3. Financial Accounting I

8/12/2019 3. Financial Accounting I

1/47

STUDY UNIT THREE

FINANCIAL ACCOUNTING I

3.1 Framework for the Preparation & Presentation of Financial Statements . . . . . . . . . . . . . . . 4

3.2 Accrual Accounting and Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83.3 Revenue Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113.4 Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143.5 Financial Assets and Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223.6 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343.7 Property, Plant, and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373.8 Intangible Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413.9 Study Unit 3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

Financial accounting provides the information reported in a complete set of financial statements.

Thebalance sheetpresents financial position, and the income statementpresents performance. The

other two basic financial statements are the statement of cash flowsand thestatement of changes

in equity. Financial statements may be prepared for any entity, e.g., a business, school, government,

or fraternal organization. This study unit outlines the international sources of the body of knowledge

regarding financial statement preparation for business entities and the underlying accounting theory. It

also covers the procedural aspects of financial reporting, the main categories of assets, and financial

liabilities. U.S. GAAP is not covered because it is not tested.

Study Units 3 and 4 coverInternational Financial Reporting Standards (IFRSs). International

Accounting Standards (IASs), related Interpretations, and the framework for the preparation and

presentation of financial statements were issued by the predecessor to the current standard setter, the

International Accounting Standards Board (IASB). They will be effective until amended or

superseded. The IASB issues IFRSs, which is also the collective term for IASs and IFRSs.

The following is a list of current Standards:

IAS 1 Presentation of Financial Statements IAS 32 Financial Instruments: Disclosure andIAS 2 Inventories Presentation **IAS 7 Cash Flow Statements IAS 33 Earnings Per ShareIAS 8 Accounting Policies, Changes in Accounting IAS 34 Interim Financial Reporting

Estimates and Errors IAS 36 Impairment of AssetsIAS 10 Events After the Balance Sheet Date IAS 37 Provisions, Contingent Liabilities and ContingentIAS 11 Construction Contracts Assets IAS 12 Income Taxes IAS 38 Intangible AssetsIAS 14 Segment Reporting* IAS 39 Financial Instruments: Recognition andIAS 16 Property, Plant and Equipment Measurement IAS 17 Leases IAS 40 Investment PropertyIAS 18 Revenue IAS 41 AgricultureIAS 19 Employee BenefitsIAS 20 Accounting for Government Grants and Disclosure

of Government Assistance IFRS 1 First-time Adoption of International Financial

IAS 21 The Effects of Changes in Foreign Exchange Rates Reporting StandardsIAS 23 Borrowing Costs IFRS 2 Share-Based PaymentIAS 24 Related Party Disclosures IFRS 3 Business CombinationsIAS 26 Accounting and Reporting by Retirement Benefit IFRS 4 Insurance Contracts

Plans IFRS 5 Noncurrent Assets Held for Sale and DiscontinuedIAS 27 Consolidated and Separate Financial Statements OperationsIAS 28 Investments in Associates IFRS 6 Exploration for and Evaluation of Mineral ResourcesIAS 29 Financial Reporting in Hyperinflationary Economies IFRS 7 Financial Statements: DisclosuresIAS 31 Interests in Joint Ventures IFRS 8 Operating Segments (effective January 1, 2009)

* (IAS 14 will be superseded when IFRS 8 becomes effective.)

** (IAS 32 applies only to presentation issues.)

1

Copyright 2008 Gleim Publications, Inc. and/or Gleim Internet, Inc. All rights reserved. Duplication prohibited. www.gleim.com
http://www.gleim.com/http://www.gleim.com/


2/47

Core Concepts

Business entities should provide information about financial position, performance, and changes infinancial position that is helpful to many users in making economic decisions. However, thesestatements do not provide all necessary information.

The principal qualitative characteristics of information in financial statements are understandability,

relevance, reliability, and comparability. The elements of financial statements are (1) assets, (2) liabilities, (3) equity, (4) income,

(5) expenses, and (6) capital maintenance adjustments.

Recognition is the inclusion in the balance sheet or income statement totals of an item depicted inwords and as a monetary amount that satisfies the definition of an element and the recognitioncriteria.

The following are recognition criteria: (1) any future economic benefit associated with the item willprobably flow to or from the entity, and (2) the cost or value of the item is measurable withreliability.

Recognition of income occurs at the same time as recognition of increases in assets or decreasesin liabilities.

Recognition of expenses occurs at the same time as recognition of increases in liabilities ordecreases in assets.

Measurement is the determination of the amounts at which the elements are to be recognized.Different measurement bases are used.

Accrual accounting recognizes the financial effects of transactions and other events in the periodswhen they occur and records and reports them in the periods to which they relate.

Financial statements are the output of the accrual accounting cycle.

IAS 18 defines revenue as the gross inflow of economic benefits during the period arising in thecourse of the ordinary activities of an entity when those inflows result in increases in equity, otherthan increases relating to contributions from equity participants.

Fair value is the amount for which an asset could be exchanged, or a liability settled, betweenknowledgeable, willing parties in an arms-length transaction.

Revenue is recognized for a sale of goods if certain conditions are met. If the outcome of a services transaction can be reliably estimated, revenue is recognized based on

the stage of completion.

Financial statements are a structured representation of the financial position and financialperformance of an entity. A complete set of financial statements includes a balance sheet, anincome statement, a statement of changes in equity, a cash flow statement, notes, and apresentation of accounting policies.

Separate classifications on the balance sheet of current and noncurrent assets and liabilitiesshould be presented unless a presentation by order of liquidity is reliable and more relevant. Theminimum presentation on the balance sheet also includes issued capital and reserves.

All recognized income and expense items are included in profit or loss unless a pronouncementrequires otherwise.

A cash flow statement is presented for each period for which financial statements are presentedbecause users need to assess the entitys ability to generate cash and cash equivalents. Cashflows are classified and separately disclosed as from operating, investing, or financing activities.

Notes describe the basis of preparation and the significant policies applied, make requireddisclosures not presented on the face of the statements, and provide additional informationneeded for a fair presentation.

An interim period is shorter than a full year. An interim financial report contains either a completeset of financial statements or a set of condensed financial statements.

2 SU 3: Financial Accounting I



3/47

A financial instrument is a contract that results in a financial asset of one entity and a financialliability or equity instrument of another entity.

A derivative is a financial instrument whose value changes with the change in the underlying. Aderivative requires little or no initial net investment compared with contracts having similarresponses to changing market conditions. It is settled in the future. An embedded derivative iscombined with a host contract so that some cash flows of the instrument vary in the same way asthose of a stand-alone derivative.

A financial asset or liability is initially recognized only when the entity is a party to the contract.Thus, rights and obligations pertaining to derivatives are recognized as assets and liabilities.

A financial asset is derecognized only when rights to its cash flows have expired or it has beentransferred. If a transfer has occurred, derecognition depends on whether substantially all risksand rewards have been retained (no derecognition) or transferred (derecognition). If neithercondition is met, the entity evaluates whether it has control.

Derecognition of a financial liability (or a part) occurs only by extinguishment.

Initial measurement of a financial asset or liability is at fair value.

Subsequent measurement of financial assets (including derivatives that are assets) is at fair valuewith certain exceptions.

Subsequent measurement of financial liabilities is normally at amortized cost. One majorexception is for items measured at fair value through profit or loss.

Impairment and uncollectibility of a financial asset is assessed at each balance sheet based onobjective evidence that a loss has been incurred.

The following are the kinds of designated hedging relationships: a fair value hedge, a cash flowhedge, and a hedge of a net investment in a foreign operation. The gain or loss arising fromremeasuring the following is recognized in profit or loss: (1) the hedging derivative at fair value or(2) the foreign currency component of a nonderivative hedging instrument measured underIAS 21,The Effects of Changes in Foreign Exchange Rates.

Inventories are measured at the lower of cost or net realizable value.

Use of LIFO is not allowed.

The costs of items of property, plant, and equipment (PPE) meet the recognition criterion if it is

probable that the entity will receive future economic benefits and the costs are reliablymeasurable. Such items are initially measured at cost.

