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Plus, I answered the very first question - what closing rate shall you apply to translate your balances at the year-end, when more rates are available (mid rate, sell rate, buy rate)?

Click HERE to listen to the IFRS Q&A 001: What closing rate to apply?

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Accounting for Deemed Disposal of Associate (IAS 28)

• Posted in:Consolidation and Groups
• Posted by:Silvia M.

15

Sometimes, the things can happen behind your back – without you even noticing.
And, these things can affect you somehow.
Let me tell you a short story.
I participated in an audit of a big insurance company and our senior asked me to look at its investments.
Not surprisingly, this insurance company held lots of shares and in some companies it exercised either control or significant influence.
I was just going through the papers and suddenly, one thing came to my attention: the investment in a medium-sized manufacturing company (let’s call it ABC).
I remembered that a few months ago, significant foreign investor acquired controlling stake in ABC. I read it in the newspapers.
The acquisition was in fact performed in 2 separate transactions:

• The investor acquired about 40% of shares by purchasing the shares from other 2 investors, and
• ABC issued additional capital to the foreign investor.

Hmmm, what does that mean?
Well, the first transaction – purchasing shares from other investors – had no impact on our client, because the other shares just changed the owner.
The problem was with the second transaction.
Why?
The reason is that ABC issued new shares and it diluted the share of my client, the insurance company.
Simply speaking – imagine you hold 20 000 shares of 1 CU each in a company with total share capital of 100 000. Thus, you have 20%.

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But, that company decides to issue new shares for 20 000 and its total share capital increases to 120 000.
You still have your 20 000, but as a result of issuing the new shares, you share drops to 16,67% (20 000/120 000).
This is exactly what happened. Although our client did literally nothing wrong (or nothing at all), they lost their share.
The first thing I went to examine – was the significant influence maintained?
I stress it all over my articles about the group accounts. The percentage of ownership is just indicator of significant influence (or control, you name it). You have to examine other factors – read more here.
What’s worse – as a result of this transaction, our client lost significant influence in ABC. And, it had a huge impact on the accounting, because when you lose the significant influence, you have to stop equity method.
End of the story. These things happen quite often. It is called “deemed disposal”.
In this article, we will deal with deemed disposals of an associate, but the rules and accounting methods apply with any other deemed disposal, too.

What is deemed disposal?

Deemed disposal of an associate or a joint venture is simply reduction in interest or share in an associate or a joint venture other than by actual disposal by the transfer of shares or liquidation.
In other words – deemed disposals mostly happen “behind your back”.
How the deemed disposal may happen? Let me name just three very common ones:

• You (investor) ignore the rights issue by the associate or joint venture (or you do not acquire the new shares fully).
• An associate issues warrants or options to own shares and someone else exercise them (thus new capital is issued).
• An associate issues new shares to someone else (just as in my short story above).

Hmmm, after I wrote this article, my husband looked over my shoulder and said: That reminds me Facebook a few years ago…
Well, yes, that is a great example of deemed disposal, too.

The Facebook deemed disposal

What happened?
In 2004, Mark Zuckerberg founded Facebook together with Eduardo Saverin. Saverin was responsible for funding and business development and Zuckerberg was a content guy.
However, the things did not work well and Zuckerberg decided to cut off Saverin from Facebook.
How did he do it? No, he did not purchase the Saverin’s share…
Making long story short – the company owning Facebook issued new shares and distributed them to every other shareholder, except for Saverin.
This is the very best example of deemed disposal. It reduced Saverin’s share in Facebook from 30% to below 10%.
Of course, lots of lawsuits and nasty fights followed and maybe you have seen the movie “Social network” describing this situation.
If you’re interested in the full story, you can read it here.

How to account for deemed disposal?

If you experience the deemed disposal of some share in your associate, then there are 2 different scenarios:

1. You lose significant influence. In this case, you have to:
   
   • Discontinue equity method and recognize gain or loss on deemed disposal;
   • Recognize your remaining investment as a financial asset under IFRS 9
2. You keep significant influence, just the percentage of ownership is lower. In this case, you have to:
   
   • Recognize gain or loss on partial disposal;
   • Continue equity method.

Let’s illustrate what happens in both scenarios.

Example: Deemed disposal of an associate

Question:

Angelo plc. held 25% share in Investee ltd. On 1 January 20X1, Investee issued 40 000 new shares of 1 CU each to Giovanni, plc. at par. You have the following information:

• Investee’s share capital before its increase was CU 150 000 (each share of 1 CU)
• Investee’s net asset on 31 December 20X0 were CU 200 000.

How should Angelo account for the deemed disposal of share, if:

1. Significant influence is lost;
2. Significant influence is maintained?

Solution

Before I outline the solution for both scenarios, let’s calculate a few very useful things (needed for both cases):

• Carrying amount of Angelo’s investment before deemed disposal = 25%*Investee’s net assets of CU 200 000 = CU 50 000
• Number of shares held by Angelo: 25%*150 000 = 37 500 (1 CU each)
• Angelo’s share after deemed disposal = 37 500/(150 000+40 000) = 37 500/190 000 = 19,7%

Now, let’s calculate the new carrying amount of Angelo’s investment in Investee:

• Carrying amount before disposal (see above): CU 50 000
• Less cost of deemed disposal = – CU 50 000 x (25%-19,7%)/25% = – 10 600
• Plus share on the new contribution = 19,7%*CU 40 000 = 7 880

New carrying amount after disposal = 47 280
Here, the loss on deemed disposal of CU 2 720 arose (difference between carrying amounts before and after disposal, that is CU 50 000 less CU 47 280).

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Now, let’s move on.

Solution #1: Significant influence is lost

As I wrote about, you MUST discontinue the equity method if significant influence is lost.
Yes, maybe it’s unfair, especially if that happened without you even knowing, but that’s what you should do.
We have calculated all the necessary numbers above so let’s draft journal entries:

1. Loss on disposal:
   • Profit or loss – loss on disposal of an associate: CU 2 720
   • Investment in associates: CU 2 720
2. Discontinuing the equity method and recognizing a financial instrument:
   • Debit Other financial investments – CU 47 280
   • Credit Investments in associates – CU 47 280

Angelo needs to classify the investment in Investee in line with IFRS 9 and as equity stakes never meet conditions for amortized cost method, it’s clear that this asset would be at fair value either through profit or loss, or through other comprehensive income (more on that here).

