Today s Agenda. HKAS 2, 16, 36 and July Nelson Lam CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) ACA. Inventories (HKAS 2) 2)

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1 HKAS 2, 16, 36 and July 2006 Nelson Lam CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) ACA Nelson 1 Today s Agenda Inventories (HKAS 2) 2) Property, Plant and Equipment (HKAS 16) Impairment of of Assets (HKAS 36) Provisions, Contingent Liabilities and Contingent Assets (HKAS 37) Simple but Comprehensive Recap and key issues Real Life Cases and Examples Nelson 2 1

2 Inventories (HKAS 2) Nelson 3 Objective and Scope of HKAS 2 The objective of HKAS 2 is to prescribe the accounting treatment for inventories. A primary issue in accounting for inventories is the amount of cost to be recognised as an asset and carried forward until the related revenues are recognised. HKAS 2 provides guidance on the determination of cost and its subsequent recognition as an expense, including any write-down to net realisable value. the cost formulas that are used to assign costs to inventories. Inventories are assets: a) a) held for for sale in in the the ordinary course of of business; b) b) in in the the process of of production for for such sale; or or c) c) in in the the form of of materials or or supplies to to be be consumed in in the the production process or or in in the the rendering of of services Nelson 4 2

3 Objective and Scope of HKAS 2 HKAS 2 applies to all inventories, except: a) work in progress arising under construction contracts, including directly related service contracts (see HKAS 11 Construction Contracts); b) financial instruments; and c) biological assets related to agricultural activity and agricultural produce at the point of harvest (see HKAS 41 Agriculture) Nelson 5 Objective and Scope of HKAS 2 A jewellery company is engaged in retailing and wholesale of gold and diamond and has a significant level of inventories on golden and diamond products. In view of the significant price fluctuation of gold and diamond in these 2 years the company considers whether it can carry such kinds of inventories at market price, instead of cost. Please advise. Example Nelson 6 3

4 Objective and Scope of HKAS 2 Example HKAS 2.3(b) states that HKAS 2 does not apply to: to: commodity broker-traders who measure their inventories at at fair fair value less costs to to sell. When such inventories are are measured at at fair fair value less costs to to sell, changes in in fair fair value less costs to to sell sell are are recognised in in profit or or loss in in the the period of of the the change. HKAS 2.5 clarifies that: Broker-traders are are those who buy buy or or sell sellcommodities for for others or or on on their own account. The inventories referred to to in in HKAS 2.3(b) are are principally acquired with the the purpose of of selling in in the the near future and and generating a profit from fluctuations in in price or or broker-traders margin. When these inventories are are measured at at fair fair value less costs to to sell, they are are excluded from only the the measurement requirements of of HKAS The jewellery company can consider accounting for for its its golden and diamond products at at fair value less costs to to sell and recognising such changes in in profit or or loss Nelson 7 Objective and Scope of HKAS 2 HKAS 2 does not apply to the measurement of inventories held by: a) producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realisable value in accordance with well-established practices in those industries. When such inventories are measured at net realisable value, changes in that value are recognised in profit or loss in the period of the change. b) commodity broker-traders who measure their inventories at fair value less costs to sell. When such inventories are measured at fair value less costs to sell, changes in fair value less costs to sell are recognised in profit or loss in the period of the change. Producers of of agriculture and minerals Using NRV (through P/L) Commodity broker-trader Using Fair Value (through P/L) Nelson 8 4

5 Measurement of Inventories Inventories shall be measured at the lower of cost and net realisable value. Cost of of Purchase Cost of of Conversion Other Costs The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition Nelson 9 Measurement of Inventories Cost Formulas Specific Identification The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs. Specific identification of cost means that specific costs are attributed to identified items of inventory Nelson 10 5

6 Measurement of Inventories Example Entity ST has the following accounting policy in its financial statements of 2006: Inventories are stated at the lower of cost and net realisable value. In respect of unsold machines, cost is determined by apportionment of the total development costs, including finance costs capitalised, attributable to unsold machines. In respect of other inventories, cost, comprising purchase cost from suppliers, is determined: on first-in-first-out basis and on the weighted average method. Please comment Nelson 11 Measurement of Inventories Cost Formulas Specific Identification FIFO Weighted Average The cost of inventories, other than those dealt with by using specific identification, shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula. For all inventories having a similar nature and use to the entity, an entity shall use the same cost formula. For inventories with a different nature or use, different cost formulas may be justified Nelson 12 6

7 Measurement of Inventories Example Entity ST has the following accounting policy in its financial statements of 2006: Inventories are stated at the lower of cost and net realisable value. In respect of unsold machines, cost is determined by apportionment of the total development costs, including finance costs capitalised, attributable to unsold machines. In respect of other inventories, cost, comprising purchase cost from suppliers, is determined: Are they having a on first-in-first-out basis and similar nature and on the weighted average method. use to the entity? Please comment. In In accordance with HKAS 2.25, an an entity shall use the same cost formula for for all all inventories having a similar nature and use to to the entity, i.e. using either the first-in, first-out (FIFO) or or weighted average cost formula but not both (unless for for inventories with a different nature or or use, different cost formulas may be be justified) Nelson 13 Measurement of Inventories Case Annual Report stated its accounting policy on inventories as: Inventories are stated at the lower of cost or net realisable value. Cost is determined on the weighted average basis and, in the case of work in progress and finished goods, comprises direct materials, direct labour and an appropriate proportion of overheads. Net realisable value is based on estimated selling prices less any estimated costs to be incurred to completion and disposal Nelson 14 7

8 Recognition as an Expense When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised. All write-down and losses of inventories shall be recognised as an expense in the period the write-down or loss occurs. Reversal of any write-down of inventories, arising from an increase in net realisable value shall be recognised as a reduction in the amount of inventories recognised as an expense in the period in which the reversal occurs. Some inventories may be allocated to other asset accounts, e.g. inventory used as a component of self-constructed property, plant or equipment Nelson 15 Disclosure The financial statements shall disclose: a) the accounting policies adopted in measuring inventories, including the cost formula used; b) the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity; c) the carrying amount of inventories carried at fair value less costs to sell; d) the amount of inventories recognised as an expense during the period; e) the amount of any write-down of inventories recognised as an expense in the period in accordance with HKAS 2.34; f) the amount of any reversal of any write-down that is recognised as a reduction in the amount of inventories recognised as expense in the period in accordance with HKAS 2.34; g) the circumstances or events that led to the reversal of a write-down of inventories in accordance with HKAS 2.34; and h) the carrying amount of inventories pledged as security for liabilities Nelson 16 8

