Every hedge fund needs to prepare NAV (Net Asset Value) and other accounting reports for their investors, as often as monthly and at least once a year. Funds also need to provide investors with annual income tax reports, Form K-1 tax reports and complex tax instructions. The above accounting reports are the building blocks of generating a "performance record" – the cornerstone for attracting investors to a fund.
Accounting and tax compliance services for hedge funds are complex. A hedge fund will face great trouble in trying to use off-the-shelf consumer accounting programs and/or accounting professionals who are not highly experienced with hedge funds.
Other Disclosures
An undertaking shall disclose in the notes:
(i) the amount of dividends proposed (or declared) before the financial statements were approved for issue, but not recorded as a distribution to owners during the period, and the related amount per share; and
(ii) the amount of any cumulative preference dividends not recorded.
An undertaking shall disclose the following, if not disclosed elsewhere in information published with the financial statements:
(i) the domicile, and legal form, of the undertaking, its country of incorporation and the address of its registered office (or principal place of business, if different from the registered office);
(ii) a description of the nature of the undertaking’s operations, and its principal activities; and
(iii) the name of the parent and the ultimate parent of the group.
(i) the amount of dividends proposed (or declared) before the financial statements were approved for issue, but not recorded as a distribution to owners during the period, and the related amount per share; and
(ii) the amount of any cumulative preference dividends not recorded.
An undertaking shall disclose the following, if not disclosed elsewhere in information published with the financial statements:
(i) the domicile, and legal form, of the undertaking, its country of incorporation and the address of its registered office (or principal place of business, if different from the registered office);
(ii) a description of the nature of the undertaking’s operations, and its principal activities; and
(iii) the name of the parent and the ultimate parent of the group.
Capital
An undertaking shall disclose information that enables users to evaluate the undertaking’s objectives, policies and processes for managing capital.
The undertaking discloses the following:
1. qualitative information about its objectives, policies and processes for managing capital, including:
a description of what comprises its capital;
when an undertaking is subject to externally imposed capital requirements, the nature of those requirements and how those requirements are incorporated into the management of capital; and
iii. how it is meeting its objectives for managing capital.
2. summary quantitative data about what comprises its capital. Some undertakings regard some financial liabilities (eg some forms of subordinated debt) as part of capital. Other undertakings regard capital as excluding some components of equity (eg components arising from cash flow hedges).
3. any changes in (1) and (2) from the previous period.
4. whether during the period it complied with any externally imposed capital requirements to which it is subject.
5. when the undertaking has not complied with such externally imposed capital requirements, the consequences of such non-compliance.
These disclosures shall be based on the information provided internally to the undertaking’s key management personnel.
An undertaking may manage capital in a number of ways and be subject to a number of different capital requirements and restrictions.
For example, a conglomerate may include undertakings that undertake insurance activities and banking activities, and those undertakings may also operate in several jurisdictions.
The undertaking shall disclose separate information for each capital requirement (rather than aggregate information) to which the undertaking is subject where this would be aid the understanding of users.
The undertaking discloses the following:
1. qualitative information about its objectives, policies and processes for managing capital, including:
a description of what comprises its capital;
when an undertaking is subject to externally imposed capital requirements, the nature of those requirements and how those requirements are incorporated into the management of capital; and
iii. how it is meeting its objectives for managing capital.
2. summary quantitative data about what comprises its capital. Some undertakings regard some financial liabilities (eg some forms of subordinated debt) as part of capital. Other undertakings regard capital as excluding some components of equity (eg components arising from cash flow hedges).
3. any changes in (1) and (2) from the previous period.
4. whether during the period it complied with any externally imposed capital requirements to which it is subject.
5. when the undertaking has not complied with such externally imposed capital requirements, the consequences of such non-compliance.
These disclosures shall be based on the information provided internally to the undertaking’s key management personnel.
An undertaking may manage capital in a number of ways and be subject to a number of different capital requirements and restrictions.
For example, a conglomerate may include undertakings that undertake insurance activities and banking activities, and those undertakings may also operate in several jurisdictions.
The undertaking shall disclose separate information for each capital requirement (rather than aggregate information) to which the undertaking is subject where this would be aid the understanding of users.
Statement of comprehensive income
An undertaking shall present all items of income and expense recognised in a period:
(i) in a single statement of comprehensive income, or
(ii) in two statements: a statement displaying components of profit or loss (separate income statement) and a second statement beginning with profit or loss and displaying components of other comprehensive income (statement of comprehensive income).
Information to be presented in the statement of comprehensive income
As a minimum, the face of the statement of comprehensive income
shall include line items that present the following amounts for the period:
(a) revenue;
(b) finance costs;
(c) share of the income statement of associates, and joint ventures accounted for using the equity method;
d) tax expense;
(e) a single amount comprising the total of:
(i) the post-tax profit or loss of discontinued operations and
(ii) the post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation;
(f) profit or loss;
(g) each component of other comprehensive income classified by nature (excluding amounts in (h));
(h) share of the other comprehensive income of associates and joint ventures accounted for using the equity method; and
(i) total comprehensive income.
An undertaking shall disclose the following items in the statement of comprehensive income as allocations of profit or loss for the period:
(a) profit or loss for the period attributable to:
(i) minority interest, and
(ii) owners of the parent.
(b) total comprehensive income for the period attributable to:
(i) minority interest, and
(ii) owners of the parent.
Additional line items, headings and subtotals shall be presented on the face of the statement of comprehensive income and the separate income statement (if presented), when such presentation is relevant to understanding the financial performance.
As the impacts of various transactions differ in frequency, potential for gain (or loss) and predictability, disclosing the components of financial performance assists in an understanding of the performance achieved, and in making projections.
Additional line items are included on the face of the statement of comprehensive income and the separate income statement (if presented), and the descriptions used (and the ordering of items) are amended, when this is necessary to explain the elements of financial performance.
EXAMPLE- Order of presentation of the income statement’s components
Issue
The description and ordering of items on the face of the income statements should be amended when this is necessary to explain the elements of performance.
Can management present the lines in the income statement in a different order from that described in IAS 1?
Background
Undertaking A’s management wishes to present the results of the undertaking’s share of profits and losses of associates accounted for using equity method before the line of finance costs.
Presented below is an extract from the undertaking’s proposed income statement
Share of results of associates
XXX
Finance costs
(XX)
Profit before tax
XXX
Solution
There is a suggested ordering of items to be reported on the face of the income statement: finance costs are presented before the results of associates.
Deviation from this general sequence would be rare, although permitted when this is necessary to explain the elements of performance.
Additionally, management should present and classify items in the income statement consistently from one period to the next.
Factors to be considered include materiality, and the nature (and function) of the components of income, and expenses. For example, a bank amends the descriptions to apply the requirements in IFRS 7. Income and expense items are not offset unless the criteria above are met.
No item should be described as extraordinary items, either on the face of the income statement, or in the notes.
Profit or loss for the period
An undertaking shall recognise all items of income and expense in a period in profit or loss unless an IFRS requires or permits otherwise.
Some IFRSs specify circumstances when an undertaking recognises particular items outside profit or loss in the current period. IAS 8 specifies two such circumstances: the correction of errors and the effect of changes in accounting policies.
Other IFRSs require or permit components of other comprehensive income that meet the Framework’s definition of income or expense to be excluded from profit or loss
Other comprehensive income for the period
An undertaking shall disclose the amount of income tax relating to each component of other comprehensive income, including reclassification adjustments, either in the statement of comprehensive income or in the notes.
An undertaking may present components of other comprehensive income
either:
(i) net of related tax effects, or
(ii) before related tax effects with one amount shown for the aggregate
amount of income tax relating to those components.
An undertaking shall disclose reclassification adjustments relating to components of other comprehensive income.
Other IFRSs specify whether and when amounts previously recognised in other comprehensive income are reclassified to profit or loss. Such reclassifications are referred to in IAS 1as reclassification adjustments.
A reclassification adjustment is included with the related component of other comprehensive income in the period that the adjustment is reclassified to profit or loss.
For example, gains realised on the disposal of available-for-sale financial assets are included in profit or loss of the current period. These amounts may have been recognised in other comprehensive income as unrealised gains in the current or previous periods.
Those unrealised gains must be deducted from other comprehensive income in the period in which the realised gains are reclassified to profit or loss to avoid including them in total comprehensive income twice.
An undertaking may present reclassification adjustments in the statement of comprehensive income or in the notes. An undertaking presenting reclassification adjustments in the notes presents the components of other comprehensive income after any related reclassification adjustments.
Reclassification adjustments arise, for example, on disposal of a foreign operation (see IAS 21), on derecognition of available-for-sale financial assets (see IAS 39) and when a hedged forecast transaction affects profit or loss (see IAS 39 in relation to cash flow hedges).
EXAMPLE- Presentation of currency translation differences
Issue
Exchange differences arise from the translation of a foreign undertaking’s financial statements for incorporation in a reporting undertaking’s financial statements.
Management should classify such differences as equity until the disposal of the net investment [IAS21].
How should management present exchange differences in the undertaking’s statement of changes in equity?
Background
An undertaking has subsidiaries in several different countries. All of them are consolidated, and management classifies the currency translation differences arising from the translation of these subsidiaries’ financial statements as translation reserve in equity.
Solution
Management should present the gain/loss on currency translations on the face of the statement of changes in equity.
Additionally, management should present, in a note to the financial statements, a reconciliation of the amount of such exchange differences at the beginning and end of the period.
Reclassification adjustments do not arise on changes in revaluation surplus recognised in accordance with IAS 16 or IAS 38 or on actuarial gains and losses on defined benefit plans recognised in accordance with IAS 19.
These components are recognised in other comprehensive income and are not reclassified to profit or loss in subsequent periods.
Changes in revaluation surplus may be transferred to retained earnings in subsequent periods as the asset is used or when it is derecognised (see IAS 16 and IAS 38).
Actuarial gains and losses are reported in retained earnings in the period that they are recognised as other comprehensive income (see IAS 19).
Income statement presentation - IFRS News - June 2005
Any group with international operations, whether listed or not, can benefit from making it easier for its major stakeholders to understand its financial statements.
Income statement presentation is an essential part of stakeholder communications and IFRS aims to add transparency and comparability to this communication. IAS 1, the standard which deals with the presentation of financial statements, contains broad guidelines on presentation format. The qualitative characteristics for the financial statements in the IFRS framework only represent general guidance.
Stakes are high for companies: broad guidelines offer opportunities to drive their communication based on financial statement presentation. The abuse of this flexibility, however, may do more harm than good in the medium term.
Analysts may be confused by presentations of ‘results before bad news and things management didn’t expect’. Regulators will not endorse such flexibility and will request strict rules to be applied. Restatements may occur and companies’ reputations will be tarnished by such behaviour.
How can companies acquire a useful and transparent presentation of their results?
How presentation format can make a difference
Most users look at the income statement first for information on the company’s financial performance. The notes may provide useful additional information but the size and complexity of these often prevent most users from considering them in detail.
The income statement presentation could influence the user’s decision-making. IAS 1 allows companies to report income statements on a functional (costs of sales, selling, marketing, etc...) or a nature (salaries, rent, depreciation, etc...) basis.
The temptation to combine both presentations is high, but will transparency and comparability result from doing so?
Imagine two similar companies: one excludes depreciation from its cost-of-sales figure to derive its gross profit figure, while presenting depreciation as a separate line item; the other includes depreciation of production equipment in costs of sales to reflect a complete functional presentation.
It would seem that the company that mixes function and nature expense categories generates more gross profit. This only reflects a choice of presentation and not the actual performance of the company.
The first presentation could create confusion for the user and it would not be comparable between different companies.
‘Industry practice’: slippery slope
Many companies suggest that analysts require certain disclosures on the face of the income statement, which are not defined or required under IFRS. ‘Earnings before interest, depreciation and amortisation’ (EBITDA) is an example, which is used in many capital intensive industries.
Many different calculation methods exist. Some companies exclude all amortisation and depreciation from the subtotal; others exclude all significant non-cash charges such as restructurings and impairments. This makes ‘EBITDA’ a wide category that is non-comparable.
Analysts must then make various adjustments to the published EBITDA figures based on information from the notes. Disclosing partial information on the face of the income statement (often without an explanation on its calculation) does not add value for users.
Transparency
Transparent reporting would result from use of a format similar to the examples in the application guidance to IAS 1. Subtotals and further line items only result in clearer presentation if certain criteria are met (see box below).
Other common reporting issues
The use of the ‘operating profit’ subtotal: many companies disclose ‘operating profit’ even though IFRS no longer requires it. If this subtotal is presented, IAS 1 states that all activities are presumed to be part of operations apart from the results of financing activities, equity-accounted investments, discontinued operations and taxation.
‘Non-recurring’ or ‘exceptional’ results: another commonly-used subtotal is the division of operating profit to ‘recurring’ and ‘non-recurring’ portions (or similar). Management may wish to make this separation to exclude ‘difficult debits’ or because the items were treated as ‘extraordinary’ under local GAAP.
These subtotals do not usually help to achieve clear and consistent presentation, but may be acceptable if the general criteria for a mixed presentation are met (see box below).
Restructuring: as restructuring provisions are not separate ‘functions’, it is unlikely that a separate line item for restructuring can be used in a functional expense presentation.
Conclusion
The income statement presentation can make a difference between companies even if the underlying results are similar. A company that follows IAS 1 will reduce subjectivity and aid comparability between different undertakings.
When is a mixed presentation acceptable?
The mixture of function and nature, and the use of subtotals, are only acceptable when all of the following requirements are met:
The proposed presentation is not misleading: the income statement presentation should be unbiased. The proposed breakdown should not result in a misleading cost-of-sales figure and overstate gross profit.
A potential for bias can exist if the subtotal gets undue prominence over the line items and the subtotals normally required by IFRS;
The presentation should be applied consistently across all years and the ‘rules’ should be set out in the accounting policies.
An undertaking that wishes to present a subtotal for non-recurring items should have an accounting policy which describes the classification rules (to avoid the cherry-picking of items to be classified as non-recurring); and
The breakdown of expenses by nature is presented in the notes to the financial statements, as required by IAS 1: the breakdown should be made in a separate note, which could be tied to the total of expenses presented on the face of the income statement.
(i) in a single statement of comprehensive income, or
(ii) in two statements: a statement displaying components of profit or loss (separate income statement) and a second statement beginning with profit or loss and displaying components of other comprehensive income (statement of comprehensive income).
Information to be presented in the statement of comprehensive income
As a minimum, the face of the statement of comprehensive income
shall include line items that present the following amounts for the period:
(a) revenue;
(b) finance costs;
(c) share of the income statement of associates, and joint ventures accounted for using the equity method;
d) tax expense;
(e) a single amount comprising the total of:
(i) the post-tax profit or loss of discontinued operations and
(ii) the post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation;
(f) profit or loss;
(g) each component of other comprehensive income classified by nature (excluding amounts in (h));
(h) share of the other comprehensive income of associates and joint ventures accounted for using the equity method; and
(i) total comprehensive income.
An undertaking shall disclose the following items in the statement of comprehensive income as allocations of profit or loss for the period:
(a) profit or loss for the period attributable to:
(i) minority interest, and
(ii) owners of the parent.
(b) total comprehensive income for the period attributable to:
(i) minority interest, and
(ii) owners of the parent.
Additional line items, headings and subtotals shall be presented on the face of the statement of comprehensive income and the separate income statement (if presented), when such presentation is relevant to understanding the financial performance.
As the impacts of various transactions differ in frequency, potential for gain (or loss) and predictability, disclosing the components of financial performance assists in an understanding of the performance achieved, and in making projections.
Additional line items are included on the face of the statement of comprehensive income and the separate income statement (if presented), and the descriptions used (and the ordering of items) are amended, when this is necessary to explain the elements of financial performance.
EXAMPLE- Order of presentation of the income statement’s components
Issue
The description and ordering of items on the face of the income statements should be amended when this is necessary to explain the elements of performance.
Can management present the lines in the income statement in a different order from that described in IAS 1?
Background
Undertaking A’s management wishes to present the results of the undertaking’s share of profits and losses of associates accounted for using equity method before the line of finance costs.
Presented below is an extract from the undertaking’s proposed income statement
Share of results of associates
XXX
Finance costs
(XX)
Profit before tax
XXX
Solution
There is a suggested ordering of items to be reported on the face of the income statement: finance costs are presented before the results of associates.
Deviation from this general sequence would be rare, although permitted when this is necessary to explain the elements of performance.
Additionally, management should present and classify items in the income statement consistently from one period to the next.
