlement of the liability for at least 12 months after the reporting period. Under this approach, interest on the bond represents servicing of the liability instead of its settlement. Therefore, the amount of interest to be paid within 12 months of the end of the reporting period does not constitute the current portion of non-current financial liabilities described in IAS The current portion of the bond would be the portion of its principal amount repayable within 12 months of the reporting period. The alternative method is to present CZK3 million separately as a current liability. This is the difference between the amortised cost carrying amount and the par value repayable on maturity. This current liability represents interest accrued at the year-end. The remaining carrying amount of CZK100 million would be classified as a non-current liability.. Example 3 - Current/Non current classification of a callable term loan Entity A borrows funds from Bank B for which repayment is scheduled over five years. However, Bank B retains a right (either via a specific clause in the loan agreement or by inclusion of a cross-reference to the bank's general terms of business) to call for repayment at any time without cause. Should the loan be classified as current or non-current by Entity A? The loan should be classified as current if the right to call for repayment at any time without cause is enforceable. IAS 1.69(d) requires that a liability should be classified as current if the borrowing entity "does not have an unconditional right (at the reporting date) to defer settlement of the liability for at least twelve months after the reporting period". Note: The conclusion above was published as an IFRS Interpretations Committee agenda decision in the November 2010 IFRIC Update. Example 4 Expected voluntary early repayment of a loan not due to be settled within twelve months after the reporting period On 1 January 2011, Entity X borrows funds from a third-party bank for long- -term financing purposes. The loan is due for repayment in The loan is classified as a non-current liability in Entity X s financial statements for the year ended 31 December At 31 December 2012, Entity X has not breached any provisions of the loan agreement and does not expect to do so in the foreseeable future. However, at that date, Entity X intends to enter into a refinancing arrangement that will involve voluntary repayment of the loan and taking out a new loan with a different lender. Entity X has notified the bank of its intentions, but has not entered into an irrevocable commitment to repay within 12 months. In January 2013 (before the 31 December 2012 financial statements are authorised for issue), the refinancing is completed as planned and the loan repaid. How should Entity X classify the loan in its financial statements at 31 December 2012? Entity X should classify the loan as a non-current liability. As at 31 December 2012, the loan is still due to be settled in 2015 (i.e. more than twelve months after the reporting period) and Entity X has not given up its unconditional right to defer settlement. The voluntary repayment after the reporting period is a non-adjusting event which, if material, should be disclosed in accordance with paragraph 21 of IAS 10 Events after the Reporting Period (including, potentially, the impact on liquidity). Refinancing or rescheduling of payments According to IAS 1.72 an entity classifies its financial liabilities as current when they are due to be settled within twelve months after the reporting period, even if: a. the original term was for a period longer than twelve months, and b. an agreement to refinance, or to reschedule payments, on a long-term basis is completed after the reporting period and before the financial statements are authorised for issue. As explained in IAS 1.BC44, the reporting of an entity s liquidity and solvency at the end of the reporting period should reflect contractual arrangements in force on that date. A refinancing after the reporting period is a non-adjusting event in accordance with IAS 10 Events after the Reporting Period and should not affect the presentation of the entity s statement of financial position. 04 continues on next page

5 IFRS According to IAS 1.73, if an entity expects, and has the discretion, to refinance or roll over an obligation for at least twelve months after the reporting period under an existing loan facility, it classifies the obligation as non-current, even if it would otherwise be due within a shorter period. However, when refinancing or rolling over the obligation is not at the discretion of the entity (for example, there is no arrangement for refinancing), the entity does not consider the potential to refinance the obligation and classifies the obligation as current. We will demonstrate the application of the requirements of paragraphs 72 and 73 of IAS 1 on the following example. Example 5 Classification of a short-term loan with a rollover option Entity A has a variable rate loan from Bank B that is due for repayment six months after the end of the reporting period. Under the terms of the loan, Entity A may roll over the loan on the same terms for another 12 months from the due date, provided that it passes a specified financial test at that date. Entity A has concluded that the extension option is not a separable embedded derivative. Should the loan be classified as current or non-current? It depends on the nature of the conditions attached to the extension option. In circumstances in which the conditions are substantive (which would normally be the case for any financial condition), or management does not expect to extend, the loan should be classified as current. However, if (1) the conditions are entirely within Entity A's control or totally perfunctory and (2) management expects to exercise its option, the substance of the option is that the rollover is at Entity A's discretion. The loan would therefore be classified as non-current in accordance with