Measurement after recognition of an item of PPE is at cost minus any accumulated depreciationand impairment losses.

An asset is impaired when its carrying amount exceeds its recoverable amount.

From the acquisition date, goodwill is allocated to the acquirers CGUs that are expected to benefitfrom the combination.

Held-for-sale assets or disposal groups are reported at the lower of their carrying amount or fairvalue minus costs to sell.

IAS 38,Intangible Assets, defines an intangible asset as an identifiable nonmonetary assetwithout physical substance. It is initially recognized at cost. It is amortized only if it has a finite

useful life.

SU 3: Financial Accounting I 3



4/47

3.1 FRAMEWORK FOR THE PREPARATION & PRESENTATION OF FINANCIAL STATEMENTS

1. Objective of Financial Statements

a. Business entities should provide information about financial position, performance, andchanges in financial position that is helpful to many users in makingeconomicdecisions. However, these statements do not provide all necessary information.

b. Financial statements should show the results of managements stewardship or itsaccountability for assets.

c. Users need to evaluate the ability of the entity to generatecashand the timing andcertainty of its generation.

d. An entitysfinancial position is determined by its economic resources, financialstructure, liquidity and solvency, and adaptability.

e. Information aboutperformanceand its variability helps to predict (1) changes in theresources the entity may control, (2) how effectively it will use additional resources,and (3) its capacity to generate cash from existing resources.

f. Information aboutchanges in financial position is useful in assessing financing,investing, and operating activities. For this purpose, funds may be defined differently.

g. Information about financial position is primarily provided in abalance sheet.Information about performance is primarily provided in anincome statement.Information about changes in financial position is provided in a separate statement,such as acash flow statementor a funds flow statement.

h. The components of financial statements interrelatebecause they present differentaspects of the same transactions and other events.

2. Oneunderlying assumptionof the preparation of financial statements is the use of theaccrual basis of accounting (see Subunit 3.2).

a. A second underlying assumption is that every business is agoing concernthat willcontinue operating indefinitely. Thus, liquidation values are not important. Forexample, if an entity is not a going concern, its intangible assets are reported atliquidation values, not at historical cost net of amortization.

3. The principalqualitative characteristicsof information in financial statements areunderstandability, relevance, reliability, and comparability.

a. Information should be readily understandableby reasonably knowledgeable users,but relevant information should not be excluded because of its complexity.

b. Relevance. Useful information is relevant to user decision making. Information hasrelevance if users are able to predict the outcome of future events or confirm orcorrect their prior expectations.

1) Materialityis a threshold or cut-off point. The issue is whether a given item orerror is large enough so that its omission or misstatement will influence users.

c. Reliability. Information is reliable if it is free of material error and bias. Users shouldbe able to depend upon it to represent faithfully the economic transactions or events

it purports to represent or could reasonably be expected to represent.1) Substance over form. To be representationally faithful, transactions and

other events must be accounted for in accordance with their substance andeconomic reality, not their legal form.

2) Neutrality. Reliable information must be free of bias intended to produce apredetermined result or induce certain behavior.

3) Prudenceis a reaction to the uncertainty arising from estimates. It includescaution in the exercise of judgment. Prudence does not approve introducingbias through deliberate understatement of assets and income or overstatementof liabilities and expenses.

4) Completeness. Reliable information is complete within the limits of materialityand cost.




5/47


6/47

3) Equityis the residual interest in the assets of the entity after deducting all itsliabilities. It is affected not only by operations but also by transactions withowners, such as dividends and contributions.

a) This definition applies regardless of the entitys form of organization.

b) Equity may be further classified, for example, into (1) contributions of funds

by owners, (2) retained earnings, (3) reserves for appropriations ofretained earnings, and (4) reserves for capital maintenance adjustments.

i) Reservesmay be required by law to give creditors protection fromlosses. Other reserves may be created when national tax lawprovides tax advantages for transfers to reserves. These transfersare not expenses.

b. The following directly relate to measuringperformance in the income statement:

1) Income is defined as increases in economic benefits during the accountingperiod in the form of inflows or enhancements of assets or decreases ofliabilities that result in increases in equity, other than those relating tocontributions from equity participants. Income includes revenues and gains.Thus, revenues and gains are not treated as separate elements.

a) Revenuesoccur in the course of ordinary activities.

b) Gainsmeet the definition of income but may not occur in the course ofordinary activities. For example, gains may result from the sale ofnoncurrent assets.

i) Gains may be unrealized.ii) Gains are usually reported separately.

2) Expensesare decreases in economic benefits during the accounting period inthe form of outflows or depletions of assets or incurrences of liabilities thatresult in decreases in equity, other than those relating to distributions to equityparticipants. Expenses include losses. Thus, losses are not treated asseparate elements.

a) Expenses include items arising in the course of ordinary activities.

b) Lossesmeet the definition of expenses but may not occur in the course ofordinary activities. For example, losses may result from the sale ofnoncurrent assets or from natural disasters.

i) Losses may be unrealized.

ii) Losses are usually reported separately and often net of relatedincome.

c. Capital maintenance adjustmentsare changes in equity resulting from revaluing orrestating assets or liabilities. These changes are not income statement items undercertain concepts of capital maintenance.

1) Financial capital maintenanceresults in profit only if the financial amount of

net assets at period-end exceeds the financial amount of net assets at theperiods beginning. Distributions to, or contributions from, owners are excludedfrom this calculation. The measurement may be in nominal units of money or inunits of constant purchasing power.

2) Physical capital maintenanceresults in profit only if the physical productivecapacity of the entity (or the equivalent resources or funds) at period-endexceeds the physical productive capacity at the periods beginning.Distributions to, or contributions from, owners are excluded from thiscalculation. The current cost measurement basis must be used.

3) Profitis earned only when inflows of assets exceed the amounts needed tomaintain capital. Thus, income must exceed expenses, including anyappropriate capital maintenance adjustments.




7/47

5. Recognition of Elements of Financial Statements

a. Recognitionis the inclusion in the balance sheet or income statement totals of anitem depicted in words and as a monetary amount that satisfies the definition of anelement and the recognition criteria. Disclosure of accounting policies used in thenotes or explanatory matter is not a satisfactory alternative to recognition.

b. Criteria. Recognition of an element should occur if the following criteria are met:1) Anyfuture economic benefit associated with the item will probably flow to or

from the entity.

a) Probabilityis the degree of uncertainty regarding the future flow ofeconomic benefits.

2) Thecost or valueof the item is measurable with reliability.

a) Reliability is not impaired if reasonable estimates are used.

c. Recognition ofincomeoccurs at the same time as recognition of increases in assetsor decreases in liabilities.

1) The usual procedures for income recognition, such as thatrevenue be earned,reflect the recognition criteria, that is, (a) reliable measurement and (b) asufficient probability. Thus, income is recognized when an increase in futureeconomic benefits associated with an increase in an asset or a decrease in aliability has arisen that can be reliably measured.

d. Recognition ofexpensesoccurs at the same time as recognition of increases inliabilities or decreases in assets.

1) Expenses are recognized if the costs aredirectly associatedwith the earning ofparticular income items. This process is often calledmatching. Matching issimultaneous or combined recognition of the revenues and expenses that resultdirectly and jointly from the same transactions or other events.

2) Expenses also are recognized when they are broadly or indirectly associatedwith income. In these cases, asystematic and rational allocationprocedure,

such as depreciation or amortization, is used.3) Immediate recognitionof expenses is appropriate when an expenditure results

in no future economic benefit or when that benefit does not qualify or ceases toqualify as an asset.

6. Measurementis the determination of the amounts at which the elements are to berecognized. Different measurement bases are used.

a. Historical costis the most common basis. Assets are recorded at the cash paid orthe fair value of other assets given. Liabilities are recorded at the amount ofproceeds received or, in some cases, at the amount of cash expected to be paid tosatisfy the obligation.

b. Current cost. Assets are recorded at the amount of cash to be paid if the same or anequivalent asset were currently obtained. Liabilities are recorded at the undiscountedamount of cash needed for current settlement.

c. Realizable (settlement) value. Assets are recorded at the amount of cash currentlyobtainable by sale in an orderly disposal. Liabilities are recorded at the undiscountedamount of cash expected to be paid for settlement in the normal course of business.

d. Present value. Assets (liabilities) are recorded at the discounted amount of the futurenet cash inflows (outflows) that are expected to be generated (required forsettlement) in the normal course of business.