Factors to be considered include materiality, and the nature (and function) of the components of income, and expenses. For example, a bank amends the descriptions to apply the requirements in IFRS 7. Income and expense items are not offset unless the criteria above are met.
No item should be described as extraordinary items, either on the face of the income statement, or in the notes.
Profit or loss for the period
An undertaking shall recognise all items of income and expense in a period in profit or loss unless an IFRS requires or permits otherwise.
Some IFRSs specify circumstances when an undertaking recognises particular items outside profit or loss in the current period. IAS 8 specifies two such circumstances: the correction of errors and the effect of changes in accounting policies.
Other IFRSs require or permit components of other comprehensive income that meet the Framework’s definition of income or expense to be excluded from profit or loss
Other comprehensive income for the period
An undertaking shall disclose the amount of income tax relating to each component of other comprehensive income, including reclassification adjustments, either in the statement of comprehensive income or in the notes.
An undertaking may present components of other comprehensive income
either:
(i) net of related tax effects, or
(ii) before related tax effects with one amount shown for the aggregate
amount of income tax relating to those components.
An undertaking shall disclose reclassification adjustments relating to components of other comprehensive income.
Other IFRSs specify whether and when amounts previously recognised in other comprehensive income are reclassified to profit or loss. Such reclassifications are referred to in IAS 1as reclassification adjustments.
A reclassification adjustment is included with the related component of other comprehensive income in the period that the adjustment is reclassified to profit or loss.
For example, gains realised on the disposal of available-for-sale financial assets are included in profit or loss of the current period. These amounts may have been recognised in other comprehensive income as unrealised gains in the current or previous periods.
Those unrealised gains must be deducted from other comprehensive income in the period in which the realised gains are reclassified to profit or loss to avoid including them in total comprehensive income twice.
An undertaking may present reclassification adjustments in the statement of comprehensive income or in the notes. An undertaking presenting reclassification adjustments in the notes presents the components of other comprehensive income after any related reclassification adjustments.
Reclassification adjustments arise, for example, on disposal of a foreign operation (see IAS 21), on derecognition of available-for-sale financial assets (see IAS 39) and when a hedged forecast transaction affects profit or loss (see IAS 39 in relation to cash flow hedges).
EXAMPLE- Presentation of currency translation differences
Issue
Exchange differences arise from the translation of a foreign undertaking’s financial statements for incorporation in a reporting undertaking’s financial statements.
Management should classify such differences as equity until the disposal of the net investment [IAS21].
How should management present exchange differences in the undertaking’s statement of changes in equity?
Background
An undertaking has subsidiaries in several different countries. All of them are consolidated, and management classifies the currency translation differences arising from the translation of these subsidiaries’ financial statements as translation reserve in equity.
Solution
Management should present the gain/loss on currency translations on the face of the statement of changes in equity.
Additionally, management should present, in a note to the financial statements, a reconciliation of the amount of such exchange differences at the beginning and end of the period.
Reclassification adjustments do not arise on changes in revaluation surplus recognised in accordance with IAS 16 or IAS 38 or on actuarial gains and losses on defined benefit plans recognised in accordance with IAS 19.
These components are recognised in other comprehensive income and are not reclassified to profit or loss in subsequent periods.
Changes in revaluation surplus may be transferred to retained earnings in subsequent periods as the asset is used or when it is derecognised (see IAS 16 and IAS 38).
Actuarial gains and losses are reported in retained earnings in the period that they are recognised as other comprehensive income (see IAS 19).
Income statement presentation - IFRS News - June 2005
Any group with international operations, whether listed or not, can benefit from making it easier for its major stakeholders to understand its financial statements.
Income statement presentation is an essential part of stakeholder communications and IFRS aims to add transparency and comparability to this communication. IAS 1, the standard which deals with the presentation of financial statements, contains broad guidelines on presentation format. The qualitative characteristics for the financial statements in the IFRS framework only represent general guidance.
Stakes are high for companies: broad guidelines offer opportunities to drive their communication based on financial statement presentation. The abuse of this flexibility, however, may do more harm than good in the medium term.
Analysts may be confused by presentations of ‘results before bad news and things management didn’t expect’. Regulators will not endorse such flexibility and will request strict rules to be applied. Restatements may occur and companies’ reputations will be tarnished by such behaviour.
How can companies acquire a useful and transparent presentation of their results?
How presentation format can make a difference
Most users look at the income statement first for information on the company’s financial performance. The notes may provide useful additional information but the size and complexity of these often prevent most users from considering them in detail.
The income statement presentation could influence the user’s decision-making. IAS 1 allows companies to report income statements on a functional (costs of sales, selling, marketing, etc...) or a nature (salaries, rent, depreciation, etc...) basis.
The temptation to combine both presentations is high, but will transparency and comparability result from doing so?
Imagine two similar companies: one excludes depreciation from its cost-of-sales figure to derive its gross profit figure, while presenting depreciation as a separate line item; the other includes depreciation of production equipment in costs of sales to reflect a complete functional presentation.
It would seem that the company that mixes function and nature expense categories generates more gross profit. This only reflects a choice of presentation and not the actual performance of the company.
The first presentation could create confusion for the user and it would not be comparable between different companies.
‘Industry practice’: slippery slope
Many companies suggest that analysts require certain disclosures on the face of the income statement, which are not defined or required under IFRS. ‘Earnings before interest, depreciation and amortisation’ (EBITDA) is an example, which is used in many capital intensive industries.
Many different calculation methods exist. Some companies exclude all amortisation and depreciation from the subtotal; others exclude all significant non-cash charges such as restructurings and impairments. This makes ‘EBITDA’ a wide category that is non-comparable.
Analysts must then make various adjustments to the published EBITDA figures based on information from the notes. Disclosing partial information on the face of the income statement (often without an explanation on its calculation) does not add value for users.
Transparency
Transparent reporting would result from use of a format similar to the examples in the application guidance to IAS 1. Subtotals and further line items only result in clearer presentation if certain criteria are met (see box below).
Other common reporting issues
The use of the ‘operating profit’ subtotal: many companies disclose ‘operating profit’ even though IFRS no longer requires it. If this subtotal is presented, IAS 1 states that all activities are presumed to be part of operations apart from the results of financing activities, equity-accounted investments, discontinued operations and taxation.
‘Non-recurring’ or ‘exceptional’ results: another commonly-used subtotal is the division of operating profit to ‘recurring’ and ‘non-recurring’ portions (or similar). Management may wish to make this separation to exclude ‘difficult debits’ or because the items were treated as ‘extraordinary’ under local GAAP.
These subtotals do not usually help to achieve clear and consistent presentation, but may be acceptable if the general criteria for a mixed presentation are met (see box below).
Restructuring: as restructuring provisions are not separate ‘functions’, it is unlikely that a separate line item for restructuring can be used in a functional expense presentation.
Conclusion
The income statement presentation can make a difference between companies even if the underlying results are similar. A company that follows IAS 1 will reduce subjectivity and aid comparability between different undertakings.
When is a mixed presentation acceptable?
The mixture of function and nature, and the use of subtotals, are only acceptable when all of the following requirements are met:
The proposed presentation is not misleading: the income statement presentation should be unbiased. The proposed breakdown should not result in a misleading cost-of-sales figure and overstate gross profit.
A potential for bias can exist if the subtotal gets undue prominence over the line items and the subtotals normally required by IFRS;
The presentation should be applied consistently across all years and the ‘rules’ should be set out in the accounting policies.
An undertaking that wishes to present a subtotal for non-recurring items should have an accounting policy which describes the classification rules (to avoid the cherry-picking of items to be classified as non-recurring); and
The breakdown of expenses by nature is presented in the notes to the financial statements, as required by IAS 1: the breakdown should be made in a separate note, which could be tied to the total of expenses presented on the face of the income statement.
Information to be Presented either on the Face of the Statement of Financial Position, or in the Notes
An undertaking shall disclose, either on the face of the statement of financial
position, or in the notes, further subclassifications of the line items presented, classified in a manner appropriate to the operations.
The detail provided in subclassifications depends on the requirements of IFRSs and on the size, nature and function of the amounts involved.
The disclosures vary for each item, for example:
(i) items of property, plant and equipment are disaggregated into classes in accordance with IAS 16;
(ii) receivables are disaggregated into amounts receivable from:
trade customers,
receivables from related parties,
prepayments and
other amounts;
(iii) inventories are subclassified, into classifications such as:
merchandise,
production supplies,
materials,
work in progress and
finished goods;
(iv) provisions are disaggregated into provisions for staff benefits, and other items; and
(v) equity capital and reserves are disaggregated into various classes, such as:
paid-in capital,
share premium and
reserves.
An undertaking shall disclose the following, either on the face of the statement of financial position, or in the notes:
(1) for each class of share capital:
(i) the number of shares authorised;
(ii) the number of shares issued and fully paid, and issued but not fully paid;
(iii) par value per share, or that the shares have no par value;
(iv) a reconciliation of the number of shares outstanding at the beginning, and end, of the period;
(v) the rights, preferences and restrictions attaching to that class, including restrictions on the distribution of dividends, and the repayment of capital;
(vi) shares in the undertaking held by the undertaking, or by its subsidiaries, or associates; and
(vii) shares reserved for issue under options, and contracts for the sale of shares, including the terms and amounts; and
(ii) a description of the nature, and purpose, of each reserve within equity.
EXAMPLE- ‘legal’ reserves
Some jurisdictions require firms to donate 10% of annual profit to a reserve, sometimes called a legal reserve, that cannot be distributed to shareholders (except in liquidation after all creditors have been paid).
Such regulations may be of concern to investors, as this will limit dividends.
An undertaking without share capital, such as a partnership or trust, shall disclose information equivalent to that required above, showing changes during the period in each category of equity interest, and the rights, preferences, and restrictions attaching to each category of equity interest
position, or in the notes, further subclassifications of the line items presented, classified in a manner appropriate to the operations.
The detail provided in subclassifications depends on the requirements of IFRSs and on the size, nature and function of the amounts involved.
The disclosures vary for each item, for example:
(i) items of property, plant and equipment are disaggregated into classes in accordance with IAS 16;
(ii) receivables are disaggregated into amounts receivable from:
trade customers,
receivables from related parties,
prepayments and
other amounts;
(iii) inventories are subclassified, into classifications such as:
merchandise,
production supplies,
materials,
work in progress and
finished goods;
(iv) provisions are disaggregated into provisions for staff benefits, and other items; and
(v) equity capital and reserves are disaggregated into various classes, such as:
paid-in capital,
share premium and
reserves.
An undertaking shall disclose the following, either on the face of the statement of financial position, or in the notes:
(1) for each class of share capital:
(i) the number of shares authorised;
(ii) the number of shares issued and fully paid, and issued but not fully paid;
(iii) par value per share, or that the shares have no par value;
(iv) a reconciliation of the number of shares outstanding at the beginning, and end, of the period;
(v) the rights, preferences and restrictions attaching to that class, including restrictions on the distribution of dividends, and the repayment of capital;
(vi) shares in the undertaking held by the undertaking, or by its subsidiaries, or associates; and
(vii) shares reserved for issue under options, and contracts for the sale of shares, including the terms and amounts; and
(ii) a description of the nature, and purpose, of each reserve within equity.
EXAMPLE- ‘legal’ reserves
Some jurisdictions require firms to donate 10% of annual profit to a reserve, sometimes called a legal reserve, that cannot be distributed to shareholders (except in liquidation after all creditors have been paid).
Such regulations may be of concern to investors, as this will limit dividends.
An undertaking without share capital, such as a partnership or trust, shall disclose information equivalent to that required above, showing changes during the period in each category of equity interest, and the rights, preferences, and restrictions attaching to each category of equity interest
Information to be Presented on the Face of the Statement of financial position (balance sheet)
As a minimum, the face of the statement of financial position shall include line items that present the following amounts:
(i) property, plant and equipment;
(ii) investment property;
(iii) intangible assets;
(iv) financial assets (excluding amounts shown under (v), (viii) and (ix));
(v) investments, accounted for using the equity method;
(vi) biological assets;
(vii) inventories;
(viii) trade and other receivables;
(ix) cash and cash equivalents;
(x) the total of assets classified as held for sale and assets included in
disposal groups classified as held for sale in accordance with IFRS 5 (see below)
(xi) trade and other payables;
(xii) provisions;
(xiii) financial liabilities (excluding amounts shown under (x) and (xi));
(xiv) liabilities and assets for current tax (as defined in IAS 12 Income Taxes);
(xv) deferred tax liabilities and deferred tax assets (as defined in IAS 12);
(xvi) minority interest, presented within equity; and
(xvii) issued capital, and reserves attributable to equity holders of the parent.
The face of the statement of financial position shall include line items that present the following amounts:
i. the total of assets classified as held for sale and assets included in disposal groups classified as held for sale in accordance with IFRS 5; and
ii. liabilities included in disposal groups classified as held for sale in accordance with IFRS 5.
Additional line items, headings and subtotals shall be presented on the face of the statement of financial position, when such presentation is relevant to an understanding of the financial position.
EXAMPLE –tax losses
You have large tax losses carried forward in your home country, but tax liabilities abroad. You chose to expand the tax liability lines to show both local tax (none) and foreign tax to clarify the position.
Deferred tax assets (and liabilities) are always non-current assets (liabilities).
Line items are included when the size, nature or function of an item (or aggregation of similar items) is such that separate presentation is relevant to an understanding of the financial position.
The descriptions used, and the ordering of items (or aggregation of similar items) may be amended according to the nature of the undertaking, and its transactions, to provide information that is relevant to an understanding of the financial position.
For example, a bank amends the above descriptions to apply the requirements in IFRS 7.
The judgement on whether additional items are presented separately is based on an assessment of:
(i) the nature and liquidity of assets;
(ii) the function of assets; and
(iii) the amounts, nature and timing of liabilities.
EXAMPLE-assets categorised by function
You lease photocopiers and drinks machines. Identifying the results and
net assets (assets and liabilities) employed by each function of the business helps users.
The use of different measurement bases, for different classes of assets, suggests that their nature (or function) differs and, therefore, that they should be presented as separate line items.
Different classes of property, plant and equipment can be carried at cost, or revalued amounts, in accordance with IAS 16.
(i) property, plant and equipment;
(ii) investment property;
(iii) intangible assets;
(iv) financial assets (excluding amounts shown under (v), (viii) and (ix));
(v) investments, accounted for using the equity method;
(vi) biological assets;
(vii) inventories;
(viii) trade and other receivables;
(ix) cash and cash equivalents;
(x) the total of assets classified as held for sale and assets included in
disposal groups classified as held for sale in accordance with IFRS 5 (see below)
(xi) trade and other payables;
(xii) provisions;
(xiii) financial liabilities (excluding amounts shown under (x) and (xi));
(xiv) liabilities and assets for current tax (as defined in IAS 12 Income Taxes);
(xv) deferred tax liabilities and deferred tax assets (as defined in IAS 12);
(xvi) minority interest, presented within equity; and
(xvii) issued capital, and reserves attributable to equity holders of the parent.
The face of the statement of financial position shall include line items that present the following amounts:
i. the total of assets classified as held for sale and assets included in disposal groups classified as held for sale in accordance with IFRS 5; and
ii. liabilities included in disposal groups classified as held for sale in accordance with IFRS 5.
Additional line items, headings and subtotals shall be presented on the face of the statement of financial position, when such presentation is relevant to an understanding of the financial position.
EXAMPLE –tax losses
You have large tax losses carried forward in your home country, but tax liabilities abroad. You chose to expand the tax liability lines to show both local tax (none) and foreign tax to clarify the position.
Deferred tax assets (and liabilities) are always non-current assets (liabilities).
Line items are included when the size, nature or function of an item (or aggregation of similar items) is such that separate presentation is relevant to an understanding of the financial position.
The descriptions used, and the ordering of items (or aggregation of similar items) may be amended according to the nature of the undertaking, and its transactions, to provide information that is relevant to an understanding of the financial position.
For example, a bank amends the above descriptions to apply the requirements in IFRS 7.
The judgement on whether additional items are presented separately is based on an assessment of:
(i) the nature and liquidity of assets;
(ii) the function of assets; and
(iii) the amounts, nature and timing of liabilities.
EXAMPLE-assets categorised by function
You lease photocopiers and drinks machines. Identifying the results and
net assets (assets and liabilities) employed by each function of the business helps users.
The use of different measurement bases, for different classes of assets, suggests that their nature (or function) differs and, therefore, that they should be presented as separate line items.
Different classes of property, plant and equipment can be carried at cost, or revalued amounts, in accordance with IAS 16.
