SBR Strategic Business Reporting (International)

A. Ethics, the framework and judgement

Ethical and professional behaviour is central to corporate reporting. Accountants must comply with accounting and sustainability standards and must not mislead users, even when management applies pressure. Unethical behaviour, such as earnings management (smoothing or inflating profit), window dressing, hiding liabilities or overstating sustainability performance, damages the reliability of reports, harms investors and other stakeholders, and can lead to loss of reputation, penalties and loss of confidence. In a scenario, identify the pressure and who applies it, the principle at risk, the consequences, and the action to take, such as raising the matter with those charged with governance, documenting it, seeking advice and, if unresolved, considering resignation.

The Conceptual Framework underpins standards. Its objective is to give useful information to investors, lenders and other creditors. The fundamental qualitative characteristics are relevance and faithful representation, and the enhancing ones are comparability, verifiability, timeliness and understandability. Recognition requires that an item meets the definition of an element and that recognising it provides relevant information and a faithful representation. Measurement bases include historical cost and current values, and the choice must consider the information that is most useful and the cost of providing it. The framework has strengths (consistency, guidance where there is no standard, a basis for judgement) and weaknesses (it is not a standard and it does not override one, it contains compromises, and it gives a lot of room for judgement).

Judgement and uncertainty. Many items need estimates, such as useful lives, fair values and provisions. Preparers must exercise judgement in an unbiased way, disclose significant judgements and sources of estimation uncertainty, and consider materiality, because information is material if omitting or misstating it could influence the decisions of primary users. A change in estimate is applied prospectively, and a change in policy or correction of a prior period error is applied retrospectively with restated comparatives.

Key terms

• Earnings management: Choosing accounting treatments or timing to give a desired profit figure.
• Materiality: Information is material if omitting or misstating it could influence users' decisions.
• Faithful representation: Information that is complete, neutral and free from error.

Study tip: For ethical scenarios, always state the action that should be taken, not just the issue.

Practice questions for section A

B. Revenue, assets and impairment

Revenue (IFRS 15). The five-step model is applied to each contract. Contract modifications are accounted for as a separate contract if they add distinct goods or services at their stand-alone selling price, and otherwise they adjust the existing contract. Variable consideration (such as rebates, bonuses and penalties) is estimated using the expected value or the most likely amount and included only to the extent that it is highly probable that a significant reversal will not occur. A principal controls the good or service before it passes to the customer and records revenue gross, and an agent records only its fee. A sale with a right of return is recognised for the amount expected to be kept, with a refund liability and an asset for the right to the returned goods. Warranties that are not separately sold and only assure the quality are provisions, and service-type warranties are separate performance obligations. Non-refundable up-front fees are recognised over the period in which the related services are provided, unless they relate to a distinct service. Revenue from performance obligations satisfied over time is recognised by a measure of progress, and contract costs to obtain or fulfil a contract may be capitalised.

Non-current assets. Property, plant and equipment is carried at cost or revalued amount, and revaluations are made for a whole class and often enough to avoid material differences. A revaluation increase goes to other comprehensive income (unless it reverses a previous loss) and a decrease goes to profit or loss (unless it reverses a previous surplus). Investment property can be carried at cost or fair value, with changes in fair value in profit or loss, and transfers happen on a change of use. A non-current asset held for sale is measured at the lower of carrying amount and fair value less costs to sell and is not depreciated. Intangible assets are recognised if they are identifiable, controlled and expected to give future benefits, and an indefinite life intangible is tested for impairment each year. Borrowing costs on qualifying assets are capitalised.

Impairment. An asset or cash-generating unit (CGU) is impaired when its carrying amount exceeds its recoverable amount (the higher of fair value less costs of disposal and value in use). A loss on a CGU is allocated first to goodwill, and then to other assets pro rata, with no asset reduced below the highest of its fair value less costs of disposal, its value in use and zero. Goodwill is tested every year. Impairment losses are recognised in profit or loss, or against the revaluation surplus for a revalued asset, and a loss is reversed for assets other than goodwill if the estimates change.