Solution #2: Significant influence is kept

Please let me remind you here that although the share of Angelo on Investee’s net assets fell below 20%, it does NOT mean that significant influence was automatically lost.
In fact, you could hold 1% and still have significant influence or even control (but let’s not talk about special purpose entities here).
If Angelo maintained significant influence, then it continues using equity method.
The problem here is that IAS 28 does not say anything about gains or losses on partial disposals when equity method is kept. However, I’ve seen it a few times and the practice is that yes, gains or losses are recognized.
The journal entry is:

• Debit Profit or loss – loss on partial disposal of shares: CU 2 720
• Investment in associates: CU 2 720

And then, Angelo continues with equity method, but the new percentage of ownership must be applied.
In these short examples, I ignored other possible complications, such as foreign currency translations or items reclassified from other comprehensive income – just make sure you take them into account.
Have your eyes open and watch your back!

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Example: How to Adopt IFRS 16 Leases

• Posted in:Leases
• Posted by:Silvia M.

26

In my last article I tried to outline the strategy and your choices when implementing the new lease standard IFRS 16 Leases.
I am grateful for many responses and comments I got from you. Almost all e-mails I received from you asked me to publish solved numerical example to see how to implement IFRS 16 in practice.
Therefore, unlike in my other usual articles, this time I’ll solve one example with one specific lease contract for you.
You might well know that the IFRS 16 affects mostly lessees who are involved in operating leases, because under the new rules they need to bring the assets from off-balance sheet to the daily light.
In other words, they will no longer be permitted to book all rental expenses from operating leases in profit or loss, but they will need to recognize the lease liability and the right of use asset.
Therefore, in this article, I illustrate the application of the full retrospective approach and modified retrospective approach to IFRS 16 adoption.
Ready for the example? Here you go!

Example: Operating lease in the lessee’s accounts under IFRS 16

ABC, the manufacturing company, needs to adopt the new standard IFRS 16 Leases in the reporting period ending 31 December 2019.
During the preparatory works, ABC discovered that the operating lease contract related to a machine might require some adjustments.
ABC entered into the contract on 1 January 2017 for 5 years, annual rental payments are CU 100 000 in arrears (that is, 31 December each year) and at the end of the lease term, the machine will be returned back to the lessor. The economic life of a machine is 10 years.

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How can ABC restate the contract under IFRS 16 using both full retrospective and modified retrospective approach?
Use the discount rate of 3%.

Little note about the discount rate

If you are a lessee, then be careful about the selection of the appropriate discount rate, because its definition in IAS 17 no longer applies.
Here, the new definition in IFRS 16 says that you should derive the interest rate implicit in the lease from:

• The lease payments,
• The unguaranteed residual value,
• The fair value of the underlying asset and
• The initial direct costs of the lessor.

This is very hard and sometimes unrealistic, because most lessors won’t share the unguaranteed residual values and their initial direct costs.
Therefore, most lessees will need to use the incremental borrowing rate – that is, the rate at which they would be able to get the new borrowings for acquisition of the same asset with similar terms.
This is quite judgmental, but at least it’s more realistic than asking your lessor for additional information in most cases.
In this numerical example, let’s assume that given 3% is the ABC’s incremental borrowing rate.

Presenting the contract under IAS 17 and IFRS 16

Before you start drafting your journal entries to adopt IFRS 16 and cease reporting the contract under IAS 17, you need to see clearly how you reported that contract under both sets of rules.

Operating lease contract under IAS 17

Here, it’s very simple and straightforward: ABC accounted for all the lease payments from the operating lease directly in profit or loss.

Operating lease contract under IFRS 16

Under IFRS 16, ABC needs to recognize the right of use asset and the lease liability.
The lease liability is calculated as all the lease payments not paid at the commencement date discounted by the interest rate implicit in the lease or incremental borrowing rate.
I have done that for you in the following table:



Note: Discount factor in the first year is calculated as 1/((1+3%) to the power of year 1), etc.
Fine, we have the lease liability.
The right of use asset equals to the lease liability at the commencement date, plus lessee’s initial direct costs, plus some other things – but in this case, we have nothing like that, so let’s just say it’s the same as the lease liability.
Under IFRS 16, the initial journal entry would be:

• Debit ROU (right of use) asset: CU 457 971
• Credit Lease liability: CU 457 971

Subsequently, ABC needs to take care about 2 things:

1. Depreciation of the ROU asset: Let’s say it’s straight line over the lease term of 5 years, thus it’s CU 91 594 per year (CU 457 971/5).
2. Lease payments: Each lease payment of CU 100 000 is split between the repayment of the lease liability and interest.

I’ve done that in the following table:

Compare the accounting under IAS 17 and IFRS 16

To calculate the adjustment in equity related to this contract, let’s summarize the profit or loss impact of the lease in individual years under both IAS 17 and IFRS 16:



As you can see, total profit or loss impact of both IAS 17 and IFRS 16 application is the same CU 500 000, however, the timing is a bit different.
So, now we have set everything and let’s see how to make adjustment in equity and how to present the restatement under both full and modified retrospective approaches.
I described both approaches in this article, so I won’t repeat it here and let me focus on numbers.

Full retrospective approach

ABC adopts IFRS 16 in its financial statements for the year ending 31 December 2019, and that means that the transition date is 1 January 2018.
We need to restate all numbers for the comparative period, too.
Most of the work has been done above (see tables 1-3), so I’ll draft the journal entries here:

1. Restatement of opening balances of the earliest period presented (that is: BEFORE 1 January 2018):
   • a) Recognizing ROU asset and lease liability:
     • Debit ROU (right of use) asset: CU 457 971
     • Credit Lease liability: CU 457 971
   • b) Reversal of the lease payments before 1 January 2018 under IAS 17 (there was just one):
     • Debit Cash: CU 100 000
     • Credit Retained earnings (equity): CU 100 000
     I know, I know! No cash moved! Wait until we are done with this exercise. This is just to illustrate that in fact, you are reversing the “old entries” and then making the “new entries”.
     And why retained earnings and not profit or loss?
     Because you are making this entry on 1 January 2018 and at this date, all profit or loss accounts from 2017 were transferred to the retained earnings.
   • c) Accounting for the lease payments before 1 January 2018 under IFRS 16 (there was just one):
     • Debit Lease liability: CU 86 261
     • Debit Retained earnings (equity): CU 13 739 – this is for the interest
     • Credit Cash: CU 100 000
     Note: The numbers come from table 2 for the year 1 (2017).
   • d) Accounting for the depreciation of the ROU asset before 1 January 2018 under IFRS 16 (there was just one year):
     • Debit Retained earnings (equity): CU 91 594
     • Credit ROU asset: CU 91 594
   In fact, you can do all 4 entries in one adjustment and it would look something like:
   