the requirements of IAS With respect to (1) above, when assessing whether the conditions are within the control of Entity A, the following factors should be considered: the defined conditions are customary for these types of financing arrangements; the assessment as to whether Entity A has met the conditions (i.e. the result of the 'test') is objectively determinable; the conditions are related to Entity A and its operations (e.g. there are no broad economic conditions or lender conditions); and it is reasonable to assume, based on facts and circumstances that exist at the end of the reporting period, that meeting the conditions at the rollover date is reasonably possible. Breaches of covenants According to IAS 1.74, when an entity breaches a provision of a long- -term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable on demand, it classifies the liability as current, even if the lender agreed, after the reporting period and before the authorisation of the financial statements for issue, not to demand payment as a consequence of the breach. An entity classifies the liability as current because, at the end of the reporting period, it does not have an unconditional right to defer its settlement for at least twelve months after that date. IAS 1.75 states that the liability is classified as non-current if the lender agreed by the end of the reporting period to provide a period of grace ending at least twelve months after the reporting period, within which the entity can rectify the breach and during which the lender cannot demand immediate repayment. We will demonstrate the application of the requirements of paragraphs 74 and 75 of IAS 1 on the following example.. Example 6 Breaches of covenants A company has an investment bank loan that is due on 20 January Unfortunately, the investment does not generate necessary income and the company is unable to settle the loan. The bankers are tolerant and conclude an amendment to the original contract on 10 January 2013 stipulating that the loan maturity date is postponed to 20 January How will the company classify the loan received in its financial statements for 2012, which will be published on 31 March 2013? This loan will be classified as a current liability in the financial statements for 2012 because the bank as the lender agreed to provide a period of grace after the end of the reporting period. The granting by the lender of a period of grace is a non-adjusting event which, if material, should be disclosed in accordance with paragraph 21 of IAS 10 Events after the Reporting Period (including, potentially, the impact on liquidity). Disclosure requirements of loans classified as current liabilities For loans classified as current liabilities, IAS 1.76 states that if the following events occur between the end of the reporting period and the date the financial statements are authorised for issue, those events are disclosed as non-adjusting events in accordance with IAS 10 Events after the Reporting Period: a. refinancing on a long-term basis; b. rectification of a breach of a long-term loan arrangement; and c. the granting by the lender of a period of grace to rectify a breach of a long- -term loan arrangement ending at least twelve months after the reporting period. 05 According to IAS 10.21, an entity shall disclose for each material category of non-adjusting event after the reporting period the nature of the event and an estimate of its financial effect, or a statement that such an estimate cannot be made.

6 IFRS US GAAP IFRS EU Endorsement Process Exit Plans and Restructuring: Contract Termination Costs The European Financial Reporting Advisory Group (EFRAG) updated its report showing the status of endorsement of each IFRS, including standards, interpretations, and amendments, most recently on 21 May As of 25 May 2013, the following three IASB pronouncements are awaiting European Commission endorsement for use in the EU: Standards IFRS 9 Financial Instruments (issued in November 2009) and subsequent amendments (amendments to IFRS 9 and IFRS 7 issued in December 2011) Amendments Amendments to IFRS 10, IFRS 12 and IAS 27 Investment Entities (issued in October 2012) Interpretation IFRIC 21 Levies (issued in May 2013) Click here for the Endorsement Status Report. In the previous issue we discussed how to account for employee termination benefits within the planned restructuring or exit plan. In the current issue, we would like to summarise how to treat the contract termination cost and other type of costs that can be incurred. How do we determine when the liability should be recognised? Contract Termination Costs The following may be the costs to terminate an operating lease or other contract: Costs to terminate the contract before the end of its term Costs that will continue to be incurred under the contract for its remaining term without economic benefit to the entity. A liability for costs to terminate a contract before the end of its term shall be recognised when the entity terminates the contract in accordance with the contract terms (for example, when the entity gives written notice to the counterparty within the notification period specified by the contract or has otherwise negotiated a termination with the counterparty). A liability for costs that will continue to be incurred under a contract for its remaining term without economic benefit to the entity shall be recognised at the cease-use date, which is the date the entity ceases using the right conveyed by the contract, for example, the right to use a leased property or to receive future goods or services. We will demonstrate below a specific case in our example. A liability for other costs associated with an exit or disposal activity shall be recognised in the period in which the liability is incurred (generally, when goods or services associated with the activity are received). How to measure the respective liabilities at inception? Contract Termination Costs A liability for costs to terminate a contract