Cloud based software in IFRS 15 Revenue

Cloud based software

Historically, companies acquiring IT and other infrastructure have only faced one decision – buy or lease? From a financial perspective, the choice was simple: lease, because it didn’t require up-front capital and potentially allowed assets to be kept off balance sheet under the old accounting rules. A buy decision meant an up-front investment of capital and a depreciating asset on the balance sheet.

However, with the evolution of technology, a new choice has emerged – cloud services, which can be obtained without Cloud based softwarebuying or leasing. Instead of expensive data centres and IT software licenses, users can choose to simply have a provider host all of their infrastructure and services. No upfront investment is required, just a simple monthly series of payments that can be scaled up, scaled back or cancelled as needed. But what does all of this mean for income statements – and your company’s balance sheet?

Cloud accounting – a different business model

Historically, any company purchasing its IT infrastructure would capitalise the costs and amortise them over time. Under the new leases standard, a company using a lease or hire purchase arrangement to access IT infrastructure would end up with a similar capitalised asset and amortisation charge over time. However, the cloud alternative represents a fundamentally different business model, one where, unlike the legacy purchase model, a user of cloud services does not ever own the underlying assets.

While this isn’t yet another article about the leases standard, it’s useful to step through some of the sensitivities in financial metrics under the leasing standard. While cloud services are likely to result in a differing accounting treatment, the all too familiar concerns in lease accounting are still relevant.

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Borrowing costs – Q&A IAS 23

Q&A Borrowing costs

Q&A Borrowing costs is a questions and answers lesson type of narrative following the captions of this rather simple IFRS Standard.

  1. General scope and definitions
  2. Borrowing costs eligible for capitalisation
  3. Foreign exchange differences
  4. Cessation of capitalisation
  5. Interaction IAS 23 and IFRS 15 Construction contracts with customers

General scope and definitions

1.1 A qualifying asset is an asset that ‘necessarily takes a substantial period of time to get ready for its intended use or sale’. Is there any bright line for determining the ‘substantial period of time’?

No. IAS 23 does not define ‘substantial period of time’. Management exercises judgement when determining which assets are qualifying assets, taking into account, among other factors, the nature of the asset. An asset that normally takes more than a year to be ready for use will usually be a qualifying asset. Once management chooses the criteria and type of assets, it applies this consistently to those types of asset.

Management discloses in the notes to the financial statements, when relevant, how the assessment was performed, which criteria were considered and which types of assets are subject to capitalisation of borrowing costs.

1.2 The IASB has amended the list of costs that can be included in borrowing costs, as part of its 2008 minor improvement project. Will this change anything in practice?

The amendment eliminates inconsistencies between interest expense as calculated under IAS 23 and IFRS 9. IAS 23 refers to the effective interest rate method as described in IFRS 9. The calculation includes fees, transaction costs and amortisation of discounts or premiums relating to borrowings. These components were already included in IAS 23. However, IAS 23 also referred to ‘ancillary costs’ and did not define this term.

This could have resulted in a different calculation of interest expense than under IFRS 9. No significant impact is expected from this change. Alignment of the definitions means that management only uses one method to calculate interest expense.

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Capitalisation of expenditure – 1 Complete answer

Capitalisation of expenditure

Capitalisation of expenditure is only possible when one of the following situations occur:

  • Capital expenditure (including equipment repairs and maintenance)
  • Recording lease contracts – Right-of-Use Assets
  • Capitalisation of borrowing costs
  • Capitalisation of cloud computing costs
  • Capitalisation of intangible assets
  • Capitalisation of internally capitalized intangible assets
  • Research & development costs
  • Prepaid expenses

Capital expenditure (including equipment repairs and maintenance)

The cost of an item of property, plant and equipment under IAS 16 Property, plant and equipment shall be recognised as an asset if, and only if:

  • it is probable that future economic benefits associated with the item will flow to the entity; and
  • the cost of the item can be measured reliably. (IAS 16.7)

Investment property

Certain properties which are used on rental are classified as an investment property in which case IAS 40 Investment property will apply. Only tangible items which have a useful life of more than one period are classified as property, plant and equipment as per IAS 16. But refer to the words “more than one period” as more than one accounting period of 12 months.

