Ind AS/IFRS for Management and Audit Committee
Responsibility of Management
The Management of a company is responsible for the preparation and fair presentation of financial statements in accordance with International Financial Reporting Standards, and for such internal control as it determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.
Judgements and Estimates
Preparing financial statements requires judgement regarding the best way in which to present financial information and the use of estimates (eg materiality judgements and going concern assessments).
IAS 1 Presentation of Financial Instruments
IAS 1 requires disclosure of:
- judgements that management has made in the process of applying the entity’s accounting policies and that have the most significant effect on the amounts recognised in the financial statements
- Information about major sources of estimation uncertainty that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year
Financial statements are, generally, prepared on the going concern basis – judgement may be required when determining whether this basis is appropriate
IAS 7 Cash Flow Statements
- The appropriate classification of cash flows into each one of the activities reflects management’s judgement.
- The information conveyed by a statement of cash flows depends on the items treated as ‘cash and cash equivalents’. Cash equivalents have a short maturity (three months at most) and exclude equity investments.
Selection of Accounting Policy when no specific requirement
When no IFRS requirement specifically applies to a transaction or event, management uses judgement to develop and apply an accounting policy that results in relevant and reliable information.
In making that judgement management considers:
- first, IFRSs that deal with similar issues
- then the definitions, recognition criteria and measurement concepts in the Framework
- optional – standards based on a similar conceptual framework (US GAAP)
Change in Accounting Policy
An entity may voluntarily change an accounting policy only if the change will leads to ‘reliable’ and more relevant information—determining whether this is the case involves judgement
When correcting prior-period errors judgement must be applied. For example in determining
- whether the prior period error is material
- whether is it practicable to determine the period-specific effects of an error on comparative information
Events after the reporting period
Management of an entity must judge the materiality threshold for the disclosure of non-adjusting events occurring after the reporting period —such as
- a major business combination or disposal,
- a plan to discontinue an operation,
- fire affecting a major production plant,
- changes in tax rates or tax laws enacted or announced
Events after the reporting period may require an assessment of the applicability of the going concern assumption at reporting date.
Unit of Account
The unit of account is the level at which an asset is aggregated or disaggregated for recognition purposes.
Most IFRS do not prescribe the unit of account therefore judgement is required in applying recognition criteria to an entity’s specific circumstances. For example:
- individually insignificant items, such as moulds, tools and dies may be aggregated when applying the recognition criteria in IAS 16.
Accounting for Inventories
Calculating the cost of a manufacturer’s inventory involves a number of judgements, including:
- normal wastage
- allocating overheads (including plant depreciation)
- allocating joint costs to joint products.
Impairment of Inventories
- identifying impaired inventories
- estimating Net realisable value - Net realisable value is an entity-specific measure and therefore judgement is required in order to determine the amounts expected to be realised upon sale of the inventory.
Accounting for Property, Plant & Equipment
Cost of some items includes significant estimates
- costs of dismantling, removal, restoration
- costs of self constructed PPE
- identifying significant components to be depreciated separately
- estimating useful life and residual value
- identifying the depreciation method that reflects most closely the consumption of the service potential of the item of PPE
Determining the classes of property, plant and equipment for presentation purposes requires judgment
Accounting for Intangible Assets
Judgement is required in determining whether an asset that incorporates both intangible and tangible elements should be treated under IAS 16 or as IAS 38
Control of an asset arises when the entity has the power to obtain future economic benefits from the underlying resource and to restrict the access of other to those benefits. Intangible items of value to an entity may not be controlled by it, eg the assembled workforce and customer relationships.
Research phase expenditures cannot be capitalised as assets. Development phase expenditures are capitalised when the specified criteria for asset recognition are satisfied.
- identifying a finite useful life intangible asset
- estimating useful life
- (residual value is usually assumed to be zero unless there is an active market)
- identifying the amortisation method that reflects most closely the consumption of the service potential of the item of the intangible asset.
Impairment testing requires many estimates.
Accounting for Investment Property
Sometimes it is difficult to identify investment property. In such cases an entity develops criteria so that it can exercise that judgement consistently
- eg, owner of a hotel transfers some responsibilities to third parties under a management contract (PPE or investment property?)
In some cases measuring fair value requires judgment
Determining the amount of borrowing costs that are directly attributable to the acquisition of a qualifying assets requires judgement.
- e.g., it might be difficult to identify a direct relationship between particular borrowings and a qualifying asset and to determine the borrowings that could otherwise have been avoided, particularly when financing is co-ordinated centrally.
Impairment of Assets
Identifying some indicators of impairment requires judgement (eg decline in an asset’s market value; adverse changes in the technological, market, economic or legal environment; increase in market interest rates, among others).
Identifying the lowest level of independent cash inflows for some groups of assets (ie cash-generating unit) requires judgement.
Allocating goodwill to cash-generating units requires judgement.
Measuring the value in use (an entity-specific measure) of an asset or group of assets involves
- estimating future cash flows that the entity expects to derive from the assets (its use and subsequent disposal) taking account of expectations about possible variations in the amount or timing of those cash flows
- adjusting for risks specific to the asset that market participants would reflect in pricing the asset
- identifying appropriate discount rates
Measuring the fair value less costs to sell of an asset or group of assets involves judgement
Accounting for Leases
Judgements and Estimates are required in
- Identifying arrangements that contain a lease
- Classifying a lease—finance or operating lease
- Determining the interest rate implicit in a lease (particularly for a lessee)
- For manufacturer or dealer lessors, bifurcating the sale and financing transactions.
