The introduction of a new accounting standard can have significant impact on an entity by changing the way in which financial statements show particular transactions or events. In many ways, the impact of a new accounting standard requires the same detailed considerations as is required when an entity first moves from local Generally Accepted Accounting Practice to International Financial Reporting Standards (IFRS).
A new or significantly changed accounting standard often provides the key focus for examination of the financial statements of listed companies by national enforcers who issue common enforcement priorities. These priorities are often highlighted because of significant changes to accounting practices as a result of new or changed standards or because of the challenges faced by entities as a result of the current economic environment. Recent priorities have included recognition and measurement of deferred tax assets and impairment of financial and non-financial assets.
Required:
(i) Discuss the key practical considerations, and financial statement implications which an entity should consider when implementing a move to a new IFRS. (7 marks)
(ii) Discuss briefly the reasons why regulators might focus on the impairment of non-financial assets and deferred tax assets in a period of slow economic growth, setting out the key areas which entities should focus on when accounting for these elements. (8 marks)
(i) The entity itself should prepare an impact assessment and project plan relating to the introduction of the new IFRS. There may be significant changes to processes, systems and controls and management should communicate the impact to investors and other stakeholders. This would include plans for disclosing the effects of new accounting standards which are issued but not yet effective. The entity should chose a path to implementation and establish responsibilities and deadlines. This may help to determine the accountability of the implementation team and allow management to identify gaps in resources.
Further, IFRS-based financial statements are used in contracts or regulation. Banking agreements often specify maximum debt levels or financial ratios which refer to figures prepared in accordance with IFRS. New financial reporting requirements can affect those ratios, with potential breach of those contracts. Many jurisdictions have regulation which restricts the amount which can be paid out in dividends, by reference to accounting profit. Further, some governments use IFRS numbers for statistical and economic planning purposes and the data as evidence to place constraints on profitability in regulated industries.
It is important that the entity communicates the effects of a move to a new IFRS to the markets and analysts. On application of the new IFRS, investors will be provided with different information upon which to base their decisions. Investors’ assessment of how management has discharged its stewardship responsibilities may be changed and this could affect the investors’ investment decision. Further, new financial reporting requirements may disclose information which is of competitive advantage to third parties and this is a cost to the entity.
A change in an accounting standard could cause some entities to no longer invest in certain assets or it may change how they contract for some activities. For example, if operating leases were to be shown on the statement of financial position, this could have adverse economic impacts on certain sectors. Additionally, the new standard could affect the calculation of performance-related pay.
Where there is the introduction of a new accounting standard, the financial statements will need to reflect the new recognition, measurement and disclosure requirements which, in turn, will mean that entities will need to consider the requirements of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. IAS 8 contains a requirement that changes in accounting policies are fully applied retrospectively unless there are specific transitional provisions. Further, IAS 8 requires the disclosure of a number of matters as regards the new IFRS. Additionally, IAS 1 Presentation of Financial Statements requires a third statement of financial position to be presented if the entity retrospectively applies an accounting policy, restates items, or reclassifies items, and those adjustments had a material effect on the information in the statement of financial position at the beginning of the comparative period.
IAS 33 Earnings Per Share requires basic and diluted EPS to be adjusted for the impacts of adjustments resulting from changes in accounting policies accounted for retrospectively and IAS 8 requires the disclosure of the amount of any such adjustments. Taxation is often calculated on the profit measured for financial reporting purposes. For jurisdictions using IFRS as the basis for income tax, a change in a standard can change the tax base. The economic consequences of the link of accounting with tax liabilities can be significant.
(ii) Impairment of non-financial assets and deferred tax assets
A continuous period of slow economic growth could indicate to regulators that non-financial assets will continue to generate lower than expected cash flows, especially in those industries experiencing a downturn in fortunes. Particular attention should be paid to the valuation of goodwill and intangible assets with indefinite life spans. The entity should focus on certain specific areas including cash flow projections, disclosure of key assumptions and judgements, and appropriate disclosure of sensitivity analysis for material goodwill and intangible assets with indefinite useful lives.