   • Debit ROU asset: CU 366 377 (CU 457 971 less depreciation of CU 91 594)
   • Debit Retained earnings in equity: CU 5 333 (-100 000+13 739+91 594, or see table 3 for the year 1)
   • Credit Lease liability: CU 371 710 (CU 457 971 less the lease liability repayment of CU 86 261, or see table 2 for the year 1)
   In reality, you would adjust in in 1 single entry, but I wanted to show the rationale behind, its breakdown and logic.
2. Restatement of the comparative period (year 2018): Here, you are only restating the 2nd lease payment made. As I’ve illustrated the breakdown of all entries above, let me show you just one summarizing entry here:
   
   • Debit Lease liability: CU 88 849
   • Debit Interest (profit or loss of 2018): CU 11 151
   • Debit Depreciation (profit or loss of 2018): CU 91 594
   • Credit ROU asset: CU 91 594
   • Credit Operating lease expenses (profit or loss of 2018): 100 000
   The numbers come from table 2 for the year 2 (2018).
3. Restatement of the current period (year 2019): Normally, you would have already applied IFRS 16 in 2019, but if not and you are doing everything during the closing works, here’s the entry:
   
   • Debit Lease liability: CU 91 514
   • Debit Interest (profit or loss of 2019): CU 8 486
   • Debit Depreciation (profit or loss of 2019): CU 91 594
   • Credit ROU asset: CU 91 594
   • Credit Operating lease expenses (profit or loss of 2019): 100 000

OK, that’s for the entries and adjustments.

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If you apply the full retrospective approach, the problem is that you have to report the comparative period – year 2018 in this case – under both IAS 17 and IFRS 16:

• In the financial statements for the year ended 31 December 2018, you are still applying IAS 17, so your current numbers for 2018 are under IAS 17, but
• In the financial statements for the year ended 31 December 2019, you apply the new IFRS 16 and also your comparatives need to be stated under the same rules – thus you need to book the above entries n. 1 and n.2 carefully.

How would your financial statements look like?
Here you go:
The statement of financial position (extract) is here:



All the numbers related to the lease liability come from table 2 above.
The extract from profit or loss statement:



Now, let’s show the modified approach.

Modified retrospective approach

Under the modified approach, ABC needs to make an equity adjustment on 1 January 2019 – that is at the beginning of the current reporting period.
Comparative numbers remain the same as presented before – so no restatement.
This is a way easier method to apply than the full retrospective approach, because you do not restate the previous years’ numbers.
However, the price for this relief is lower comparability.
It is quite difficult to compare current year under IFRS 16 with the previous year under IAS 17 and it does not say much about how your leases developed.
Just see it for yourself in the below extracts from the financial statements.
But first, let’s draft the journal entries:

1. Restatement of opening balances at 1 January 2019:
   • a) Recognizing ROU asset and lease liability:
     • Debit ROU (right of use) asset: CU 457 971
     • Credit Lease liability: CU 457 971
   • b) Reversal of the lease payments before 1 January 2019 under IAS 17 (there were two):
     • Debit Cash: CU 200 000
     • Credit Retained earnings (equity): CU 200 000
   • c) Accounting for the lease payments before 1 January 2019 under IFRS 16 (there were two):
     • Debit Lease liability: CU 175 110
     • Debit Retained earnings (equity): CU 24 890 (= interest)
     • Credit Cash: CU 200 000
     Note: The numbers come from table 2 for the years 1 and 2 – you need to make a total for these 2 years (2017 and 2018).
   • d)Accounting for the depreciation of the ROU asset before 1 January 2019 under IFRS 16 (there were 2 years):
     • Debit Retained earnings (equity): CU 183 188 (= interest)
     • Credit ROU asset: CU 183 188
   Similarly as with the full approach, you can make just one aggregate entry instead of these four:
   
   • Debit ROU asset: CU 274 782 (CU 457 971 less depreciation of CU 91 594*2)
   • Debit Retained earnings in equity: CU 8 079 (-200 000+24 890+183 188, or see table 3 for the years 1 and 2)
   • Credit Lease liability: CU 282 861 (CU 457 971 less the lease liability repayments of CU 86 261 and CU 88 849, or see table 2 for the years 1 and 2)
   Note: Here, I measured the ROU asset as if IFRS 16 has always been applied – in this case, it was easier for me as I have already calculated all the numbers above.
   However, you can measure your ROU asset in the amount of the lease liability. This would be even easier, because you would not have to recalculate ROU asset in the past. You would simply calculate the lease liability (=present value of the remaining lease payments) and that’s it.
   
2. Restatement of the current period (year 2019): It’s the same as under the full retrospective approach and if you have accounted for your operating leases under IAS 17 during the whole 2019, then you need to do this adjustment:
   
   • Debit Lease liability: CU 91 514
   • Debit Interest (profit or loss of 2019): CU 8 486
   • Debit Depreciation (profit or loss of 2019): CU 91 594
   • Credit ROU asset: CU 91 594
   • Credit Operating lease expenses (profit or loss of 2019): 100 000

What about the ABC’s financial statements?
Here you go:
The extract from the statement of financial position:



Please note that there are zeros for the comparative year 2018 – the reason is obvious. We are presenting the previous year under IAS 17 and there was no lease liability and right of use asset under IAS 17.
The extract from profit or loss:



This was just a basic example with a very simple and straightforward contract. If you’d like to learn more about IFRS 16, its application, adoption and see many practical examples solved in Excel, then I recommend checking out my IFRS Kit – IFRS 16 is extensively covered!
Any questions or comments?
Let me know below – thanks!

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How to Implement IFRS 16 Leases

• Posted in:Leases
• Posted by:Silvia M.