9 Property, Plant and Equipment (HKAS 16) Nelson 17 From SSAP 17 to HKAS 16 Summary 1. Scope 2. Definitions 3. Recognition 4. Measurement at recognition 5. Measurement after recognition 6. Derecognition 7. Disclosure Exempted entities deleted, some properties excluded Cost and residual value revised Same recognition principle applied to all costs Element of cost extended Measurement of assets from exchange of assets revised Commencement and cessation of depreciation revised Annual review of residual value needed Sections of transfer, retirements and disposals eliminated Derecognition rule introduced No exemption on disclosure of comparative figures (comparative on reconciliation needed) Nelson 18 9

10 Scope Changes & Implication Exemption for not-for-profit entities eliminated The exemption in SSAP 17 for charitable, government subvented and not-for-profit organisations was eliminated in HKAS 16 Specific transitional provisions for this elimination additionally introduced in Nov Charities, not-for-profit entities must follow Implies that all such entities are required to depreciate its PPE from the financial period beginning from 1 Jan Those entities that have previously taken advantage of the exemption under SSAP 17 are permitted to deem the carrying amount of an item of PPE immediately before applying HKAS 16 on its effective date (or earlier) as the cost of that item More to be discussed later Nelson 19 Objective and Scope Are the following assets PPE? Example Copier acquired under an operating lease Motor vehicle acquired under finance leases Owned property used for rental purpose Investment property under re-development Property held for a currently undetermined future use Leasehold land separated from the leasehold building HKAS 17 HKAS 40 HKAS 40 HKAS 40 HKAS Nelson 20 10

11 Definition Revised Cost is the amount of cash or cash equivalents paid or the fair value of other consideration given to acquire an asset at the time of its acquisition or construction, or where applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other HKFRSs e.g. HKFRS 2 Share-based Payment Residual value Revised but discussed later Cost extended Residual value Nelson 21 Recognition Principle Change Recognition criteria (capitalisation) for Initial Cost Subsequent Expenditure In SSAP 17 In HKAS 16 Criteria not the same Same criteria Probable that future Probable that future economic benefit of of economic benefits in in the asset will flow to to excess of of the originally the enterprise assessed standard of of Cost measured performance of of the reliably existing asset will flow to to the entity Probable that future economic benefit of of the asset will flow to to the entity Cost measured reliably Same criteria applied to to both costs Expenditure not fulfilling the recognition criteria will be charged to income statement Clearer approach on on so-called Component Accounting Nelson 22 11

12 Recognition Principle Change Case Capitalise Expense Hong Kong Aircraft Engineering Company Limited Annual Report 2005 states: Property, plant and equipment are carried at cost less accumulated depreciation and accumulated impairment losses. Cost includes expenditure that is directly attributable to the acquisition of the items. Subsequent costs are included in the asset s carrying amount or recognised as a separate asset, as appropriate, only when it is probable that future economic benefits associated with the item will flow to the Group and the cost of the item can be measured reliably. All other repairs and maintenance are expensed in the profit and loss account during the financial period in which they are incurred Nelson 23 Recognition Principle Change Case Capitalise 2005 Annual Report stated its accounting policy on cost of restoring and improving PPE as follows: The plant components are depreciated over the period to overhaul. Major costs incurred in restoring the plant components to their normal working condition to allow continued use of the overall asset are capitalised and depreciated over the period to the next overhaul. Improvements are capitalised and depreciated over their expected useful lives to the Group Nelson 24 12

13 Measurement at Recognition Element of cost extended In HKAS 16, the cost of an item of PPE comprises: a) its purchase price, including import duties and nonrefundable purchase taxes, after deducting trade discounts and rebates; b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. Purchase Price Directly Attributable Cost Dismantling Cost New element of PPE cost Nelson 25 Measurement at Recognition Example Several same air-condition plants have been installed by GV in several leasehold properties. When the properties are returned to the landlord in 4 years, the plants should be removed. The properties include factory (3 plants installed), show room (1 plant installed) and head office (2 plants installed). The purchase cost of each plant is $1,000. The installation cost is $1,000 for each plant. Present value of removal costs of the plant include $400 resulted from installation only and $400 from the usage during the 4 years. What is the cost of each plant to be recognised? In In accordance with HKAS the the cost of of each plant installed in in the the factory should be be $2,400 (the purchase cost, installation cost and and present value of of removal cost from installation). the the cost of of each plant installed in in the the show room and and head office should be be $2,800 (including the the present value of of all all removal costs) Since the the removal costs of of such plants are are incurred as as a consequence of of having used the the machine during a particular period for for purposes, other than to to produce inventories during that that period Nelson 26 13

14 Measurement at Recognition Element of cost extended Rule on Exchange of Assets Revised Same amendment in in HKAS 38 and HKAS 40 Cost of PPE acquired in exchange is measured at fair value But not required if: Commercial Substance Fair Value of of Exchanged Asset In SSAP 17 it is an exchange for similar assets In HKAS 16 the exchange transaction lack of Commercial Substance, or the Fair Value is not reliably measurable (both asset received and given up) If the acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset given up Nelson 27 Measurement after Recognition Depreciation Requirements revised in HKAS 16 Each part of an item of PPE with a cost that is significant in relation to the total cost of the item shall be depreciated separately Begins when PPE is available for use Ceases at the earlier of the date that PPE is classified as held for sale (under HKFRS 5), and derecognised Each significant component shall be depreciated separately (not clearly required in the past) Implied that depreciation still required even PPE becomes idle or is retired from active use Clearer approach on on so-called Component Accounting Nelson 28 14

15 Measurement after Recognition Depreciation Residual Value As stated before, definition of Residual Value is revised as the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life Inflation may be incorporated in residual value New requirements (on both residual value and useful life) shall be reviewed at least at each financial year end if expectations differ from previous estimates, the change shall be accounted for as a change in an accounting estimate in accordance with HKAS 8 No such requirement in SSAP Nelson 29 Measurement after Recognition Depreciation Residual Value PPE s residual value may increase to an amount equal to or greater than the asset s carrying amount If it does, the depreciation charge is zero unless and until its residual value subsequently decreases to an amount below the asset s carrying amount Be careful By referring to the definition of residual value It is still limited to the estimates that it would receive currently for the asset if the asset were already of the age and in the condition expected at the end of its useful life Implication: If If estimated residual value value > carrying amount amount no no depreciation is is required But But feasible only only if if the the management clearly clearly intends intends to to dispose of of the the PPE PPE before before the the end end of of its its physical usage usage life life otherwise, the the estimated residual value value is is minimal or or even even zero zero Nelson 30 15