Current Liabilities
A liability shall be classified as current, when it satisfies any of the following criteria:
(i) it is expected to be settled in normal operating cycle;
(ii) it is held primarily for the purpose of being traded;
(iii) it is due to be settled within twelve months after the end of the reporting period; or
(iv) the undertaking does not have an unconditional right to defer settlement of the liability, for at least twelve months after the end of the reporting period.
All other liabilities shall be classified as non-current.
Some current liabilities, such as trade payables and some accruals for staff and other operating costs, are part of the working capital used in the normal operating cycle.
TRADE AND OTHER PAYABLES summary
What are trade and other payables?
Trade and other payables are current liabilities for which the amount to be settled is usually known rather than uncertain (as for provisions). Undertakings, almost without exception, carry some type of trade and other payables on their statement of financial position.
Items generally included in trade and other payables are: trade payables; amounts payable under statutory obligations such as social security obligations and payroll taxes.
These items are presented within the "Trade and other payables" line item on the face of the statement of financial position.
Current liabilities are those expected to be settled in the normal course of the undertaking’s operating cycle; due to be settled within twelve months of the date of the end of the reporting period; held primarily for the purpose of being traded; or those for which the undertaking does not have an unconditional right to defer settlement for at least twelve months after the date of the end of the reporting period.
Most trade and other payables fall within the definition of financial liabilities and are subject to the recognition and measurement rules that apply to those liabilities.
Initial recognition
An undertaking should recognise trade and other payables when it becomes a party to the contractual provisions of the instrument.
An undertaking’s obligations concerning trade and other payables are usually easily identified and the point of recognition is clear.
Most obligations are legally enforceable and arise under contractual arrangements. These include amounts owed for assets purchased or services obtained (trade creditors), and obligations to provide goods and services where an external party has paid in advance.
Obligations are often imposed by statute. An undertaking should recognise these obligations on the basis of notices and requests for payment from the relevant authority. Constructive obligations should be recognised on the basis of amounts promised to third parties.
An undertaking often incurs obligations in the form of financial and performance guarantees. For example, an undertaking may sell its receivables yet retain a portion of the credit risk in these receivables through guarantees.
The recognition of guarantees depends on their nature. Financial guarantees that provide for payments to be made if the debtor fails to make a payment when due should be recognised as part of provisions or, when the recognition criteria are not met, disclosed as contingent liabilities.
Financial guarantees that provide for payments to be made in response to changes in a specified index such as a credit rating should be recognised as financial instruments.
Accrued expenses are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier.
The recognition of accrued expenses results directly from the recognition of expenses for items of goods and services consumed during the period. Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions.
Initial measurement
Initial measurement of trade and other payables is usually at fair value. The initial measurement of financial liabilities not at fair value through profit or loss includes transaction costs directly attributable to the acquisition or issue of the financial liability.
Initial fair value is established by reference to amounts agreed between the undertaking and the supplier and amounts invoiced from statutory authorities. Accrued expenses are measured at management’s estimate of the fair value of the goods and services received but not yet invoiced.
Financial guarantees that provide for payments to be made if the debtor fails to make a payment when due should initially be recognised at fair value.
Subsequent measurement
Items classified within trade and other payables are not usually re-measured, as the obligation is usually known with a high degree of certainty and its settlement is short-term.
Financial guarantees that provide for payments to be made if the debtor fails to make a payment when due should be re-measured at the higher of (i) the amount recognised under IAS 37 and (ii) the amount initially recognised (that is, fair value) less, where appropriate, cumulative amortisation recognised in accordance with IAS 18.
Derecognition
Derecognition occurs when the contractual obligation is cancelled, expired or discharged, for example through payment of the amount due, or through the counterparty forgiving the debt.
Presentation and disclosure
Trade and other payables should be presented as a separate line item on the face of the statement of financial position.
Such items are classified as current liabilities, even if they are due to be settled more than twelve months after the end of the reporting period.
The same normal operating cycle applies to the classification of assets and liabilities. When the undertaking’s normal operating cycle is not identifiable, it is assumed to be twelve months.
Examples of current liabilities are financial liabilities, classified as ‘held for trading’, bank overdrafts, and the current portion of non-current financial liabilities, dividends payable, income taxes and other non-trade payables.
EXAMPLE- Presentation of loan from parent
Issue
An undertaking shall present further sub-classifications of the line items presented in the statement of financial position. Those sub-classifications may be presented either on the face of the statement of financial position or in the notes, classified in a manner appropriate to the undertaking’s operations.
Should a parent, in its single-undertaking financial statements, present amounts due from a subsidiary on the face of its statement of financial position as an asset, and if so how should it be classified?
Background
A parent provides a loan to a subsidiary. Interest of 8% is paid annually. There is no specified repayment date; however, the loan is payable on demand.
Solution
Disclosure on the face of the statement of financial position is not mandatory, but it is best practice. IFRS require separate disclosure of amounts due from subsidiaries, but allow this to be presented in the notes rather than on the face of the statement of financial position.
The liability is current because the subsidiary does not have unconditional right to defer settlement of the liability. The parent, in its separate financial statements, should also classify the amount due from the subsidiary as a current asset.
Financial liabilities that provide financing on a long-term basis (not part of the working capital) and are not due for settlement within twelve months after the end of the reporting period, are non-current liabilities.
EXAMPLE- Classification and presentation of current liabilities
Issue
The following current liabilities should be disclosed on the face of the statement of financial position:
a) trade and other payables;
b) provisions;
c) financial liabilities (excluding trade and other payables and provisions); and
d) current income tax liabilities.
The following example highlights specific classes of current liabilities to be disclosed on the face of the statement of financial position, together with examples of items to be included under the headings.
Solution
a) Trade and other payables, including:
trade creditors;
accruals (for example, accruals for audit fees payable); and
social security taxes and other amounts, such as payroll taxes payable in respect of wages and salaries.
b) Provisions
Provisions for litigation, claims and assessments; and
Current portion of provisions for long term employee benefits such as jubilee payments.
c) Financial liabilities
Current portion of fixed term interest-bearing loans; and
Loans repayable on demand.
d) Current income tax liabilities, including:
corporate income taxes; and income taxes payable on dividends.
Presentation of provisions and other liabilities with current and non-current portion
Issue
How should management present the current and non-current portions of different types of provisions and liabilities in the undertaking’s statement of financial position?
Background
An undertaking has recognised the following liabilities in its statement of financial position:
a) warranty provisions;
b) provisions for environmental liabilities;
c) pension liabilities; and
d) deferred tax liabilities.
Solution
a) Warranty provisions - current or non-current liabilities
The classification will depend on the terms of the warranty. Warranties that guarantee product performance for a twelve-month period are classified as current liabilities. Conversely, warranties that guarantee product performance for an extended period are classified as non-current liabilities.
b) Provisions for environmental liabilities - non-current liabilities
This type of provision is unlikely to be part of an undertaking’s working capital. Management should therefore classify environmental provisions as non-current liabilities.
c) Pension liabilities - non-current liabilities
Considering the nature of these liabilities, management is often not able to reasonably determine the current and non-current portion reliably. It should therefore classify these liabilities as non-current liabilities.
d) Deferred tax liabilities - non-current liabilities
Management should present any deferred tax liabilities as non-current liabilities, even if the temporary differences giving rise to the liabilities are expected to reverse within 12 months.
The treatment of financial liabilities, such as bank loans is strict. The end of the reporting period is the key day by which everything must be in place. If refinancing is to take place, the end of the reporting period is the benchmark.
Failure to refinance by this date may require the undertaking to record a finance liability as current, even if it is being renegotiated to be repaid over a longer period.
This may have severe consequences, even prohibiting the financial statements to be prepared on a going-concern basis.
An undertaking classifies its financial liabilities as current, when they are due to be settled within twelve months after the end of the reporting period, even if:
(i) the original term was for a period longer than twelve months; and
(ii) an agreement to refinance, or to reschedule payments, on a long-term basis is completed after the end of the reporting period, and before the financial statements are approved for issue.
EXAMPLE- refinancing after the end of the reporting period
You need to refinance your long-term loan. Your end of the reporting period is December, you sign the refinancing in January and approve your financial statements in February.
The long-term loan is shown as a current liability, as it was not refinanced by the end of the reporting period.
If an undertaking has the discretion to refinance (or roll over) an obligation for at least twelve months after the end of the reporting period, under an existing loan facility, it classifies the obligation as non-current, even if it would otherwise be due within a shorter period.
EXAMPLE- refinancing after the end of the reporting period, but with an option
You need to refinance your long-term loan. You have an option to renew your facility. Your end of the reporting period is December, you sign the refinancing in January and approve your financial statements in February.
The long-term loan is shown as a non-current liability, as you had the refinancing option.
EXAMPLE- Classification of liability with roll-over facilities
Issue
If an obligation can be refinanced or rolled over at the discretion of the undertaking for at least twelve months after the date of the end of the reporting period under an existing loan facility, it shall be classified as non-current.
This rule applies even if the obligation would otherwise be due within a shorter period. However, when the undertaking has not the discretion to refinance or roll over the obligation (for example, there is no agreement to refinance), the potential to refinance is not considered and the obligation is classified as current.
What are the conditions under which an undertaking might classify borrowings to be repaid within the operating cycle as non-current liabilities?
Background
Undertaking A’s management has entered into a facility arrangement with a financial institution to ensure the availability of A’s bank financing over the long term.
The committed facility has a scheduled maturity and the lender is not able to cancel unilaterally. This facility does not expire within the next 12 months.
Solution
Undertaking A should classify the borrowing as a non-current liability.
The borrowing can be rolled over at the undertaking’s discretion and is not therefore part of its working capital.
Conversely, where an undertaking does not have the discretion to refinance its borrowings, amounts due should be classified as current liabilities.
When refinancing (or rolling over) the obligation is not at the discretion of the undertaking (there is no agreement to refinance), the obligation is classified as current.
When an undertaking breaches a covenant of a long-term loan agreement on, or before, the end of the reporting period, with the impact that the liability becomes payable on demand, the liability is classified as current.
This applies even if the lender has agreed, after the end of the reporting period, and before the approval of the financial statements for issue, not to demand payment, as a consequence of the breach.
EXAMPLE- amending a breach of covenant, after the end of the reporting period
You breach the terms of your long-term loan. It becomes payable on demand.
Your end of the reporting period is December, the lender agrees not to demand payment as a consequence of the breach in January, and you approve your financial statements in February.
The long-term loan is shown as a current liability: you were in breach at the end of the reporting period.
The liability is classified as current because, at the end of the reporting period, the undertaking does not have an unconditional right to defer its settlement for at least twelve months, after that date.
However, the liability is classified as non-current, if the lender agreed by the end of the reporting period to provide a period of grace ending at least twelve months after the end of the reporting period, within which the undertaking can rectify the breach, and during which, the lender cannot demand immediate repayment.
(i) it is expected to be settled in normal operating cycle;
(ii) it is held primarily for the purpose of being traded;
(iii) it is due to be settled within twelve months after the end of the reporting period; or
(iv) the undertaking does not have an unconditional right to defer settlement of the liability, for at least twelve months after the end of the reporting period.
All other liabilities shall be classified as non-current.
Some current liabilities, such as trade payables and some accruals for staff and other operating costs, are part of the working capital used in the normal operating cycle.
TRADE AND OTHER PAYABLES summary
What are trade and other payables?
Trade and other payables are current liabilities for which the amount to be settled is usually known rather than uncertain (as for provisions). Undertakings, almost without exception, carry some type of trade and other payables on their statement of financial position.
Items generally included in trade and other payables are: trade payables; amounts payable under statutory obligations such as social security obligations and payroll taxes.
These items are presented within the "Trade and other payables" line item on the face of the statement of financial position.
Current liabilities are those expected to be settled in the normal course of the undertaking’s operating cycle; due to be settled within twelve months of the date of the end of the reporting period; held primarily for the purpose of being traded; or those for which the undertaking does not have an unconditional right to defer settlement for at least twelve months after the date of the end of the reporting period.
Most trade and other payables fall within the definition of financial liabilities and are subject to the recognition and measurement rules that apply to those liabilities.
Initial recognition
An undertaking should recognise trade and other payables when it becomes a party to the contractual provisions of the instrument.
An undertaking’s obligations concerning trade and other payables are usually easily identified and the point of recognition is clear.
Most obligations are legally enforceable and arise under contractual arrangements. These include amounts owed for assets purchased or services obtained (trade creditors), and obligations to provide goods and services where an external party has paid in advance.
Obligations are often imposed by statute. An undertaking should recognise these obligations on the basis of notices and requests for payment from the relevant authority. Constructive obligations should be recognised on the basis of amounts promised to third parties.
An undertaking often incurs obligations in the form of financial and performance guarantees. For example, an undertaking may sell its receivables yet retain a portion of the credit risk in these receivables through guarantees.
The recognition of guarantees depends on their nature. Financial guarantees that provide for payments to be made if the debtor fails to make a payment when due should be recognised as part of provisions or, when the recognition criteria are not met, disclosed as contingent liabilities.
Financial guarantees that provide for payments to be made in response to changes in a specified index such as a credit rating should be recognised as financial instruments.
Accrued expenses are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier.
The recognition of accrued expenses results directly from the recognition of expenses for items of goods and services consumed during the period. Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions.
Initial measurement
Initial measurement of trade and other payables is usually at fair value. The initial measurement of financial liabilities not at fair value through profit or loss includes transaction costs directly attributable to the acquisition or issue of the financial liability.
Initial fair value is established by reference to amounts agreed between the undertaking and the supplier and amounts invoiced from statutory authorities. Accrued expenses are measured at management’s estimate of the fair value of the goods and services received but not yet invoiced.
Financial guarantees that provide for payments to be made if the debtor fails to make a payment when due should initially be recognised at fair value.
Subsequent measurement
Items classified within trade and other payables are not usually re-measured, as the obligation is usually known with a high degree of certainty and its settlement is short-term.
Financial guarantees that provide for payments to be made if the debtor fails to make a payment when due should be re-measured at the higher of (i) the amount recognised under IAS 37 and (ii) the amount initially recognised (that is, fair value) less, where appropriate, cumulative amortisation recognised in accordance with IAS 18.
Derecognition
Derecognition occurs when the contractual obligation is cancelled, expired or discharged, for example through payment of the amount due, or through the counterparty forgiving the debt.
Presentation and disclosure
Trade and other payables should be presented as a separate line item on the face of the statement of financial position.
Such items are classified as current liabilities, even if they are due to be settled more than twelve months after the end of the reporting period.
The same normal operating cycle applies to the classification of assets and liabilities. When the undertaking’s normal operating cycle is not identifiable, it is assumed to be twelve months.
Examples of current liabilities are financial liabilities, classified as ‘held for trading’, bank overdrafts, and the current portion of non-current financial liabilities, dividends payable, income taxes and other non-trade payables.
EXAMPLE- Presentation of loan from parent
Issue
An undertaking shall present further sub-classifications of the line items presented in the statement of financial position. Those sub-classifications may be presented either on the face of the statement of financial position or in the notes, classified in a manner appropriate to the undertaking’s operations.
Should a parent, in its single-undertaking financial statements, present amounts due from a subsidiary on the face of its statement of financial position as an asset, and if so how should it be classified?
Background
A parent provides a loan to a subsidiary. Interest of 8% is paid annually. There is no specified repayment date; however, the loan is payable on demand.
Solution
Disclosure on the face of the statement of financial position is not mandatory, but it is best practice. IFRS require separate disclosure of amounts due from subsidiaries, but allow this to be presented in the notes rather than on the face of the statement of financial position.
The liability is current because the subsidiary does not have unconditional right to defer settlement of the liability. The parent, in its separate financial statements, should also classify the amount due from the subsidiary as a current asset.
Financial liabilities that provide financing on a long-term basis (not part of the working capital) and are not due for settlement within twelve months after the end of the reporting period, are non-current liabilities.
EXAMPLE- Classification and presentation of current liabilities
Issue
The following current liabilities should be disclosed on the face of the statement of financial position:
a) trade and other payables;
b) provisions;
c) financial liabilities (excluding trade and other payables and provisions); and
d) current income tax liabilities.
The following example highlights specific classes of current liabilities to be disclosed on the face of the statement of financial position, together with examples of items to be included under the headings.
Solution
a) Trade and other payables, including:
trade creditors;
accruals (for example, accruals for audit fees payable); and
social security taxes and other amounts, such as payroll taxes payable in respect of wages and salaries.
b) Provisions
Provisions for litigation, claims and assessments; and
Current portion of provisions for long term employee benefits such as jubilee payments.
c) Financial liabilities
Current portion of fixed term interest-bearing loans; and
Loans repayable on demand.
d) Current income tax liabilities, including:
corporate income taxes; and income taxes payable on dividends.