8/47

3.2 ACCRUAL ACCOUNTING AND TIME VALUE OF MONEY

1. Undercash-basis accounting, income is recognized when cash is received.

a. Expense is recognized when paid.

b. Cash-basis accounting is subject to manipulation by arranging payments or receiptsbefore or after the end of an accounting period.

c. The cash basis cannot properly reflect transactions in which cash payments orreceipts relate to several financial reporting periods.

2. To overcome the problems of cash-basis accounting,accrual-basis accountingis used.Accrual accounting recognizes the financial effects of transactions and other events in theperiods when they occur and records and reports them in the periods to which they relate.

a. Accordingly, accrual accounting considers not only cash transactions but alsononcash (1) exchanges of goods or services, (2) credit transactions,(3) nonreciprocal transfers, (4) price changes, (5) changes in form of assets orliabilities, etc.

b. Most accounting transactions are recorded whencashis paid or received (or aspecific commitment to pay or receive cash is made or received).

1) As a result,adjusting entriesare made at the end of a period to ensure properincome and expense recognition for that period.

a) Reversing entriesare then made at the beginning of the next period.

2) When an item of income or expense has met the recognition criteria but the cashhas not been received or paid, the income or expense must be accrued.Accruals anticipate future cash flows. They recognize assets or liabilitiesand the related liabilities, assets, revenues, expenses, gains, or losses. Salesor purchases on account, interest, and taxes are common accruals.

a) Accruals of incomeare made when the recognition criteria are met priorto receipt of payment (debit a receivable, credit income).

b) Accruals of expenseare recorded when expense has been incurred butnot paid (debit expense, credit a payable).

c) Accrual entries may be reversed at the beginning of the next period.

3) When cash has been received or paid but the receipt or payment has not metthe recognition criteria for income or expense, the item must be deferred.Deferrals concern past cash flows. They recognize liabilities (for receipts)and assets (for payments), with deferral of the related income and expenseitems. The deferral ends when the obligation is satisfied or the future economicbenefit is used up. Prepaid insurance and unearned subscriptions are typicaldeferrals.

a) Deferrals of expenseoccur when expenses have been prepaid.

i) If an expense was debited when cash was paid, the adjusting entry is

to debit prepaid expense and to credit expense.ii) If an asset (prepaid expense) was debited, the adjusting entry is to

debit expense and credit prepaid expense.

b) Deferrals of incomeoccur when income has been received in advance.

i) If income was credited when cash was received, the adjusting entryis to debit income and to credit deferred income.

ii) If a liability (deferred income) was credited, the adjusting entry is todebit unearned income and to credit income.




9/47

3. Financial statements are the output of the accrualaccounting cycle. The order of steps inthe accounting cycle is as follows: (a) identification and measurement of transactions andevents required to be recognized, (b) journalization, (c) posting from the journals to theledgers, (d) the development of a trial balance, (e) adjustments to produce an adjusted trialbalance, (f) statement presentation, (g) closing, (h) taking a post-closing trial balance(optional), and (i) making reversing entries (optional).

4. The Time Value of Money

a. A quantity of money to be received or paid in the future is worth less than the sameamount now. The difference is measured in terms of interest calculated using theappropriatediscount rate. Interest is the payment received by holders of moneyfrom the current consumer to forgo current consumption.

b. Standard tables have been developed to facilitate the calculation of present and futurevalues. Each entry in one of these tables represents the factor by which anymonetary amount can be modified to obtain its present or future value.

c. Thepresent value (PV) of an amount is the value today of some future payment.

1) It equals the future payment times the present value of 1 (a factor found in astandard table) for the given number of periods and interest rate.

2) EXAMPLE:Present Value

No. of Periods 6% 8% 10%

1 0.943 0.926 0.9092 0.890 0.857 0.8263 0.840 0.794 0.7514 0.792 0.735 0.6835 0.747 0.681 0.621

a) The present value of 1,000, to be received in 3 years and discounted at8%, is 794 (1,000 0.794).

d. Thefuture value (FV) of an amount is the amount available at a specified time in thefuture based on a single investment (deposit) today. The FV is the amount to be

computed if one knows the present value and the appropriate discount rate.1) It equals the current payment times the future value of 1 (a factor found in a

standard table) for the given number of periods and interest rate.

2) EXAMPLE:Future Value


1 1.0600 1.0800 1.10002 1.1236 1.1664 1.21003 1.1910 1.2597 1.33104 1.2625 1.3605 1.46415 1.3382 1.4693 1.6105

a) The future value of 1,000 invested today for 4 years at 10% interest will be1,464 (1,000 1.464).

e. Annuities. An annuity is usually a series of equal payments at equal intervals of time,e.g., 1,000 at the end of every year for 10 years.

1) Anordinary annuity (annuity in arrears)is a series of payments occurring atthe end of each period. In anannuity due (annuity in advance) the paymentsare made (received) at the beginning of each period.

a) Present value. The first payment of an ordinary annuity is discounted.The first payment of an annuity due is not discounted.

b) Future value. Interest is not earned for the first period of an ordinaryannuity. Interest is earned on the first payment of an annuity due.




10/47

2) ThePV of an annuity. A typical present value table is for an ordinary annuity,but the factor for an annuity due can be easily derived. Select the factor for anordinary annuity for one less period (n1) and add 1.000 to it to include theinitial payment (which is not discounted).

a) EXAMPLE:

Present ValueNo. of Periods 6% 8% 10%

1 0.943 0.926 0.9092 1.833 1.783 1.7363 2.673 2.577 2.4874 3.465 3.312 3.1705 4.212 3.993 3.791

i) To calculate the present value of an ordinary annuity of fourpayments of 1,000 each discounted at 10%, multiply 1,000 by theappropriate factor (1,000 3.170 = 3,170).

ii) Using the same table, the present value of an annuity due of fourpayments of 1,000 each may also be calculated. This value equals1,000 times the factor for one less period (4 1 = 3), increased by1.0. Thus, the present value of the annuity due for four periods at10% is 3,487 [1,000 (2.487 + 1.0)].

iii) The present value of the annuity due (3,487) is greater than thepresent value of the ordinary annuity (3,170) because the paymentsoccur 1 year sooner.

3) TheFV of an annuityis the value that a series of equal payments will have at acertain moment in the future if interest is earned at a given rate.

a) EXAMPLE:

Future Value


1 1.0000 1.0000 1.0000

2 2.0600 2.0800 2.10003 3.1836 3.2464 3.31004 4.3746 4.5061 4.64105 5.6371 5.8667 6.1051

i) To calculate the FV of a 3-year ordinary annuity with payments of1,000 each at 6% interest, multiply 1,000 by the appropriate factor(1,000 3.184 = 3,184).

ii) The FV of an annuity due can also be determined from the sametable. Multiply the 1,000 payment by the factor for one additionalperiod (3 + 1 = 4) decreased by 1.0 (4.375 1.0 = 3.375) to arriveat a FV of 3,375 (1,000 3.375).

iii) The future value of the annuity due (3,375) is greater than the future

value of an ordinary annuity (3,184). The deposits are made earlier.




11/47

3.3 REVENUE RECOGNITION

1. TheFrameworkdefines revenue as income arising in the ordinary course of an entitysactivities. The timing of recognition is the principal issue in accounting for revenue.

a. Recognitionoccurs when the flow of future economic benefits to the entity isprobable, and such benefits are reliably measurable.

2. IAS 18,Revenue, is the pronouncement with the widest applicability to revenue recognition.It concerns revenue resulting from sales of goods, rendering of services, and others use ofentity assets that provides returns of interest, royalties, and dividends.

a. Goodsinclude not only items produced for sale but also merchandise, land, and otherproperty held for resale.

b. Servicesinvolve the performance by the entity of a contractually agreed task over anagreed period.

c. Other standards apply to certainother revenues, for example, those from leases,equity-based investments, and changes in fair value of financial assets and liabilities.

