Loss making contracts FOREIGN EXCHANGE

Chapter 28 – Mineral Resources Page 386 8 Self Test Questions Chapter 28 1. Which TWO of the following models may be applied by entities for the measurement after recognition of exploration and evaluation assets, in accordance with IFRS6 Exploration for and evaluation of mineral resources? A Cost B Revaluation C Realisation D Present value 2. Does IFRS6 Exploration for and evaluation of mineral resources apply to the following types of expenditure? 1 The extraction and processing of mineral resources for transport to market. 2 The commercial review of possible areas for mineral extraction before bidding for the legal rights to explore a specific area. Expenditure 1 Expenditure 2 A IFRS6 does not apply IFRS6 does not apply B IFRS6 does not apply IFRS6 does apply C IFRS6 does apply IFRS6 does not apply D IFRS6 does apply IFRS6 does apply 3. The Strider Company is involved in the exploration for mineral resources. Its policy is to recognise exploration assets and measure them initially at cost. It is currently exploring a new gas field in Ruritania. The exploration licence for the new Ruritanian gas field is about to expire and Strider is now preparing to undertake an impairment review. Strider reports its financial performance as Mineral Production and Energy Trading in its financial statements in accordance with IFRS8 Operating segments. The Mineral Production segment comprises two cash-generating units – oil production and gas production. In accordance with IFRS6 Exploration for and evaluation of mineral resources, what is the highest level at which the impairment test can be undertaken? A A cash-generating unit based on the assets in the Ruritanian gas field B Gas production cash-generating unit C Oil production and gas production cash-generating units combined D A cash-generating unit at The Strider Company level Chapter 28 – Mineral Resources Page 387 4. The Harlech Company is involved in the exploration for mineral rights. Its policy is to recognise exploration assets and measure them initially at cost. During 20X8 Harlech incurs the following expenditure: Exploratory drilling for minerals on site and related activities CU200 Roads and infrastructure to access exploration site CU350 Expenditures relating to the subsequent development of the resources CU340 In accordance with IFRS6 Exploration for and evaluation of mineral resources, at what amount should exploration assets be initially recognised at in the financial statements of Harlech? A CU200 B CU540 C CU550 D CU890 5. The Sandringham Company is involved in the exploration for mineral resources. Its policy is to recognise exploration assets and measure them initially at cost. At the end of 20X8 the following amounts were extracted from Sandringhams financial statements: Trenching and sampling expenditure CU100 Drilling rigs used for exploration, carrying amount CU200 Drilling rigs used for exploration, depreciation expense CU30 In accordance with IFRS6 Exploration for and evaluation of mineral resources, at what amount should intangible exploration assets be initially recognised at in the financial statements of Sandringham? A CU100 B CU130 C CU300 D Nil Chapter 29 – Insurance Page 389 Chapter 29 INSURANCE 1 Business Context An insurance entity assesses the risks from which another party wishes to be sheltered and prices an insurance contract accordingly. Where in making that assessment an insurance entity decides that the risks in the contract are potentially too great for it to take on alone, it has the ability to offload some of the risk by selling it on to another insurer. The second insurer will take a share in the premium income, but will also share in the associated risks in the contract. This is known as reinsurance. There are a number of underlying complex issues in relation to insurance contracts, with the overriding one being uncertainty, resulting from the underlying risks that an insurance entity is exposed to. IFRS 4 Insurance contracts attempts to provide a framework within which a common set of reporting principles are set out to provide relevant information that will assist a user’s understanding of the entity’s financial statements. 2 Chapter Objectives The objective of this chapter is to set out the requirements of IFRS 4 which represents the first phase of the IASB project on accounting for insurance contracts. On completion of this chapter you should be able to:  understand what an insurance contract is;  appreciate the nature of insurance risk; and  understand the disclosure requirements relating to insurance contracts. 3 Objectives, Scope and Definitions of IFRS 4 Currently there is a wide range of accounting practices used for insurance contracts and the practices adopted often differ from those used in other sectors. As a result the IASB embarked on a substantial project to address the issues surrounding the accounting for insurance contracts. Rather than issuing one standard that covered all areas, the IASB decided to tackle the project in two phases. Interim guidance has been issued in phase one of the project in the form of IFRS 4; it is a stepping stone to the second phase of the project. IFRS 4 largely focuses on improving the disclosure requirements in relation to insurance contracts; however it also includes a number of limited improvements to existing accounting requirements. A Discussion Paper was published by the IASB in May 2007 in relation to phase two of the insurance contracts projects. However, a significant amount of work is still required on the project and a final standard is not expected until 2009 at the earliest. Phase two of the project considers the main components of an accounting model for insurance contracts. IFRS 4 was issued as a temporary measure and, because it allows too much diversity, it will be replaced when phase two of the project is finalised. Although IFRS 4 sets out a number of