Presentation of provisions and other liabilities with current and non-current portion
Issue
How should management present the current and non-current portions of different types of provisions and liabilities in the undertaking’s statement of financial position?
Background
An undertaking has recognised the following liabilities in its statement of financial position:
a) warranty provisions;
b) provisions for environmental liabilities;
c) pension liabilities; and
d) deferred tax liabilities.
Solution
a) Warranty provisions - current or non-current liabilities
The classification will depend on the terms of the warranty. Warranties that guarantee product performance for a twelve-month period are classified as current liabilities. Conversely, warranties that guarantee product performance for an extended period are classified as non-current liabilities.
b) Provisions for environmental liabilities - non-current liabilities
This type of provision is unlikely to be part of an undertaking’s working capital. Management should therefore classify environmental provisions as non-current liabilities.
c) Pension liabilities - non-current liabilities
Considering the nature of these liabilities, management is often not able to reasonably determine the current and non-current portion reliably. It should therefore classify these liabilities as non-current liabilities.
d) Deferred tax liabilities - non-current liabilities
Management should present any deferred tax liabilities as non-current liabilities, even if the temporary differences giving rise to the liabilities are expected to reverse within 12 months.
The treatment of financial liabilities, such as bank loans is strict. The end of the reporting period is the key day by which everything must be in place. If refinancing is to take place, the end of the reporting period is the benchmark.
Failure to refinance by this date may require the undertaking to record a finance liability as current, even if it is being renegotiated to be repaid over a longer period.
This may have severe consequences, even prohibiting the financial statements to be prepared on a going-concern basis.
An undertaking classifies its financial liabilities as current, when they are due to be settled within twelve months after the end of the reporting period, even if:
(i) the original term was for a period longer than twelve months; and
(ii) an agreement to refinance, or to reschedule payments, on a long-term basis is completed after the end of the reporting period, and before the financial statements are approved for issue.
EXAMPLE- refinancing after the end of the reporting period
You need to refinance your long-term loan. Your end of the reporting period is December, you sign the refinancing in January and approve your financial statements in February.
The long-term loan is shown as a current liability, as it was not refinanced by the end of the reporting period.
If an undertaking has the discretion to refinance (or roll over) an obligation for at least twelve months after the end of the reporting period, under an existing loan facility, it classifies the obligation as non-current, even if it would otherwise be due within a shorter period.
EXAMPLE- refinancing after the end of the reporting period, but with an option
You need to refinance your long-term loan. You have an option to renew your facility. Your end of the reporting period is December, you sign the refinancing in January and approve your financial statements in February.
The long-term loan is shown as a non-current liability, as you had the refinancing option.
EXAMPLE- Classification of liability with roll-over facilities
Issue
If an obligation can be refinanced or rolled over at the discretion of the undertaking for at least twelve months after the date of the end of the reporting period under an existing loan facility, it shall be classified as non-current.
This rule applies even if the obligation would otherwise be due within a shorter period. However, when the undertaking has not the discretion to refinance or roll over the obligation (for example, there is no agreement to refinance), the potential to refinance is not considered and the obligation is classified as current.
What are the conditions under which an undertaking might classify borrowings to be repaid within the operating cycle as non-current liabilities?
Background
Undertaking A’s management has entered into a facility arrangement with a financial institution to ensure the availability of A’s bank financing over the long term.
The committed facility has a scheduled maturity and the lender is not able to cancel unilaterally. This facility does not expire within the next 12 months.
Solution
Undertaking A should classify the borrowing as a non-current liability.
The borrowing can be rolled over at the undertaking’s discretion and is not therefore part of its working capital.
Conversely, where an undertaking does not have the discretion to refinance its borrowings, amounts due should be classified as current liabilities.
When refinancing (or rolling over) the obligation is not at the discretion of the undertaking (there is no agreement to refinance), the obligation is classified as current.
When an undertaking breaches a covenant of a long-term loan agreement on, or before, the end of the reporting period, with the impact that the liability becomes payable on demand, the liability is classified as current.
This applies even if the lender has agreed, after the end of the reporting period, and before the approval of the financial statements for issue, not to demand payment, as a consequence of the breach.
EXAMPLE- amending a breach of covenant, after the end of the reporting period
You breach the terms of your long-term loan. It becomes payable on demand.
Your end of the reporting period is December, the lender agrees not to demand payment as a consequence of the breach in January, and you approve your financial statements in February.
The long-term loan is shown as a current liability: you were in breach at the end of the reporting period.
The liability is classified as current because, at the end of the reporting period, the undertaking does not have an unconditional right to defer its settlement for at least twelve months, after that date.
However, the liability is classified as non-current, if the lender agreed by the end of the reporting period to provide a period of grace ending at least twelve months after the end of the reporting period, within which the undertaking can rectify the breach, and during which, the lender cannot demand immediate repayment.
Current Assets
An asset shall be classified as current, when it satisfies any of the following criteria:
(i) it is expected to be converted to cash (or is intended for sale, or consumption) in the normal operating cycle;
(ii) it is held primarily for the purpose of being traded;
(iii) it is expected to be converted to cash within twelve months, after the end of the reporting period; or
(iv) it is cash (or a cash equivalent, as defined in IAS 7), unless it is restricted from being exchanged (or used to settle a liability), for at least twelve months after the end of the reporting period.
EXAMPLE - Presentation of cash subject to restrictions over use
Issue
Should an undertaking include in its consolidated financial statements cash and cash equivalents, held by a subsidiary that is not available for use by other group undertakings?
Background
A subsidiary holds cash and cash equivalent balances with domestic banks. It operates in a country where there are exchange controls and the subsidiary is restricted from sending cash abroad to fellow subsidiaries and to the parent.
The amount of cash held is neither excessive nor short of the subsidiary’s operating needs.
Solution
The existence of currency restrictions in a foreign jurisdiction would not preclude the classification of the subsidiary’s cash and cash equivalent balance as a current asset in the consolidated financial statements.
The subsidiary needs the cash to meet its operating requirements, and will therefore use it freely.
The undertaking should, however, disclose the amount of cash and cash equivalents that is not available for use by the group [IAS7].
The disclosure should include a commentary that will help users understand the impact of these restrictions in the undertaking’s financial position and liquidity.
All other assets shall be classified as non-current.
IAS 1 uses the term ‘non-current’ to include tangible, intangible and financial assets of a long-term nature. It does not prohibit the use of alternative descriptions, if the meaning is clear.
The operating cycle is the time between the acquisition of assets for processing, and their conversion in cash. When the normal operating cycle is not clearly identifiable, it is assumed to be twelve months.
(i) it is expected to be converted to cash (or is intended for sale, or consumption) in the normal operating cycle;
(ii) it is held primarily for the purpose of being traded;
(iii) it is expected to be converted to cash within twelve months, after the end of the reporting period; or
(iv) it is cash (or a cash equivalent, as defined in IAS 7), unless it is restricted from being exchanged (or used to settle a liability), for at least twelve months after the end of the reporting period.
EXAMPLE - Presentation of cash subject to restrictions over use
Issue
Should an undertaking include in its consolidated financial statements cash and cash equivalents, held by a subsidiary that is not available for use by other group undertakings?
Background
A subsidiary holds cash and cash equivalent balances with domestic banks. It operates in a country where there are exchange controls and the subsidiary is restricted from sending cash abroad to fellow subsidiaries and to the parent.
The amount of cash held is neither excessive nor short of the subsidiary’s operating needs.
Solution
The existence of currency restrictions in a foreign jurisdiction would not preclude the classification of the subsidiary’s cash and cash equivalent balance as a current asset in the consolidated financial statements.
The subsidiary needs the cash to meet its operating requirements, and will therefore use it freely.
The undertaking should, however, disclose the amount of cash and cash equivalents that is not available for use by the group [IAS7].
The disclosure should include a commentary that will help users understand the impact of these restrictions in the undertaking’s financial position and liquidity.
All other assets shall be classified as non-current.
IAS 1 uses the term ‘non-current’ to include tangible, intangible and financial assets of a long-term nature. It does not prohibit the use of alternative descriptions, if the meaning is clear.
The operating cycle is the time between the acquisition of assets for processing, and their conversion in cash. When the normal operating cycle is not clearly identifiable, it is assumed to be twelve months.
Identification of the Financial Statements
The financial statements shall be identified clearly, and distinguished from other information in the same document. Users must be able to distinguish information that is prepared using IFRSs, from other information that is not the subject of those requirements.
Survey of income statements IFRS News
April 2007
The financial statements of 2,800 companies were surveyed, specifically looking at the additional income measures companies included in their financial statements beyond the minimum required by IFRS.
The survey also examined how companies present these non-GAAP measures in their income statements.
“Investors tell us that additional income measures are useful and that they take
them into account when making investment decisions,” says Leandro van
Dam, PwC partner in the Netherlands and co-sponsor of the survey.
“They are also looking for non-GAAP measures that management uses to run the business. They want consistency of information over time and comparability among companies.” Debate on the use of non-GAAP measures is gathering interest.
Some highlights from the report are summarised below.
A bridge from old to IFRS
Companies have aligned their choice and presentation of non-GAAP measures under IFRS as much as possible with what they reported under national GAAP.
This has allowed users to compare non-GAAP measures calculated using IFRS recognition and measurement principles with the measures calculated on the previous basis.
No evidence of cherry-picking
Companies do not appear to have cherry-picked additional income measures to show their results in a more positive light; the overall trends (rise or fall) for the alternative income measures reported were similar to the trends for net profit under IFRS.
Companies generally met IFRS presentation requirements for the income statement.
Industry variations
Industry variations in EBITDA and similar measures are consistent between 2004 reporting under national GAAP and 2005 IFRS reporting. Companies already appear to be responding to investor demands for international comparability within industry sectors.
National trends are still strong
Countries that have historically reported certain non-GAAP measures still do so under IFRS; those that did not report specific non-GAAP measures did not start to do so.
International comparability of non-GAAP reporting in the first year of application was unlikely to arise spontaneously. Management had little opportunity to
compare reporting practices with their peers and limited experience of IFRS-related discussions with investors, regulators and other parties.
Many conferences and industry sessions focused on recognition and measurement and paid little attention to format requirements and options for additional line items in the income statement.
There was therefore was no real platform for development of market norms.
Companies may find the research useful in deciding what to communicate to the
market in next year’s IFRS financial statements.
“This research should enable management to look at what peers are doing,” says Leandro, “and consider whether current diversity of non-GAAP measurement and presentation holds any clues for better ways of communicating with investors in future.”
Download the PDF from pwc.com/ifrs
Each component of the financial statements shall be identified clearly. In addition, the following information shall be displayed prominently (and repeated when it is necessary), for a proper understanding of the information presented:
(i) the name of the reporting undertaking, and any change from the preceding end of the reporting period;
(ii) whether the financial statements cover the individual undertaking, or a group;
(iii) the date of the end of the reporting period, or the period covered by the financial statements, whichever is appropriate to that component of the financial statements;
(iv) the presentation currency,
(v) the level of rounding used in presenting amounts in the financial statements.
These requirements are normally met by presenting page headings, and abbreviated column headings, on each page of the financial statements. Judgement is required in determining the best presentation.
When the financial statements are presented electronically, separate pages are not always used; the above items are then presented frequently enough to ensure a proper understanding of the information.
Financial statements are often made more understandable by presenting information in thousands (or millions) of units of the presentation currency. This is acceptable if the level of rounding in presentation is disclosed, and material information is not omitted.
12. Frequency of Reporting
Financial statements shall be presented at least annually.
When the end of the reporting period changes, and the annual financial statements are presented for a period longer (or shorter) than one year, an undertaking shall disclose, (in addition to the period covered):
(i) the reason for using a longer (or shorter) period; and
(ii) the fact that comparative amounts for the financial statements are not entirely comparable.
EXAMPLE- change of end of the reporting period
Your firm has just been purchased by an investor, who wishes to change your year-end from June to December. Your first set of financial statements (under the new regime) will be for a 6 month period, and will not be comparable with prior periods. The above disclosures will need to be made.
Normally, financial statements are consistently prepared covering a one-year period. Some undertakings prefer to report for a 52-week period. IAS 1 does not preclude this practice, because the financial statements are unlikely to be materially different from those that would be presented for one year.
EXAMPLE-52-week period
You operate department stores. Your period is 52 weeks, so that you can end the period on a Sunday, and count inventory on a Monday.
13. Statement of financial position
Current/Non-current Distinction
An undertaking shall present current and non-current assets, and current and non-current liabilities, as separate classifications on the face of its statement of financial position, except when a presentation based on liquidity provides information that is more relevant.
When that exception applies, all assets and liabilities shall be presented broadly in order of liquidity.
EXAMPLE-Financial Institutions
Your firm is a financial institution, and you present your statement of financial position items broadly in order of liquidity (see IFRS 7 workbook).
For each asset and liability line item that combines amounts expected to be recovered (or settled)
no more than twelve months after the end of the reporting period, and
more than twelve months after the end of the reporting period,
an undertaking shall disclose the amount expected to be recovered (or settled) after more than twelve months.
When an undertaking supplies goods (or services) within a clearly identifiable operating cycle, separate classification of current and non-current assets (and liabilities) provides useful information, by distinguishing the net assets that are continuously circulating as working capital, from those used in long-term operations.
EXAMPLE-Current and non-current distinction based on operating cycle
Issue
An asset that satisfies any of the following criteria shall be classified as a current asset:
a) its realisation, sale or consumption is expected to occur in the undertaking’s normal operating cycle;
b) it is held for sale;
c) its realisation is expected to occur within twelve months after the date of the end of the reporting period; or
d) it is unrestricted cash or a cash equivalent.
Can an undertaking classify a receivable that it does not expect to realise within twelve months as a current asset in its statement of financial position?
Background
Undertaking A builds airplanes for national airlines. The average operating cycle is 15 months, based on the length of time it takes to build a plane. A’s management presents a classified balance sheet to distinguish its current and non-current assets and liabilities. The undertaking carries accounts receivable that it expects to realise in 15 months.
Solution
Yes, A should classify the receivable as a current asset, as it expects to realise the receivable in the normal course of its 15-month operating cycle.
The undertaking’s accounting policy note should describe the policy on classification of current and non-current items.
It also highlights assets that are expected to be converted into cash within the current operating cycle, and liabilities that are due for settlement within the same period.
An undertaking is permitted to present some of its assets and liabilities using a current/non-current classification, and others in order of liquidity, when this provides information that is more relevant.
The need for a mixed basis of presentation might arise when an undertaking has diverse operations.
Information about expected dates of conversion into cash of assets and liabilities is useful in assessing the liquidity, and solvency, of an undertaking. IFRS 7 requires disclosure of the maturity dates of financial assets, and financial liabilities.
Financial assets include trade and other receivables, and financial liabilities include trade and other payables.
Information on the expected date of recovery and settlement of non-monetary assets and liabilities, such as inventories and provisions, is also useful, whether or not assets and liabilities are classified as current or non-current.
An undertaking discloses the amount of inventories that are expected to be sold more than twelve months after the end of the reporting period.
Survey of income statements IFRS News
April 2007
The financial statements of 2,800 companies were surveyed, specifically looking at the additional income measures companies included in their financial statements beyond the minimum required by IFRS.
The survey also examined how companies present these non-GAAP measures in their income statements.
“Investors tell us that additional income measures are useful and that they take
them into account when making investment decisions,” says Leandro van
Dam, PwC partner in the Netherlands and co-sponsor of the survey.
“They are also looking for non-GAAP measures that management uses to run the business. They want consistency of information over time and comparability among companies.” Debate on the use of non-GAAP measures is gathering interest.
Some highlights from the report are summarised below.
A bridge from old to IFRS
Companies have aligned their choice and presentation of non-GAAP measures under IFRS as much as possible with what they reported under national GAAP.
This has allowed users to compare non-GAAP measures calculated using IFRS recognition and measurement principles with the measures calculated on the previous basis.
No evidence of cherry-picking
Companies do not appear to have cherry-picked additional income measures to show their results in a more positive light; the overall trends (rise or fall) for the alternative income measures reported were similar to the trends for net profit under IFRS.
Companies generally met IFRS presentation requirements for the income statement.
Industry variations
Industry variations in EBITDA and similar measures are consistent between 2004 reporting under national GAAP and 2005 IFRS reporting. Companies already appear to be responding to investor demands for international comparability within industry sectors.
National trends are still strong
Countries that have historically reported certain non-GAAP measures still do so under IFRS; those that did not report specific non-GAAP measures did not start to do so.