3. IAS 18 definesrevenueas the gross inflow of economic benefits during the period arisingin the course of the ordinary activities of an entity when those inflows result in increases in

equity, other than increases relating to contributions from equity participants.

a. Thus, amounts collected on behalf of a principal or otherwise on behalf of third parties,such as sales or value-added taxes, are not revenue.

4. Measurement. Revenue is measured at the fair value of the consideration received orreceivable by the entity. This amount is ordinarily determined by the parties to thetransaction after due allowance for trade discounts and volume rebates.

a. Fair valueis the amount for which an asset could be exchanged, or a liability settled,between knowledgeable, willing parties in an arms-length transaction.

b. When the cash inflow is deferred, the fair value may be less than the nominal amountsof cash received or receivable, for example, when the seller accepts a note with abelow-market rate.

1) Imputed interest. If the transaction is effectively a financing arrangement,future receipts are discounted at an imputed rate to determine the fair value.This rate is the more clearly determinable of either (a) the prevailing rate for asimilar instrument given the issuers credit standing or (b) the rate thatdiscounts the nominal amount to the cash sales price.

a) The difference between the nominal consideration and the fair value isinterest revenue.

c. Anexchangeis not deemed to result in revenue when the goods or services involvedare of a similar nature or value.

1) In an exchange ofdissimilar goods or services, revenue is generated that ismeasured at the fair value received (or given up) and adjusted for any cash

transferred.

5. Therecognition criteriamay need to be applied separately to differentparts of atransaction, as when a sale of goods also provides for subsequent servicing.

a. The recognition criteria also may need to be applied totwo or more transactions, aswhen a sale of goods occurs at the same time as a separate agreement by the sellerto repurchase.




12/47

6. Sales of Goods

a. Revenue is recognized whenfive conditionsare met:

1) The entity has transferred the significantrisks and rewardsof ownership.

a) This transfer usually occurs with the passage of title or possession.

b) Retention of significant risks of ownership may occur in many ways. Forexample, (1) a sale may be contingent upon resale; (2) the buyer mayrescind for a reason stated in the contract, and the probability of returnmay be uncertain; or (3) the seller may be obligated for unsatisfactoryperformance beyond the normal warranty.

c) Mere retention of legal title does not preclude revenue recognition.

2) The entity has neither continuing managerial involvementto an extentassociated with ownership nor effectivecontrolover the goods.

3) The amount can bereliably measured.

4) It is probable that theeconomic benefitswill flow to the entity.

a) In some cases, this criterion may be met only when the consideration isreceived or when an uncertainty is eliminated.

i) If an uncertainty arises regarding the collectibility of recognizedrevenue, the amount involved is recognized as an expense, not asan adjustment of revenue. This principle applies to revenue fromservices, interest, royalties, and dividends, as well as sales ofgoods.

5) Transaction costscan be reliably measured.

a) Revenues and expenses related to the same transaction or other eventshould be matched. But if expenses cannot be reliably measured,revenues are not recognized, and any consideration already received isrecorded as a liability.

7. Rendering of Services

a. If the outcome of a services transaction can be reliably estimated, revenue isrecognized based on thestage of completion. The outcome can be reliablyestimated when four conditions are met:

1) Revenue can bereliably measured.2) It is probable that theeconomic benefitswill flow to the entity.3) Thestage of completioncan be reliably measured.

a) Recognition based on the stage of completion is the percentage-of-completion method. Construction contracts are accounted for in thismanner.

4) Thecosts incurredand thecosts to complete can be reliably measured.

b. Reliable estimatesordinarily are possible pursuant to an agreement among theparties that stipulates the enforceable rights of each party, the consideration, and theterms of settlement.

1) An effective internal financial budgeting and reporting system is also needed.

2) As services are performed,revisions of estimatesare customary. They do notnecessarily indicate that reliable measurement of revenue is not feasible.

c. The stage of completion of services should be estimated using the method that resultsin a reliable measurement of the particular transaction. Examples are surveys ofwork performed, services performed to date divided by total services, or costsincurred to date divided by total costs.

1) Progress payments and advancesare not necessarily correlated with theservices performed.




13/47

d. In practice, if the number of acts to be performed over a defined period cannot bedetermined, thestraight-line methodof revenue recognition is used. However,another method is used, given evidence that it is more representative of the stage ofcompletion.

e. If the outcome of aservices transactioncannot be reliably estimated, recognizedrevenue equals recognized recoverable expenses.

8. Interest, Royalties, and Dividends

a. These amounts result from the use by others of entity assets. Revenue from thesesources is recognized if two conditions are met:

1) It is probable that the economic benefits will flow to the entity.2) Revenue can be reliably measured.

b. Interest is recognized using theeffective interest method.

1) Only interest accrued after acquisition of an interest-bearing investment isrecognized as revenue.

c. Royalties, for example, fees for use of patents, copyrights, or software, arerecognized pursuant to the relevant agreement on the accrual basis. Royalties

accrue according to the relevant agreement unless, based on the substance of thatagreement, another systematic and rational basis is more appropriate.

d. Dividendsare recognized when the shareholder has the right to be paid. Dividendsfrom pre-acquisition profit are a recovery of the cost of the equity securities.However, dividends are revenue unless they clearly represent such a recovery.

9. Construction Contracts

a. If the outcome of the contract can beestimated reliably, revenue, expense, and profitare recognized based on thestage of completionat the balance sheet date (thepercentage-of-completion method).

1) Anexpected loss(total costs > total revenue) is alwaysexpensedimmediately.

2) Thestage of completion is estimated using the method that reliably measuresthe work. (Butprogress paymentsby customers may not indicate the extentof work.) Possible methods include

a) Determining the ratio of costs incurred to total costsb) Surveying work donec) Measuring the physical proportion of work done

3) Costs incurred related tofuture activityare recorded as an asset if it isprobable they will be recovered. The entity may use a construction inprogress (CIP) account to record costs and profit.

Construction in progress XXXCash or accounts payable XXX

Construction in progress XXXConstruction profit XXX

4) Ordinarily,progress billingsare made and payments are received during theterm of the contract.

Accounts receivable XXXProgress billings XXX

As cash is received, cash is debited and accounts receivable is credited. Neitherbilling nor the receipt of cash affects profit.




14/47

5) The difference between CIP (costs and recognized profit) and progress billingsto date is a current assetif CIP is greater or as a current liabilityif billings aregreater.

a) Theclosing entryis to debit progress billings and to credit CIP.

6) A variation on the preceding entries is to credit periodic revenue for the gross

amount. This practice requires adebit to a nominal account (a cost ofrevenue earned account similar to cost of goods sold) that equals the costsincurred in the current period.

Construction in progress (profit) XXXConstruction expenses (a nominal account) XXX

Gross revenue XXX

10. IAS 18 provides fordisclosuresthat include accounting policies related to revenuerecognition, such as the method for determining the stage of completion. It also providesfor disclosure of the amounts of the significant categories of revenue for the period and theamount of revenue from exchanges included in each significant category.

3.4 FINANCIAL STATEMENTS

1. IAS 1,Presentation of Financial Statements, defines financial statements as a structuredrepresentation of the financial position and financial performance of an entity. Thegoverning body of an entity is responsible for the statements.

2. Acomplete set of financial statements includes a balance sheet, an income statement, astatement of changes in equity, a cash flow statement, notes, and a presentation ofaccounting policies.

a. The statement of changes in equity shows either all such changes or all changesexcept those from transactions with equity holders.

3. Pervasive Issues

a. Financial position, financial performance, and cash flows should be fairly presented,and properly applying IFRSs almost always results in fair presentation.

1) Compliance with IFRSsshould be explicitly stated provided all requirements ofrelevant pronouncements are met.

2) Thenotesand disclosure of accounting policiescannot be used tocompensate for inappropriate accounting.