24

The new lease standard IFRS 16 is exactly one of these earthshaking things that can make your head spin around.
Well, especially if your company uses the operating lease as an effective tool of getting your assets quickly with relatively low risk.
I wrote a few articles in the past for you:

• Summary of IFRS 16 Leases – contains the nice video
• Troubles with IFRS 16 Leases – I discussed the main difficulties when applying this standard
• IFRS 16 vs. IAS 17: How the lease accounting changed – you can find an easy numerical illustration of the whole trouble there.

Plus, I added the full course about the IFRS 16 Leases and its application into the IFRS Kit, so if you are dealing with that right now, I highly recommend checking out!
However, I keep getting the questions about how to implement IFRS 16.
What to do first and what to do next.
And, additional questions like: “Do I really need to go study my old 4 000 contracts and reassess them under the new rules? Oh holy s..t!!!”
As usual, I’d love to help a bit and give a helping hand.
In this article, you will learn:

• 3D strategy to implement IFRS 16
• What accounting policies do you have and what accounting policies are the best for you to select
• Do you really need to reassess everything???

3D strategy to implement IFRS 16

No worries, I’m not going to show you any special visual 3D effects here – I leave that to Mr. Spielberg or other Hollywood masters.
Each D stands for some step to take in order to adopt IFRS 16 and stay healthy, sane and cool at the same time.
Maybe you have already started with this process, but if not, let me quickly sum up:

D1: Diagnose

In the first stage, you should focus on assessing your own business and impact of IFRS 16 on it.
What should you be diagnosing?
Here’s the short list:

• Is your company heavily exposed to the changes in lease accounting or not? How big is the impact?
• Do you have the sufficient database of your leases containing all the information necessary for the new disclosures?
• Will the change require any technology or system updates?
• Will the change trigger the change in the business development or purchasing? Contracting?

D2: Decide

After you analyze and diagnose, you should focus on the important decisions.
I would say that two of them are especially important:

1. When are you going to implement IFRS 16? You have to apply IFRS 16 mandatorily for all periods starting on or after 1 January 2019.
   However, there’s another big change – the new revenue standard IFRS 15 Revenue from Contracts with Customers that needs to be adopted earlier, from 1 January 2018.
   For me, it’s always better to do all the changes at once, in order to make just one system or technology upgrade, just one restatement in the financial statements and just one big work.
   Therefore, would you rather implement IFRS 16 one year earlier, from 1 January 2018?
2. Which accounting policies are you going to select? There are more transitional options in IFRS 16. You can select more accounting policies to adopt IFRS 16.
   Which one is the best for your business? I write more below, just keep on reading.

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D3: Do

At this stage, you need to work hard, spend a lot of money and simply go ahead.
If you did your homework in the first 2 stages well, then you have an easier job.
So, upgrade your software, amend your contracts and train your people to work under the new system.
Don’t forget to involve people from across your company, not only accountants, because omitting the purchasers, lawyers or other relevant areas could result in inefficiencies and you paying a price.
OK, that was a very rough outline of what you should do and if you haven’t started yet by now, I would say it’s time.

Do we have to reassess all existing lease contracts?

The standard IFRS 16 introduced the new lease definition and as a result, some contracts might contain the lease under IFRS 16, but not under IAS 17 or IFRIC 4.
What does it practically mean?
Well, if you want to apply the new lease standard to all contracts, then you should go through all of them and seek whether they contain the lease as defined under IFRS 16.
A lot of work!
Luckily, IFRS 16 brings so-called practical expedient. It is a relief that permits:

• To apply IFRS 16 to the same contracts as to which IAS 17 and IFRIC 4 were applied, and
• Not to apply IFRS 16 to the contracts to which IAS 17 or IFRIC 4 were not applied.

Simply speaking, you don’t have to reassess the contracts and seek whether they contain the lease.
You can just take all lease contracts that you currently treat as the lease contracts under IAS 17 Leases and apply the new rules to them.
But, of course, you have to assess the new contracts entered into after the date of initial application. The exception applies only to the older contracts.
In my opinion, most companies will apply this expedient and simply account for the change on “old lease contracts” without seeking the lease in other contracts.
However, I can imagine the situation in which you had an operating lease contract, but not a lease under IFRS 16.
In this case, I would probably forget about expedient and reassess the lease, because I would definitely prefer keep that contract off balance sheet rather than accounting for the right-of-use asset.
Also, you should keep in mind that you can’t apply the expedient only to some selected contracts. Either you apply it fully to all contracts, or not at all.

Do we have to bring all the operating leases to the balance sheet?

No.
If you the lease term is maximum 12 months, or the leased asset has the low value (like furniture or computer), then you can account for an operating lease payments straight in profit or loss.

How to account for IFRS 16 adoption?

In other words – how to make transition in your financial statements?
The standard IFRS 16 offers 2 methods of a transition:

1. The full retrospective approach Under the full approach, you need to apply IFRS 16 retrospectively in line with IAS 8.
   It means that you need to restate all prior financial information and recognize an adjustment in equity as of the beginning of the earliest period presented.
   Therefore, if you adopt IFRS 16 for the period beginning on 1 January 2019, you need to book the adjustment in equity on 1 January 2018.
   Also, all your comparative information for the year 2018 will be presented under IFRS 16.
   This method is more demanding, because in fact, you need to present the data for the year 2018 under both new and old rules:
   
   • In the financial statements for the year ended 31 December 2018, you present your leases under IAS 17;
   • In the financial statements for the year ended 31 December 2019, you present your leases under IFRS 16, including the comparative information – year 2018.
   Lots of work!
   
   Special For You! Have you already checked out the IFRS Kit? It’s a full IFRS learning package with more than 30 hours of private video tutorials, more than 100 IFRS case studies solved in Excel, more than 120 pages of handouts and many bonuses included. If you take action today and subscribe to the IFRS Kit, you’ll get it at discount! Click here to check it out!
   
   I guess that exactly because of the terrible amount of work connected with this approach, many companies will select the second one – modified retrospective approach.
   However, the full retrospective approach has its big advantage – although there’s a lot of work, you are presenting the fully comparative data, because both the years 2019 and 2018 are prepared under the same rules (in the financial statements for the year 2019).
2. The modified retrospective approach Here, you need to apply IFRS 16 from the beginning of the current reporting period.
   It means that you do NOT need to restate the financial information for the prior comparative year.
   You simply leave the prior year under older rules of IAS 17.
   The adjustment to bring your leases under the new rules of IFRS 16 is recognized in equity as of the beginning of the current reporting period (not the earliest presented as under the full approach).
   Also, you don’t need to present some disclosures as under the full approach.
   Overall, this is a very cost effective, although not very comparable methodology and I bet it will be the most popular among all companies restating their leases.