accounting principles as essentially best practice, it does not require an entity to use these if it currently adopts different accounting practices. An insurance entity is however prohibited from changing its current accounting policies to a number of specifically identified practices. Chapter 29 – Insurance Page 390 IFRS 4 specifies the financial reporting of insurance contracts by any entity that issues such contracts, or holds reinsurance contracts. It does not apply to other assets and liabilities held by insurers. It is important to distinguish between insurance contracts and other contracts that are not covered by IFRS 4 but which might look like insurance contracts. To provide clarification IFRS 4 specifically identifies a number of areas where its provisions do not apply, for example:  the provision of product warranties given directly by the manufacturer, dealer or retailer;  employers’ assets and liabilities in relation to employee benefit plans and obligations under a defined benefit plan;  a contractual right, or obligation, that is contingent on the right to use a non-financial item, for example some licences;  a finance lease that contains a residual value guaranteed by the lessee, i.e. a specified value for the asset at the end of the lease is guaranteed by the lessee;  financial guarantees within the scope of IAS 39 Financial instruments: recognition and measurement;  contingent consideration that has arisen as a result of a business combination; and  insurance contracts that the entity holds as policyholder. 3.1 What is an insurance contract? Insurance contracts are contracts between two parties, where one party, the insurer, agrees to compensate the other party, the policyholder, if it is adversely affected by an uncertain future event. [IFRS 4 Appendix A] An uncertain future event exists where at least one of the following is uncertain at the inception of an insurance contract:  the occurrence of an insured event;  the timing of the event; or  the level of compensation that will be paid by the insurer if the event occurs. [IFRS 4 Appendix B] Some insurance contracts may offer payments-in-kind rather than compensation payable to the policyholder directly. For example, an insurance repair contract may pay for a washing machine to be repaired if it breaks down; the contract will not necessarily pay monetary compensation. In identifying an insurance contract it is important to make the distinction between financial risk and insurance risk. A contract that exposes the issuer to financial risk without significant insurance risk does not meet the definition of an insurance contract. Financial risk is where there is a possible change in a financial or non-financial variable, for example a specified interest rate, commodity prices, an entity’s credit rating or foreign exchange rates. Insurance risk is defined as being a risk that is not a financial risk. The risk in an insurance contract is whether an event will occur rather than arising from a change in something, for example a theft, damage to property, or product or professional liability. Appendix B to IFRS Chapter 29 – Insurance Page 391 4, which forms an integral part of the standard, includes an extensive list of examples of insurance contracts including:  life insurance and prepaid funeral plans. It is the timing of the event that is uncertain here; for example certain life cover plans only pay out if death occurs within a specified period of time;  disability and medical cover;  credit insurance, covering the policyholder for non-recoverable receivables; and  travel cover to provide against any loss suffered whilst travelling. Illustration 1 Examples of an insurer taking on insurance risk are:  An insurance contract issued to a policyholder against the escalation of claims from faulty motorcycles. The fault was discovered a year ago and the extent of total claims is yet to be established. This is an insurance contract since the insured event is the discovery of the ultimate cost of the claims.  A gas boiler repair service available from a supplier who, for the payment of a fixed fee, will fix the malfunctioning boiler. This is an insurance contract as it is a payment-in-kind contract, with the uncertain event being whether the boiler will break down and the policyholder will be adversely affected. 4 Recognition and Measurement IFRS 4 exempts an insurer temporarily during phase one of the IASB’s insurance project from the need to consider the IASB Framework in selecting accounting policies for insurance contracts where there is no specific accounting requirement set out in another international standard. However, IFRS 4 expressly:  requires a test for the adequacy of recognised insurance liabilities – referred to as the ‘liability adequacy test’;  prohibits provisions for possible claims under contracts that are not in existence at the reporting date referred to as catastrophe or equalisation provisions;  requires an impairment test for reinsurance assets. An impairment is only recognised where, after the commencement of a reinsurance contract, an event has occurred that will lead to amounts due under the contract not being recovered in full, and a reliable estimate of the shortfall can be assessed; and  requires an insurer to retain insurance liabilities in its statement of financial position until they are discharged, cancelled or expire, and to present such liabilities without offsetting them against related reinsurance assets. An insurer recognises its insurance liabilities at each reporting date based on the current estimate of future contractual cash flows, and related items such as handling costs, arising under the insurance contracts. This provision should be reassessed at each reporting date and any identified shortfall should be recognised immediately in profit or loss for the period. This is the so called ‘liability adequacy test’. [IFRS 4.15] If the accounting policies of an insurer do not demand that a liability adequacy test should be carried out, as described above, then an assessment is still required of the potential net Chapter 29 – Insurance Page 392 liability i.e. the relevant insurance liabilities less any related deferred acquisition costs. In these circumstances the insurer is required to recognise at least the amount that would be required to be recognised as a provision under the application of IAS 37 Provisions, contingent liabilities and contingent assets. 