International comparability of non-GAAP reporting in the first year of application was unlikely to arise spontaneously. Management had little opportunity to
compare reporting practices with their peers and limited experience of IFRS-related discussions with investors, regulators and other parties.
Many conferences and industry sessions focused on recognition and measurement and paid little attention to format requirements and options for additional line items in the income statement.
There was therefore was no real platform for development of market norms.
Companies may find the research useful in deciding what to communicate to the
market in next year’s IFRS financial statements.
“This research should enable management to look at what peers are doing,” says Leandro, “and consider whether current diversity of non-GAAP measurement and presentation holds any clues for better ways of communicating with investors in future.”
Download the PDF from pwc.com/ifrs
Each component of the financial statements shall be identified clearly. In addition, the following information shall be displayed prominently (and repeated when it is necessary), for a proper understanding of the information presented:
(i) the name of the reporting undertaking, and any change from the preceding end of the reporting period;
(ii) whether the financial statements cover the individual undertaking, or a group;
(iii) the date of the end of the reporting period, or the period covered by the financial statements, whichever is appropriate to that component of the financial statements;
(iv) the presentation currency,
(v) the level of rounding used in presenting amounts in the financial statements.
These requirements are normally met by presenting page headings, and abbreviated column headings, on each page of the financial statements. Judgement is required in determining the best presentation.
When the financial statements are presented electronically, separate pages are not always used; the above items are then presented frequently enough to ensure a proper understanding of the information.
Financial statements are often made more understandable by presenting information in thousands (or millions) of units of the presentation currency. This is acceptable if the level of rounding in presentation is disclosed, and material information is not omitted.
12. Frequency of Reporting
Financial statements shall be presented at least annually.
When the end of the reporting period changes, and the annual financial statements are presented for a period longer (or shorter) than one year, an undertaking shall disclose, (in addition to the period covered):
(i) the reason for using a longer (or shorter) period; and
(ii) the fact that comparative amounts for the financial statements are not entirely comparable.
EXAMPLE- change of end of the reporting period
Your firm has just been purchased by an investor, who wishes to change your year-end from June to December. Your first set of financial statements (under the new regime) will be for a 6 month period, and will not be comparable with prior periods. The above disclosures will need to be made.
Normally, financial statements are consistently prepared covering a one-year period. Some undertakings prefer to report for a 52-week period. IAS 1 does not preclude this practice, because the financial statements are unlikely to be materially different from those that would be presented for one year.
EXAMPLE-52-week period
You operate department stores. Your period is 52 weeks, so that you can end the period on a Sunday, and count inventory on a Monday.
13. Statement of financial position
Current/Non-current Distinction
An undertaking shall present current and non-current assets, and current and non-current liabilities, as separate classifications on the face of its statement of financial position, except when a presentation based on liquidity provides information that is more relevant.
When that exception applies, all assets and liabilities shall be presented broadly in order of liquidity.
EXAMPLE-Financial Institutions
Your firm is a financial institution, and you present your statement of financial position items broadly in order of liquidity (see IFRS 7 workbook).
For each asset and liability line item that combines amounts expected to be recovered (or settled)
no more than twelve months after the end of the reporting period, and
more than twelve months after the end of the reporting period,
an undertaking shall disclose the amount expected to be recovered (or settled) after more than twelve months.
When an undertaking supplies goods (or services) within a clearly identifiable operating cycle, separate classification of current and non-current assets (and liabilities) provides useful information, by distinguishing the net assets that are continuously circulating as working capital, from those used in long-term operations.
EXAMPLE-Current and non-current distinction based on operating cycle
Issue
An asset that satisfies any of the following criteria shall be classified as a current asset:
a) its realisation, sale or consumption is expected to occur in the undertaking’s normal operating cycle;
b) it is held for sale;
c) its realisation is expected to occur within twelve months after the date of the end of the reporting period; or
d) it is unrestricted cash or a cash equivalent.
Can an undertaking classify a receivable that it does not expect to realise within twelve months as a current asset in its statement of financial position?
Background
Undertaking A builds airplanes for national airlines. The average operating cycle is 15 months, based on the length of time it takes to build a plane. A’s management presents a classified balance sheet to distinguish its current and non-current assets and liabilities. The undertaking carries accounts receivable that it expects to realise in 15 months.
Solution
Yes, A should classify the receivable as a current asset, as it expects to realise the receivable in the normal course of its 15-month operating cycle.
The undertaking’s accounting policy note should describe the policy on classification of current and non-current items.
It also highlights assets that are expected to be converted into cash within the current operating cycle, and liabilities that are due for settlement within the same period.
An undertaking is permitted to present some of its assets and liabilities using a current/non-current classification, and others in order of liquidity, when this provides information that is more relevant.
The need for a mixed basis of presentation might arise when an undertaking has diverse operations.
Information about expected dates of conversion into cash of assets and liabilities is useful in assessing the liquidity, and solvency, of an undertaking. IFRS 7 requires disclosure of the maturity dates of financial assets, and financial liabilities.
Financial assets include trade and other receivables, and financial liabilities include trade and other payables.
Information on the expected date of recovery and settlement of non-monetary assets and liabilities, such as inventories and provisions, is also useful, whether or not assets and liabilities are classified as current or non-current.
An undertaking discloses the amount of inventories that are expected to be sold more than twelve months after the end of the reporting period.
General Review
The business and accounting knowledge of users is assumed to be reasonable, but they are not assumed to have a comprehensive of your business. This guides the level of detail and explanation that will be provided in the financial statements.
IAS 1 requires particular disclosures on the face of the statement of financial position, income statement, and statement of changes in equity, and requires disclosure of other line items either on the face of those statements, or in the notes. IAS 7 sets out requirements for the presentation of a cash flow statement.
Disclosures are made either on the face of the statement of financial position, income statement, statement of changes in equity or cash flow statement (whichever is relevant), or in the notes.
Structure and Content
Introduction
IAS 1 requires particular disclosures in the statement of financial position or of comprehensive income, in the separate income statement (if presented), or in the statement of changes in equity and requires disclosure of other line items either in those statements or in the notes.
IAS 1 requires particular disclosures on the face of the statement of financial position, income statement, and statement of changes in equity, and requires disclosure of other line items either on the face of those statements, or in the notes. IAS 7 sets out requirements for the presentation of a cash flow statement.
Disclosures are made either on the face of the statement of financial position, income statement, statement of changes in equity or cash flow statement (whichever is relevant), or in the notes.
Structure and Content
Introduction
IAS 1 requires particular disclosures in the statement of financial position or of comprehensive income, in the separate income statement (if presented), or in the statement of changes in equity and requires disclosure of other line items either in those statements or in the notes.
Comparative Information
An undertaking disclosing comparative information shall present, as a minimum, two statements of financial position, two of each of the other statements, and related notes.
When an undertaking applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements or when it reclassifies items in its financial statements, it shall present, as a minimum, three statements of financial position, two of each of the other statements, and related notes.
An undertaking presents statements of financial position as at:
(a) the end of the current period,
(b) the end of the previous period (which is the same as the beginning of the current period), and
(c) the beginning of the earliest comparative period.
Narrative information provided in the financial statements for the previous period may be relevant in the current period.
EXAMPLE- Comparative narrative information
Issue
Undertakings should include comparative information for narrative and descriptive information when it is relevant to an understanding of the current period’s financial statements.
When should management include comparative narrative information in the financial statements?
Background
An undertaking has an exclusive 3-year licence to operate the domestic mobile phone service; the government had granted the licence. The government sued the undertaking in 20X2, alleging that it has been providing service below the quality limits of the concession agreement. The government has indicated its intention to cancel the agreement that gives the undertaking the exclusivity to operate the service. The dispute is to be settled legally and at the balance date is yet to be resolved.
Solution
The undertaking should disclosure information about the dispute that is useful to the users of the financial statements. The information should not necessarily be limited to the events of the current period. The disclosure should focus on:
a) summary of the dispute;
b) the actual and potential financial effect; and
c) the likely outcome and the expected timing of a resolution.
The following is an example of an appropriate disclosure:
Note 10 Domestic mobile phone licence - dispute with government
In 20X1 the government granted the company a 3-year licence to operate the domestic mobile phone service. The company derives 25% of its revenue from domestic phone service.
The conditions of the licence included seven performance targets. The company is currently in dispute with the government over whether it has met a specific target.
The dispute has not impacted on the undertaking’s financial performance in 20X1
or 20X2. Withdrawal of the licence could potentially reduce the undertaking’s revenue in 20X3.
Management is confident however that it has met all performance targets, and the company’s legal advisers have confirmed this view.
Details of a legal dispute, the outcome of which was uncertain at the last end of the reporting period, and is yet to be resolved, are disclosed in the current period.
Users benefit from information that the uncertainty existed at the last end of the reporting period, and about the steps that have been taken during the period, to resolve the uncertainty.
When an undertaking applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements or when it reclassifies items in its financial statements, it shall present, as a minimum, three statements of financial position, two of each of the other statements, and related notes.
An undertaking presents statements of financial position as at:
(a) the end of the current period,
(b) the end of the previous period (which is the same as the beginning of the current period), and
(c) the beginning of the earliest comparative period.
Narrative information provided in the financial statements for the previous period may be relevant in the current period.
EXAMPLE- Comparative narrative information
Issue
Undertakings should include comparative information for narrative and descriptive information when it is relevant to an understanding of the current period’s financial statements.
When should management include comparative narrative information in the financial statements?
Background
An undertaking has an exclusive 3-year licence to operate the domestic mobile phone service; the government had granted the licence. The government sued the undertaking in 20X2, alleging that it has been providing service below the quality limits of the concession agreement. The government has indicated its intention to cancel the agreement that gives the undertaking the exclusivity to operate the service. The dispute is to be settled legally and at the balance date is yet to be resolved.
Solution
The undertaking should disclosure information about the dispute that is useful to the users of the financial statements. The information should not necessarily be limited to the events of the current period. The disclosure should focus on:
a) summary of the dispute;
b) the actual and potential financial effect; and
c) the likely outcome and the expected timing of a resolution.
The following is an example of an appropriate disclosure:
Note 10 Domestic mobile phone licence - dispute with government
In 20X1 the government granted the company a 3-year licence to operate the domestic mobile phone service. The company derives 25% of its revenue from domestic phone service.
The conditions of the licence included seven performance targets. The company is currently in dispute with the government over whether it has met a specific target.
The dispute has not impacted on the undertaking’s financial performance in 20X1
or 20X2. Withdrawal of the licence could potentially reduce the undertaking’s revenue in 20X3.
Management is confident however that it has met all performance targets, and the company’s legal advisers have confirmed this view.
Details of a legal dispute, the outcome of which was uncertain at the last end of the reporting period, and is yet to be resolved, are disclosed in the current period.
Users benefit from information that the uncertainty existed at the last end of the reporting period, and about the steps that have been taken during the period, to resolve the uncertainty.
Consistency of Presentation
The presentation, and classification, of items in the financial statements shall be retained from one period to the next unless:
(i) it is apparent, following a significant change in the nature of the undertaking’s operations, or a review of its financial statements, that another presentation would be more appropriate, having regard to the criteria for the application of policies in IAS 8; or
(ii) a Standard requires a change in presentation.
EXAMPLE-consistent policies
Using different measurement systems of inventory (FIFO and weighted-average cost are permitted by IFRS) generates different results. Consistent use of one method is essential to allow users to compare one period with another.
There should be no change of method, unless a Standard decrees it, or it would help users.
If other undertakings, in the same industry, use particular accounting policies, users will benefit if yours are consistent with theirs, to enable comparison.
A significant acquisition (or disposal), or a review of the presentation of the financial statements, might suggest that the financial statements need to be presented differently.
An undertaking changes the presentation of its financial statements only if the new presentation provides information that is reliable, and is more relevant to users, and the revised structure is likely to continue, so that comparability is not impaired.
(i) it is apparent, following a significant change in the nature of the undertaking’s operations, or a review of its financial statements, that another presentation would be more appropriate, having regard to the criteria for the application of policies in IAS 8; or
(ii) a Standard requires a change in presentation.
EXAMPLE-consistent policies
Using different measurement systems of inventory (FIFO and weighted-average cost are permitted by IFRS) generates different results. Consistent use of one method is essential to allow users to compare one period with another.
There should be no change of method, unless a Standard decrees it, or it would help users.
If other undertakings, in the same industry, use particular accounting policies, users will benefit if yours are consistent with theirs, to enable comparison.
A significant acquisition (or disposal), or a review of the presentation of the financial statements, might suggest that the financial statements need to be presented differently.
An undertaking changes the presentation of its financial statements only if the new presentation provides information that is reliable, and is more relevant to users, and the revised structure is likely to continue, so that comparability is not impaired.
Going Concern
When preparing financial statements, management shall make an assessment of an undertaking’s ability to continue as a going concern. Financial statements shall be prepared on a going-concern basis, unless management either intends to liquidate the undertaking or to cease trading, or has no realistic alternative but to do so.
EXAMPLE-going concern
Banks provide loans under specific conditions, including the financial performance of clients. A breach of these conditions may enable the bank to liquidate the client’s business. In these circumstances, unless the client can secure an alternative source of finance, financial statements should not be prepared on a going concern basis.
When management is aware of material uncertainties that may cast significant doubt upon the undertaking’s ability to continue as a going concern, those uncertainties shall be disclosed.
When financial statements are not prepared on a going concern basis, that fact shall be disclosed, together with the basis on which the financial statements are prepared, and the reason why the undertaking is not regarded as a going concern.
In assessing whether the going-concern assumption is appropriate, management takes into account all available information about the future, which is at least twelve months from the end of the reporting period.
EXAMPLE-going concern
Management reviews its budgets to identify times when cash flows will be under pressure. It reviews its credit lines to ensure that sufficient funds will be available to cover any anticipated shortfalls. It arranges further lines of credit, if necessary. Having done this, it can produce accounts on a going-concern basis.
When an undertaking has a history of profitable operations, and ready access to financial resources, a conclusion that the going-concern basis is appropriate may be reached without detailed analysis.
In other cases, management may need to consider a wide range of factors, relating to current and expected profitability, debt repayment schedules and potential sources of replacement financing, before it can satisfy itself that the going-concern basis is appropriate
EXAMPLE-going concern
Banks provide loans under specific conditions, including the financial performance of clients. A breach of these conditions may enable the bank to liquidate the client’s business. In these circumstances, unless the client can secure an alternative source of finance, financial statements should not be prepared on a going concern basis.
When management is aware of material uncertainties that may cast significant doubt upon the undertaking’s ability to continue as a going concern, those uncertainties shall be disclosed.
When financial statements are not prepared on a going concern basis, that fact shall be disclosed, together with the basis on which the financial statements are prepared, and the reason why the undertaking is not regarded as a going concern.
In assessing whether the going-concern assumption is appropriate, management takes into account all available information about the future, which is at least twelve months from the end of the reporting period.
EXAMPLE-going concern
Management reviews its budgets to identify times when cash flows will be under pressure. It reviews its credit lines to ensure that sufficient funds will be available to cover any anticipated shortfalls. It arranges further lines of credit, if necessary. Having done this, it can produce accounts on a going-concern basis.
When an undertaking has a history of profitable operations, and ready access to financial resources, a conclusion that the going-concern basis is appropriate may be reached without detailed analysis.
In other cases, management may need to consider a wide range of factors, relating to current and expected profitability, debt repayment schedules and potential sources of replacement financing, before it can satisfy itself that the going-concern basis is appropriate
EXAMPLE-Additional disclosure to enhance fair presentation
EXAMPLE-Additional disclosure to enhance fair presentation
Issue
A fair presentation of an undertaking’s financial position may require, in rare situations, additional disclosures to those that IFRS require.
When it is appropriate to provide additional disclosure about the reconciliation of the opening deferred tax balance to the closing deferred tax balance?
Background
An undertaking has material unused tax losses and its management has no expectation that future taxable profit will be available before they expire.
Solution
IAS 12’s required disclosures may not in this case provide enough information to understand the current period’s financial statements. Management should present additional notes.
Issue
A fair presentation of an undertaking’s financial position may require, in rare situations, additional disclosures to those that IFRS require.
When it is appropriate to provide additional disclosure about the reconciliation of the opening deferred tax balance to the closing deferred tax balance?
Background
An undertaking has material unused tax losses and its management has no expectation that future taxable profit will be available before they expire.
Solution
IAS 12’s required disclosures may not in this case provide enough information to understand the current period’s financial statements. Management should present additional notes.
Fair Presentation and Compliance with IFRSs
Financial statements shall present fairly the financial position, financial performance and cash flows of an undertaking.