3) In rare cases, compliance with a pronouncement may be misleading. Departurefrom it is permitted when necessary for a fair presentation if full disclosure ismade.

b. Accounting policiesare specific bases, conventions, rules, and practices adopted toprepare and present financial statements. They should be selected and applied tomeet all requirements of standards and interpretations. Absent a requirement,management must use its judgment to provide relevant and reliable information.

1) Managements judgment may be guided by standards and interpretationsconcerning similar issues, the Framework, previous comments of otherstandard setters, and industry practices.

c. Financial statements are prepared on agoing concern basisunless management,based on an assessment of information for at least the next 12 months, expects toliquidate the entity or cease trading.

1) Disclosure should be made of material uncertainties relating to circumstancesthat may create significant doubt about the entitys ability to continue.




15/47

d. Theaccrual basisshould be used to prepare all financial statements except the cashflow statement.

e. Consistencyof presentation and classification, including consistent application ofaccounting policies, should be retained unless a change in presentation is indicatedby

1) A significant change in operations or by a review of the financial statementpreparation

2) A standard or interpretation

f. Eachmaterialclass of similar items is separately presented. Omissions ormisstatements are material if they could, individually or collectively, influence theeconomic decisions of users taken on the basis of the financial statements.Materiality depends on the size or nature of the omission or misstatement judged inthe surrounding circumstances.

g. Offsettingof assets, liabilities, income, and expenses ordinarily is not allowed unlessrequired or permitted by a pronouncement or unless gains, losses, and expensesfrom similar transactions or events are immaterial.

h. Comparative informationordinarily should be disclosed regarding the previous

period for all numerical information in the financial statements.1) Comparative, descriptive, or narrative information also should be presented if it

is relevant to understanding the current statements.

2) An amendment of the presentation or classification of financial statement itemsrequires reclassification of comparative amounts unless such reclassification isimpracticable.

4. Structure and Content

a. Financial statements, and components of financial statements, should beidentifiedclearly. Furthermore, the following should be prominently displayed:

1) Identification of the reporting entity2) Whether the statements are for one entity or a group3) The balance sheet date or the period covered4) The currency used5) The precision of the amounts reported

b. Financial statements arereported annuallyor more frequently. If the balance sheetdate changes, however, annual statements may cover a different period.

1) The reason for the nonannual reporting period and the lack of comparability ofcomparative amounts should be disclosed.

c. Balance Sheet

1) Separate classifications on the balance sheet ofcurrent and noncurrentassetsand liabilities should be presented unless a presentation by order of liquidity isreliable and more relevant. In either case, however, amounts expected to be

recovered or settled in more than 12 months should be disclosed.

a) Current assetsare expected to be realized, or are held for sale orconsumption, in the normal course of the operating cycle. Assets also arecurrent if they are unrestricted cash items or cash equivalents or are heldfor trading purposes or are expected to be realized within 12 months.

i) All other assets arenoncurrent, including long-term tangible,intangible, and financial assets.




16/47

ii) Theoperating cycleextends from the acquisition of assets forprocessing to realization in cash or cash equivalents.

Inventories and trade receivables that enter into the normaloperating cycle are current even though they are expected tobe realized in more than 12 months.

Assetsheld primarily for trading and the current portion ofnoncurrent assets are classified as current.

b) Current liabilitiesare (1) expected to be settled in the normal course ofthe operating cycle, (2) due to be settled within 12 months after thebalance sheet date, (3) held primarily to be traded, or (4) obligations forwhich the entity does not have an unconditional right to defer payment for12 months after the balance sheet date.

i) All other liabilities arenoncurrent, including obligations the entityexpects and hasdiscretion to refinance or roll overfor at least12 months after the balance sheet date under an existing loanagreement. However, abreachof a long-term loan agreement thatcauses an obligation to bedue on demandat the balance sheet

date results in current classification.ii) Certain liabilities, such as trade payables and accruals for various

operating costs, are part of working capital. They are current evenif they are due to be settled in more than 12 months after thebalance sheet date. Other liabilities, such as thecurrent portionof long-term debt, are not settled as part of the current operatingcycle but are classified as current because they are due within12 months after the balance sheet date.

2) Theminimum presentationon the face of the balance sheet includes thefollowing (but no particular order or format is prescribed):

a) Property, plant, and equipmentb) Investment property

c) Intangible assetsd) Financial assets [other than e), h), and i)]e) Equity-based investmentsf) Biological assetsg) Inventoriesh) Trade and other receivablesi) Cash and cash equivalents

j) Trade and other payablesk) Current and deferred income tax liabilities and assetsl) Provisionsm) Financial liabilities [other than j) and l)]n) Minority interest

o) Issued capital and reserves3) Additional itemsshould be separately presented based on judgments about

(a) the nature and liquidity of assets; (b) the function of assets within the entity;and (c) the amounts, nature, and timing of liabilities.

4) Furtherdisclosuresshould be made on the face of the balance sheet or in thenotes. These subclassifications of line items should be appropriate to theentitys operations.

5) Deferred tax amountsare not classified as current.

6) Totalassets held for saleand assets in disposal groups held for sale arereported in line items. Liabilities in disposal groups held for sale also arereported in a line item.




17/47

7) Equity disclosuresinclude (a) shares authorized, issued, fully paid, or not paid;(b) par value (or that there is none); (c) a reconciliation of shares outstanding atthe beginning and end of the period; (d) rights of, and restrictions on, shares;(e) shares held by the entity itself or its subsidiaries and associates; (f) sharesreserved under option and sales contracts; and (g) reserves of equity.

d. Income Statement

1) The IFRSs do not require a particular income statement format, although, at aminimum, certain line items must be presented. Thesingle-stepincomestatement provides one grouping for income items and one for expense items.The single step is the one subtraction necessary to arrive at profit or loss.Themultiple-step income statement matches operating income and expensesseparately from nonoperating items.

2) All recognized income and expense items are included in profit or loss unless apronouncement requires otherwise. Theminimum presentationon the face ofthe income statement includes the following line items:

a) Revenue

b) Finance costs

c) Share of profits and losses of associates and joint ventures accounted forunder the equity method

d) Tax expense

e) One amount for the sum of (1) after-tax profit (loss) on discontinuedoperations and (2) after-tax gain (loss) on the measurement at fair valueminus cost to sell or on disposal of the assets or disposal groups

f) Profit or loss

3) To explain the elements of performance,additional line itemsand amendeddescriptions and ordering of items may be needed. The materiality, nature, andfunctions of income and expenses are relevant to these judgments.

4) Under the IFRSs,no items are classified as extraordinary, either on the

statement or in the notes.5) The nature and amount ofmaterial items of income and expense must be

disclosed separately. Examples are writedowns or disposals of property, plant,and equipment; writedowns of inventory; restructurings; discontinuedoperations; and disposals of investments.

6) Ananalysis of expensesbased on their nature or function preferably should bepresented on the face of the income statement. However, it also may bepresented in the notes.

a) Thenature-of-expense methodaggregates items based on their nature,for example, depreciation, wages, cost of materials, or advertising.

b) Thecost-of-sales methodrequires allocating costs to functions, that is,cost of sales, distribution, or administration.

i) Gross profit (margin) equals sales revenue minus cost of sales.

c) The method chosen depends on which results in the fairest presentation.If the cost-of-sales method is used, additional disclosures about thenature of expenses is required.

7) Dividendsrecognized and dividends per share should be disclosed on the faceof the income statement, the statement of changes in equity, or in the notes.Declared dividends, the per-share amount, and unrecognized cumulativepreference (preferred) dividends are disclosed in the notes.