5 Changing Accounting Policies An insurer is required to apply the general principles in IAS 8 Accounting policies, changes in accounting estimates and errors to any change that it wishes to make in its accounting policies. A change in accounting policy is therefore only permitted where the new policy will provide more relevant and no less reliable information to the users of the financial statements. [IFRS 4.22] As IFRS 4 is only the first phase of the insurance project, there are a number of relaxations in the application of the standard and how it interrelates to other international standards. For example, IFRS 4 sets out an accounting policy for the remeasurement of designated insurance liabilities to reflect current market interest rates, with any changes being reported directly in profit or loss. To encourage insurers to adopt this policy the standard specifically exempts them from having to carry out, and justify, the relevance and reliability test for such a change in policy. IFRS 4 also identifies a number of accounting policies which may continue to be used if they represent existing practice of an insurer, but which may not be adopted as a new policy because they do not meet the “more relevant and no less reliable” test. Such policies include:  measuring insurance liabilities on an undiscounted basis;  measuring contractual rights to future investment management fees at an amount that is in excess of their fair value, as implied by a comparison with current fees being charged by other market participants for similar services; and  using non-uniform accounting policies for the insurance contracts of subsidiaries. Where an insurer uses excessive prudence i.e. it is over cautious in its accounting for insurance contracts, there is no requirement to change to a less prudent policy. But an insurer already using sufficient prudence may not change to excessive prudence. IFRS 4 sets out a number of accounting policies that an insurance entity is permitted to follow, although there is no requirement to do so at present. These relate to future investment margins, shadow accounting, insurance contracts acquired in a business combination or portfolio transfer and discretionary participation features. 6 Disclosures IFRS 4 requires that information is disclosed in the financial statements of an insurer that identifies and explains amounts that arise from insurance contracts. [IFRS 4.36] This information should include the accounting policies adopted and the identification of recognised assets, liabilities, income and expense arising from insurance contracts. More generally, the risk management objectives and policies of an entity should be disclosed, since this will explain how an insurer deals with the uncertainty it is exposed to. [IFRS 4.38] Comparative disclosures are required in relation to accounting policies adopted and the identification of recognised assets, liabilities, income and expense arising from insurance contracts. Chapter 29 – Insurance Page 393 7 Chapter Review This chapter has considered the nature of, and accounting for, insurance contracts. In summary, this chapter has covered:  identifying an insurance contract;  understanding the various forms that an insurance contract may take; and  setting out the disclosure requirements which help to explain the risks associated with an insurance contract. Chapter 29 – Insurance Page 394 8 Self Test Questions Chapter 29 1. An entity should apply IFRS4 Insurance contracts to which ONE of the following? A Contingent consideration receivable in a business combination B Product warranties issued by an entity which is a manufacturer C Employers assets and liabilities under employment benefit plans D Reinsurance contracts issued by the entity 2. The Corella Company is applying IFRS4 Insurance contracts. Which TWO of the following accounting policies may Corella continue to apply? A Recognising provisions for possible future claims B Offsetting reinsurance income and expenses against the income and expenses of related reinsurance contracts C Measuring insurance liabilities on an undiscounted basis D Using non-uniform accounting policies for the insurance contracts of subsidiaries 3. Are the following statements about IFRS4 Insurance contracts true or false? 1 IFRS4 requires an insurer to consider the requirements of the IASB Framework in selecting accounting policies for insurance contracts. 2 IFRS4 requires an insurer to test for the adequacy of recognised insurance liabilities. Statement 1 Statement 2 A False False B False True C True False D True True 4. Which TWO of the following are requirements of IFRS4 Insurance contracts? A The offset of reinsurance assets against related insurance liabilities B An annual assessment of the adequacy of recognised insurance liabilities C An impairment test for reinsurance assets D Recognition of provisions for future claims relating to a catastrophe Chapter 29 – Insurance Page 395 5. The Kokam Company and its subsidiaries are applying IFRS4 Insurance contracts for the first time in the preparation of consolidated financial statements. Which ONE of the following accounting policies for insurance contracts is permitted by IFRS4? A Using equalisation provisions for possible claims on future insurance contracts B Recognising in the statement of changes in equity any deficiency arising from the liability adequacy test C Introducing additional