16 Measurement after Recognition Example At 1 Jan. 1985, Entity A bought a flat in Tai Koo Shing at HK$ 0.5 million Entity A aimed to use it for 50 years until the end of its estimated useful life The original estimated residual value is zero Depreciation is calculated on a straight-line basis At 31 Dec. 2004, the depreciated historical cost (and carrying amount) of the property was HK$0.3 million Now, the price of a similar flat in Tai Koo Shing is about HK$ 3M Shall A revise the residual value? If A changes its intention and aims to dispose of the flat in 10 years (i.e. 2015) Shall A revise the residual value? No! A has has not not changed its its usage plan and and the the residual value after the the estimated useful live live would still still be be around zero Yes! If If A can can demonstrate that that it it has has an an intention to to dispose of of it it before the the end end of of its its economic life life Nelson 31 Derecognition Sections of Transfer, Retirements and Disposals in SSAP 17 were deleted in HKAS 16 (new transfer section added in HKAS 40, to discuss later) In HKAS 16 The carrying amount of an item of PPE shall be derecognised: a) on disposal; or b) when no future economic benefits are expected from its use or disposal. The gain or loss arising from the derecognition of an item of PPE shall be included in profit or loss when the item is derecognised (unless HKAS 17 requires otherwise on a sale and leaseback) Gains shall NOT be classified as revenue Nelson 32 16

17 Derecognition Derecognition on replacement If, under the initial recognition principle, an entity recognises in the carrying amount of an item of PPE the cost of a replacement for part of the item then it derecognises the carrying amount of the replaced part regardless of whether the replaced part had been depreciated separately Nelson 33 Disclosure Detailed information and reconciliation of the carrying amount of PPE are required The reconciliation of the carrying amount of PPE for prior period, i.e. comparative reconciliation is now required The carrying amount of the PPE net book value of PPE In HK SSAP 17, the requirement is a reconciliation of the gross carrying amount and the accumulated depreciation at the beginning and end of the period Nelson 34 17

18 Disclosure Case Leasehold improvements, furniture, equipment and Leasehold buildings Computer trading and clearing systems Other computer hardware and software motor vehicles Total $ 000 $ 000 $ 000 $ 000 $ 000 Net book value at 1 Jan 2003 as previously reported (note ii) 117, , ,304 71, ,108 effect of adopting HKAS 17 (98,500) (98,500) as restated (note i) 18, , ,304 71, ,608 Additions 13,431 16,775 6,041 36,247 Disposals (3,474) (6,659) (1,604) (11,737) Depreciation (748) (109,510) (39,703) (31,778) (181,739) Revaluation (note 34) Net book value at 31 Dec , ,679 75,717 44, ,927 At 31 Dec 2003 At cost 1,345, , ,519 1,924,307 At valuation 18,300 18,300 Accumulated depreciation (1,000,724) (271,668) (187,288) (1,459,680) Net book value 18, ,679 75,717 44, , Nelson 35 Disclosure However, in SME FRS, the requirement is the same (except no comparative requirement), but it it gives the following illustrative e notes: Property, plant and equipment Cost: At 1 January 20X5 Additions Disposals At 31 December 20X5 Accumulated depreciation and impairment losses: At 1 January 20X5 Depreciation for the year Written back on disposal At 31 December 20x5 Net carrying amount: At 31 December 20X5 At 31 December 20x4 Leasehold land and buildings HK$ 5,040, ,040,000 2,160,000 80,000-2,240,000 2,800,000 2,880,000 Furniture, fixtures and equipment HK$ 2,428,180 2,381,530 (1,527,470) 3,282,240 1,204, ,770 (878,000) 811,940 2,470,300 1,224,010 Example Total HK$ 7,468,180 2,381,530 (1,527,470) 8,322,240 3,364, ,770 (878,000) 3,051,940 5,270,300 4,104, Nelson 36 18

19 Transitional Provisions For exchange of assets The requirements regarding the initial measurement of an item of PPE acquired in an exchange of assets transaction shall be applied prospectively to future transactions Nelson 37 Transitional Provisions For those entities (charities and not-for-profit entities) that have previously taken advantage of the exemption under SSAP 17 They are permitted to deem the carrying amount of an item of PPE immediately before applying HKAS 16 on its effective date (or earlier) as the cost of that item. Depreciation on the deemed cost of an item of property, plant and equipment commences from the time at which HKAS 17 is first applied. In the case where a carrying amount is used as a deemed cost for subsequent accounting, this fact and the aggregate of the carrying amounts for each class of property, plant and equipment presented shall be disclosed Nelson 38 19

20 Transitional Provisions What is the implication on the following cases when HKAS 16 is adopted? Example All the costs of PPE of an notfor-profit entity had been written off to income and expenditure statement before All the costs of PPE of an notfor-profit entity had not been depreciated before The The entity is is permitted not not to to restate restate the the costs costs of of PPE PPE to to carry carry zero zero beginning balance on on PPE PPE in in to to follow follow HKAS HKAS from from The The entity is is permitted to to begin begin depreciation from from to to follow follow HKAS HKAS from from For For both both cases, the the fact fact and and the the aggregate of of the the carrying amounts for for each class of of PPE PPE presented shall shall be be disclosed Nelson 39 Impairment of Assets (HKAS 36) Amendment as a result of the introduction of HKFRS 3 Revise the impairment requirements on cash-generating unit and goodwill Nelson 40 20

21 Impairment of Assets - Summary Triggering events Recoverable Amount Impairment Loss At each reporting date, an entity shall assess whether there is any indication that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset. It is the higher of an asset s Fair value less Net Selling Price costs to sell and Value in Use If, and only if, the recoverable amount of an asset is less than its carrying amount The carrying amount of the asset shall be reduced to its recoverable amount. That reduction is an impairment loss Nelson 41 Impairment of Assets Scope HKAS 36 applies to financial assets classified as: a) subsidiaries, as defined in HKAS 27 Consolidated and Separate Financial Statements; b) associates, as defined in HKAS 28 Investments in Associates; and c) joint ventures, as defined in HKAS 31 Interests in Joint Ventures. For impairment of other financial assets, refer to HKAS Nelson 42 21

22 Identify An Asset That May Be Impaired Triggering events At each reporting date, an entity shall assess whether there is any indication that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset. Except for Intangible assets, and Goodwill Intangible Assets Goodwill Nelson 43 Identify An Asset That May Be Impaired Triggering events Intangible Assets Goodwill Irrespective of whether there is any indication of impairment, an entity shall also: a) test an intangible asset with an indefinite useful life, or an intangible asset not yet available for use for impairment annually by comparing its carrying amount with its recoverable amount. b) test goodwill acquired in a business combination for impairment annually Nelson 44 22

23 Identify An Asset That May Be Impaired Case Intangible Assets Goodwill 2006 Annual Report states: Assets that have an indefinite useful life are not subject to amortisation, but are tested at least annually for impairment and also reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Goodwill is tested annually for impairment and carried at cost less accumulated impairment losses Nelson 45 Identify An Asset That May Be Impaired Intangible Assets Goodwill Timing of impairment test on intangible assets This impairment test may be performed at any time during an annual period provided it is performed at the same time every year. Different intangible assets may be tested for impairment at different times. However, if such an intangible asset was initially recognised during the current annual period that intangible asset shall be tested for impairment before the end of the current annual period. Timing of impairment test on goodwill To be discussed later Nelson 46 23