18/47

8) Adiscontinued operation (DO)is a component of an entity that has beendisposed of or meets the criteria for classification as held for sale. It is (a) aseparate major line of business or geographical operating area, (b) part of asingle plan to dispose of such a line or area, or (c) a subsidiary acquired solelyfor resale.

a) Acomponent of an entity consists of operations and cash flows that areclearly distinguishable from the rest of the entity for financial reporting aswell as operationally.

b) Asingle amountis disclosed on the face of the income statement equal tothe sum of (1) after-tax profit (loss) on DOs and (2) after-tax gain (loss) on(a) remeasurement of noncurrent assets (or disposal groups) classified asheld for sale atfair value minus cost to sell or (b) disposal of the assetsor disposal groups that constituted the DO.

c) Ananalysis of the single amountis disclosed in the notes or on the faceof the income statement. The analysis includes (1) revenues,(2) expenses, (3) pre-tax profit (loss) on DOs, (4) related income taxexpense, (5) recognized gain or loss, and (6) related income tax expense.

d) Net operating, investing, and financingcash flowsof DOs are disclosed inthe notes or on the face of the income statement.

e. Statement of Changes in Equity

1) Aseparate financial statementshould present

a) Profit or loss

b) Each item of income and expense recognized directly in equity and thetotal of such items

c) The total of a) and b) with separate presentation of totals for the parent andthe minority interest

d) The effects on each component of equity of changes in accounting policiesand error corrections

2) Thisstatement or the notesshould present

a) Transactions with equity holders as such, with separate presentation ofdistributions

b) Beginning and ending balances of accumulated profit or loss (retainedearnings) and the changes during the period

c) A reconciliation of the beginning and ending balances of each class ofcontributed equity and each reserve, with separate disclosure of eachchange

f. Cash Flow Statement

1) A cash flow statement is presented for each period for which financialstatements are presented because users need to assess the entitys ability to

generate cash and cash equivalents.

a) Cash equivalentsare short-term, highly liquid investments readilyconvertible to known amounts of cash. Their risk of changes in value isinsignificant. Usually, only investments with short maturities, e.g.,3 months or less, qualify.

2) Cash flows are classified and separately disclosed as from operating, investing,or financing activities.




19/47

3) Operating activitiesare the principal revenue-producing activities of the entity.They also include any other activities that are not investing or financingactivities. Examples are

a) Cash inflows from sales of goods and services, royalties, fees,commissions, refunds of taxes, and contracts held for dealing or trading

i) Securities and loans held for dealing or trading are similar toinventory. Thus, the related cash flows are deemed to be fromoperating activities.

b) Cash outflows to suppliers, employees, and governments

4) Investing activities include acquiring, or disposing of, long-term assets andother investments that are not cash equivalents. Examples are

a) Cash inflows from (1) sales and cash outflows from purchases of property,plant, and equipment; (2) intangibles; (3) other long-term assets;(4) equity or debt of other enterprises; and (5) interests in joint ventures.

b) Cash inflows from repayments of advances and loans made to others andfrom futures, forward, option, and swap contracts.

c) Cash outflows from advances and loans made to others and from futures,forward, option, and swap contracts.

5) Financing activitiesresult from changes in contributed equity and borrowing.Examples are

a) Cash inflows from issuing equity instruments and long- or short-term debt.

b) Cash outflows from purchases and redemptions of the entitys own sharesand from repayments of debt. These outflows include a lesseespayments that reduce the liability arising from a finance lease.

6) Cash flows from operating activitiesare reported using the direct method orthe indirect method.

a) Thedirect methoddiscloses major classes of gross cash flows. It is the

preferable (but not required) method because it provides more informationthan the indirect method. This information may be obtained from theaccounting records or by adjusting sales, cost of sales, and other incomestatement items for

i) Changes in inventories and in operating receivables and payablesii) Other noncash itemsiii) Investing or financing cash flows

b) Theindirect methodadjusts profit or loss for (1) noncash transactions,(2) deferrals or accruals of past or future operating cash flows, and(3) income or expense related to investing or financing cash flows. Theresult is net cash flow from (used by) operating activities.

i) The adjustments are similar to those for the direct method.7) Major classes of grosscash flows from investing and financing activities are

reported separately.

8) Cash flows may be reported on anet basisif they are on behalf of customersand reflect customers activities, for example, demand deposit transactions of abank or funds held by a brokerage for its clients.

a) Cash flows also may be reported on a net basis if the turnover of items isquick, amounts are large, and maturities are short. Examples areprincipal amounts for credit card debt, purchases and sales ofinvestments, and other short-term borrowings.




20/47

b) Afinancial institutionmay report certain cash flows on a net basis:

i) Acceptances and repayments of deposits with fixed maturitiesii) Deposit transactions with other institutionsiii) Advances and loans made to, and repaid by, customers

9) Atransaction in a foreign currency is recorded using the exchange rate at the

date of the cash flow between the entitys functional currency and the foreigncurrency.

a) Translationof a foreign subsidiarys cash flows is also at current rates.

b) However,IAS 21,The Effects of Changes in Foreign Exchange Rates,permits use of a weighted-average rate that approximates the actual ratefor recording foreign currency transactions and for translation purposes.

i) The effects of exchange rate fluctuations on cash and cashequivalents is separately reported as a reconciling item afteroperating, investing, and financing activities.

10) Cash flows frominterest and dividendsshould be separately disclosed andconsistently classified as operating, investing, or financing.

a) Total interest paid is disclosed whether it was expensed or capitalized.b) Afinancial institutioncustomarily classifies interest paid or received and

dividends received as operating items, but other enterprises have notreached a consensus on their treatment. Interest paidmay be anoperating or financing cash flow. Interest and dividends receivedmaybe operating or investing cash flows.

c) Dividends paid are operating or financing cash flows.

11) A cash flow associated withincome taxesis separately disclosed. It isclassified as an operating item unless specifically and practicably identified withinvesting or financing activities.

12) If the equity or cost method is used to account for aninvestment in anassociate or a subsidiary, cash flow reporting is limited to cash flows between

the investor and the investee.

a) Ifproportionate consolidationis used to report a joint venture, aproportionate share of the jointly controlled entitys cash flows areincluded in the consolidated cash flow statement. If the equity method isused, the cash flows reported are those related to the investment andother transactions between the entity and the jointly controlled entity.

13) Aggregate cash flows fromacquisitions and disposals of business unitsareseparately disclosed and classified as investing items.

14) Noncash investing and financing transactionsare not reported in the cashflow statement. They are disclosed elsewhere in the financial statements in amanner that conveys all relevant information. Examples are acquisition of abusiness unit by issuing equity instruments, a finance lease, and the conversionof debt to equity.

15) The policy for determining thecomponents of cash and cash equivalentsshould be disclosed.

a) The amounts in the cash flow statement and the balance sheet should bereconciled.

g. Notes to the Financial Statements

1) Notes describe thebasis of preparationand thesignificant policiesapplied,make required disclosures not presented on the face of the statements, andprovide additional information needed for a fair presentation.

a) Notes are presented systematically, and each statement is cross-referenced to any related information in the notes.




21/47

b) When presented in normal order, the notes include a statement ofcompliance with standards. It is followed by a statement of themeasurement basis(es) and accounting policies applied, supportinginformation for financial statement items, and other disclosures.

c) Other disclosuresinclude (1) contingencies, (2) commitments,(3) nonfinancial disclosures (e.g., risk management policies),(4) significant judgments about applying policies (other than those aboutestimates), (5) key sources of estimation uncertainty, and (6) capitaldisclosures (information about managing capital, what the entity treats ascapital, whether it has complied with capital requirements, and the effectsof not complying).

h. Interim Financial Reporting

1) Aninterim period is shorter than a full year. Aninterim financial reportcontains either a complete set of financial statements or a set of condensedfinancial statements.

2) Theminimum contentof an interim financial report includes condensedversions of the balance sheet, income statement, statement of changes in

equity, and cash flow statement. It also includes selected notes.3) If the interim report includes acomplete set of statements, they should meet

the requirements for annual statements. If condensed statements arepublished, they should include the headings and subtotals in the annualstatements.

a) Other line items or notesare included if necessary to prevent the interimreport from being misleading.

b) Basic and diluted earnings per share (EPS)are presented on the face ofthe income statement.

c) Thenotesshould contain information about use of accounting policies andcomputational methods, the seasonality of operations, unusual items,changes in estimates, debt and equity transactions, dividends, segment

data, material subsequent events, changes in the entitys composition,and changes in contingencies.

4) The interim report should contain various comparative and cumulativestatements.

5) Materialityis determined in relation to the interim data.