Fair presentation requires the faithful representation of the impacts of transactions, in accordance with the definitions (and recognition criteria) for assets, liabilities, income and expenses set out in the Framework (see Framework workbook).
The application of IFRSs (with additional disclosure when necessary) is presumed to result in financial statements that achieve a fair presentation.
Financial statements that comply with IFRSs shall make an explicit and unreserved statement of such compliance in the notes. Financial statements shall not be described as complying with IFRSs, unless they comply with all the requirements of IFRSs.
A fair presentation also requires an undertaking:
(i) to select and apply accounting policies in accordance with IAS 8 Accounting Policies. IAS 8 sets out a hierarchy of guidance that management considers (in the absence of a Standard) that specifically applies to an item.
(ii) to present information, including policies, in a manner that provides relevant, reliable, comparable and understandable information.
(iii) to provide additional disclosures, when compliance with the specific requirements in IFRSs is insufficient to enable users to understand the impact of particular transactions, on the undertaking’s financial position, and performance.
Fair presentation requires the faithful representation of the impacts of transactions, in accordance with the definitions (and recognition criteria) for assets, liabilities, income and expenses set out in the Framework (see Framework workbook).
The application of IFRSs (with additional disclosure when necessary) is presumed to result in financial statements that achieve a fair presentation.
Financial statements that comply with IFRSs shall make an explicit and unreserved statement of such compliance in the notes. Financial statements shall not be described as complying with IFRSs, unless they comply with all the requirements of IFRSs.
A fair presentation also requires an undertaking:
(i) to select and apply accounting policies in accordance with IAS 8 Accounting Policies. IAS 8 sets out a hierarchy of guidance that management considers (in the absence of a Standard) that specifically applies to an item.
(ii) to present information, including policies, in a manner that provides relevant, reliable, comparable and understandable information.
(iii) to provide additional disclosures, when compliance with the specific requirements in IFRSs is insufficient to enable users to understand the impact of particular transactions, on the undertaking’s financial position, and performance.
Definitions
General purpose financial statements (referred to as ‘financial statements’) are those intended to meet the needs of users who are not in a position to require an undertaking to prepare reports tailored to their particular information needs.
Impracticable Applying a requirement is impracticable when the undertaking cannot apply it, after making every reasonable effort to do so.
Material Omissions (or misstatements of items) are material if they could influence the decisions of users, taken on the basis of the financial statements.
Materiality depends on the size, and nature, of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor.
Notes contain information in addition to that presented in the statement of financial position, statement of comprehensive income, separate income statement (if presented), statement of changes in equity, and statement of cash flows.
Notes provide narrative descriptions, or disaggregations of items in those statements, and information about items that do not qualify for recognition in those statements.
Assessing whether an omission, or misstatement, could influence decisions of users, and so be material, requires consideration of the characteristics of those users.
Users are assumed to have a reasonable knowledge of business and accounting, and a willingness to study the information with reasonable diligence.
The assessment needs to take into account how users, with such attributes, are influenced in making decisions.
Other comprehensive income comprises items of income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or permitted by other IFRSs.
The components of other comprehensive income include:
(i) changes in revaluation surplus (see IAS 16 Property, Plant and
Equipment and IAS 38 Intangible Assets);
(ii) actuarial gains and losses on defined benefit plans recognised in accordance IAS 19 Employee Benefits;
(iii) gains and losses arising from translating the financial statements of a foreign operation (see IAS 21);
(iv) gains and losses on remeasuring available-for-sale financial assets
(see IAS 39 Financial Instruments);
(v) the effective portion of gains and losses on hedging instruments in a cash
flow hedge (see IAS 39).
Owners are holders of instruments classified as equity.
Profit or loss is the total of income less expenses, excluding the components of other comprehensive income.
Reclassification adjustments are amounts reclassified to profit or loss in the current period that were recognised in other comprehensive income in the current or previous periods.
Total comprehensive income is the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners.
Total comprehensive income comprises all components of ‘profit or loss’
and of ‘other comprehensive income’.
Although IAS 1 uses the terms ‘other comprehensive income’, ‘profit or loss’ and ‘total comprehensive income’, an undertaking may use other terms to describe the totals as long as the meaning is clear. For example, an undertaking may use the term ‘net income’ to describe profit or loss.
Profit or loss is the total of income less expenses, excluding the components of other comprehensive income.
Reclassification adjustments are amounts reclassified to profit or loss in the current period that were recognised in other comprehensive income in the current or previous periods.
Total comprehensive income is the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners.
Total comprehensive income comprises all components of ‘profit or loss’
and of ‘other comprehensive income’.
Although IAS 1 uses the terms ‘other comprehensive income’, ‘profit or loss’ and ‘total comprehensive income’, an undertaking may use other terms to describe the totals as long as the meaning is clear.
For example, an undertaking may use the term ‘net income’ to describe profit or loss.
3
Impracticable Applying a requirement is impracticable when the undertaking cannot apply it, after making every reasonable effort to do so.
Material Omissions (or misstatements of items) are material if they could influence the decisions of users, taken on the basis of the financial statements.
Materiality depends on the size, and nature, of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor.
Notes contain information in addition to that presented in the statement of financial position, statement of comprehensive income, separate income statement (if presented), statement of changes in equity, and statement of cash flows.
Notes provide narrative descriptions, or disaggregations of items in those statements, and information about items that do not qualify for recognition in those statements.
Assessing whether an omission, or misstatement, could influence decisions of users, and so be material, requires consideration of the characteristics of those users.
Users are assumed to have a reasonable knowledge of business and accounting, and a willingness to study the information with reasonable diligence.
The assessment needs to take into account how users, with such attributes, are influenced in making decisions.
Other comprehensive income comprises items of income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or permitted by other IFRSs.
The components of other comprehensive income include:
(i) changes in revaluation surplus (see IAS 16 Property, Plant and
Equipment and IAS 38 Intangible Assets);
(ii) actuarial gains and losses on defined benefit plans recognised in accordance IAS 19 Employee Benefits;
(iii) gains and losses arising from translating the financial statements of a foreign operation (see IAS 21);
(iv) gains and losses on remeasuring available-for-sale financial assets
(see IAS 39 Financial Instruments);
(v) the effective portion of gains and losses on hedging instruments in a cash
flow hedge (see IAS 39).
Owners are holders of instruments classified as equity.
Profit or loss is the total of income less expenses, excluding the components of other comprehensive income.
Reclassification adjustments are amounts reclassified to profit or loss in the current period that were recognised in other comprehensive income in the current or previous periods.
Total comprehensive income is the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners.
Total comprehensive income comprises all components of ‘profit or loss’
and of ‘other comprehensive income’.
Although IAS 1 uses the terms ‘other comprehensive income’, ‘profit or loss’ and ‘total comprehensive income’, an undertaking may use other terms to describe the totals as long as the meaning is clear. For example, an undertaking may use the term ‘net income’ to describe profit or loss.
Profit or loss is the total of income less expenses, excluding the components of other comprehensive income.
Reclassification adjustments are amounts reclassified to profit or loss in the current period that were recognised in other comprehensive income in the current or previous periods.
Total comprehensive income is the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners.
Total comprehensive income comprises all components of ‘profit or loss’
and of ‘other comprehensive income’.
Although IAS 1 uses the terms ‘other comprehensive income’, ‘profit or loss’ and ‘total comprehensive income’, an undertaking may use other terms to describe the totals as long as the meaning is clear.
For example, an undertaking may use the term ‘net income’ to describe profit or loss.
3
Financial statements
Financial statements are a structured representation of the financial position, and financial performance, of an undertaking.
The objective of financial statements is to provide information about the financial position, financial performance, and cash flows, which is useful to a wide range of users in making decisions.
Financial statements also show the results of management’s stewardship of resources. To meet this objective, financial statements provide information about an undertaking’s:
(i) assets;
(ii) liabilities;
(iii) equity;
(iv) income and expenses, including gains and losses;
(v) contributions by, and distributions to owners in their capacity as owners; and
(vi) cash flows.
This information, with other information in the notes, assists users of financial statements in predicting the undertaking’s future cash flows and, their timing and certainty.
A complete set of financial statements comprises:
(i) a statement of financial position as at the end of the period;
(ii) a statement of comprehensive income for the period;
(iii) a statement of changes in equity for the period;
(iv) a statement of cash f lows for the period;
(v) notes, comprising a summary of significant accounting policies and other explanatory information; and
(vi) a statement of financial position as at the beginning of the earliest comparative period when an undertaking applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements.
An undertaking may use titles for the statements other than those used in IAS 1.
An undertaking shall present with equal prominence all of the financial statements in a complete set of financial statements.
An undertaking may present the components of profit or loss either as part of a single statement of comprehensive income or in a separate income statement.
When an income statement is presented it is part of a complete set of financial statements and shall be displayed immediately before the statement of comprehensive income.
An audit report is not compulsory, but it will provide readers with independent assurance of the figures.
Many undertakings present, outside the financial statements, a financial review by management, that describes the main features of the undertaking’s financial performance, and financial position, and the uncertainties it faces.
Such a report may include a review of:
(i) the main factors determining financial performance, including changes in the environment, the undertaking’s response to those changes and their impact, and the policy for investment to maintain (and enhance) performance, including its dividend policy;
(ii) sources of funding and targeted ratio of liabilities to equity; and
(iii) resources not recorded in the statement of financial position in accordance with IFRSs.
Many undertakings also present reports, such as environmental reports and value added statements, particularly in industries in which environmental factors are significant, and when staff are regarded as an important user group.
Reports and statements presented outside financial statements are outside the scope of IFRSs.
The objective of financial statements is to provide information about the financial position, financial performance, and cash flows, which is useful to a wide range of users in making decisions.
Financial statements also show the results of management’s stewardship of resources. To meet this objective, financial statements provide information about an undertaking’s:
(i) assets;
(ii) liabilities;
(iii) equity;
(iv) income and expenses, including gains and losses;
(v) contributions by, and distributions to owners in their capacity as owners; and
(vi) cash flows.
This information, with other information in the notes, assists users of financial statements in predicting the undertaking’s future cash flows and, their timing and certainty.
A complete set of financial statements comprises:
(i) a statement of financial position as at the end of the period;
(ii) a statement of comprehensive income for the period;
(iii) a statement of changes in equity for the period;
(iv) a statement of cash f lows for the period;
(v) notes, comprising a summary of significant accounting policies and other explanatory information; and
(vi) a statement of financial position as at the beginning of the earliest comparative period when an undertaking applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements.
An undertaking may use titles for the statements other than those used in IAS 1.
An undertaking shall present with equal prominence all of the financial statements in a complete set of financial statements.
An undertaking may present the components of profit or loss either as part of a single statement of comprehensive income or in a separate income statement.
When an income statement is presented it is part of a complete set of financial statements and shall be displayed immediately before the statement of comprehensive income.
An audit report is not compulsory, but it will provide readers with independent assurance of the figures.
Many undertakings present, outside the financial statements, a financial review by management, that describes the main features of the undertaking’s financial performance, and financial position, and the uncertainties it faces.
Such a report may include a review of:
(i) the main factors determining financial performance, including changes in the environment, the undertaking’s response to those changes and their impact, and the policy for investment to maintain (and enhance) performance, including its dividend policy;
(ii) sources of funding and targeted ratio of liabilities to equity; and
(iii) resources not recorded in the statement of financial position in accordance with IFRSs.
Many undertakings also present reports, such as environmental reports and value added statements, particularly in industries in which environmental factors are significant, and when staff are regarded as an important user group.
Reports and statements presented outside financial statements are outside the scope of IFRSs.
SCOPE
IAS 1 shall be applied to all general purpose financial statements presented in accordance with IFRS.
IAS 1 does not apply to interim financial statements, (see IAS 34 Interim Financial Reporting). IAS 1 applies equally to all undertakings, whether they need to prepare consolidated, or separate financial statements.
IFRS 7 specifies additional requirements for banks and similar financial institutions, which are consistent with the requirements of IAS 1.
IAS 1 uses terminology that is suitable for profit-oriented undertakings, including public-sector business undertakings.
Similarly, undertakings that do not have equity as defined in IAS 32: some mutual funds, and undertakings whose share capital is not equity: some co-operative undertakings may need to adapt the of members’ (or unitholders’) interests.
IAS 1 does not apply to interim financial statements, (see IAS 34 Interim Financial Reporting). IAS 1 applies equally to all undertakings, whether they need to prepare consolidated, or separate financial statements.
IFRS 7 specifies additional requirements for banks and similar financial institutions, which are consistent with the requirements of IAS 1.
IAS 1 uses terminology that is suitable for profit-oriented undertakings, including public-sector business undertakings.
Similarly, undertakings that do not have equity as defined in IAS 32: some mutual funds, and undertakings whose share capital is not equity: some co-operative undertakings may need to adapt the of members’ (or unitholders’) interests.
OBJECTIVE
The objective of IAS 1 is to prescribe the presentation of financial statements, to ensure comparability both with financial statements of previous periods, and with the financial statements of other undertakings.
IAS 1 sets out requirements for the presentation of financial statements, guidelines for their structure, and minimum requirements for their content.
(The recognition, measurement and disclosure of specific transactions and other events are dealt with in other Standards and in Interpretations).
IAS 1 sets out requirements for the presentation of financial statements, guidelines for their structure, and minimum requirements for their content.
(The recognition, measurement and disclosure of specific transactions and other events are dealt with in other Standards and in Interpretations).
Presentation of Financial Statements - Introduction
OVERVIEW
Aim
The aim of this workbook is to assist the individual in understanding the IFRS Presentation of Financial Statements. This is the subject of IAS 1.
IAS 1 was updated in 2007. The changes are listed in the Annex to this workbook. One of the changes is the retitling of the balance sheet as the statement of financial position.
The Board decided to rename a new statement a ‘statement of comprehensive income’. The term ‘comprehensive income’ is not defined in the Framework but is used in IAS 1 to describe the change in equity of an undertaking during a period from transactions, events and circumstances other than those resulting from transactions with owners in their capacity as owners.
Although the term ‘comprehensive income’ is used to describe the aggregate of all components of comprehensive income, including profit or loss, the term ‘other comprehensive income’ refers to income and expenses that under IFRSs are included in comprehensive income but excluded from profit or loss.
The Board decided that an undertaking should have the choice of presenting all income and expenses recognised in a period in one statement or in two statements. An undertaking is prohibited from presenting components of income and expense (ie non-owner changes in equity) in the statement of changes in equity.
The Board acknowledged that the titles ‘income statement’ and ‘statement of profit or loss’ are similar in meaning and could be used interchangeably, and decided to retain the title ‘income statement’ as this is more commonly used.
This workbook is complemented by the Illustrative Corporate Financial Statements and the IFRS Disclosure Checklist which appear on the project website.
Aim
The aim of this workbook is to assist the individual in understanding the IFRS Presentation of Financial Statements. This is the subject of IAS 1.
IAS 1 was updated in 2007. The changes are listed in the Annex to this workbook. One of the changes is the retitling of the balance sheet as the statement of financial position.
The Board decided to rename a new statement a ‘statement of comprehensive income’. The term ‘comprehensive income’ is not defined in the Framework but is used in IAS 1 to describe the change in equity of an undertaking during a period from transactions, events and circumstances other than those resulting from transactions with owners in their capacity as owners.
Although the term ‘comprehensive income’ is used to describe the aggregate of all components of comprehensive income, including profit or loss, the term ‘other comprehensive income’ refers to income and expenses that under IFRSs are included in comprehensive income but excluded from profit or loss.
The Board decided that an undertaking should have the choice of presenting all income and expenses recognised in a period in one statement or in two statements. An undertaking is prohibited from presenting components of income and expense (ie non-owner changes in equity) in the statement of changes in equity.
The Board acknowledged that the titles ‘income statement’ and ‘statement of profit or loss’ are similar in meaning and could be used interchangeably, and decided to retain the title ‘income statement’ as this is more commonly used.
This workbook is complemented by the Illustrative Corporate Financial Statements and the IFRS Disclosure Checklist which appear on the project website.
Banking Laws
aws affecting banking by which banks are organized, regulated and controlled in their relations with the public and with each other, are the result of many years' of experience in banking. As we have had occasion to note in the opening chapters, banking is based primarily on natural or economic laws. Statute laws pertaining to banking have been added to and revised from time to time, not because there has been any appreciable change in the fundamentals of business, but because men through experience and a study of the lessons taught by experience have found how to correct flaws in banking methods and so avoid the dangers and pitfalls of a previous generation. Thus banking systems have undergone a gradual but steady change toward safer and more efficient standards. It is like the discovery of a safe channel in a narrow and dangerous waterway. After there have been many wrecks and disasters the difficult harbor is finally reached in comparative safety by following buoys and lights that mark the location of submerged rocks. So with banking laws. Each is a lighthouse that safeguards all who would embark in this business of chance and risk, from losing ship and cargo upon the same treacherous reef that has wrecked many another.