The comparison of both approaches is here:


 

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How to Account for Debt Factoring or Selling of Receivables

• Posted in:Financial Instruments
• Posted by:Silvia M.

2

When I was auditing the financial statements of one of our clients, I spotted a few strange things:

• There was a huge balance of cash on client’s bank account at the year-end.
  
  And I mean HUGE. To illustrate: normally, the client had about CU 100 000 on the bank account with some variations, but at the year-end, the balance was ten times greater, about CU 1 mil. (CU means currency unit).
• Client’s receivables showed an extremely low balance. In comparison with the previous year, the balance dropped by 90%.

I was a freshman in that audit year and the first thing I did before I started to bother our senior auditor was to look at the client’s bank statements from January next year – that is AFTER the reporting date.
Guess what I discovered!
I was staring at that January bank statement with shock.

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The balance of cash was back to about CU 100 000.
WOW!
Where did this CU 900 000 go?
Just to be on the safe side, I checked also the subledger of receivables.
Not such a big surprise there – the receivables were also back to their normal levels.
Hmmm, something smells here…
Instead of bothering the senior auditor, I went to bother client’s CFO.
The nice talkative lady explained that just before the year-end, they sold a significant amount of receivables… (a Hollywood smile).
My question: Did you buy them back in January?
The smile faded slightly: “Oooh, yes….”
Me, still puzzled: “Why did you do it?”
The remaining smile is replaced with an annoyed look: “Well, there’s nothing wrong with that… we needed to meet the bank’s covenants for our loan and show enough cash on our bank account…”
OK, I understood.
This is called “window dressing” – doing something just before the year-end only to make your numbers looking better than they are.
However in this particular case, the client did it wrong.
In other words, it did not help at all.
Why?
You’re just about to find out!

Why sell receivables?

Many companies regularly sell their receivables to someone else.
There are few reasons for that:

• They need cash and don’t want to (or cannot) wait until their own clients pay invoices.
• They don’t want to deal with the credit risk of their clients.
• They don’t want to employ people who try to call clients, remind them about due dates and missing payments – in other words, they don’t want to bother with collecting of receivables.
• They are trying to “window-dress” their financial statements, just as my client did – but in reality, it does not happen very often.

What is a debt factoring?

In a modern business world, factoring of receivables, or selling receivables with discount is a normal practice of cash management.
Here’s how it works:


 

1. You (food producer in the scheme) sell your products to the customers and issue invoices.
2. As the invoices are due in 90 days (if you deal with big retail chains, then the credit terms are even longer), you cannot afford to wait for the cash and sell the receivables to a factor (factoring company). The receivables are sold with discount that represents both:
   
   • Your fee for having cash immediately (interest on the loan provided by the factor),
   • The revenue of the factoring company.
3. Your customers (retailers in the scheme) pay the invoices when they are due directly to the factoring company.

Now, the principal question is:

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Should you remove the receivables from the financial statements?
Well, it depends.
In fact, you need to decide whether the conditions for derecognition of financial asset were met or not.
If you remember, IFRS 9 Financial Instruments is very sticky in derecognition and it’s much easier to recognize an asset than to derecognize it.
For this reason, IFRS 9 contains a big decision tree helping you to determine whether you should derecognize your asset or not.
When you sell receivables, you need to assess whether you transfer significant risks and rewards of ownership or not in the first instance.
Then, if you don’t, you need to assess whether you retain some control or you have some continuing involvement in the receivables.
There are many types of factoring arrangements with various conditions. The three main types are:

1. Factoring without recourse – in this case, the factor buys all the receivables from you with no right of return to you (if your customers do not pay, then it’s factor’s care).
2. Factoring with recourse – in this case, the factor has the right to return uncollectible receivables to you.
3. Factoring with limited recourse (guarantee) – in this case, you guarantee the losses up to certain amount and the factor can return the receivables only up to the guarantee.

Let me show you how to account for the first two types.

Example: Factoring without recourse

Question:
Tradex is a trading company. Due to urgent cash shortage, it decides to transfer trade receivables to the factoring company for 90% of their nominal amount. Total transferred receivables amount to CU 300 000. The factor has no right of returning the receivables back to Tradex.
Solution
Tradex transfers all the risks and rewards resulting from the receivables to the factoring company.
As a result, Tradex derecognizes the receivables fully, because the derecognition criteria in IFRS 9 are met.
Journal entries are:

• Debit Bank account (CU 300 000*90%): CU 270 000
• Profit or loss – finance expenses (see note below): CU 30 000
• Credit Receivables: CU 300 000

Note: Most of these finance expenses represent the interest, because factoring is a form of a loan from the factor. Therefore, if material, you should accrue the interest expenses and recognize them over the period of financing (not one-time as shown here).
In this case, when the clients do not pay to the factor and go bankrupt, it’s the factor’s care and not Tradex’s care. That’s the biggest advantage of non-recourse factoring.
On the other hand, the discount (the fees) are higher than when factoring is with recourse.

Example: factoring with recourse

Question:
The same situation as above. This time, Tadex transfers the receivables for 96% of their nominal amount. Total transferred receivables amount to CU 300 000. The factor has the full right of returning the receivables back to Tradex if they become uncollectible.

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Solution
Tradex retains some risks resulting from the receivables to the factoring company. The clients’ credit risk was not transferred because the factor has the right of return.
As a result, Tradex keeps the receivables in the balance sheet, because the derecognition criteria in IFRS 9 are not met.
The amount received from factoring company is recognized as a liability.
Journal entries are:

• Debit Bank account (CU 300 000*96%): CU 288 000
• Debit Profit or loss – finance expenses (see note below): CU 12 000
• Credit Refund liability: CU 300 000

Note: Most of these finance expenses represent the interest, because factoring is a form of a loan from the factor. Therefore, if material, you should accrue the interest expenses and recognize them over the period of financing (not one-time as shown here).
The subsequent journal entries are:

1. When the customer goes bankrupt and the factor applies the recourse right:
   • Debit Refund liability: CU 10 000 (the amount of uncollectible receivable)
   • Credit Bank account: CU 10 000
2. When the customers pay to the factor (based on some payment report from factor):
   • Debit Refund liability: CU 50 000 (the amount actually collected by the factor)
   • Credit Receivables: CU 50 000

Factoring with guarantee

The most common type of factoring transaction is something in between these two “black or white” cases described above.
Factors often require a guarantee up to certain amount.
As a result, the factor does not have the right to the full return up to nominal amount of receivables, but only up to a guarantee.
Here, there is a continuing involvement in the receivables, so you cannot derecognize them fully.
In the IFRS Kit, there’s an example of this type of factoring solved in Excel file and clearly explained in the video, so please, check it out if interested!