Key terms

• Variable consideration: A part of the transaction price that depends on future events, such as a rebate or bonus.
• Principal: An entity that controls a good or service before it is passed to the customer.
• Recoverable amount: The higher of fair value less costs of disposal and value in use.

Study tip: For revenue scenarios, take the five steps in order and say which step the problem affects.

Practice questions for section B

C. Financial instruments and hedging

Classification and measurement (IFRS 9). A financial asset is classified by the business model and the contractual cash flows. If the business model is to hold to collect contractual cash flows and the cash flows are solely payments of principal and interest (the SPPI test), it is measured at amortised cost. If the model is both to collect and to sell, and the SPPI test is met, it is at fair value through other comprehensive income (FVOCI). Other assets are at fair value through profit or loss (FVTPL), and an entity can irrevocably elect FVOCI for equity investments that are not held for trading. A financial liability is normally at amortised cost, and the fair value option can be used where it removes an accounting mismatch. A modification of the terms of a financial liability is accounted for as an extinguishment if the terms are substantially different (usually a 10 percent test on the present value of the cash flows).

Impairment uses an expected credit loss (ECL) model. At initial recognition, a loss allowance is set at 12-month expected credit losses (stage 1). If there has been a significant increase in credit risk since initial recognition, lifetime expected credit losses are recognised (stage 2), and if the asset is credit-impaired, lifetime losses are recognised and interest is calculated on the net carrying amount (stage 3). Purchased or originated credit-impaired assets use a credit-adjusted effective interest rate. Derecognition of a financial asset occurs when the rights to cash flows expire or when it is transferred and substantially all the risks and rewards are transferred.

Hedge accounting reduces the mismatch that arises when a derivative and the item it hedges are measured differently. The criteria are formal designation and documentation, an economic relationship between the instrument and the item, and a hedge ratio that reflects how it is managed. In a fair value hedge, the gain or loss on the hedging instrument and the adjustment to the carrying amount of the hedged item both go to profit or loss. In a cash flow hedge, the effective portion of the gain or loss on the instrument (the lower of the cumulative gain or loss on the instrument and the cumulative change in the present value of the expected cash flows of the item) goes to other comprehensive income, and the ineffective portion goes to profit or loss. When the hedged transaction occurs, the amount in equity is reclassified or, for a non-financial item, included in its initial cost.

Worked figures

ECL: a loan of $1,000,000 has a 12-month probability of default of 2 percent and a loss given default of 40 percent. The 12-month expected credit loss is 1,000,000 x 2% x 40% = $8,000 (ignoring discounting).

Cash flow hedge: a forward contract has gained $300,000 since inception, and the present value of the change in the expected cash flows of the hedged forecast purchase is $280,000. The effective portion is the lower, $280,000, which goes to other comprehensive income, and the ineffective $20,000 goes to profit or loss.

Key terms

• SPPI test: A test that contractual cash flows are solely payments of principal and interest.
• Expected credit loss: A probability-weighted estimate of credit losses.
• Cash flow hedge: A hedge of the variability in the cash flows of a forecast transaction or recognised item.

Study tip: Say which stage of the ECL model applies and why before you calculate anything.

Practice questions for section C

D. Leases, employee benefits, share-based payment and tax

Leases (IFRS 16). A lessee recognises a right-of-use asset and a lease liability, unless the lease is short-term or for a low-value asset. The lease liability is remeasured when there is a change in the lease term, in the assessment of an option to purchase, in amounts expected under a residual value guarantee, or in future payments that depend on an index or rate. A contract may have lease and non-lease components, which are separated, and the consideration is allocated on a stand-alone price basis. A lessor classifies a lease as a finance lease if it transfers substantially all the risks and rewards, and as an operating lease otherwise, and a sublease is classified by reference to the right-of-use asset. In a sale and leaseback, if the transfer is a sale, the seller-lessee measures the right-of-use asset at the proportion of the previous carrying amount that relates to the rights retained and recognises only the gain that relates to the rights transferred.