A study of financial history with its eras of commercial prosperity alternating with crises and depressions will disclose the reason for many present-day banking laws. In our own country where each state has had and still has a banking code of its own, modified it is true by the national system made necessary by one of the most terrible wars of modern times, we can trace the effect of all these factors upon our latest legislation, the Federal Reserve Act.
It is not within the scope of the present volume to discuss the Federal Reserve Act. Before the student is able to grasp the true significance of its provisions, he must first have a clear conception of the underlying principles involved in banking and banking laws, and it is with this elementary phase of the subject that we are here concerned. We may, therefore, discuss briefly a few typical national bank laws that will serve to illustrate the nature and purpose of all banking legislation, whether state or national.
Many of the more important regulations have to do with the capital, in fact nearly all the privileges and restrictions of the business are based directly or indirectly upon this first item of the bank's liabilities. The minimum amount of capital is fixed by the population of the town or city where the bank is located; the larger the city the greater the amount of capital required. The reason for this is that since there can be no limit to the amount of business a bank may do, it is necessary to anticipate the probable security that must be given to prospective depositors who would very likely be more numerous in a large city than in a small village. To make the security even greater, stockholders of all national banks and also in many state institutions are doubly liable. That is, if the bank should fail with not enough assets to meet the claims of depositors and other creditors, not only would the money due the stockholders represented by the capital and surplus be forfeited, but the stockholders may be assessed an amount up to the par value of their stock to meet any deficiency. A bank may not hold or purchase its own stock since the effect of such a privilege would be to reduce the amount of the capital by that much. Not all the provisions in law tax the stockholder or owner of the bank to safeguard the interests of those who trust their deposits with the institution. There is one provision which protects the capital as well as the deposit. National banks are required to build up a surplus until that item is at least 20 per cent, of the capital stock.
Any losses can then be charged to this fund without depreciating the capital. Thus it is the aim of all well-managed banks to create as large a surplus as possible which gives additional strength and has a tendency to attract deposits.
One of the greatest financial dangers that beset a nation is credit inflation. In "boom" times, when all lines of trade are active, crops good, labor well employed and everybody enjoying unusual prosperity, there is a national tendency for men to reach out for even greater riches. This is the result of that predominant characteristic of human wants which we noted in an early chapter, the insatiability of men's desire for more and better things. During such periods as we have described, men are apt to become overly optimistic as to their prospects. The result is that credit is often extended too freely, being based upon hopes founded on fancy rather than on fact. When several important ventures collapse, the credit that was based upon them becomes valueless and then a sudden fear takes hold of the public. The result is a "panic." It is the purpose of such laws as the Federal Reserve Act not only to curb an undue expansion of credit, but also to help banks prevent a panicky situation from spreading.
There are many safeguards provided by law against credit inflation. As the first may be set down the trained judgment of the sagacious banker who investigates his customer's statements upon which the loan is to be based. The banker knows that if the loan cannot be paid at maturity, his bank may lose money. Then there is the scrutiny of the bank examiner to be counted on; will that loan pass his inspection? There is the further restriction that not more than 10 per cent, of the capital and surplus can be loaned to one interest. This, too, has a tendency to prevent too wide an extension in any one direction. It prevents the bank from risking too many eggs in one basket. Next, then, is the provision in the Federal Reserve Act which restricts rediscounting to loans growing out of actual commercial transactions. That is, the loans must be "self-liquidating" or payable out of the proceeds of the sale of the commodity the loans represent. It will not do to rediscount real estate loans, because real estate is a fixed and constant quantity which does not increase merely by change of ownership, whereas staple goods that men use in the satisfaction of wants are produced, bought and sold - and paid for - at all times and in ever - increasing amounts. And when more money is needed to handle the increase of business, the issue of Federal reserve notes must be "covered" by 100 per cent, of paper representing these liquid commercial loans. The issue must also be backed by 40 per cent, gold reserve. If we trace the entire process back to the original loan we discover that at every step the law throws one safeguard or another against inflation.
The successful banker, therefore, is not he who is satisfied merely to avoid losses and make profits for his stockholders; he is the man trained not only in local credits, but also in national and international conditions. He is well versed in fundamental economics; he knows the financial history of his own and other countries, he does not protest against sound bank laws because he knows why those laws are written. In fact, for him there is no law, because his judgment is proof against those errors which law seeks to prevent. And finally, he never forgets that banking is conducted for the benefit of all the people and not for the exclusive profit of the banker; that it is other people's money as well as his own that is entrusted to his care, that it may be wisely used for the welfare of all men.
A study of financial history with its eras of commercial prosperity alternating with crises and depressions will disclose the reason for many present-day banking laws. In our own country where each state has had and still has a banking code of its own, modified it is true by the national system made necessary by one of the most terrible wars of modern times, we can trace the effect of all these factors upon our latest legislation, the Federal Reserve Act.
It is not within the scope of the present volume to discuss the Federal Reserve Act. Before the student is able to grasp the true significance of its provisions, he must first have a clear conception of the underlying principles involved in banking and banking laws, and it is with this elementary phase of the subject that we are here concerned. We may, therefore, discuss briefly a few typical national bank laws that will serve to illustrate the nature and purpose of all banking legislation, whether state or national.
Many of the more important regulations have to do with the capital, in fact nearly all the privileges and restrictions of the business are based directly or indirectly upon this first item of the bank's liabilities. The minimum amount of capital is fixed by the population of the town or city where the bank is located; the larger the city the greater the amount of capital required. The reason for this is that since there can be no limit to the amount of business a bank may do, it is necessary to anticipate the probable security that must be given to prospective depositors who would very likely be more numerous in a large city than in a small village. To make the security even greater, stockholders of all national banks and also in many state institutions are doubly liable. That is, if the bank should fail with not enough assets to meet the claims of depositors and other creditors, not only would the money due the stockholders represented by the capital and surplus be forfeited, but the stockholders may be assessed an amount up to the par value of their stock to meet any deficiency. A bank may not hold or purchase its own stock since the effect of such a privilege would be to reduce the amount of the capital by that much. Not all the provisions in law tax the stockholder or owner of the bank to safeguard the interests of those who trust their deposits with the institution. There is one provision which protects the capital as well as the deposit. National banks are required to build up a surplus until that item is at least 20 per cent, of the capital stock.
Any losses can then be charged to this fund without depreciating the capital. Thus it is the aim of all well-managed banks to create as large a surplus as possible which gives additional strength and has a tendency to attract deposits.
One of the greatest financial dangers that beset a nation is credit inflation. In "boom" times, when all lines of trade are active, crops good, labor well employed and everybody enjoying unusual prosperity, there is a national tendency for men to reach out for even greater riches. This is the result of that predominant characteristic of human wants which we noted in an early chapter, the insatiability of men's desire for more and better things. During such periods as we have described, men are apt to become overly optimistic as to their prospects. The result is that credit is often extended too freely, being based upon hopes founded on fancy rather than on fact. When several important ventures collapse, the credit that was based upon them becomes valueless and then a sudden fear takes hold of the public. The result is a "panic." It is the purpose of such laws as the Federal Reserve Act not only to curb an undue expansion of credit, but also to help banks prevent a panicky situation from spreading.
There are many safeguards provided by law against credit inflation. As the first may be set down the trained judgment of the sagacious banker who investigates his customer's statements upon which the loan is to be based. The banker knows that if the loan cannot be paid at maturity, his bank may lose money. Then there is the scrutiny of the bank examiner to be counted on; will that loan pass his inspection? There is the further restriction that not more than 10 per cent, of the capital and surplus can be loaned to one interest. This, too, has a tendency to prevent too wide an extension in any one direction. It prevents the bank from risking too many eggs in one basket. Next, then, is the provision in the Federal Reserve Act which restricts rediscounting to loans growing out of actual commercial transactions. That is, the loans must be "self-liquidating" or payable out of the proceeds of the sale of the commodity the loans represent. It will not do to rediscount real estate loans, because real estate is a fixed and constant quantity which does not increase merely by change of ownership, whereas staple goods that men use in the satisfaction of wants are produced, bought and sold - and paid for - at all times and in ever - increasing amounts. And when more money is needed to handle the increase of business, the issue of Federal reserve notes must be "covered" by 100 per cent, of paper representing these liquid commercial loans. The issue must also be backed by 40 per cent, gold reserve. If we trace the entire process back to the original loan we discover that at every step the law throws one safeguard or another against inflation.
The successful banker, therefore, is not he who is satisfied merely to avoid losses and make profits for his stockholders; he is the man trained not only in local credits, but also in national and international conditions. He is well versed in fundamental economics; he knows the financial history of his own and other countries, he does not protest against sound bank laws because he knows why those laws are written. In fact, for him there is no law, because his judgment is proof against those errors which law seeks to prevent. And finally, he never forgets that banking is conducted for the benefit of all the people and not for the exclusive profit of the banker; that it is other people's money as well as his own that is entrusted to his care, that it may be wisely used for the welfare of all men.
Bank Examinations
Against the liabilities the bank must hold an equal amount of assets, otherwise the bank is insolvent and must close its doors. If we go into a restaurant for luncheon we are not satisfied merely to read the bill-of-fare; we want to try some of the dishes for ourselves. If we order chicken soup and the waiter brings us a bowl of warm water, we refuse to accept it, no matter if the proprietor insists that it is chicken soup that has been set before us. But when a man wishes to purchase the stock of a bank or deposit money with it, he cannot personally test for himself the quality or quantity of the assets set forth on the bank's statement and thus assure himself that the bank is sound. There may be no intention whatever on the part of the bank to deceive or defraud. The bank itself may be deceived in its ability to pay the amount of the deposit on demand just as borrowers often honestly overestimate their ability to repay a loan when it is due. Therefore the law provides an official examiner who "tests the soup" for the general public who may deposit or invest their money in the bank.
The purpose of bank examination is twofold; first, to see that the institution is solvent, having a dollar of assets with which to pay every dollar of liabilities; and, second, to ascertain that the bank is obeying the law. From the examiner's viewpoint the principal reason for insisting upon a strict observance of the law is that the bank may continue to be solvent. The nature of these laws will be explained in the final chapter.
Bank examinations are of four kinds, two of which may be said to be internal and two external. In the first class are examinations by a committee of the directors and examinations by certified public accountants whom the directors may employ to make this audit and examination for them. The official Federal, or State examinations, and clearing house examinations may be classed as external examinations. The internal examinations are, of course, not unexpected by the officers of the bank, who, with the directors, arrange for them. The official or external examinations are never announced in advance, and hence they may be said to be more effective if there should exist any condition due to fraud or weakness that might be covered up temporarily.
It is rather difficult to draw the line clearly between an audit and an examination; yet the examination by directors or accountants for the directors is more in the nature of an audit than an examination. It is the duty of the auditor of a bank to see that all settlements are properly made by the various clerks and departments, to check all cross entries on the books, to prove interest calculations, to reconcile accounts with other banks and to supervise the entire accounting system generally. In small banks one of the officers has charge of this work. When the directors make their annual or semi-annual examination they certify to the correctness of all transactions as of a certain day. Their examination includes a proof of the cash and a checking up of the loans and discounts. In very large banks they usually have the assistance of the clerks who are interchanged so that the same men will not be used in proving any books or cash to which they have previously had access. Bank directors make their examinations to assure themselves that the bank's affairs are in proper condition. Although they may commit the operation of the bank to the authorized officers, the directors cannot thus escape their responsibility or liability under the law for the safe administration of the institution. The employment of a certified public accountant to do this work is a more thorough way of making an internal examination, since the accountant and his assistants are trained men and have the advantage of a disinterested point of view.
The National or State examiners make their visits without notice; usually just after the bank has closed for the day. The settlement for that day's business is then checked and all cash, checks and securities are put under seal so that no substitution can be made over night. The examination then proceeds the following days until every detail of the business is investigated and accounted for. The general policy of the bank is taken into consideration, as indicated by the nature of the loans, the borrowing habits of the customers, the methods of accounting used and the general observance of safe and conservative business rules. Like the physician who examines a patient, the official examiner bases his methods upon the assumption that there may be something wrong which it is his duty to detect and remedy.
The clearing house examination plan is a sort of combination between the directors' examination by certified accountants and the official examination. The clearing house examiner is employed jointly by all the banks of a city and his examination is made for them, but in his power of criticism and in the timing of his visits he is independent. His examination is just as thorough as that made by the Federal or State examiner, in fact, in some cities the two examinations are conducted jointly. Where the clearing house examination differs is in the attention given to the loans and discounts. The clearing house examiner makes a record of all loans over a certain amount in every bank in the Association, so that he is able to base an intelligent opinion on the true value of the bank's largest group of assets. This information is kept under lock and key by the examiner and is used by him as credit memoranda. He is thus able to advise the banks if any local dealer is borrowing more heavily than his business warrants. The official examiners are limited in their powers of criticism to infringement of the laws, but it is the duty of the clearing house examiner to act in an advisory capacity, and to seek to prevent any unsound condition from arising. The Federal Reserve Act provides for special examinations of member banks for the purpose of informing the reserve banks of the lines of credit being extended by member banks. In principle, these special examinations are similar to clearing house examinations.
The purpose of bank examination is twofold; first, to see that the institution is solvent, having a dollar of assets with which to pay every dollar of liabilities; and, second, to ascertain that the bank is obeying the law. From the examiner's viewpoint the principal reason for insisting upon a strict observance of the law is that the bank may continue to be solvent. The nature of these laws will be explained in the final chapter.
Bank examinations are of four kinds, two of which may be said to be internal and two external. In the first class are examinations by a committee of the directors and examinations by certified public accountants whom the directors may employ to make this audit and examination for them. The official Federal, or State examinations, and clearing house examinations may be classed as external examinations. The internal examinations are, of course, not unexpected by the officers of the bank, who, with the directors, arrange for them. The official or external examinations are never announced in advance, and hence they may be said to be more effective if there should exist any condition due to fraud or weakness that might be covered up temporarily.
It is rather difficult to draw the line clearly between an audit and an examination; yet the examination by directors or accountants for the directors is more in the nature of an audit than an examination. It is the duty of the auditor of a bank to see that all settlements are properly made by the various clerks and departments, to check all cross entries on the books, to prove interest calculations, to reconcile accounts with other banks and to supervise the entire accounting system generally. In small banks one of the officers has charge of this work. When the directors make their annual or semi-annual examination they certify to the correctness of all transactions as of a certain day. Their examination includes a proof of the cash and a checking up of the loans and discounts. In very large banks they usually have the assistance of the clerks who are interchanged so that the same men will not be used in proving any books or cash to which they have previously had access. Bank directors make their examinations to assure themselves that the bank's affairs are in proper condition. Although they may commit the operation of the bank to the authorized officers, the directors cannot thus escape their responsibility or liability under the law for the safe administration of the institution. The employment of a certified public accountant to do this work is a more thorough way of making an internal examination, since the accountant and his assistants are trained men and have the advantage of a disinterested point of view.
The National or State examiners make their visits without notice; usually just after the bank has closed for the day. The settlement for that day's business is then checked and all cash, checks and securities are put under seal so that no substitution can be made over night. The examination then proceeds the following days until every detail of the business is investigated and accounted for. The general policy of the bank is taken into consideration, as indicated by the nature of the loans, the borrowing habits of the customers, the methods of accounting used and the general observance of safe and conservative business rules. Like the physician who examines a patient, the official examiner bases his methods upon the assumption that there may be something wrong which it is his duty to detect and remedy.
The clearing house examination plan is a sort of combination between the directors' examination by certified accountants and the official examination. The clearing house examiner is employed jointly by all the banks of a city and his examination is made for them, but in his power of criticism and in the timing of his visits he is independent. His examination is just as thorough as that made by the Federal or State examiner, in fact, in some cities the two examinations are conducted jointly. Where the clearing house examination differs is in the attention given to the loans and discounts. The clearing house examiner makes a record of all loans over a certain amount in every bank in the Association, so that he is able to base an intelligent opinion on the true value of the bank's largest group of assets. This information is kept under lock and key by the examiner and is used by him as credit memoranda. He is thus able to advise the banks if any local dealer is borrowing more heavily than his business warrants. The official examiners are limited in their powers of criticism to infringement of the laws, but it is the duty of the clearing house examiner to act in an advisory capacity, and to seek to prevent any unsound condition from arising. The Federal Reserve Act provides for special examinations of member banks for the purpose of informing the reserve banks of the lines of credit being extended by member banks. In principle, these special examinations are similar to clearing house examinations.