before the end of its term shall be measured at its fair value when the entity terminates the contract in accordance with the contract terms. If the contract is an operating lease, the fair value of the liability at the cease- -use date shall be determined based on the remaining lease rentals adjusted for the effects of any prepaid or deferred items recognised under the lease, and reduced by estimated sublease rentals that could be reasonably obtained for the property, even if the entity does not intend to enter into a sublease. Remaining lease rentals shall not be reduced to an amount less than zero. A liability for costs that will continue to be incurred under a contract for its remaining term without economic benefit to the entity shall be measured at its fair value at the cease-use date. Other Associated Costsy Other costs associated with an exit or disposal activity include, but are not limited to, costs to consolidate or close facilities and relocate employees. The liability shall not be recognised before it is incurred, even if the costs are incremental to other operating costs and will be incurred as a direct result of a plan. 06 continues on next page

7 US GAAP Other Associated Costs A liability for other costs associated with an exit or disposal activity shall be measured at its fair value in the period in which the liability is incurred (generally, when goods or services associated with the activity are received).. In following example we will demonstrate how to treat costs to terminate an operating Lease: This Example illustrates the situation related to terminating an operating lease at the cease-use date and after the cease-use date. An entity leases a facility under an operating lease that requires the entity to pay lease rentals of $100,000 per year for 10 years. After using the facility for five years, the entity commits to an exit plan. In connection with that plan, the entity will cease using the facility in one year (after using the facility for six years), at which time the remaining lease rentals will be $400,000 ($100,000 per year for the remaining term of four years). A liability for the remaining lease rentals, reduced by actual (or estimated) sublease rentals, would be recognised and measured at its fair value at the cease-use date. The liability would be adjusted for changes, if any, resulting from revisions to estimated cash flows after the cease-use date, measured using the credit-adjusted risk- -free rate that was used to measure the liability initially. Based on market rentals for similar leased property, the entity determines that if it desired, it could sublease the facility and receive sublease rentals of $300,000 ($75,000 per year for the remaining lease term of four years). However, for competitive reasons, the entity decides not to sublease the facility (or otherwise terminate the lease) at the cease-use date. The fair value of the liability at the cease-use date is $89,427, estimated using an expected present value technique. The expected net cash flows of $100,000 ($25,000 per year for the remaining lease term of four years) are discounted using a credit-adjusted risk-free rate of 8 percent. In this case, a risk premium is not considered in the present value measurement. Because the lease rentals are fixed by contract and the estimated sublease rentals are based on market prices for similar leased property for other entities having similar credit standing as the entity, there is little uncertainty in the amount and timing of the expected cash flows used in estimating fair value at the cease-use date and any risk premium would be insignificant. In other circumstances, a risk premium would be appropriate if it is significant. Thus, a liability (expense) of $89,427 would be recognised at the cease-use date. Accretion expense would be recognised after the cease-use date - the entity will recognise the impact of deciding not to sublease the property over the period the property is not subleased. For example, in the first year after the cease-use date, an expense of $75,000 would be recognised as the impact of not subleasing the property, which reflects the annual lease payment of $100,000 net of the liability extinguishment of $25,000. At the end of one year, the competitive factors referred to above are no longer present. The entity decides to sublease the facility and enters into a sublease. The entity will receive sublease rentals of $250,000 ($83,333 per year for the remaining lease term of three years), negotiated based on market rentals for similar leased property at the sublease date. The entity adjusts the carrying amount of the liability at the sublease date to $46,388 to reflect the revised expected net cash flows of $50,000 ($16,667 per year for the remaining lease term of three years), which are discounted at the credit-adjusted risk-free rate that was used to measure the liability initially (8 percent). 07

8 If you have any questions regarding any of the articles in this publication, please contact one of the following audit experts: Czech Accounting Stanislav Staněk: IFRS and US GAAP Martin Tesař: Soňa Plachá: Gabriela Jindřišková: Deloitte Advisory s.r.o. Nile House Karolinská 654/ Prague 8 - Karlín Czech Republic Tel.: Fax: This publication contains general information only, and none of Deloitte Touche Tohmatsu Limited, any of its member firms or any of the foregoing s affiliates (collectively the Deloitte Network ) are, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your finances or your business. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person who relies on this publication. *** Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. With a globally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and high-quality service to clients, delivering the insights they need to address their most complex business challenges. Deloitte's approximately 195,000 professionals are committed to becoming the standard of excellence Deloitte Czech Republic