Employee benefits (IAS 19). In a defined benefit plan, the entity bears the risk. The net defined benefit liability (asset) is the present value of the obligation less the fair value of plan assets, subject to the asset ceiling. Current service cost, past service cost and gains or losses on settlement are in profit or loss, and net interest on the net liability (using the discount rate) is also in profit or loss. Remeasurements (actuarial gains and losses and the return on plan assets above the interest amount) go to other comprehensive income and are not reclassified. Long-term benefits are measured in a similar way but remeasurements go to profit or loss. Termination benefits are recognised at the earlier of when the offer cannot be withdrawn and when related restructuring costs are recognised.

Share-based payment (IFRS 2). For equity-settled transactions with employees, the expense is based on the fair value of the equity instruments at the grant date, and is spread over the vesting period. The number expected to vest is estimated at each period end, and the cumulative expense is adjusted (with no change to the grant date fair value for vesting conditions that are not market conditions). The credit is to equity. For cash-settled transactions, a liability is recognised and remeasured at fair value at each reporting date, with changes in profit or loss.

Income taxes (IAS 12). Deferred tax is recognised on temporary differences, and it also arises in a business combination because fair value adjustments to the assets of the subsidiary may not change their tax base, which creates a temporary difference, and it affects goodwill. A deferred tax asset is recognised only to the extent that it is probable that taxable profit will be available.

Worked figures

Share options: 100 employees are granted 200 options each with a grant date fair value of $5, vesting after 3 years. At the end of year 1, the entity expects 90 employees to vest. Expense in year 1 = 90 x 200 x $5 x 1/3 = $30,000. At the end of year 2, it expects 92 to vest, so the cumulative expense is 92 x 200 x 5 x 2/3 = $61,333 and the year 2 expense is $31,333.

Defined benefit: the present value of the obligation is $5,200,000 and the fair value of plan assets is $4,700,000, so the net liability is $500,000. If the net liability at the start of the year was $400,000 and the discount rate is 5 percent, net interest is $20,000, which is in profit or loss.

Key terms

• Asset ceiling: The limit on a net defined benefit asset to the present value of the economic benefits available.
• Vesting period: The period over which the conditions for an award must be met.
• Remeasurement: Actuarial gains and losses and the return on plan assets above net interest, recognised in other comprehensive income.

Study tip: Always state where each item goes: profit or loss, other comprehensive income, or equity.

Practice questions for section D

E. Groups, joint arrangements and foreign operations

Control. A parent controls an investee if it has power, exposure to variable returns and the ability to use power to affect them. Potential voting rights, de facto control and structured entities need to be considered. A business combination is accounted for under the acquisition method: identify the acquirer, measure consideration at fair value (including contingent consideration), measure the identifiable assets and liabilities at fair value (including intangible assets and contingent liabilities that are present obligations), and recognise goodwill. Goodwill is the consideration plus the non-controlling interest (at fair value or at the proportionate share of net assets) plus any previously held interest at fair value, less the net assets. A bargain purchase gain goes to profit or loss.

Business combinations in stages. If control is obtained in stages, the previously held interest is remeasured to fair value at the acquisition date and the gain or loss goes to profit or loss. A change in ownership that does not result in loss of control is an equity transaction between owners: no gain or loss and no change in goodwill. If control is lost, the assets and liabilities (and goodwill and NCI) are derecognised, any retained interest is remeasured at fair value, and the gain or loss is in profit or loss. A subsidiary held for sale is shown in a single line as a disposal group. Discontinued activities are presented separately.

