ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 12: Leases and substance over form

One example is where an Entity X sells an asset to another entity, Entity Y and

leases the same asset back. Entity Y also agrees to sell back the asset to the lessee at a

predetermined price at the end of the lease period. The overall effect is that the

arrangements provide Entity B with a yield of LIBOR plus 1.5% over the term of the

lease. (The substance of the transaction is that Entity X is borrowing from Entity Y in

the form of a secured loan with interest at LIBOR plus 1.5%.)

4.8 IFRIC 4: Deciding whether an arrangement contains a lease

An entity might enter into a contractual agreement, or a series of related

transactions, which does not include a lease in its legal form. However the nature of

the transaction could mean that in economic substance, it does include an

arrangement that is effectively a lease and as such should be accounted for in

accordance with the requirements of IAS 17.

IFRIC Interpretation 4 offers guidance on deciding whether an arrangement or

transaction does contain an arrangement that, in substance if not in legal form, is a

lease. According to IFRIC 4, there are two key issues to consider in deciding

whether a lease arrangement does exist in these circumstances:

 Fulfilment of the agreement by the supplier of the goods or services should be

dependent on the use of a specific asset or assets (‘the asset’).

 The arrangement should convey the right to the purchaser of the goods or

services to use the asset.

Fulfilment of the agreement is dependent on use of a specific asset

If a supplier undertakes to supply a quantity of goods or services to a purchaser, but

the agreement does not specify the use of a specific asset to supply the goods or

services, a lease does not exist. An exception is where it would not be economically

feasible or practicable for the supplier to provide the goods or services through the

use of alternative assets, so that a specific asset would have to be used to fulfil the

supplier’s commitments.

The arrangement conveys a right to use the asset

A lease exists in substance when an arrangement gives the purchaser the right to

control the use of the underlying asset. The right to control the use of the asset exists

when the buyer obtains or controls more than an insignificant amount of the output

from the asset and has the right to direct others to operate the asset or controls

access to the asset.

Alternatively the right to use an asset exists when it is unlikely that other customers

will take more than an insignificant amount of output from the asset and in addition

the price that the purchaser will pay for output from the asset is neither a fixed price

nor the existing market price at the time of delivery of the output to the purchaser.

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

Example

Some illustrative examples accompany IFRIC 4. One is described here.

A production company arranges with a supplier for the supply of gas to its

manufacturing operation for a specified period of time. The supplier builds a facility

next to the manufacturer’s plant to produce and supply the gas required. The

supplier retains ownership and control over the facility.

The facility is specifically identified in the contractual agreement. The supplier has a

contractual right to supply gas from the facility to other customers, but the facility

has the capacity only to supply the purchaser and the supplier has no plans to

expand the facility. The supplier is responsible for maintenance and repairs of the

facility and is contractually required to supply a minimum quantity of gas. The

purchaser will pay a fixed charge per month plus a variable charge based on actual

gas production taken, and the variable charge is a percentage amount of the

supplier’s variable costs.

In this example, a lease does exist in substance, and should be accounted for as such

buy the supplier and by the purchaser. An asset is identified in the agreement and

fulfilment of the agreement is dependent on the asset. The purchaser has the

effective right to use the asset because effectively the asset has been built to meet the

specific needs of the purchaser. It is most unlikely that any other customer will buy

more than an insignificant amount of output from the asset, and the price paid by

the purchaser is not a fixed price or the current market price for gas at the time of

delivery.

4.9 DP 2009/1: Leases

This is a part of a joint project between the IASB and FASB.

Existing lease accounting standards require lessees to classify their lease contracts as

either finance leases or operating leases. Finance leases are defined as those leases

that transfer to the lessee substantially all the risks and rewards incidental to

ownership of the leased asset. All other leases are operating leases.

Criticisms of the existing accounting model

Operating leases give rise to assets and liabilities which both meet the definitions

and satisfy the recognition criteria in “The Framework” but these are not recognised

in the financial statements of lessees. Many users routinely adjust the recognised

amounts in an attempt to recognise those assets and liabilities and reflect the effect

of lease contracts in profit or loss.

Operating leases are a source of unrecognised financing that can be difficult for

users to understand.

The existence of two different accounting models for leases means that similar

transactions can be accounted for very differently. This reduces comparability for

users.

The two different accounting models provide opportunities to structure transactions

so as to achieve a particular lease classification and thus a particular impact in the

financial statements.

Chapter 12: Leases and substance over form



Example

The following example was used earlier to illustrate accounting for a finance lease:

ABC Company needs a new machine for its business. The fair value to buy the

machine outright is $260,000 but instead it enters into a 20-year finance lease on 1

January 20X0. Payment terms are $16,000 every six months, payable in arrears,

commencing 30 June 20X0. The interest rate implicit in the lease is 5.4%.

The company’s financial year ends on 31st December.

Analysis

It was shown earlier that if the lease is a finance lease:

 the total finance charge for the year to 31 December 20X0 is $27,974

 the total finance charge for the year to 31 December 20X1 is $27,528.