excessive prudence in measuring insurance contract liabilities D Continuing to use non-uniform accounting policies to measure the insurance liabilities of the subsidiaries Chapter 30 – Agriculture Page 397 Chapter 30 AGRICULTURE 1 Business Context Accounting practices for the agricultural sector have historically been varied, since international standards generally excluded such activities due to their specialist nature. The nature of agricultural activity makes it difficult to apply a traditional cost model, since such items are constantly changing through growth and regeneration. Since the use of an historical cost model was not seen as wholly appropriate for accounting for agricultural activity, the IASB issued IAS 41 Agriculture based on a fair value model. The basic business issues in the farming sector have many unique aspects. For example, animals and plants, described as biological assets, have characteristics which are not present in other industries. Another important feature is that government assistance in the agricultural sector is common and is often substantial. Entities in the farming industry are often small or family run, but with the increasing awareness of organic produce and fair trade we have seen an expansion of such businesses in recent years. 2 Chapter Objectives On completion of this chapter you should be able to:  understand the distinction between biological assets and agricultural produce;  demonstrate a knowledge of the treatment of biological assets and agricultural produce;  deal with gains and losses on biological assets and agricultural produce; and  account for government grants in the agricultural sector. 3 Objectives, Scope and Definitions of IAS 41 IAS 41 sets out the accounting treatment, including presentation and disclosure requirements, for agricultural activity. Agricultural activity is defined as the management of the biological transformation of biological assets for sale, into agricultural produce, or into additional biological assets. Such activities include, for example, raising livestock, forestry and cultivating orchards and plantations. [IAS 41.5] A biological transformation comprises the processes of growth, degeneration, production and procreation that cause qualitative or quantitative changes in a biological asset. In its simplest form, it is the process of growing something such as a crop, although it also incorporates the production of agricultural produce such as wool and milk. [IAS 41.5] A biological asset is a living plant or animal. [IAS 41.5] Agricultural produce is the harvested produce of an entity’s biological assets. [IAS 41.5] IAS 41 considers the classification of biological assets and how their characteristics, and hence value, change over time. The standard applies to agricultural produce up to the point of harvest, after which IAS 2 Inventories is applicable. A distinction is made between the two because IAS 41 applies to biological assets throughout their lives but to agricultural produce only up to the point that it is harvested. Chapter 30 – Agriculture Page 398 IAS 41 includes a table of examples which clearly sets out three distinct stages involved in the production of biological assets. Examples include the identification of dairy cattle as the biological asset, milk the agricultural produce and cheese the product that is processed after the point of harvest. Another example is, vines are the biological asset, grapes the agricultural produce and wine the end product. IAS 41 does not apply to agricultural lands IAS 16 Property, plant and equipment and IAS 40 Investment property apply instead, nor to intangible assets related to agriculture IAS 38 Intangible assets applies. Illustration 1 Calves and cows are biological assets as they are living animals. Beef and milk are agricultural produce. Apples are agricultural produce. The related trees and orchards are biological assets. 4 Recognition and Measurement A biological asset or agricultural produce should only be recognised when: [IAS 41.10]  the entity controls the asset as a result of past events, for example the acquisition of dairy cattle. The past event is the purchase, and control is obtained as the entity is now the legal owner;  it is probable that future economic benefits will flow to the entity, because the dairy cattle will produce milk which can be sold or processed into cheese and sold; and  fair value, or cost, of the asset can be measured reliably. A biological asset should initially be measured at its fair value less estimated point of sale costs, such as duty and commission to brokers or dealers. [IAS 41.12] Point of sale costs do not include any costs that are necessary to get the asset to a market, for example transport. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. Where an active market exists for a biological asset, the quoted price in the market is the appropriate fair value. [IAS 41.8] Where an active market does not exist, then fair value may be derived by using:  the most recent transaction in the market, assuming that similar economic conditions exist at the time of the transaction and at the end of the reporting period; or  market prices for similar assets with appropriate adjustments to reflect differences; or  sector based benchmarks, for example the value of meat per kilogram. IAS 41 includes the presumption that it will be possible to fair value a biological asset. But if fair value cannot be measured reliably at the time of initial recognition, then the biological asset should be recognised at cost less accumulated depreciation and impairment losses i.e. the decrease in the recoverable amount of an asset. Fair value should then be used as soon as a reliable measurement can be made. [IAS 41.30] At subsequent period ends a biological asset should continue to be measured at its fair value. Once a biological asset has been measured at fair value, it is not permissible to revert to cost.