Finally…

Let’s come back to my client from the beginning of this article.
I handed the case to our senior auditor (so finally yes, I bothered him), but this appeared to be the major audit finding.
The senior auditor revised the contract for sale of receivables and it clearly stated that our client has an obligation to buy these receivables back in January next year.
As a result, not all the risks and rewards were transferred and the client needed to put the receivables back to its balance sheet and recognize a refund liability.
Of course, the client did not agree and we issued an audit report with qualification. But that’s another story.

Desde IFRS Box

How to Make Consolidated Statement of Cash Flows with Foreign Currencies

• Posted in:Consolidation and Groups, Financial Statements, Foreign currency, IFRS videos
• Posted by:Silvia M.

1

Did you know that many groups prepare their consolidated cash flow statement completely incorrectly?
And, if you are well-experienced accountant, you can actually spot the faulty numbers instantly when you look to the statement of cash flows.
Sadly, this wrong method is often taught in many accounting courses.
What method is it?
Similarly as with the individual statement of cash flows, you take the consolidated statements of financial position, consolidated statement of total comprehensive income, then you calculate “deltas” or the differences between the closing and opening balances of your assets, liabilities and equity items…
… there you go, I described this method here with details in the video.
It’s very simple method and you’ll get nice consolidated statement of cash flows.
But it’s incorrect.
Don’t get me wrong now – this method is perfectly OK for consolidated cash flows when the parent and the subsidiary use the same functional currency.
Therefore, if you both use EUR (or any other currency) – use it.
Or, if you attend an exam and the question gives you two sets of financial statements, both in the same currency – use it. You’ll be fine.
However, as soon as foreign currencies are involved, then I do NOT recommend using this method.
Why?
Because, it does not comply with IAS 7 Statement of Cash Flows.
The reason is that under IAS 7, you should apply the rates applicable at the dates of transaction, or at least the average rates prevalent during the reporting period.
You need to realize that the consolidated balance sheet was prepared using the closing rates, because you had to translate all assets and liabilities in different functional currency using closing rates.
Therefore, if you make consolidated statement of cash flows based on the consolidated balance sheet, you are automatically using the wrong translation foreign exchange rates.
As a result, the individual line items in your consolidated cash flow statement would contain lots of effects of changes in foreign exchange rates – and maybe you know that this effect should be reported separately at the end.
How can you spot this wrong methodology in any financial statements?

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If you compare the effect of changes in foreign exchange rates in the cash flow statement with currency translation difference in the balance sheet, you’ll see it’s the same number.
It should NOT be!
So, what’s the right method?
Let’s explain in a few simple steps and illustrate on an example.

Example: Consolidated Statement of Cash Flows with Foreign Currencies

Hello, the UK company has owned 100% in GutenTag, a German subsidiary since January 2015. The following transactions occurred in 2016:

• On 31 October 2016, GutenTag paid dividend on EUR 1 000 to Hello.
• On 30 November 2016, Hello purchased goods from GutenTag for EUR 5 000 (GutenTag’s cost: EUR 4 500). The goods remained unsold at the year-end and the payable was unpaid.

The applicable exchange rates GBP/EUR:

• 31 December 2015: 0,7340
• 31 October 2016: 0,9005
• 30 November 2016: 0,8525
• 31 December 2016: 0,8562
• Average in 2016: 0,8188

The financial statements of Hello and GutenTag as at 31 December 2016:


 


 
Prepare consolidated statement of cash flows for the year ended 31 December 2016.

Step 1 – Prepare individual statements of cash flows of both parent and subsidiary

Clear enough.
I am not going to do this step in details here, because I published a complex article on how to prepare statement of cash flows here.
Also, if you need more detailed explanations with analysis of various types of transactions, then I recommend checking out my IFRS Kit where cash flows are extensively covered.


 

Step 2 – Translate subsidiary’s individual statement of cash flows to the presentation currency

In this step, you need to recalculate all the line items in subsidiary’s cash flows to show them in presentation currency.
What rates should you use?
Standard IAS 7 par. 26 and 27 clearly says that you should translate cash flows using the foreign exchange rate at the date of cash flow (transaction date) and you can use the average rate for the period for approximation.
Therefore, we can use the average rate in 2016 and for the specific cash flow – dividends paid – we use the actual rate valid at the date of cash flow.


 
Please note that we did not use any specific rate for translating the profit before tax. So where does the amount of GBP 14 907 come from?
This amount comes from the statement of profit or loss of GutenTag translated to presentation currency.
The reason why you should use it is that the individual items in profit or loss can be translated using different rates (average vs. transaction date) and the total profit figure is calculated.
I attached the excel file with all these calculations into the IFRS Kit, so if you are subscribed, you can check it there.
Also, please note that the opening balance of cash was translated using closing rate in 2015, and the closing balance of cash was translated using closing rate in 2016.
This is perfectly right, because these numbers must correspond with the consolidated balance sheet.
However, if you sum up all the movements, then the net decrease of cash plus opening cash balance in GBP do not give you the closing balance of cash in GBP.
Yes, because you applied different translation rates.
Therefore, you simply add the extra line – “effect of exchange rate changes on cash” and this would be your balancing figure.
Actually, it’s possible to verify this number by recalculations.

Step 3 – Aggregate parent’s cash flows and subsidiary’s cash flows

Simple as that.
Put both statement of cash flows in the same presentation currency next to each other and sum up. Done.


 

Step 4 – Eliminate intragroup transactions

This step requires some work to do and that’s probably the reason why many groups try to avoid this method and prepare cash flow statements from the consolidated balance sheets.
When you are eliminating, please be extremely careful about the exchange rates you use.