24 Identify An Asset That May Be Impaired Case Intangible Assets Intangible assets that have an indefinite useful life, or are not yet ready for use are tested for impairment annually. This impairment test may be performed at any time during an annual period, provided it is performed at the same time every year. An intangible asset recognised during the current period is tested before the end of the current annual period Nelson 47 Cash-Generating Unit and Goodwill If it is not possible to estimate the recoverable amount of the individual asset an entity shall determine the recoverable amount of the cash-generating unit to which the asset belongs (the asset s cash-generating unit). Intangible Assets Intangible assets may be such individual asset. Goodwill is definitely such individual asset. Goodwill Amendments of of HKAS are are mainly for for the the requirements on on cash-generating unit unit and and goodwill Nelson 48 24

25 Cash-Generating Unit and Goodwill A cash-generating unit (CGU) is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Discussion points on CGU and goodwill include: Allocating Goodwill to CGU Testing CGU with Goodwill for Impairment Minority Interest Timing of Impairment Tests Nelson 49 Cash-Generating Unit and Goodwill Allocating Goodwill to CGU Initial allocation For the purpose of impairment testing, goodwill acquired in a business combination shall from the acquisition date, be allocated to each of the acquirer s CGUs (or groups of CGUs) that are expected to benefit from the synergies of the combination irrespective of whether other assets or liabilities of the acquiree are assigned to those units or groups of units. Goodwill CGU 1 CGU 2 CGU Nelson 50 25

26 Cash-Generating Unit and Goodwill Allocating Goodwill to CGU Initial allocation Each unit or group of units to which the goodwill is so allocated shall: a) represent the lowest level within the entity at which the goodwill is monitored for internal management purposes; and b) not be larger than a segment based on either the entity s primary or the entity s secondary reporting format determined in accordance with HKAS 14 Segment Reporting. Goodwill CGU 1 CGU 2 CGU Nelson 51 Cash-Generating Unit and Goodwill Allocating Goodwill to CGU Initial allocation If the initial allocation of goodwill cannot be completed as required that initial allocation shall be completed before the end of the first annual period beginning after the acquisition date (i.e. within 12 months). In accordance with HKFRS 3 if the initial accounting for a business combination can be determined only provisionally, the acquirer: a) accounts for the combination using those provisional values; and Goodwill b) recognises any adjustments to those provisional values as a result of completing the initial accounting within 12 months of the acquisition date. CGU 1 CGU 2 CGU Nelson 52 26

27 Cash-Generating Unit and Goodwill Case Allocating Goodwill to CGU Initial allocation Hong Kong Aircraft Engineering Company Limited Annual Report 2005 states: Goodwill is tested annually for impairment and carried at costs less accumulated impairment losses. Any impairment arising on goodwill is recognised in the profit and loss account immediately Goodwill is allocated to cash-generating units for the purpose of impairment testing. For the purposes of assessing impairment, assets are grouped at the lowest levels for which there are separately identifiable cash flows (cash-generating units) Nelson 53 Cash-Generating Unit and Goodwill Allocating Goodwill to CGU Disposal If goodwill has been allocated to a CGU and the entity disposes of an operation within that CGU the goodwill associated with the operation disposed of shall be: a) included in the carrying amount of the operation when determining the gain or loss on disposal; and b) measured on the basis of the relative values of the operation disposed of, and the portion of the CGU retained, unless the entity can demonstrate that some other method better reflects the goodwill associated with the operation disposed of Nelson 54 27

28 Cash-Generating Unit and Goodwill Example Allocating Goodwill to CGU Disposal An entity sells for $100 an operation that was part of a CGU to which goodwill has been allocated. The goodwill allocated to the unit cannot be identified or associated with an asset group at a level lower than that unit, except arbitrarily. The recoverable amount of the portion of the CGU retained is $300. $100 $300 Because the goodwill allocated to to the CGU cannot be be non-arbitrarily identified or or associated with an an asset group at at a level lower than that unit, the goodwill associated with the operation disposed of of is is measured on on the basis of of the relative values of of the operation disposed of, of, and the portion of of the unit retained. Therefore, 25% of of the goodwill ($100 // $400) allocated to to the CGU is is included in in the carrying amount of of the operation that is is sold Nelson 55 Cash-Generating Unit and Goodwill Case Allocating Goodwill to CGU Disposal At the date of disposal of a business attributable goodwill is included in the Group s share of net assets in the calculation of the gain or loss on disposal. In its 2005 Interim Report, full set of HKFRS was adopted: Goodwill is tested annually for impairment and carried at cost less accumulated impairment losses. Gains and losses on the disposal of an entity include the carrying amount of goodwill relating to the entity sold. Goodwill is allocated to cash-generating units for the purpose of impairment testing. Any improvement? Nelson 56 28

29 Cash-Generating Unit and Goodwill Case In its 2005 Interim Report, full set of HKFRS was adopted: Goodwill is tested annually for impairment and carried at cost less accumulated impairment losses. Gains and losses on the disposal of an entity include the carrying amount of goodwill relating to the entity sold. Goodwill is allocated to cash-generating units for the purpose of impairment testing. Business, Any improvement? instead of Entity Nelson 57 Cash-Generating Unit and Goodwill On Parent P Sub S Property $ 0 $ 6,000 Investment 0 0 Cash at bank 30,000 2,000 30,000 8,000 Issued equity $ (30,000) $ (5,000) Retained earnings 0 (3,000) (30,000) (8,000) Example On Parent P acquired 20% interest in Subsidiary S at $3,500 by cash. Fair value of the property of S was $8,000. During 2005 Parent P reported nil profit and profit of S was HK$6,000 (became cash). Fair value of S is HK$30,000 at year-end. P accounted for S as held for trading. On P acquired additional 60% interest in S at $22,000 by cash. Fair value of the property of S was $11, Nelson 58 29

30 Cash-Generating Unit and Goodwill Example On Parent P Sub S Property $ 0 $ 6,000 Goodwill 0 0 Investment 28,000 0 Cash at bank 4,500 8,000 32,500 14,000 Issued equity $ (30,000) $ (5,000) Retained earnings (2,500) (9,000) Revaluation reserves 0 0 Minority interest 0 0 (32,500) (14,000) J#1 J#2 Consolidated 5,000 $ 11,000 12,100 12,100 (2,500) (25,500) 0 12,500 35,600 5,000 $ (30,000) 2,500 7,800 (1,200) (600) (600) (3,800) (3,800) (35,600) Nelson 59 Cash-Generating Unit and Goodwill Example Assume S mainly involved in holding investment property to derive rental and had 2 properties managed independently. On , S disposed of one property at $8,000 (cost $3,000) and the remaining property s recoverable amount was $14,000 (cost $3,000). On On company level of of S: S: Sales Sales proceed of of property $ 8,000 8,000 Cost Cost of of property (3,000) (3,000) Gain Gain on on disposal $ 5,000 5,000 On On consolidated level: Sales Sales proceed of of property $ 8,000 8,000 Cost Cost of of property to to the the group group ($11,000 22,000 22,000x 8,000) 8,000) 4,000 4,000 Gain Gain on on disposal at at group group level level $ 4,000 4,000 Goodwill written written off off in in accordance with with HKAS HKAS ($12,100 That s all? 22,000 22,000x 8,000) 8,000) $ 4,400 4,400 all? Nelson 60 30