Clearing Houses
A bank check may be defined as a written order drawn upon a bank by a depositor directing the bank to pay a certain sum of money to bearer, to a payee named on the instrument, or to someone else named by the payee. In the majority of cases the payee does not himself present the check for payment. Instead he deposits it to his credit in another bank, thus constituting that bank his agent. The principal business dealings that banks have with each other grow out of the use of checks by individuals and their presentation and collection by banks.
The extensive use of the check is interesting from the bank clerk's point of view. Approximately 90 per cent, of payments are made by check. These settlements are not made in money but in credit. That is to say, the credit that A has with his bank is transferred to B in the payment of debt through the use of the check. Very little money, in comparison with the volume of transactions involved, ever changes hands. This use of the credit instrument instead gives employment to probably more than 75 per cent, of all the employees of banks doing a commercial business. Tellers, bookkeepers and their assistants in all departments are engaged principally in keeping the records incidental to deposits and withdrawals by check.
In a small town having but one bank all of the checks growing out of purely local business are drawn upon that institution. Let us suppose that A and B are both depositors in the same bank. A gives B his check for $100.00 in payment for a horse. It is not necessary for B to present the check, receive the money and then redeposit the cash to his own credit. Instead, he deposits the check, the bank crediting his account and charging the account of A. The same process is being followed by all the depositors in making settlements with each other. No actual cash changes hands; there is merely an offsetting of debits with credits on the books of the bank. This is known as the "clearing principle."
Banks make use of this principle in settling accounts with each other. The agency through which they avoid the constant transfer of money among themselves is the Clearing House. The term is used to apply either to the building used for this purpose or to the organization or association of the banks united together for this and other purposes. In its practical sense the clearing house represents a plan rather than a tangible thing. Let us suppose there are five banks which are members of a clearing house. At the end of the day's business each member finds itself with checks drawn upon the other four. The checks of each are endorsed with the bank stamp, enclosed in a separate envelope for each bank and a total of the checks is listed on the outside. The totals are then listed opposite the bank names on a double column sheet and a footing is struck. In theory each bank assumes that these checks are not payable by the individual banks but by the "clearing house." Therefore, at a fixed time, usually about ten o'clock A.M., each bank sends a messenger to the clearing house with its checks against the other banks. In a small town the office of one of the members is used as a clearing house and an officer of that bank acts as "manager." The packages are then exchanged. Each clerk writes opposite the proper name, the amount of the checks on his bank presented by the others.
These amounts are added up and the smaller amount is subtracted from the larger. If the messenger receives more checks on his own bank than his bank had on the others, then he is a "debtor." If the reverse is true then he is a "creditor." The manager then takes the record of the debtor and creditor balances which, of course, must be equal, thus proving the correctness of the exchange. The clerks return to their respective banks having checks only on themselves, whereas they came to the clearing with checks only on their neighbors. The whole transaction will not have consumed more than ten minutes. Even in the very largest cities, with millions of dollars involved, the exchange is made almost as quickly. The large cities usually have a separate building for clearing purposes and employ a regular manager who is in charge of the clearing process.
The exchanges having been made, the banks now prepare to settle the balances. There are various ways of doing this, depending upon the size of the city and the number of banks in the clearing house. In the smaller towns the manager of the clearing house draws drafts upon the debtor banks which he gives to the creditors, who then present them and receive either the cash or its equivalent. Or the manager may deposit the drafts of the debtor banks with one of the members and draw his own checks against this deposit in favor of the creditors. Another method is to make payment by draft upon the Federal Reserve Bank of the district or upon other reserve agents. In the larger cities settlement is made in cash or its equivalent, payment being made by the debtor banks to the clearing house which acts as agent in paying over the money to the creditor banks. To avoid the handling of even this money, many clearing houses conduct a depository where deposits of gold and currency are received, and certificates in large denominations, $5,000.00 and $10,000.00 are then issued. Settlements made with these certificates are upon a cash basis, yet the danger of loss or error in handling the actual money is avoided. The saving of time and the use of money is well illustrated by the fact that in New York Cityevery clearing house member is enabled to exchange checks with every other member in about fifteen minutes each day, and the balances to be settled average less than 5 per cent, of the total checks exchanged.
Certain rules are prescribed by clearing house associations covering the method of conducting the exchanges and regulating in general the business which the banks do with each other. For example, the rules fix the hour for clearing, method of making settlements, returning of unpaid items, hours for opening and closing the banks, and many other matters that are adjusted in the interest of regularity and uniformity.
Some of the associations employ an official clearing house examiner who supplements the examination by the national or state bank examiner, paying particular attention to the loans and discounts. He is employed by the banks to give them advice as to their methods of doing business, his information and suggestions being extremely confidential. He makes record of the lines of credit being extended by the various member banks and is thus able to check unsound lines before any damage is done. His functions will be described in greater detail in the next chapter.
The clearing principle as applied to check collection is not limited to the items payable in one city. Many clearing houses have also a department for the clearing of country checks. In such cases all the member banks send their out-of-town items within a certain district to the clearing house which operates as one bank acting for all. Thus, instead of receiving a daily letter from each bank in the city, the country bank gets all its checks from that city in one letter from the clearing house, to which it then remits with a single draft. The Federal Reserve Act has carried this process one step further by requiring the Federal reserve banks to act as clearing houses for their member banks. Checks which each member bank sends to the Federal reserve bank acts as the credit offset to the checks which the Federal reserve bank receives on that member. It may be said that much of the Federal Reserve Act is the result of experience with clearing house methods and regulations.
The extensive use of the check is interesting from the bank clerk's point of view. Approximately 90 per cent, of payments are made by check. These settlements are not made in money but in credit. That is to say, the credit that A has with his bank is transferred to B in the payment of debt through the use of the check. Very little money, in comparison with the volume of transactions involved, ever changes hands. This use of the credit instrument instead gives employment to probably more than 75 per cent, of all the employees of banks doing a commercial business. Tellers, bookkeepers and their assistants in all departments are engaged principally in keeping the records incidental to deposits and withdrawals by check.
In a small town having but one bank all of the checks growing out of purely local business are drawn upon that institution. Let us suppose that A and B are both depositors in the same bank. A gives B his check for $100.00 in payment for a horse. It is not necessary for B to present the check, receive the money and then redeposit the cash to his own credit. Instead, he deposits the check, the bank crediting his account and charging the account of A. The same process is being followed by all the depositors in making settlements with each other. No actual cash changes hands; there is merely an offsetting of debits with credits on the books of the bank. This is known as the "clearing principle."
Banks make use of this principle in settling accounts with each other. The agency through which they avoid the constant transfer of money among themselves is the Clearing House. The term is used to apply either to the building used for this purpose or to the organization or association of the banks united together for this and other purposes. In its practical sense the clearing house represents a plan rather than a tangible thing. Let us suppose there are five banks which are members of a clearing house. At the end of the day's business each member finds itself with checks drawn upon the other four. The checks of each are endorsed with the bank stamp, enclosed in a separate envelope for each bank and a total of the checks is listed on the outside. The totals are then listed opposite the bank names on a double column sheet and a footing is struck. In theory each bank assumes that these checks are not payable by the individual banks but by the "clearing house." Therefore, at a fixed time, usually about ten o'clock A.M., each bank sends a messenger to the clearing house with its checks against the other banks. In a small town the office of one of the members is used as a clearing house and an officer of that bank acts as "manager." The packages are then exchanged. Each clerk writes opposite the proper name, the amount of the checks on his bank presented by the others.
These amounts are added up and the smaller amount is subtracted from the larger. If the messenger receives more checks on his own bank than his bank had on the others, then he is a "debtor." If the reverse is true then he is a "creditor." The manager then takes the record of the debtor and creditor balances which, of course, must be equal, thus proving the correctness of the exchange. The clerks return to their respective banks having checks only on themselves, whereas they came to the clearing with checks only on their neighbors. The whole transaction will not have consumed more than ten minutes. Even in the very largest cities, with millions of dollars involved, the exchange is made almost as quickly. The large cities usually have a separate building for clearing purposes and employ a regular manager who is in charge of the clearing process.
The exchanges having been made, the banks now prepare to settle the balances. There are various ways of doing this, depending upon the size of the city and the number of banks in the clearing house. In the smaller towns the manager of the clearing house draws drafts upon the debtor banks which he gives to the creditors, who then present them and receive either the cash or its equivalent. Or the manager may deposit the drafts of the debtor banks with one of the members and draw his own checks against this deposit in favor of the creditors. Another method is to make payment by draft upon the Federal Reserve Bank of the district or upon other reserve agents. In the larger cities settlement is made in cash or its equivalent, payment being made by the debtor banks to the clearing house which acts as agent in paying over the money to the creditor banks. To avoid the handling of even this money, many clearing houses conduct a depository where deposits of gold and currency are received, and certificates in large denominations, $5,000.00 and $10,000.00 are then issued. Settlements made with these certificates are upon a cash basis, yet the danger of loss or error in handling the actual money is avoided. The saving of time and the use of money is well illustrated by the fact that in New York Cityevery clearing house member is enabled to exchange checks with every other member in about fifteen minutes each day, and the balances to be settled average less than 5 per cent, of the total checks exchanged.
Certain rules are prescribed by clearing house associations covering the method of conducting the exchanges and regulating in general the business which the banks do with each other. For example, the rules fix the hour for clearing, method of making settlements, returning of unpaid items, hours for opening and closing the banks, and many other matters that are adjusted in the interest of regularity and uniformity.
Some of the associations employ an official clearing house examiner who supplements the examination by the national or state bank examiner, paying particular attention to the loans and discounts. He is employed by the banks to give them advice as to their methods of doing business, his information and suggestions being extremely confidential. He makes record of the lines of credit being extended by the various member banks and is thus able to check unsound lines before any damage is done. His functions will be described in greater detail in the next chapter.
The clearing principle as applied to check collection is not limited to the items payable in one city. Many clearing houses have also a department for the clearing of country checks. In such cases all the member banks send their out-of-town items within a certain district to the clearing house which operates as one bank acting for all. Thus, instead of receiving a daily letter from each bank in the city, the country bank gets all its checks from that city in one letter from the clearing house, to which it then remits with a single draft. The Federal Reserve Act has carried this process one step further by requiring the Federal reserve banks to act as clearing houses for their member banks. Checks which each member bank sends to the Federal reserve bank acts as the credit offset to the checks which the Federal reserve bank receives on that member. It may be said that much of the Federal Reserve Act is the result of experience with clearing house methods and regulations.
Trust Companies
A trust is anything of value, such as money or personal property which is committed into the care of another for the safekeeping, use or benefit of the owner. This implies confidence on the part of the owner in the integrity and reliability of the person trusted who is called the trustee. Trustees are appointed because those who have property either cannot or, for one reason or another, prefer not to act for themselves. Thus, while all banks are in a broad sense trustees for their depositors in that they care for the deposits of their customers, a certain group of banks are organized primarily for the purpose of administering trusts and acting in a fiduciary capacity generally. Such banks are called Trust Companies. Trust companies are of comparatively recent origin and they are the newest of the three great groups of banks. The step in their development or evolution has not been from the bank to the trust company, but from the individual trustee to the corporate trustee or trust company. In the early days of the country, individuals assumed the obligation of trustees for other individuals and in fact this custom still obtains, especially in sparsely settled districts. As men have become more wealthy and as accumulations of property have increased, there has arisen the need for some organized and efficiently trained body of men who could administer the estates and affairs of other men whether living or dead. There are many reasons why the trust company is better fitted than the individual to perform the functions of a trustee. The individual trustee may die, or move away, or become incapacitated through illness or lack of knowledge of the law. The trust company may be said to be perpetual; it is managed by men trained both in law and in finance who give their entire time to this particular business.
Trust companies act not only for individuals, but also for societies, corporations and municipalities. Their principal functions are to act as executor of wills, administrator of estates, guardian of minors, agents for individuals, trustee under mortgages, transfer agent and registrar for corporations, fiscal agent for governments, states and municipalities, and receiver for firms and corporations. As executor or administrator they administer the estate of the deceased according to the law, and the fees for such service are fixed by law at the same rates as individuals are permitted to charge for like services. As agents for individuals they may care for property, collect rents and perform whatever other duties they may be charged with. As trustee under mortgages, the trust company safeguards the interests of the mortgagee and will foreclose the mortgage if principal or interest are unpaid at maturity. This particular feature of the trust company's business is usually confined to acting as trustee under a bond issue which is secured by a mortgage upon corporation property. As transfer agent and registrar, the trust company certifies as to the genuineness of either a stock or bond issue and records all transfers of such stock or bonds. The company does not guarantee the payment of bonds or of dividends upon stock; it merely vouches for the regularity of issue and the validity of the transactions involved. As fiscal agent for civic divisions, money is collected and disbursed upon warrants and in the payment of interest on bond issues, etc. In addition to the above, trust companies act in various other capacities of a similar nature.
The banking department of a trust company is conducted like any other bank. Deposits are received subject to check, interest is allowed on savings deposits, and in practically every particular this branch of the business is the same as that of the ordinary bank of deposit and discount.
Tellers receive and enter deposits, pay checks, collect drafts and notes; bookkeepers keep ledgers and make credit and debit records just as the work is done in any other bank, and similar books and systems of accounting are used. In Minnesota, Michigan and Wisconsin, trust companies are not permitted to do an active banking business, but are restricted to the handling of trusts and other fiduciary matters. As to loans and investments permitted trust companies, state laws differ, but the general statement is true that they employ their funds just as do the commercial state banks.
It is chiefly in the trust department that the functions of a trust company are distinctive. The estates and funds of both the living and the dead are cared for by this department. The organization of the trust department is kept separate from the banking department. As money is received by the trust department representing the income from property or investments of funds held in trust, it is deposited in the banking department and is checked against by the trust department as if the department were an outside depositor or customer. It would be possible for either department to exist without the other. The field of the trust company has become so highly developed and its trust functions have become so well understood by the public that there is a growing demand for a further extension of trust company powers. This is evidenced by one of the provisions of the Federal Reserve Act, which gives to national banks the privilege of acting in a fiduciary capacity when not in contravention of state laws.
Trust companies act not only for individuals, but also for societies, corporations and municipalities. Their principal functions are to act as executor of wills, administrator of estates, guardian of minors, agents for individuals, trustee under mortgages, transfer agent and registrar for corporations, fiscal agent for governments, states and municipalities, and receiver for firms and corporations. As executor or administrator they administer the estate of the deceased according to the law, and the fees for such service are fixed by law at the same rates as individuals are permitted to charge for like services. As agents for individuals they may care for property, collect rents and perform whatever other duties they may be charged with. As trustee under mortgages, the trust company safeguards the interests of the mortgagee and will foreclose the mortgage if principal or interest are unpaid at maturity. This particular feature of the trust company's business is usually confined to acting as trustee under a bond issue which is secured by a mortgage upon corporation property. As transfer agent and registrar, the trust company certifies as to the genuineness of either a stock or bond issue and records all transfers of such stock or bonds. The company does not guarantee the payment of bonds or of dividends upon stock; it merely vouches for the regularity of issue and the validity of the transactions involved. As fiscal agent for civic divisions, money is collected and disbursed upon warrants and in the payment of interest on bond issues, etc. In addition to the above, trust companies act in various other capacities of a similar nature.
The banking department of a trust company is conducted like any other bank. Deposits are received subject to check, interest is allowed on savings deposits, and in practically every particular this branch of the business is the same as that of the ordinary bank of deposit and discount.
Tellers receive and enter deposits, pay checks, collect drafts and notes; bookkeepers keep ledgers and make credit and debit records just as the work is done in any other bank, and similar books and systems of accounting are used. In Minnesota, Michigan and Wisconsin, trust companies are not permitted to do an active banking business, but are restricted to the handling of trusts and other fiduciary matters. As to loans and investments permitted trust companies, state laws differ, but the general statement is true that they employ their funds just as do the commercial state banks.
It is chiefly in the trust department that the functions of a trust company are distinctive. The estates and funds of both the living and the dead are cared for by this department. The organization of the trust department is kept separate from the banking department. As money is received by the trust department representing the income from property or investments of funds held in trust, it is deposited in the banking department and is checked against by the trust department as if the department were an outside depositor or customer. It would be possible for either department to exist without the other. The field of the trust company has become so highly developed and its trust functions have become so well understood by the public that there is a growing demand for a further extension of trust company powers. This is evidenced by one of the provisions of the Federal Reserve Act, which gives to national banks the privilege of acting in a fiduciary capacity when not in contravention of state laws.
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