In measuring value-in-use, cash flow projections should be based on reasonable and supportable assumptions which represent the best estimate of the range of future economic conditions. IAS 36 Impairment of Assets points out that greater weight should be given to external evidence when determining the best estimate of cash flow projections. Each key assumption should be consistent with external sources of information, or there should be disclosure of how these assumptions differ from experience or external sources of information.
Such an economic climate could result in the recognition of tax losses or the existence of deductible temporary differences where perhaps impairments are not yet deductible for tax purposes. The recognition of deferred tax assets requires detailed consideration of the carry forward of unused tax losses, whether future taxable profits exist, and the need for disclosing judgements made in these circumstances.
IAS 12 Income Taxes limits the recognition of a deferred tax asset to the extent that it is probable that future taxable profits will be available against which the deductible temporary difference can be utilised. IAS 12 states that the existence of unused tax losses is strong evidence that future taxable profit might not be available. Therefore, recent losses make the recognition of deferred tax assets conditional upon the existence of convincing other evidence. The probability that future taxable profit will be available to utilise the unused tax losses will need to be reviewed and if convincing evidence is available, there should be disclosure of the amount of a deferred tax asset and the nature of the evidence supporting its recognition. It is particularly relevant to disclose the period used for the assessment of the recovery of a deferred tax asset as well as the judgements made.
Pod is a listed company specialising in the distribution and sale of photographic products and services. Pod’s statement of financial position included an intangible asset which was a portfolio of customers acquired from a similar business which had gone into liquidation. Pod changed its assessment of the useful life of this intangible asset from ‘finite’ to ‘indefinite’. Pod felt that it could not predict the length of life of the intangible asset, stating that it was impossible to foresee the length of life of this intangible due to a number of factors such as technological evolution, and changing consumer behaviour.
Pod has a significant network of retail branches. In its financial statements, Pod changed the determination of a cash generating unit (CGU) for impairment testing purposes at the level of each major product line, rather than at each individual branch. The determination of CGUs was based on the fact that each of its individual branches did not operate on a standalone basis as some income, such as volume rebates, and costs were dependent on the nature of the product line rather than on individual branches. Pod considered that cash inflows and outflows for individual branches did not provide an accurate assessment of the actual cash generated by those branches. Pod, however, has daily sales information and monthly statements of profit or loss produced for each individual branch and this information is used to make decisions about continuing to operate individual branches.
Required:
Discuss whether the changes to accounting practice suggested by Pod are acceptable under International Financial Reporting Standards.(8 marks)
Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks)
Under IAS 38 Intangible Assets, an intangible asset has an indefinite useful life only if there is no ‘foreseeable’ limit to its useful life as in the case of a brand name. In the case of Pod, the customer relationship is with individuals and therefore there is by definition a time limit to that relationship. Difficulties in accurately determining an intangible asset’s useful life do not provide a basis for regarding that useful life as indefinite. Where the cash flows are expected to continue for a finite period, the useful life of the asset is limited to that period, whereas if the cash flows are expected to continue indefinitely, the useful life is indefinite. The concept of indefinite not meaning infinite life refers to the fact that for intangible assets with an indefinite useful life, maintenance costs are necessary in order that cash inflows may continue for an unlimited period of time. For example, brand names do not have an infinite useful life if no investment is made in them. This argument does not apply to the circumstances of this case and therefore Pod is in contravention of IAS 38.
According to IAS 36 Impairment of Assets, a CGU is defined as the smallest identifiable group of assets generating cash inflows which are largely independent of the cash inflows from other assets or groups of assets. In accordance with IAS 36, one factor to be considered is the monitoring of the entity’s operations. Pod used the daily sales information and monthly statements of profit or loss of each individual branch to monitor its operations and to make decisions about continuing or disposing of its assets and operations. Each individual branch generates cash inflows which are largely independent of those generated by the other individual branches. Therefore, each branch should be identified as a separate CGU because Pod monitors and makes decisions about its assets and operations at the individual branch level.