31 Cash-Generating Unit and Goodwill Example Original consolidation journals: Dr($) Cr($) Dr Retained earnings 2,500 Cr Investment 2,500 To restate the initial 20% investment in Subsidiary S to cost Dr Property fair value adjustment ($11,000 - $6,000) 5,000 Issued equity subsidiary (given) 5,000 Retained earnings subsidiary (given) 9,000 Goodwill (as calculated in last slide) 12,100 Cr Investment cost of combinations (twice) 25,500 Minority interest (19,000 x 20%) 3,800 Retaining earnings recognised (to the extent that they relate to the previously held ownership interests) 1,200 Revaluation reserves 600 To recognise the goodwill and eliminate the investments with the equity shares Nelson 61 Cash-Generating Unit and Goodwill Example Additional consolidation journals: Dr($) Cr($) Dr Income statement (Retained earnings) 1,000 Cr Property 1,000 To adjust the gain recognised in S as fair value had been taken up at group level before Dr Retained earnings 800 Cr Minority interest (4,000 x 20%) 800 To allocate the gain on disposal of property to minority interest Dr Income statement (Retained earnings) 4,400 Cr Goodwill 4,400 To write off the goodwill allocated to the business in accordance with HKAS Nelson 62 31

32 Cash-Generating Unit and Goodwill Example On Parent P Sub S Property $ 0 $ 3,000 Goodwill 0 0 Investment 28,000 0 Cash at bank 4,500 16,000 32,500 19,000 J#1 J#2 J#3 Consolidated 5,000 (1,000) $ 7,000 12,100 (4,400) 7,700 (2,500) (25,500) 0 20,500 35,200 Issued equity $ (30,000) $ (5,000) Retained earnings (2,500) (14,000) Revaluation reserves 0 0 Minority interest 0 0 (32,500) (19,000) 5,000 $ (30,000) 2,500 7,800 6,200 0 (600) (600) (3,800) (800) (4,600) (35,200) A portion of the fair value changes from 1st to 2nd acquisition relating to the 2 properties should also be realised when one of them was disposed of, $600 22,000 x 8,000 = $218. Please suggest journal! Nelson 63 Cash-Generating Unit and Goodwill Allocating Goodwill to CGU Reorganise If an entity reorganises its reporting structure in a way that changes the composition of one or more CGUs to which goodwill has been allocated the goodwill shall be reallocated to the CGUs affected Nelson 64 32

33 Cash-Generating Unit and Goodwill Example Allocating Goodwill to CGU Reorganise Goodwill had previously been allocated to CGU A. The goodwill allocated to CGU A cannot be identified or associated with an asset group at a level lower than CGU A, except arbitrarily. A is to be divided and integrated into 3 other CGUs, namely B, C and D. Because the the goodwill allocated to to CGU A cannot be be non-arbitrarily identified or or associated with with an an asset group at at a level level lower than than CGU A. A. Goodwill is is reallocated to to CGU B, B, C and and D on on the the basis of of the the relative values of of the the 3 portions of of CGU A before those portions are are integrated with with CGU B, B, C and and D. D Nelson 65 Cash-Generating Unit and Goodwill Testing CGU with Goodwill for Impairment Goodwill Unallocated When goodwill relates to a CGU but has not been allocated to that unit the unit shall be tested for impairment, whenever there is an indication that the CGU may be impaired any impairment loss shall be recognised Goodwill Allocated A CGU to which goodwill has been allocated shall be tested for impairment annually, and whenever there is an indication that the unit may be impaired If the carrying amount of the CGU exceeds its recoverable amount, the entity shall recognise any impairment loss Nelson 66 33

34 Cash-Generating Unit and Goodwill Minority Interest In accordance with HKFRS 3 goodwill recognised in a business combination represents the goodwill acquired by a parent based on the parent s ownership interest, rather than the amount of goodwill controlled by the parent as a result of the business combination. Thus, goodwill attributable to a minority interest is not recognised in the parent s consolidated financial statements. New requirement Nelson 67 Cash-Generating Unit and Goodwill Minority Interest For the purpose of impairment testing a non-wholly-owned CGU with goodwill the carrying amount of that CGU is notionally adjusted, before being compared with its recoverable amount Notional adjustment accomplished by grossing up the carrying amount of goodwill allocated to the CGU to include the goodwill attributable to the minority interest. this notionally adjusted carrying amount is then compared with the recoverable amount of the unit to determine whether the CGU is impaired. If it is impaired, the entity allocates the impairment loss first to reduce the carrying amount of goodwill allocated to the CGU Nelson 68 34

35 Cash-Generating Unit and Goodwill Minority Interest Example Entity A acquires 80% interest in GV at $1,600 on 1 Jan It implies that 100% interest of GV to Entity A would be $2,000. Subsidiary GV has identifiable net assets at a fair value of $1,500 80% 100% Cost of combination $1,600 $2,000 Fair value of GV 1,200 1,500 Goodwill Goodwill recognised in the consolidation is $400. Assume at 30 Jun. 2005, the carrying amount of all the balances are the same but the recoverable amount of GV (a single CGU) is $1,900. Compare the calculation with or without notional adjustment on goodwill attributable to minority interest Nelson 69 Cash-Generating Unit and Goodwill Minority Interest Example Without Notional Adjustment Carrying amount of of GV GV in in A s A s consolidation $ 1,500 Goodwill recognised (attributable to to A) A) Total carrying amount $ 1,900 Recoverable amount of of GV GV $ 1,900 With With Notional Adjustment Total carrying amount (as (as above) $ 1,900 Notional adjustment Goodwill attributable to to minority interest Notionally adjusted carrying amount $ 2,000 Recoverable amount of of GV GV $ 1,900 No impairment observed Impairment loss of $ Nelson 70 35