Associates and joint arrangements. An associate is accounted for by the equity method (investment at cost plus share of post-acquisition changes, less impairment, with unrealised profit eliminated). A joint arrangement is classified by the rights and obligations of the parties. A joint operation is accounted for by recognising the party's own assets, liabilities, revenue and expenses, and a joint venture is accounted for under the equity method.

Foreign operations. The foreign operation's statements are translated into the presentation currency: assets and liabilities at the closing rate, income and expenses at the rate at the date of the transaction (an average may be used), with exchange differences in other comprehensive income. Goodwill and fair value adjustments are treated as assets of the foreign operation and are expressed in its functional currency. Exchange differences accumulate in a separate component of equity and are reclassified to profit or loss on disposal. A consolidated statement of cash flows is prepared from the group statements, with adjustments for acquisitions and disposals, the effect of exchange rates, dividends to NCI and associates.

Worked figures

Step acquisition: the parent held 20 percent with a carrying amount of $600,000 and a fair value of $1,000,000. It buys another 40 percent for $2,200,000 and gains control. The NCI (40 percent) at fair value is $1,800,000 and the fair value of net assets is $4,500,000. Goodwill = 2,200,000 + 1,000,000 + 1,800,000 - 4,500,000 = $500,000. The remeasurement gain on the previously held interest is 1,000,000 - 600,000 = $400,000 in profit or loss.

Foreign operation: opening net assets are FC 8,000,000 at FC 2.0 to $1, which is $4,000,000. Profit of FC 1,000,000 is translated at an average rate of 2.1, giving $476,190. Closing net assets of FC 9,000,000 at a closing rate of 2.2 are $4,090,909. The exchange difference in other comprehensive income is 4,090,909 - 4,000,000 - 476,190 = $-385,281, which is a loss.

Key terms

• Step acquisition: A business combination achieved in stages.
• Joint operation: A joint arrangement in which the parties have rights to the assets and obligations for the liabilities.
• Functional currency: The currency of the primary economic environment in which an entity operates.

Study tip: Set out the consolidation workings (net assets, goodwill, NCI, reserves) in separate columns and cross-check them.

Practice questions for section E

F. Sustainability, performance reporting and developments

The IFRS Sustainability Disclosure Standards. IFRS S1 requires disclosure of sustainability-related risks and opportunities that could reasonably be expected to affect the entity's prospects, with information on governance, strategy, risk management, and metrics and targets, connected to the financial statements and for the same period. IFRS S2 applies this to climate-related risks (physical and transition) and opportunities, including greenhouse gas emissions and climate scenario analysis. The standards aim at investors, lenders and other creditors, and use financial materiality. The European Sustainability Reporting Standards add double materiality (the impacts of the entity on people and the environment as well as the financial effects on the entity). The usefulness of the disclosures depends on their quality, comparability, reliability (assurance) and the clear linking of them to the financial information.

Analysis and performance. Users want to assess the earnings per share, cash flows, performance measures and prospects. Management-defined performance measures (for example adjusted profit) can be useful but they may be biased, so they should be clearly labelled, reconciled to the nearest IFRS figure and consistent. Operating segment disclosures show the performance of the parts of the business that management reviews and help users to judge risks and returns. The quality of information is also affected by management commentary, and by the use of non-financial indicators, so users should consider both together.

Developments. Preparers must be able to appraise the effect of new standards and to apply existing ones to contemporary issues such as digital assets (for example crypto-assets, which may be classified as intangible assets or inventories depending on the facts), natural disasters, climate change and global events, using the Conceptual Framework where there is no specific standard. For each one, identify the item, the relevant standard, the judgement needed and the disclosure required.

Key terms

• Financial materiality: Materiality based on the effect of information on the decisions of investors and creditors.
• Management-defined performance measure: A subtotal of income and expenses that management uses to communicate performance.
• Digital asset: A digital representation of value or rights, such as a crypto-asset.

Study tip: For contemporary issues, there may be no specific standard. Say so, then reason from the definitions in the Conceptual Framework.

Practice questions for section F