In addition, the lessee must charge depreciation on the asset, which may be $13,000

each year ($260,000/20 years).

If the company had classified the lease as an operating lease, the only entry in the

financial statements would be the $32,000 rental expense in profit or loss. So in the

first two years of the lease (and for several years after that), the charge to profit or

loss will be less than it would be for a finance lease.

In addition, the lessee has no asset and no liability to a lessor in its statement of

financial position. Clearly, accounting for the lease as an operating lease is much

more preferable than accounting for the lease as a finance lease.

Tentative proposals

The discussion paper sets out a series of proposals for discussion. These are

described as tentative decisions. (This phrase simply means that the boards have not

come to firm conclusions yet).

The proposals include the following.

The distinction between finance leases and operating leases should be replaced by a

new accounting model for leases that results in the lessee recognising:

 an asset representing its right to use the leased item for the lease term (the ‘right-

of-use’ asset); and

 a liability for its obligation to pay rentals.

The lessee’s obligation to pay rentals should be measured initially at the present

value of the lease payments discounted using the lessee’s incremental borrowing

rate. Subsequent measurement would be on an amortised cost basis.

The lessee’s right-of-use asset should be measured initially at cost. Cost equals the

present value of the lease payments discounted using the lessee’s incremental

borrowing rate. The asset should then be amortised over the shorter of the lease

term and the economic life of the leased item.

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Paper P2 (INT)

Corporate Reporting

CHAPTER

Reporting requirements for

listed companies

Contents

1 IFRS 8: Operating segments

2 IAS 33: Earnings per share

3 IAS 34: Interim financial reporting

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IFRS 8: Operating segments

 Scope of IFRS 8

 Operating segments

1 IFRS 8: Operating segments

1.1 Scope of IFRS 8

Many companies operate in several different industries (or ‘product markets’) or

diversify their operations across several geographical locations. A consequence of

diversification is that companies are exposed to different rates of profitability,

different growth prospects and different amounts of risk for each separate ‘segment’

of their operations.

IFRS 8 Operating segments was issued in 2006 and replaced IAS 14 Segment reporting.

The reason for the replacement of IAS 14 was the harmonisation project between the

US and the IASB.

IFRS 8 recommends the US approach to identifying operating segments. This is

based on a management approach that is linked to the company’s internal financial

reporting system, and so it is much less subjective than the previous standard

(IAS14).

Objective of IFRS 8

IFRS 8 requires quoted companies to disclose information about their different

operating segments, in order to allow users of the financial statements to gain a

better understanding of the company’s financial position and performance.

Users are able to use the information about the main segments of the company’s

operations to carry out ratio analysis, identify trends and make predictions about

the future. Without segment information, good performance in some segments may

‘hide’ very poor performance in another segment, and the user of the financial

statements will not see the true position of the company.

Segment reporting is required for any entity whose debt or equity is quoted on a

public securities market (stock market) and also entities that are in the process of

becoming quoted. If an entity includes some segment information in the annual

report that doesn’t comply with IFRS 8, it cannot call it ‘segmental information.’

Chapter 13: Reporting requirements for listed companies

1.2 Operating segments

IFRS 8 defines an operating segment as a component of an entity:

 that engages in business activities from which it earns revenues and incurs

expenses

 whose operating results are regularly reviewed by the entity’s chief operating

decision maker to make decisions about resources to be allocated to the segment

and assess its performance, and

 for which discrete financial information is available.

Not every part of an entity is necessarily an operating segment. For example a

corporate head office may not earn revenue and would not be an operating

segment.

The standard requires a segment to have its results reviewed by the chief operating

decision maker. The reason for this part of the definition of an operating segment is

to ensure that an entity reports segments that are used by management of the entity

to monitor the business.

Aggregation of segments

Two or more operating segments may be aggregated into a single operating

segment if they have similar economic characteristics, and the segments are similar

in each of the following respects:

 the nature of the products and services

 the nature of the production process

 the type or class of customer for their products and services

 the methods used to distribute their products or provide their services, and

 if applicable, the nature of the regulatory environment, for example, banking

insurance or public utilities.

Quantitative thresholds

An entity must report separately information about an operating segment that

meets any of the following quantitative thresholds:

 its reported revenue, including external sales and intersegment sales is 10% or

more of the combined internal and external revenue of all operating segments

 its reported profit is 10% or more of the greater of the combined profit of all

segments that did not report a loss and the combined reporting loss of all

segments that reported a loss

 its assets are 10% or more of the combined assets of all operating segments

Reportable segments

An entity must report separately information about each operating segment that:

 has been identified in accordance with the definition of an operating segment

shown above

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 or is aggregated with another segment

 or exceeds the quantitative thresholds.

If the total external revenue reported by operating segments constitutes less than

75% of the entity’s total revenue, then additional operating segments must be

identified as reporting segments, even if they do not meet the criteria, until 75% of

revenue is included in reportable segments.