36 Cash-Generating Unit and Goodwill Timing of Impairment Tests Annual impairment test for a CGU to which goodwill has been allocated may be performed at any time during an annual period, provided the test is performed at the same time every year. Different CGUs may be tested for impairment at different times. However, if some or all of the goodwill allocated to a CGU was acquired in a business combination during the current annual period, that unit shall be tested for impairment before the end of the current annual period. Similar to that for Intangible Assets! Nelson 71 Cash-Generating Unit and Goodwill Timing of Impairment Tests The most recent detailed calculation made in a preceding period of the recoverable amount of a CGU to which goodwill has been allocated may be used in the impairment test of that CGU in the current period provided all of the following criteria are met: a) the assets and liabilities making up the CGU have not changed significantly b) the most recent recoverable amount calculation resulted in an amount that exceeded the carrying amount of the CGU by a substantial margin; and c) the likelihood that a current recoverable amount determination would be less than the current carrying amount of the CGU is remote Nelson 72 36

37 Cash-Generating Unit and Goodwill Corporate Assets are assets other than goodwill that contribute to the future cash flows of both the CGU under review and other CGUs. Examples include: Building of of a headquarter EDP EDP Equipment Research centre In testing a CGU for impairment an entity shall identify all the corporate assets that relate to the CGU under review. The allocation approach of the corporate assets is also amended Nelson 73 Cash-Generating Unit and Goodwill Corporate Assets Can be allocated on a reasonable and consistent basis Cannot be allocated on a reasonable and consistent basis Firstly, test smaller CGU Then, test larger CGU containing the goodwill such portion shall be included as part of the carrying amount of the CGU for impairment test The entity shall: 1) compare the carrying amount of the CGU (excluding the corporate asset) with its recoverable amount recognise any impairment loss first 2) identify the smallest group of CGUs that includes the CGU under review and to which a portion of the carrying amount of the corporate asset can be allocated on a reasonable and consistent basis; and 3) compare the carrying amount of that group of CGUs, including the portion of the carrying amount of the corporate asset allocated to that group of CGUs, with the recoverable amount of the group of CGUs. Any impairment loss shall be recognised Nelson 74 37

38 Impairment loss for CGU An impairment loss shall be recognised for a CGU if, and only if, the recoverable amount of the CGU (group of CGUs) is less than the carrying amount of the CGU (group of CGUs). shall be allocated to reduce the carrying amount of the assets of the CGU (group of CGUs) in the following order: a) first, to reduce the carrying amount of any goodwill allocated to the CGU (group of CGUs); and b) then, to the other assets of the CGU (group of CGUs) pro rata on the basis of the carrying amount of each asset in the CGU (group of CGUs). These reductions in carrying amounts shall be treated as impairment losses on individual assets Goodwill first Other on on pro pro rata Nelson 75 Impairment loss for CGU In allocating an impairment loss for a CGU, an entity shall not reduce the carrying amount of an asset below the highest of: a) its fair value less costs to sell (if determinable); b) its value in use (if determinable); and c) zero. The amount of the impairment loss that would otherwise have been allocated to the asset shall be allocated pro rata to the other assets of the CGU (group of CGUs). A liability shall be recognised for any remaining amount of an impairment loss for a CGU if, and only if, that is required by another HKAS/HKFRS Nelson 76 38

39 Impairment loss for CGU Example Entity A performed an impairment review on the CGU X, which has the following assets on hand: Carrying amount Goodwill $ 1,500 Property, plant and equipment (carried at revalued amounts) 4,000 Property, plant and equipment (carried at cost) 5,700 Inventory, at net realisable value 2,400 AFS financial assets, at fair value 1,300 Total 14,900 After an impairment review, Entity A found that the recoverable amount of CGU X is $12,000. Calculate the impairment loss and allocate to the individual asset Nelson 77 Impairment loss for CGU Example Carrying Carrying amount after Allocated amount after impairment loss impairment loss impairment loss Goodwill $ 1,500 $ (1,500) $ 0 Property, plant and equipment (carried at revalued amounts) 4,000 (577) 3,423 Property, plant and equipment (carried at cost) 5,700 (823) 4,877 Inventory 2,400-2,400 AFS financial assets 1,300-1,300 Total 14,900 (2,900) 12,000 Firstly, the impairment loss reduces any amount of goodwill Then, the residual loss is allocated to other non-current assets pro rata based on the carrying amounts of those non-current asset Nelson 78 39

40 Reversing an Impairment Loss Largely the same as SSAP 31, except for reversal of impairment loss on goodwill An impairment loss recognised for goodwill shall not be reversed in a subsequent period. HKAS 38 Intangible Assets prohibits the recognition of internally generated goodwill. Any increase in the recoverable amount of goodwill subsequent to the recognition of an impairment loss for that goodwill is likely to be an increase in internally generated goodwill, rather than a reversal of the impairment loss recognised for the acquired goodwill Nelson 79 Reversing an Impairment Loss Case HKEX (2004 Annual Report) Accounting Policy on Impairment of Assets In respects of assets other than goodwill, an impairment loss is reversed if there has been a change in the estimates used to determine the recoverable amount and the circumstances and events leading to the impairment cease to exist. A reversal of impairment loss is limited to the asset s carrying amount that would have been determined had no impairment loss been recognised in prior years. Reversal of impairment losses are credited to the profit and loss account except when the asset is carried at valuation, in which case the reversal of impairment loss is treated as a revaluation movement Nelson 80 40

41 Transition and Effective Date If an entity elects to apply HKFRS 3 from any date before the effective dates set out in HKFRS 3, it also shall apply HKAS 36 prospectively from that same date. Otherwise, an entity shall apply HKAS 36: a) to goodwill and intangible assets acquired in business combinations for which the agreement date is on or after 1 January 2005; and b) to all other assets prospectively from the beginning of the first annual period beginning on or after 1 January Entities to which the above paragraph applies are encouraged to apply the requirements of HKAS 36 before the effective dates specified above. However, if an entity applies HKAS 36 before those effective dates, it also shall apply HKFRS 3 and HKAS 38 Intangible Assets at the same time Nelson 81 Disclosure More extensive disclosure required now Main additional disclosure requirements include: Extensive information for each CGU (or group of CGUs) for which the carrying amount of goodwill or intangible assets with indefinite useful lives allocated, including Key assumptions used and the management approach to measure the recoverable amounts (aligned with revised HKAS 1) Period for cash flow projection, growth rate, discount rate Certain other information when a reasonably possible change in a key assumption would cause the carrying amount of CGUs to exceed its recoverable amount any portion of the goodwill acquired in a business combination during the period has not been allocated to a CGU (group of CGUs) at the reporting date the amount of the unallocated goodwill shall be disclosed together with the reasons why that amount remains unallocated Nelson 82 41