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In general, you should use the same exchange rates as were used at preparing the individual line items.
I’ll explain.
In our example, we need to eliminate 3 items:

1. Dividends paid by GutenTag and received by Hello Sure, this is an intragroup transaction and if you report 2 companies as 1, nothing happened.
   You should eliminate the dividends exactly from the affected captions:
   
   1. Profit before tax: Parent’s profit was increased by the dividends, so we must bring it down (deduct dividend)
   2. Adjustment for finance income and expenses net: The net expenses were added, but they were lowered by the dividends paid, so we must increase them again (add dividend)
   3. Dividend received: No dividend was received by the group, so deduct.
   4. Divided paid: No dividend was paid to the group, so add back.
   The sum of these adjustments shall be zero. Look to the first adjustment in the picture below and see.
   By the way, we used the same rate for all 4 entries, because we assume that the parent recognized the dividend income using the transaction date rate; and the dividend paid in subsidiary’s statement of cash flows was recalculated using the same rate.
2. Intragroup receivable and payable of EUR 5 000 Similarly as with balance sheet, we do the same thing here.
   We eliminate as follows:
   
   1. Subsidiary GutenTag had receivable of EUR 5 000 to the parent. This affected the increase in trade receivables’ line. Without this intragroup receivable, the decrease would have been lower by 5 000 EUR, so we add this amount back.
      
      What rate? Subsidiary’s cash flow statements were translated using average rate, so we translate the elimination in the decrease with average rate, too.
      As a result, you add GBP 4 094 back to the line “increase in trade receivables” (5 000*0,8188).
   2. Parent Hello had an intragroup payable of EUR 5 000. This affected the decrease in trade payables’ line. Without this intragroup payable, the decrease would have been higher by 5 000 EUR, so we deduct this amount.
      
      What rate? Parent’s cash flow statement was prepared from its balance sheet and the intragroup payable was translated by the closing rate there.
      As a result, you deduct GBP 4 281 from the line “decrease in trade payables” (5 000*0,8562).
   3. The difference between GBP 4 094 and GBP 4 281 resulted from the application of different exchange rates and therefore, you need to report GBP 187 in the line “Effect of changes in foreign exchange”.
3. Unrealized profit on inventories The parent bought inventories from the subsidiary and the subsidiary made profit of EUR 500. The inventories remained unsold by the group at the year-end, therefore in fact, no profit was realized from the group’s view and we need to eliminate it in the statement of cash flows.
   We eliminate as follows:
   
   1. Subsidiary GutenTag made profit of EUR 500 and reported it in the line “Profit before tax”. We need to deduct EUR 500 from that line.
      
      What rate? In subsidiary’s profit, intragroup sale was translated using the actual transaction date rate, so use the same rate when eliminated unrealized profit.
      Therefore, we deduct GBP 426 (EUR 500*0,8525) from the line “Profit before taxation”.
   2. Parent’s inventories are overstated by the unrealized profit of EUR 500 and it affected the line “increase in inventories”. Without this profit, the increase would have been lower and therefore, we need to add it back.
      
      What rate? UK parent recognized the inventories at the transaction date rate (historical rate). The inventories are non-monetary item and therefore, they remained the same, without recalculating by closing rate, at the year-end.
      Therefore, we add GBP 426 (EUR 500*0,8525) back to the line “Increase in inventories”.

That’s it.
The last step is to sum up aggregated numbers with all adjustments and here you go, you get a nice consolidated statement of cash flows in the last column.

Final word and a video

This was the illustration of the consolidated statement of cash flows using indirect method. If you use the direct method, the principles are basically the same.

Desde IFRS Box

How to Make Hedging Documentation

If your company enters into some derivatives or other contracts to protect against any (potentially adverse) changes in cash flows or fair values, then it’s probably beneficial to apply hedge accounting.
I wrote a few articles about hedge accounting, therefore if you need to refresh your memory, here they are:

• Hedge accounting: IAS 39 vs. IFRS 9
• Difference Between Fair Value Hedge and Cash Flow Hedge
• Hedge Accounting Under IFRS 9: Rebalancing – What Is This New Concept?

I need to stress that hedge accounting is OPTIONAL.
No, you do NOT have to apply it.
Instead, you can book all profits or losses resulting from your derivatives straight in profit or loss statement.
However, this approach is not very beneficial for two reasons:

1. You are NOT showing the true character and substance of your derivatives (or other instruments) and it can look you are speculating on the market;
2. Profits and losses that you report in your financial statements can look like an electrocardiogram of a heart attack – lots of bumps, ups and downs, with great volatility.

I’m convinced that YES, once you take some derivatives or something else to protect your assets/liabilities/cash flows, you DO WANT to apply hedge accounting.
BUT!
It’s not a free ride.
You need to meet three conditions before you can apply the hedge accounting.

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If you don’t meet them, then sorry, no hedge accounting.
These conditions are described in IFRS 9 Financial Instruments par. 6.4.1 and one of them is to have a hedging documentation ready.
In today’s article, I tried to explain how you should prepare your hedging documentation in order to be acceptable.
I never planned to write it, because frankly speaking – hedge accounting is not my favorite topic, but I got so many requests from you, guys, that persuaded me to go into these deep waters again. I really hope you enjoy!

What is hedging documentation?

It’s a document that describes your hedging.
While the term “hedging documentation” is not defined in IFRS, IFRS 9 specifies (par. 6.4.1) what you need to write in your documentation:

• What your risk management objective is and why you undertake the hedge
• What your hedging instrument is(e.g. derivative)
• What your hedged item is (Receivables? Forecast sales?)
• What risk you’re protecting against (Foreign exchange risk? Interest rate risk? Commodity price risk? Etc.).
• You should state the type of the hedge here (Fair value? Cash flow?)
• How you assess the hedge effectiveness

One of the biggest mistakes that accountants do is that they try to apply hedge accounting, yet they don’t have the sufficient hedging documentation and as a result, they do not meet the hedge accounting criteria.
I’ve seen so many sad examples while working with my clients that I included this mistake in my report “Top 7 IFRS Mistakes That You Should Avoid” (by the way, you’ll receive it on your e-mail if you subscribe to my free newsletter here).