6) If anestimatein an interim report changes significantly in the final interimperiod, but no interim report is published for that period, disclosures should bemade in the notes to the annual statements.

7) Accounting policiesare the same in interim and annual statements.

a) Frequency of measurement should not affect annual results, so interimmeasurements are made on ayear-to-date basis. Thus, if an item is

recognized and measured in an earlier interim period and the estimatechanges in a later interim period, the earlier estimate is adjusted in thelater interim report.

8) Revenues received and costs incurred unevenlyover the year should not beanticipated or deferred at the end of an interim period unless such treatment isappropriate at year-end.

9) Interim reports ordinarily require agreater use of estimates than annualreports.




22/47

3.5 FINANCIAL ASSETS AND LIABILITIES

1. IAS 39,Financial Instruments: Recognition and Measurement, applies to most financialinstruments and entities.

2. Definitions (IAS 32),Financial Instruments: Disclosure and Presentation

a. Afinancial instrumentis a contract that results in a financial asset of one entity and afinancial liability or equity instrument of another entity.

b. Financial assetsare (1) cash, (2) contract rights to receive cash or another financialasset, (3) contract rights to exchange financial instruments under potentially favorableconditions, (4) another entitys equity instruments, and (5) certain contracts to besettled in the entitys own equities.

c. Financial liabilitiesare (1) contract obligations to deliver cash or another financialasset, (2) contract obligations to exchange financial instruments under potentiallyunfavorable conditions, and (3) certain contracts to be settled in the entitys ownequities.

d. Anequity instrumentis a contract that is evidence of a residual interest in an entitysnet assets.

3. Aderivativemay be, for example, a futures, forward, swap, or option contract. It is afinancial instrument whose value changes with the change in the underlying. Theunderlying is a specified interest rate, security price, foreign currency exchange rate, priceindex, commodity price, etc. A derivative requireslittle or no initial net investmentcompared with contracts having similar responses to changing market conditions. It issettled in the future.

a. Anembedded derivativeis combined with a host contractso that some cash flowsof the instrument vary in the same way as those of a stand-alone derivative.

1) An embedded derivative and the host contract are accounted for separately if(a) theeconomic characteristics and risks of the derivative are not closelyrelated to the host contract, (b) a separate instrumentwith the same termswould qualify as a derivative, and (c) thehybrid instrumentis not measured atfair value with changes therein included in profit or loss. Examples areconvertible debt or a put option on an equity instrument.

2) If the criteria for separate treatment are met but the components cannot beseparately measured, the combined instrument is classified as held for trading.

4. The categories offinancial instruments include the following:

a. Financial assets or liabilitiesat fair value through profit or losssatisfy one of the twofollowing criteria:

1) Financial assets or liabilities held for tradingare intended to be sold orrepurchased in the near term. Regardless of intent, however, a financial assetor liability is held for trading if it is included in a portfolio with a recent pattern ofshort-term profit taking. Derivativesalso are deemed to be held for tradingunless they are designated and effective as hedging instruments.

2) Certain financial assets or liabilities within the scope of IAS 39 that do nototherwise qualify may be designated as at fair value through profit or losswhen they are initially recognized. However, fair value must be reliablymeasurable.

a) Thefair value optionis available only ifone of the following criteria ismet:

i) It significantly reduces anaccounting mismatch, that is, ameasurement or recognition inconsistency. A mismatch resultsfrom measuring assets or liabilities (not just those that are financial)or recognizing gain or loss on them using different methods.




23/47

ii) A group of financial assets or liabilities is managed and evaluated ona fair value basis in accordance with a risk management orinvestment strategy.

iii) An instrument has an embedded derivative. But the fair value optionis not available if (a) the embedded derivative does not significantlyaffect the related cash flows or (b) separation of the embeddedderivative from the host contract is clearly inappropriate.

b. Held-to-maturity investmentsare nonderivatives that have fixed or determinablepayments and a fixed maturity. Moreover, the enterprise must have a positive intentand ability to hold such investments to maturity. However, this classification excludesitems in the other categories.

c. Loans and receivablesare nonderivatives that have fixed or determinable paymentsbut are not quoted in an active market. This category excludes items (1) to be sold inthe near term, (2) initially designated as available for sale or at fair value throughprofit or loss, and (3) for which the initial investment may not be substantiallyrecovered (other than because of credit risk). Potential items in this category aretrade receivables, loan assets, bank deposits, and investments in debt.

d. Available-for-sale financial assetsare nonderivatives that (1) are designated assuch or (2) do not fall within one of the other classifications.

5. A financial asset or liability isinitially recognizedonly when the entity is a party to thecontract. Thus, rights and obligations pertaining to derivativesare recognized as assetsand liabilities. However, afirm commitmentto buy or sell goods or services does notresult in recognition until at least one party has performed and is entitled or obligated toreceive or disburse an asset.

6. An issuer of afinancial guarantee initially recognizes a liability and measures it at fair value(unless the issuer qualifies to elect insurance accounting). Subsequent measurement is atthe greater of (a) the amount based on accounting for provisions or (b) the amortizedamount.

7. Derecognition of a Financial Asset

a. An asset is normally considered for derecognition only in its entirety. However, if theasset ispart of a financial asset, it is considered for derecognition if the partconsists solely of

1) Specifically identified cash flows(e.g., the counterparty receives the right tointerest but not principal payments in an interest rate strip),

2) Afully proportionate share of cash flows(e.g., the counterparty receives theright to 80% of all cash flows from a bond), or

3) Afully proportionate share of specifically identified cash flows (e.g., thecounterparty receives the right to 80% of interest cash flows).

b. A financial asset is derecognized only when rights to its cash flows have expired or ithas been transferred. An entity transfers theoriginal asset only if it

1) Transfers the contract rights to the cash flowsor

2) Retains those rights but hasassumed a contractual obligation to pay the cashflows to one or more recipients(eventual recipients), and the entity

a) Is not obligated to pay unless it has collected from the original asset,b) Cannot sell or pledge the original asset,andc) Must remit cash flows it collects without material delay.




24/47

c. If the conditions for transfer of a financial asset are met, the entity determines whetheritretains the risks and rewards of ownership (significant exposure to variability innet cash flows of the transferred asset).

1) If substantiallyall risks and rewards are

a) Retained, no derecognition occurs. The entire transferred asset continues

to be recognized. A financial liability is recognized for the considerationreceived.

b) Transferred, the financial asset is derecognized. Assets or liabilities areseparately recognized for rights and obligations retained or created, e.g.,a new financial asset or liability or a servicing asset or liability.

2) If the entity does nottransfer or retain substantially all risks and rewards, itevaluates whether it retains control. The entity has retained controlunlessthetransferee can unilaterally sell the entire asset to an unrelated third partywithout any transfer restrictions.

a) If the entity hasnot retained control, the financial asset is derecognized,with recognition of any assets or liabilities retained or created.

b) If the entity retains control, it recognizes the financial asset to the extent ofitscontinuing involvement. For example, this may be in the form of anoption on the transferred asset or a guarantee.

i) The entity recognizes and measures an asset andassociatedliabilityon a basis that reflects its rights and obligations. Forexample, this basis may be at a net carrying amount equal to thefair value retained if the transferred asset is measured at fair value.

ii) Incomeon the transferred asset arising from continued involvementandexpenseon the associated liability are recognized.

iii) An entity may havecontinuing involvement in only part of afinancial asset (e.g., an option to repurchase that part).




25/47

3) The following summarizes the process for determining whether all or part of afinancial assetshould be derecognized:

d. When the entity derecognizes an entire financial asset, it recognizes inprofit or lossthe difference between

1) The carrying amount and

2) The sum of the consideration received and any cumulative gain or lossrecognized in equity.

e. The carrying amount of a larger financial asset is allocated based on relative fairvalues when atransferred part (e.g., an interest rate strip) qualifies for derecognitionin its entirety.

1) The calculation of the amount recognized in profit or loss is similar to that initem d. above (after allocation of any cumulative gain or loss in equity).

f. A recognized transferred asset and the associated liability arenot offset. Relatedincome and expense also are not offset.