42 Disclosure Case Esprit Holdings Limited In accordance with IAS 36, the Group completed its annual impairment test for Esprit trademarks by comparing their recoverable amount to their carrying amount as at June 30, The Group appointed independent professional valuers to conduct a valuation of the Esprit trademarks as one corporate asset based on value-in-use calculation. The resulting value of the Esprit trademarks as at June 30, 2004 was significantly higher than their carrying amount. Only these Nelson 83 Disclosure Case Esprit Holdings Limited This valuation uses cash flow projections based on financial estimates covering a three-year period, expected royalty rates deriving from the Esprit trademarks in the range of 3% to 8% and a discount rate of 14%. The cash flows beyond the three-year period are extrapolated using a steady 3% growth rate. This growth rate does not exceed the long-term average growth rate for apparel markets in which the Group operates. Management has considered the above assumptions and valuation and also taken into account the business expansion plan going forward, the current wholesale order books and the strategic retail expansion worldwide and believes that there is no impairment in the Esprit trademarks. Management believes that any reasonably foreseeable change in any of the above key assumptions would not cause the aggregate carrying amount of trademarks to exceed the aggregate recoverable amount Nelson 84 42

43 Provisions, Contingent Liabilities and Contingent Assets (HKAS 37) Nelson 85 Objective of HKAS 37 To ensure appropriate recognition criteria and measurement bases are applied to Provision Contingent liabilities Contingent assets that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount Nelson 86 43

44 Provisions Definition A provision is a liability of uncertain timing or amount Provision A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits Not include those adjustments to the carrying amount of assets, say provision for depreciation, provision for doubtful debt Distinguished from other liabilities such as trade payables and accruals because there is Uncertainty about the timing or Uncertainty about the amount of the future expenditure required in settlement Nelson 87 Provisions Definition Recognition Present obligation Past event Probable outflow Reliable estimate A provision shall be recognised when: a) an entity has a present obligation (legal or constructive) as a result of a past event; b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision shall be recognised Nelson 88 44

45 Provisions Example Present obligation Entity A gives warranties at the time of sale to buyers of its product commits to make good (by repair or replacement) manufacturing defects that become apparent within 3 years from the date of sale On past experience, it is probable (i.e. more likely than not) that there will be some claims under the warranties. Is there present obligation as a result of a past obligating event? Yes The obligating event is is the sale of of the product with a warranty, which gives rise to to a legal obligation. As As it it is is also probable to to have an an outflow of of resources embodying economic benefits in in settlement, a provision is is recognised for for the best estimate of of the costs of of making good under the warranty products sold before the balance sheet date Nelson 89 Provisions Definition Recognition Present obligation Past event A past event that leads to a present obligation is called an Obligating event Legal Obligation Constructive Obligation An obligating event is an event that creates a legal obligation or constructive obligation that results in an entity having no realistic alternative to settling that obligation Nelson 90 45

46 Provisions Definition Recognition Present obligation Past event Legal obligation is an obligation that derives from: a) a contract (through its explicit or implicit terms); b) legislation; or c) other operation of law. Legal Obligation Constructive Obligation Constructive obligation is an obligation that derives from an entity s actions where: a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities Nelson 91 Provisions Definition Recognition Present obligation Past event The only liabilities recognised in an entity s balance sheet are those that exist at the balance sheet date. Independent of future actions (i.e. the future conduct of business) Examples of such obligations are Penalties or clean-up costs for unlawful environmental damage Provision for the decommissioning costs of an oil installation (to the extent that the entity is obliged to rectify damage already caused) Nelson 92 46

47 Provisions Example Present obligation Past event Entity A in the nuclear power industry causes contamination but cleans up only when required by the law. Country X in which Entity A operates has had no legislation requiring cleaning up, and Entity A has been contaminating land there for many years. At 31 Dec. 2000, it is virtually certain that a draft law requiring a clean-up of land already contaminated will be enacted shortly after the year end. Is there present obligation as a result of a past obligating event? Yes The obligating event is is the contamination of of the land because of of the virtual certainty of of legislation requiring cleaning up. As As it it is is also probable to to have an an outflow of of resources embodying economic benefits in in settlement, a provision is is recognised for for the best estimate of of the costs of of the clean-up Nelson 93 Provisions Example Present obligation Past event Entity C operating power station causes contamination and in Country Z where there is no environmental legislation. has a widely published environmental policy in which it undertakes to clean up all contamination that it causes. has a record of honouring this published policy. Is there present obligation as a result of a past obligating event? Yes The obligating event is is the contamination of of the land, which gives rise to to a constructive obligation because the conduct of of the entity has created a valid expectation on on the part of of those affected by by it it that the entity will clean up up contamination. As As it it is is also probable to to have an an outflow of of resources embodying economic benefits in in settlement, a provision is is recognised for for the best estimate of of the costs of of the clean-up Nelson 94 47

48 Provisions Example Nette has recently constructed a natural gas extraction facility and commenced production one year ago (1 June 2003). There is an operating licence given to the company by the government which requires the removal of the facility at the end of its life which is estimated at 20 years. Depreciation is charged on the straight-line basis. The cost of the construction of the facility was $200 million and the net present value at 1 June 2003 of the future costs to be incurred in order to return the extraction site to its original condition are estimated at $50 million (using a discount rate of 5% per annum). 80% of these costs relate to the removal of the facility and 20% relate to the rectification of the damage caused through the extraction of the natural gas. The auditors have told the company that a provision for decommissioning has to be set up. Explain with reasons and suitable extracts/computations the accounting situations in the financial statements for the year ended 31 May 2004; and Discuss whether the treatment of the items appears consistent with the Framework Nelson 95 Provisions Answers a) a) Under HKAS 37, a provision should be made at at the balance sheet date for the discounted cost of of the removal of of the extraction facility because of of the following reasons: i) i) The installation of of the facility creates an obligating event ii) ii) The operating licence creates a legal obligation which is is likely to to occur iii) The costs of of removal will have to to be incurred irrespective of of the future operations of of the company and cannot be avoided iv) A transfer of of economic benefits (i.e. the costs of of removal) will be required to to settle the obligation v) v) A reasonable estimate of of the obligation can be made although it it is is difficult to to estimate a cost which will be incurred in in twenty years time (HKAS 37 says that only in in exceptional circumstances will it it not be possible to to make some estimate of of the obligation) Nelson 96 48

49 Provisions Answers The cost to to be incurred will be treated as part of of the cost of of the facility to to be depreciated over its production life. However, the costs relating to to the damage caused by the extraction should not be included in in the provision, until the gas is is extracted which in in this case would be 20% of of the total discounted provision. The accounting for the provision is is as follows: $m Present value of of obligation at at 1 June Provision for decommissioning (80% x $50m) 40 Provision for damage through extraction (20% x $50m 20 years x ) (note) 1.33 Note: A simple straight line basis has been used to to calculate the required provision for damage. A more complex method could be used whereby the present value of of the expected cost of of the provision ($10m) is is provided for over 20 years and the discount thereon is is unwound over its life. This would give a charge in in the year of of $0 5m + $10m x 5% i.e. $1m Nelson 97 Provisions Answers Balance Sheet at at 31 May 2004 (extracts) Tangible non current assets: $m Cost of of extraction facility 200 Provision for decommissioning Less: depreciation ( years) (12) Carrying value 228 Other provisions: Provision for decommissioning 40 Unwinding of of discount ($40m x 5%) 2 42 Provision for damage Income statement $m Depreciation 12 Provision for damage 1.33 Unwinding of of discount (finance cost) Nelson 98 49