What your auditor would NOT accept as a hedging documentation

Here are few examples of totally unacceptable hedging documentation:

1. Few sentences in the accounting manual The common practice is that bigger groups or holdings elaborate their own group accounting manual with all accounting policies so that all subsidiaries can apply the same accounting rules.
   Within this accounting manual, there’s a few sentences stating something like:
   “ABC Group enters into interest rate swaps in order to hedge the interest rate risk. By swapping the floating rate for fixed rate, the interest payments are fixed and cash flow risk is eliminated.”
   Pardon me, but this is NOT the hedging documentation.
   It’s merely a description of the hedging strategy, and I doubt it’s sufficient even for this purpose.
   Your auditor should definitely NOT accept it.
2. A hedging documentation with insufficient details One of my clients elaborated a 5-page document titled “Hedging documentation”.
   I was so happy to hold it in my hands… well, until I started reading it.
   The company’s accountants loosely described their transactions. They wrote something like:
   
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   “ABC Ltd. partially finances its research activities with the bank loans and pays floating interest rate. In order to minimize the volatility of cash flows risk, ABC enters into interest rate swaps and uses them as the hedging instruments.”
   Then, on the remaining 4.5 pages, individual paragraphs from IFRS 9 were copied.
   This is also unacceptable, because it does NOT describe ABC’s hedging relationship at all.
3. Hedging documentation worked out subsequently Some companies were even not aware of the fact that they needed a hedging documentation, so they had none.
   But, they still wanted to apply hedge accounting and therefore, they quickly prepared some document with description of what’s happening.
   OK, I will be silent about the question whether the auditor can or cannot accept the hedging documentation prepared well after the hedged item and hedging instruments have already been in place for some while.
   Just let me remind you that you need to think UPFRONT.
   You should work out your hedging documentation AT THE INCEPTION of the hedging relationship and not when it has already started.
4. Too general hedging documentation I have also experienced the companies who prepared their hedging documentation for all hedges they have, without precise identification of individual hedged items and hedging instruments.
   Hedging documentation contained other necessities, such as the type of the hedge, the nature of the risk hedged, methods for effectiveness testing, etc.
   However, their hedging documentation was still NOT sufficient, because it is necessary to identify precisely WHAT specifically the hedged item is and WHAT specifically the hedging instrument is.
   Writing: “The hedged item are all loans with floating interest rate and the hedged instruments are interest rate swaps pay fixed receive floating” is not enough.
   You should precisely give details of each loan and each swap that you use.

How to make your hedging documentation

If you read this far, please don’t be scared.
The hedging documentation does NOT need to be very complex or lengthy document.
If it contains all necessary information as I listed above, just 1 or 2 pages will be sufficient.
IFRS 9 does NOT prescribe the format, so it’s up to you to decide.
Just don’t forget to include everything it needs and don’t forget to make it AT THE INCEPTION of your hedging relationship.

Example – hedging documentation

EUtec, a producer of technical equipment operating in Germany with the functional currency of EUR, enters into a contract to produce and sell technical equipment for USlab, an American R&D company.
The contract was signed on 1 February 20X1 with the total contract price of USD 25 million. The equipment will be delivered on 31 July 20X1 and the payment terms are as follows:

• USD 5 million: upon contract signature
• USD 20 million: within 30 days after delivery

EUtec is worried about the adverse movement in foreign exchange rates and their negative effect on EUtec’s cash flows (that is, EUtec is afraid that the USD will weaken against EUR and EUtec will receive less EUR for 20 mil. USD than it would have received at the inception).
Therefore, in order to hedge foreign exchange exposure, EUtec enters into a foreign currency forward contract with BigBank under the following terms:

• Start date: 1 February 20X1
• End date: 30 August 20X1 (30 days after delivery)
• EUtec pays 20 million USD and receives 18 million EUR

Note: here, I am not going to show you how to calculate the fair value changes of the forward contract, or journal entries, or measuring the hedge effectiveness. I solve these questions in the IFRS Kit. Here, we are solving only the hedge documentation.
Before EUtec can apply the hedge accounting, it must prepare the hedge documentation on 1 February 20X1, that is on the inception of the hedging relationship.
It can look as follows:

EUtec: Hedging documentation #01/20X1

Risk management objective:

To protect the cash flows resulting from the future sale of equipment produced for USlab denominated in USD and the subsequent conversion of USD to the functional currency of EUR.

Strategy for undertaking the hedge:

EUtec is exposed to foreign exchange risk when selling to clients overseas in currencies different from EUR. Therefore, its strategy is to minimize the risk of adverse impact of foreign exchange rate movements on EUtec’s cash flows by entering into offsetting foreign currency forward contracts.

Type of the hedge:

Cash flow hedge

Nature of the risk being hedged:

Foreign currency risk

Hedged item:

Cash flows in USD resulting from the future sale of technical equipment to USlab, American R&D company, based on the contract signed on 1 February 20X1.
Exposed cash flows amount to USD 20 million and EUtec expects to receive them on 30 August 20X1.

Hedging instrument:

Foreign currency forward contract #346/20X1. The counterparty is BigBank.
The forward contract starts on 1 February 20X1, matures on 30 August 20X1, EUtec pays 20 million USD and BigBank pays 18 million EUR.

Method of assessing the hedge effectiveness:

EUtec uses both qualitative and quantitative methods for assessing the hedge effectiveness. Hedge is assessed at the inception:

1. An economic relationship between the hedged item (cash flows of 20 million EUR) and hedging instrument (foreign currency forward contract) was tested by:
   • The qualitative analysis: comparing the critical terms of both items and concluding that they are offsetting.
   • The quantitative analysis: simple scenario analysis method was used.
     EUtec simulated a few scenarios. EUtec examined how the fair value of the hedging instrument moved when the fair value of the hedged item was shifted in various directions.
     The conclusion is that the changes in fair values of the hedged item and the hedging instrument are moving in the opposing directions and the change in fair value of hedging instrument highly offsets the change in fair value of the hedged item (note – it would be perfect if you could prepare this analysis and document it).
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2. Credit ratings of both EUtec and BigBank are solid, therefore credit risk does not affect any value changes in the hedging relationship.
3. The hedge ratio is 1:1, which is exactly 20 million USD (quantity of hedged item) to 20 million USD (quantity of notional amount in foreign currency forward).

EUtec assessed that based on these 3 criteria, the hedge is highly effective and hedge accounting can be applied.
DONE!