Also, an entity shall determine a threshold limit commensurate to its size for recognizing a tangible item as property, plant and equipment. For example, a tangible item of insignificant amount although satisfying the definition of property, plant and equipment may be expensed.

Initial recognition of indirect costs

Items of property, plant and equipment may be acquired for safety or environmental reasons. The acquisition of such property plant and equipment, although not directly increasing the future economic benefits of any particular existing item of property, plant and equipment, may be necessary for an entity to obtain the future economic benefits from its other assets.

Such items of property plant and equipment qualify for recognition as assets because they enable an entity to derive future economic benefits from related assets in excess of what could be derived had those items not been acquired.

Subsequent recognition of indirect costs

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The real meaning of Integrated reporting

The real meaning of integrated reporting

Integrated reporting is more than only aimed at informing interested stakeholders about performance achieved against targets, the vision and strategy adopted to serve the stakeholders’ interests, and other factors that can influence business performance in future.

Clearly regulations require companies to exercise transparency. However, a more fundamental reason for reporting lies in accountability: a company needs to account for the impact it has on the stakeholders it relates to. Not exercising such transparency would impose serious risks, including high financing costs to compensate for a lack of transparency or governance or, ultimately, losing the license to operate. By contrast, a transparent approach would not only improve reputation, but also would bind stakeholders such as employees to the company’s objectives.

The reason for including environmental and social factors in reporting

In today’s world companies play a significant role in shaping the future of society. Awareness of this has risen significantly over the last decades, resulting in changed attitudes towards the role business is expected to play.

It also resulted in changes in the views of business leaders about the role they want to play.

Business these days is seen more than ever as the agent of a wide group of stakeholders. Unlike the old paradigm that ‘the business of business is business’, companies accept wider accountability in current times towards the stakeholders whose interests they impact – no longer can companies focus only on the interests of those with a financial interest.

This wider accountability implies that companies have to fulfil the (information) needs of those who provide them with integrated reportingother economic resources such as labour, space, air or natural resources and those who enter into transactions with the organization such as customers. Therefore a company’s current performance and future ability to continue operations and achieve business growth needs to be evaluated on the basis of a comprehensive set of factors that influence these.

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Acquisitions and mergers as per IFRS 3

Acquisitions and mergers

Acquisitions and mergers are becoming more and more common as entities aim to achieve their growth objectives. IFRS 3 ‘Business Combinations’ contains the requirements for these transactions, which are challenging in practice.

This narrative sets out how an entity should determine if the transaction is a business combination, and whether it is within the scope of IFRS 3.

Identifying a business combination

IFRS 3 refers to a ‘business combination’ rather than more commonly used phrases such as takeover, acquisition or Acquisitions and mergersmerger because the objective is to encompass all the transactions in which an acquirer obtains control over an acquiree no matter how the transaction is structured. A business combination is defined as a transaction or other event in which an acquirer (an investor entity) obtains control of one or more businesses.

An entity’s purchase of a controlling interest in another unrelated operating entity will usually be a business combination (see case below).

Case – Straightforward business combination

Entity T is a clothing manufacturer and has traded for a number of years. Entity T is deemed to be a business.

On 1 January 2020, Entity A pays CU 2,000 to acquire 100% of the ordinary voting shares of Entity T. No other type of shares has been issued by Entity T. On the same day, the three main executive directors of Entity A take on the same roles in Entity T.

Consider this…..

Entity A obtains control on 1 January 2020 by acquiring 100% of the voting rights. As Entity T is a business, this is a business combination in accordance with IFRS 3.

However, a business combination may be structured, and an entity may obtain control of that structure, in a variety of ways.

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Embedded derivatives best 1 to read

Embedded derivatives are a component of a hybrid contract that also includes a non-derivative host, so some cash flows vary similar to a stand alone derivative

Amortised cost and the effective interest method

Amortised cost and the effective interest method

This narrative explores the factors that an entity needs to consider in calculating the amortised cost of a financial asset or financial liability and recognising interest revenue and expense based on the effective interest rate (EIR).

Calculating amortised cost

The amortised cost of a financial asset or financial liability is calculated in the same way as under IAS 39, although IFRS 9 introduces the concept of ‘gross carrying amount’ for financial assets. The gross carrying amount is the amortised cost grossed up for the impairment allowance. The elements of amortised cost are illustrated below.