Example

The following information relates to Oakwood, a quoted company with five

divisions of operation:

Wood

sales

Furniture

sales

Veneer

sales

Waste

sales

Other

sales

Total

$m $m $m $m $m $m

Revenuefrom

externalcustomers

220 256 62 55 57 650

Intersegment

revenue

38 2 ‐ 5 3 48

Reportedprofit 54 45 12 9 10 130

Totalassets 4,900 4,100 200 400

600 10,200

Which of the business divisions are reportable segments under IFRS 8 Operating

segments?



Answer

IFRS 8 states that a segment is reportable if it meets any of the following criteria:

 its internal and external revenue is more than 10% of the total entity internal and

external revenue.

 its reported profit is 10% or more of the greater of the combined profit of all

segments that did not report a loss.

 its assets are 10% or more of the combined assets of all operating segments.

From the table above, only the Wood and Furniture department sales have more

than 10% of revenue, assets and profit and meet the requirements for an operating

segment. The other three divisions do not meet the criteria: none of them pass the

10% test for assets, profit or revenue.

Additionally IFRS 8 states that if total external revenue reported by operating

segments constitutes less than 75% of the entity’s revenue then additional operating

segments must be identified as reporting segments, until 75% of revenue is included

in reportable segments

The total external revenue of Wood and Furniture is $476m and the total entity

revenue is $650m, which means that the revenue covered by reporting these two

segments is only 73%. This does not meet the criteria so we must add another

Chapter 13: Reporting requirements for listed companies

operating segment to be able to report on 75% of revenue. It doesn’t matter that any

of the other entities do not meet the original segment criteria.

In this case, we can add on any of the other segments to achieve the 75% target. If

we add in Veneer sales, this gives total sales of $538m, which is 83% of the sales

revenue of $650m. This is satisfactory for the segmental report.

Disclosure

IFRS 8 states that an entity must disclose information so that users of the financial

statements can evaluate the nature and financial effects of the business activities in

which it engages and the economic environments in which it operates.

The information that is to be disclosed is:

 a measure of profit or loss for each reportable segment

 a measure of total assets liabilities for each reportable segment if such an amount

is reported regularly to the chief operating decision maker

 information about the following items if they are specified and included in the

measure of segment profit that is reported to the chief operating decision maker:

− revenues from external customers

− revenues from transactions with other operating segments of the same entity

− interest revenue

− interest expense

− depreciation and amortisation

− material items of income and expense in accordance with IAS 1

− the entity’s interest in the profit or loss of associates and joint ventures

accounted for by the equity method

− income tax expense or income

− material non-cash items other than depreciation and amortisation.

 the amount of investment in associates and joint ventures accounted for by the

equity method and the amounts of additions to non current assets (excluding

financial instruments, deferred tax assets, post employment benefit assets and

rights arising under insurance contracts), providing these amounts are included

in segment assets.

Additionally, the following reconciliations are required:

 reconciliation of the totals of segment revenues to the entity’s revenue

 reconciliation of the total of reported segment profits or losses to the entity’s

profit before tax and discontinued operations

 reconciliation of the total of the assets of the reportable segments to the entity’s

assets

 reconciliation of the total of the liabilities of the reportable segments to the

entity’s liabilities (but only if segment liabilities are reported)

 reconciliation of the total of the assets of the other material items to the entity’s

corresponding items.

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Also, the factors used to identify the entity’s reportable segments, including the

basis of organisation, (i.e. whether the entity is organised around different products

and services or geographical area), and the types of products and service from

which the reportable segments derive their income must all be disclosed.

Measurement

IFRS 8 requires that the amount of each segment item reported shall be the measure

reported to the chief operating decision maker for the purposes of making decisions

about allocating resources to the segment and assessing its performance. This is

based on the internal structure of how division of the entity report their results to

the chief operating decision maker. Any adjustments and eliminations made in

preparing an entity’s financial statements shall be included in determining segment

results only if they are included in the measure of the segment’s results used by the

chief operating decision maker.

The minimum amount the entity must disclose is:

 The basis of accounting for any transactions between reportable segments

 The nature of any differences between the measurement of the reportable

segments’ profit or loss before tax and the entity’s profit or loss, for example, the

allocation of centrally incurred costs.

 The nature of any differences between the measurement of the reportable

segments’ assets and the assets of the entity.

 The nature of any differences between the measurement of the reportable

segments’ liabilities and the liabilities of the entity.

 The nature of any changes from prior periods in measurement methods used to

determine segment profit or loss and the effect on profit or loss from those

changes.

 The nature of asymmetrical allocations to reportable segments. For example, a

reportable segment may be charged the depreciation expense for a particular

asset but the depreciable asset might not have been allocated to the segment.

Entity wide disclosures

The reporting entity must also make the following disclosures in the financial

statements, even if it only has one reportable segment:

 Revenue from external customers for each product and service or each group of

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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