50 Provisions Answers b) b) The HK Framework would require recognition of of the full discounted liability for the decommissioning. The problem is is that this can only be achieved by creating an asset on the other side of of the balance sheet. This asset struggles to to meet the Framework s definition of of an asset and is is somewhat dubious by nature. An asset is is a resource controlled by the company as a result of of past events and from which future economic benefits are expected to to flow. It It is is difficult to to see how a future cost can meet this definition. The other strange aspect to to the treatment of of this item is is that depreciation (and hence part of of the provision) will be treated as an operating cost and the unwinding of of the discount could be treated as a finance cost. This latter treatment could fail any qualitative test in in terms of of the relevance and reliability of of the information. A liability is is defined in in the Framework as a present obligation arising from past events, the settlement of of which is is expected to to result in in an outflow of of economic benefits. The idea of of a constructive obligation utilised in in HKAS 37 is is also included as a requirement in in the Framework. Assets and liabilities are essentially a collection of of rights and obligations. (ACCA ) Nelson 99 Provisions Definition Recognition Present obligation Past event Probable outflow For recognition of provision, an entity also considers the probability of an outflow of resources embodying economic benefits to settle that obligation An outflow of resources (or other event) is regarded as probable if the event is more likely than not to occur i.e. the probability that the event will occur is greater than the probability that it will not Where it is not probable that a present obligation exists an entity discloses a contingent liability, unless the possibility is remote Where there are a number of similar obligations (e.g. product warranties or similar contracts) the probability is determined by considering the class of obligations as a whole Nelson

51 Provisions Case Hong Kong Aircraft Engineering Company Limited Annual Report 2005 states: Provisions are recognised when the Group has a present legal or constructive obligation as a result of past events; it is more likely than not that an outflow of resources will be required to settle the obligation; and the amount has been reliably estimated. Where there are a number of similar obligations, the likelihood that an outflow will be required in settlement is determined by considering the class of obligations as a whole. A provision is recognised even if the likelihood of an outflow with respect to any one item included in the same class of obligations may be small Nelson 101 Provisions Definition Recognition Present obligation Past event Probable outflow Possible obligation Remote Provision Contingent liability Do nothing Nelson

52 Provisions Definition Recognition Present obligation Past event Probable outflow Reliable estimate Use of estimates an essential part of the preparation of financial statements does not undermine their reliability especially true in the case of provisions, which by their nature are more uncertain than most other balance sheet items. An entity (except in extremely rare cases) will be able to determine a range of possible outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to use in recognising a provision. Provision More on measurement Nelson 103 Provisions Definition Recognition Present obligation Past event Probable outflow Reliable estimate Possible obligation Remote Provision Contingent liability Do nothing Nelson

53 Contingent Liabilities Definition No Recognition Disclosed unless remote A contingent liability is: a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity; or b) a present obligation that arises from past events but is not recognised because: i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or ii) the amount of the obligation cannot be measured with sufficient reliability. An entity shall not recognise Contingent liability Nelson 105 Contingent Liabilities Definition No Recognition Disclosed unless remote Possible obligation Reliable estimate Remote Contingent liability Nelson

54 Contingent Assets Definition No Recognition Disclosed A contingent asset is: a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. An entity shall not recognise a contingent asset Nelson 107 Provisions Measurement Definition Recognition Measurement 1. Best estimate the amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the balance sheet date. expected value can be used 2. Risks and uncertainties that inevitably surround many events and circumstances shall be taken into account in reaching the best estimate of a provision Provision Nelson

55 Provisions Measurement Definition Recognition Measurement 3. Present Value where the effect of the time value of money is material the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation the discount rate shall be a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability not reflect risks for which future cash flow estimates have been adjusted Provision Nelson 109 Provisions Measurement Definition Recognition Measurement 4. Future events that may affect the amount required to settle an obligation shall be reflected in the amount of a provision where there is sufficient objective evidence that they will occur 5. Expected disposal of assets shall not be taken into account Provision Nelson

56 Provisions Measurement Example Entity A is involved in a court case about the plagiarism of software. Legal opinion seems to indicate that Entity A will lose the case. Entity A estimates that the most likely outcome (60% chance) will be a settlement payment of costs and penalties of $1 million in 2 years time the best case scenario (30% chance) is deemed to be a settlement payment of $500,000 in one year s time and the worst case scenario (10% chance) will be a settlement payment of $2 million in 3 years time (discount rate is 5%) Discuss the implication on the financial position Nelson 111 Provisions Measurement Example As regards the plagiarism case the following table illustrates the potential outcomes (present values at at 5%): $000 Year PV($000) Probability Total ($) Best case % 142,857 Most likely 1, % 544,218 Worse case 2, ,728 10% 172, ,843 As compared with the most likely outcome, which indicates a provision of of $907,000, the expected value of of the provision as above is is $859,843. The difference, while an accounting estimate has been used, is is not material. In In consequence, a provision of of $860,000 can be made as it it is is estimated by a more scientific approach. (ACCA ) Nelson

57 Provisions Measurement Case Annual Report 2004/05: Provisions are recognised for liabilities of uncertain timing or amount when the Board has a legal or constructive obligation arising as a result of a past event, it is probable that an outflow of economic benefits will be required to settle the obligation and a reliable estimate can be made. Where the time value of money is material, provisions are stated at the present value of the expenditure expected to settle the obligation Nelson 113 Provisions Reimbursements Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party the reimbursement shall be recognised when, and only when, it is virtually certain that reimbursement will be received if the entity settles the obligation. The reimbursement shall be treated as a separate asset. The amount recognised for the reimbursement shall not exceed the amount of the provision. In the income statement, the expense relating to a provision may be presented net of the amount recognised for a reimbursement Nelson

58 Provisions Reimbursements Case 2005 Annual Report stated its accounting policy on provisions as follows: Provisions are recognised when the Group has a present legal or constructive obligation as a result of past events, it is probable that an outflow of resources will be required to settle the obligation, and a reliable estimate of the amount can be made. Where the Group expects a provision to be reimbursed, the reimbursement is recognised as a separate asset but only when the reimbursement is virtually certain Nelson 115 Provisions Changes and Use Provisions shall be reviewed at each balance sheet date and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resources embodying economic benefits will be required to settle the obligation the provision shall be reversed. A provision shall be used only for expenditures for which the provision was originally recognised Nelson