Financial assets

Financial liabilities

Fair value at initial recognition

At recognition a loan receivable or payable is recognised at fair value measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (currency, term, etc.) with a similar credit rating.

MINUS

Principal redemptions/repayments

ADD

Periodical interest income based on the effective interest method

Periodical interest expense based on the effective interest method

MINUS

Gross carrying amount

N/A

Loss allowance

= Amortised costs

= Amortised costs

(no adjustment for loss allowance)

Calculating the EIR

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Impairment testing cash generating unit with IFRS 16 leases

Impairment testing cash generating unit with leases (or impairment of leased assets) is about a right-of-use asset (leased asset) and  such an asset will frequently be included in a cash generating unit to be tested for impairment. At initial recognition, the right-of-use-asset equals the recognised lease liability, plus any lease payments made at or before the commencement date, less any lease incentives received, plus any initial direct costs incurred by the lessee and an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset and restoring the site on which the leased asset is located.

The most significant part of the right-of-use asset will often be the lease liability, which is the present value of the lease payments discounted at the interest rate implicit in the lease if this rate is readily determinable, or otherwise at the lessee’s incremental borrowing rate.

Therefore, the discount rate applied to determine the lease liability can have a significant effect on the carrying amount of the right-of-use asset at initial recognition. If the value in use is determined in an impairment test mechanically, ignoring the lease liability and related lease payments from both the carrying amount and the value in use of the cash generating unit, the following effects will occur when compared with the value in use with operating leases under IAS 17:

These two effects will usually have an offsetting effect. As a result, generally, there will be a limited effect on the impairment test, i.e., the amount of headroom or impairment calculated will not be substantially different.

However, if the IAS 36 discount rate (for example, a discount rate based on the weighted average cost of capital (WACC)) exceeds the IFRS 16 discount rate (for example, the lessees’ incremental borrowing rate), this will have a net negative impact on the results of the impairment test as the carrying amount of the cash generating unit will increase more than the value in use of the cash generating unit.

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Impairment of financial assets

Impairment of financial assets

The following table summarises how the key concepts of the model are explained throughout this narrative.

1. Scope of the impairment requirements

3. General approach

Special cases

3.1 Expected credit loss model

6. Assets that are credit impaired at initial recognition

7. Simplified approach for trade and lease receivables and contract assets

3.2.1 12-month ECL

3.2.2 Lifetime ECL

3.4.6 Modifications

4 Measurement

5 Write-offs

1 Scope of the impairment requirements

1.1 General requirements

The following table sets out instruments that are in and out of the scope of IFRS 9’s impairment requirements. (IFRS 9.2, IFRS 9.4.2.1, IFRS 9.5.5.1)

In scope

Out of scope

IFRS 9 has a single impairment model that applies to all financial instruments in its scope.

Food for thought – Scope of the impairment requirements

(IAS 39.2(h), IAS 39.63-70, IAS 39.AG4(a), IFRS 9.BC5.259)

The existence of several impairment models under IAS 39 creates complexity. Under IAS 39, there were different models for:

In addition, losses relating to loan commitments and financial guarantees issued by banks were generally accounted for under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. This has created a practical issue for banks, because they often manage credit risk on financial guarantees and loan commitments in the same way as credit risk on loans and other debt instruments, whereas for accounting purposes they are treated differently.

In addition, for revolving credit facilities (see 4.3.2) banks often manage the amount receivable and the undrawn amount of the commitment together for risk management purposes – i.e. on a facility level.

Under IFRS 9, a single set of impairment requirements applies to all instruments in the scope of IFRS 9 that are not accounted for at FVTPL. This may simplify the requirements and align them more closely with the way banks manage their credit risk. However, differences may arise in practice between the way banks perform the calculations for internal risk management purposes and the specific requirements of IFRS 9. These are discussed further in 4.2.2 in respect of loan commitments.

The new model may also have an impact on corporates that apply IAS 39 to issued financial guarantee contracts, and therefore recognise a provision on such contracts only when it is probable that an outflow will occur. For discussion of the IFRS 9 impairment model’s impact on financial guarantee contracts issued, see 4.9.1.

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