26/47

g. Noncash collateral provided by the transferor to the transferee. If the transfereemay sell or repledge the collateral, the transferor reclassifies the asset separately onits balance sheet.

1) If the transfereesells the collateral, it recognizes the proceeds and a liability forreturn at fair value.

2) If the transferor loses the right of redemption through default, it derecognizesthe collateral. The transfereeeither recognizes an asset or derecognizes theliability for return.

8. Regular way purchases or salesof financial assets may be accounted for using trade dateor settlement date accounting if consistently applied to each category of assets.

a. Thetrade dateis the date of commitment to a purchase or sale. Interest accrualbegins at the settlement date.

b. Thesettlement dateis the date of delivery. The change in fair value from the trade tothe settlement date is accounted for in the same way as the asset. For example, it isrecognized in profit or loss if the asset is classified as at fair value through profit orloss.

9. Derecognition of a financial liability(or a part) occurs only by extinguishment. Thiscondition is satisfied only when the debtor pays the creditor or is legally released fromprimary responsibility either by the creditor or through the legal process.

a. An extinguishment and derecognition of the old debt and recognition of new debtoccurs when the borrower and lender exchange debt instruments with substantiallydifferent terms. The respective discounted cash flows must differ by at least 10%.

1) Asubstantial modification of termsalso is an extinguishment.

b. The difference between the carrying amount (including unamortized costs) of a liability(or a part) that has been extinguished or transferred and the amount paid is includedin profit or loss.

10. Initial measurementof a financial asset or liability is at fair value. If the asset or liability is

not at fair value through profit or loss, direct transaction costs also are included.a. Fair value is measured on a going-concernbasis.

1) Aquoted pricein an active market is the best evidence of fair value.

2) Otherwise, the entity must use avaluation technique, such as discounted cashflow analysis (using time-value-of-money concepts), recent arms-length markettransactions, and any factors market participants are likely to consider that areconsistent economic pricing methods.

11. Subsequent measurement of financial assets(including derivatives that are assets) is atfair value with certain exceptions.

a. Loans and receivablesand held-to-maturity investmentsare measured atamortized costusing the effective interest method.

b. Unquoted equity instrumentswhose fair value is not reliably measurable arereported atcost.

12. Subsequent measurement of financial liabilities is at amortized cost using the effectiveinterest method unless they

a. Are classified as at fair value through profit or loss

b. Arise when a transfer of a financial asset does not qualify for derecognition or isaccounted for on a continuing involvement basis




27/47

13. Reclassifications

a. If investments no longer qualify asheld-to-maturity, they should be remeasured atfair value and classified as available for sale.

b. Financial assets or liabilities maynot have been reliably measurable at fair value.If reliable measurements become available for items required to be reported at fair

value, they should be remeasured accordingly.c. If it becomes appropriate to carry financial assets or liabilities atcost or amortized

cost, the fair value on that date becomes the cost or amortized cost. Any previousgain or loss recognized directly in equity is amortized to profit or loss over theremaining useful life ofheld-to-maturity investments. If the financial assets do nothave a fixed maturity, the full amount is included in profit or loss when the assets aredisposed of.

d. A financial instrument should not be reclassified into or out of thefair value throughprofit or losscategory.

14. Again or lossfrom a change in fair valueof financial assets or liabilities that are not part ofa hedge results in recognition of a gain or loss in profit or loss if the items are classified asat fair value through profit or loss.

a. A gain or loss on anavailable-for-sale financial asset is recognized directly in equitythrough the statement of changes in equity except for impairment losses and foreignexchange gains and losses. The accumulated gain or loss is included in profit or losswhen the asset is derecognized.

15. If a financial asset or liability is measured atamortized cost, a gain or loss is recognized inprofit or loss when it is derecognized or impaired or through amortization.

16. Impairment and uncollectibilityof a financial asset is assessed at each balance sheetbased on objective evidence that a loss has been incurred.

a. The loss onloans and receivablesor held-to-maturity investmentsaccounted foratamortized costequals the excess of the carrying amount over the estimated cashflows discounted at the assets original effective rate. The loss is recognized in profit

or loss, with the loss subtracted from the asset balance or credited to an allowance.This loss may be reversed given subsequent objective evidence, such as animproved credit rating.

1) If the effect of discounting onshort-term receivables is not material, their cashflows are not discounted. Moreover, a creditor may estimate impairment of afinancial asset reported at amortized cost using an observable market price.

b. The loss on assets measured atcost(e.g., unquoted equity instruments) equals theexcess of the carrying amount over the estimated cash flows discounted at themarket rate for such assets. No loss reversal is permitted.

c. When the decrease in fair value of available-for-salefinancial assets is recognizeddirectly in equity, impairment results in recognition in profit or loss of the cumulativeamount recorded in equity. The assets need not be derecognized.

1) Impairment loss on a debt butnot an equity instrumentmay be reversedthrough profit or loss in proper circumstances.




28/47

17. Hedge Accounting

a. The following are the kinds of designatedhedging relationships:

1) Afair value hedgeis a hedge of the exposure to changes in fair value of arecognized asset or liabilityor unrecognized firm commitment. Theexposure must be due to a given risk and be able to affect profit or loss.

a) The hedge of the foreign currency risk of a firm commitment also may beaccounted for as a cash flow hedge.

2) Acash flow hedgeis a hedge of the exposure to variability in cash flows that(a) is due to a given risk associated with a recognized asset or liability(e.g.,interest on variable rate debt) or a highly probable forecast transactionand(b) could affect profit or loss.

3) A hedge of anet investment in a foreign operation.

b. Criteria for Hedge Accounting

1) The hedge is formallydesignated and documentedat its inception, along withthe risk management objective and strategy.

2) The hedge is expected to behighly effectiveand can bereliably measured.

3) Aforecast transactionsubject to a cash flow hedge must be highly probableand be able to affect profit or loss.

4) The hedge iscontinually assessedand determined to have been effective.

c. Fair value hedge. The gain or loss arising from remeasuring the following isrecognized inprofit or loss: (1) thehedging derivativeat fair value or (2) theforeign currency component of a nonderivative hedging instrument measured underIAS 21,The Effects of Changes in Foreign Exchange Rates.

1) The gain or loss on thehedged itemdue to the hedged risk is recognized inprofit or loss. It is an adjustment of the carrying amount.

2) If the hedged item is a financial instrument accounted for using theeffectiveinterest method, the adjustment is amortized to profit or loss. Amortization

beginsno later than the date when the hedged item is no longer adjusted. Theeffective rate is the recalculated rate when amortization begins. Amortizationshould be complete by thematurity date.

d. Cash flow hedge. Theeffective portionof the gain or loss on the hedginginstrument is recognizeddirectly in equity. The rest is recognized in profit or loss.Thus, the balance of the separate component of equity equals the lower of theabsolute amountof (1) the cumulative gain or loss on the hedging instrument or(2) the cumulative change in fair value of the future cash flows on the hedged item.

1) A hedgedforecast transactionmay result in recognition of a financial asset orliability. The gain or loss recorded in equity is then reclassifiedinto profit orloss when such asset or liability affects profit or loss.

a) Any lossnot expected to be recovered is reclassified immediately.

b) A forecast transaction for anonfinancial asset or liabilitymay become afirm commitmentsubject to a fair value hedge. Moreover, a hedge of aforecast transaction may result in recognition of a nonfinancial asset orliability. In these cases, the entity may, if it does so consistently,

i) Reclassify the gain or loss as described in d.1)or

ii) Remove the gain or loss from equity and include it in the initialcarrying amount of the asset or liability.




29/47

2) Forother cash flow hedges, the gain or loss in equity is recognized in profit orloss when the hedged forecast transaction affects profit or loss.

3) A hedge of anet investment in a foreign operationis accounted for in thesame manner as a cash flow hedge. The amount recognized in equity isreclassified into profit or loss on disposal of the operation.

e. Examples of Hedging Transactions1) Fair value hedge. A company wishes to hedge the fair value of its investment in

an inventory of Commodity A. It sells futures contracts on August 1, Year 1, fordeliver

Documents

3. Financial Accounting I