Non-current Assets held for sale
The classification of an asset as ‘held for sale’ is based on actions taken by management before the end of the reporting period and management’s expectation that a sale will be achieved.
- The asset must be available for immediate sale in its present condition (subject only to terms that are usual and customary for sales of such assets).
- The sale must be highly probable (appropriate management commitment, actively seeking a buyer, reasonable price, 12 month limit).
Measuring the fair value less costs to sell of assets held for sale (absent an active market).
Identifying the entity’s chief operating decision maker (as a function, not a specific title).
- matrix form of organisations require management judgement to segmentation that satisfy IFRS 8’s objective.
Identifying which operating segments can be aggregated
Identifying reportable segments that do not meet the quantitative threasholds for reportable segments.
Fair Value Measurements
- Determining fair value and the highest and best-use.for a non-financial asset.
- Assumptions that a market participant would use (including assumptions about risk).
- Determining the correct valuation technique to use and the inputs to the techniques, particularly on the income approach, require a wide range of estimates as:
- discount rates
- future cash flows
- risks and uncertainty
The inputs used in the valuation techniques should primarily be based on observable inputs (where possible) to minimise the use of unobservable inputs.
Related Parties Disclosures
Identifying related parties—focus on substance of a relationship rather than merely its legal form.
- Identifying the degree of influence exerted by one party on the other (ie control or significant influence).
- Identifying key management personnel depends on the level of authority and responsibility and may include seconded staff and people engaged under outsourcing contracts.
- Identifying close members of the family of a key management personnel involves judging whether that person is expected to influence (or be influenced by) by that person in their dealing with the entity.
Accounting for Share-based payments
- Identifying share-based payment transactions may not always be straightforward.
- Istinguishing equity-settled and cash-settled plans.
- Understanding of plan terms.
- Estimating the fair value of an options and use of valuation models (Black-Scholes, binomial, Monte Carlo).
- Estimating vesting periods and vesting conditions.
In some cases judgement is required to determine the functional currency of an entity.
- A foreign operation (regardless of its legal form) may be carried out as an extension of the reporting entity and the assessment of its functional currency depends on factors such as degree of autonomy, significance of transactions with reporting entity and the level of financial dependence.
Business Combination and Consolidation
Determining whether an investor controls an investee involves assessing whether the investor:
- Has power over the investee
- Exposure, or rights, to variable returns from its involvement with the investee
- The ability to use its power over the investee to affect the amount of the investor’s returns.
Determining whether a particular set of assets and activities is a business requires assessing their capabilities of being conducted and managed for the purpose of providing economic benefits.
Identifying the acquirer in some business combinations that combine two or more entities can require judgement.
Accounting for business combinations requires broad use of fair value estimates. Level 3 fair value measurement can require significant judgements and estimates
The acquiree’s identifiable intangible assets at the acquisition date are recognised separately and might include assets that have not been recognised by the acquiree.
Joint Ventures and Joint Control
- Assessing whether the parties, or a group of parties, have joint control of an arrangement (see IFRS 10 for judgements about control).
- Determining whether the joint arrangement is a joint operation or a joint venture requires consideration of the structure and legal form of the arrangement, the terms agreed and when relevant other facts and circumstances.
- Investors must exercise judgement in the context of all available information to determine whether they have significant influence over an investee.
- There is no exemption from equity accounting when severe long-term restrictions impair the associate’s ability to transfer funds to the investor.
Provisions, Contingent Liabilities and Contingent Assets
Judgements and estimates are required
- In some cases judgement is used to determine whether to recognise a provision (liability) or merely to disclose a contingent liability.
- For example, when defending a court case in which it is difficult to predict the outcome.
- In other cases judgement is used to determine whether to disclose a contingent asset.
- For example, a plaintiff in a court case in which it is difficult to predict the outcome.
- Measuring a provision requires estimating the amount that the entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time.
- the risks and uncertainties that inevitably surround many events and circumstances are taken account in measuring a provision (eg measure a provision at its expected value by weighing all possible outcomes by their associated probabilities).
- To measure the liability for a defined benefit post-employment plan (eg mortality, employee turnover, age at and date of retirement, future salary and benefit levels, future medical costs, the discount rate and fair value of plan assets).
- Extensive disclosures required to: explain characteristics of the plan and associated risks; identify and explain related amounts in financial statements; possible affects on the amount, timing and uncertainty of future cash flows.
- Measuring obligations for profit-sharing plans often require estimates of expected payments to employees and expected forfeitures if loyalty period applies.
- Accumulating compensated absence schemes (eg some sick leave, holiday leave, maternity leave, military leave and long-service leave schemes) require estimates of expected employee compensated absences.
Equity vs Liability
Some financial instruments may have the legal form of equity but their substance is one of a liability.
- Separating the liability and equity components requires fair value estimates of the liability component based on the contractual stream of future cash flows discounted at the market rate that would have been applied without the conversion option.
Classification of financial assets into IFRS 9 categories drives the subsequent measurement and requires careful consideration of all available evidence.
- Classification is made primarily based on an entity’s business model
Fair value measurement requires maximum possible use of observable market data and the minimum use of entity-specific factors. In the absence of a quoted active market, it will be necessary to use valuation techniques.
Determining whether it is probable that the entity will generate sufficient taxable profit to allow for the recognition of a deferred tax asset for:
- deductible temporary differences
- unused tax losses and unused tax credits
Estimating the tax rates that are expected to apply when temporary differences reverse (eg when tax rates are graduated)
Judging when a tax rate becomes substantively enacted