The definitions of assets, liabilities, income, and expense are to be the same for interim period reporting as at year-end. These items are defined in the IASB’s Framework. The effect of stipulating that the same definitions apply to interim reporting is to further underscore the concept of interim periods being discrete units of time upon which the statements report.
For example, given the definition of assets as resources generating future economic benefits for the entity, expenditures that could not be capitalized at year-end because of a failure to meet this definition could similarly not be deferred at interim dates. Thus, by applying the same definitions at interim dates, IAS 34 has mandated the same recognition rules as are applicable at the end of full annual reporting periods.
However, while the overall implication is that identical recognition and measurement rules are to be applied to interim financial statements, there are a number of exceptions and modifications to the general rule. Some of these are in simple acknowledgment of the limitations of certain measurement techniques, and the recognition that applying those definitions at interim dates might necessitate interpretations different from those useful for annual reporting. In other cases, the standard clearly departs from the discrete view, since such departures are not only wise, but probably fully necessary. These specific recognition and measurement issues are addressed by IAS 34 as it is revealed through this post. Read on…
Recognition of Annual Costs Incurred Unevenly During The Year
It is frequently observed that certain types of costs are incurred in uneven patterns over the course of a fiscal year, while not being driven strictly by variations in volume of sales activity. For example, major expenditures on advertising may be prepaid at the inception of the campaign; tooling for new product production will obviously be heavily weighted to the preproduction and early production stages. Certain discretionary costs, such as research and development, will not bear any predictable pattern or necessary relationship with other costs or revenues.
If an integral view approach had been designated by IAS 34, there would be potent arguments made in support of the accrual or deferral of certain costs. For instance, if a major expenditure for overhauling equipment is scheduled to occur during the final interim period, logic could well suggest that the expenditure should be anticipated in the earlier interim periods of the year, if those periods were seen as integral parts of the fiscal year.
Under the discrete view adopted by the standard, however, such an accrual would be seen as an inappropriate attempt to smooth the operating results over all the interim periods constituting the full fiscal year.
Accordingly, such anticipation of future expenses is prohibited, unless the future expenditure gives rise to a true liability in the current period, or meets the test of being a contingency which is probable and the magnitude of which is reasonably estimable.
For example, many business entities grant bonuses to managers only after the annual results are known; even if the relationship between the bonuses and the earnings performance is fairly predictable from past behavior, these remain discretionary in nature and need not be granted. Such a bonus arrangement would not give rise to a liability during earlier interim periods, inasmuch as the management has yet to declare that there is a commitment that will be honored.
(Note: Compare this with the situation where managers have contracts specifying a bonus plan, which clearly would give rise to a legal liability during the year, albeit one which might involve complicated estimation problems. Also, a bonus could be anticipated for interim reporting purposes if it could be considered a constructive obligation, for example, based upon past practice for which the entity has no realistic alternative, and assuming that a realistic estimate of that obligation can be made).
Another Example Involves Contingent Lease Arrangements
Often in operating lease situations the lessee will agree to a certain minimum or base rent, plus an amount that is tied to a variable such as sales revenue. This is typical, for instance, in retail rental contracts, such as for space in shopping malls, since it encourages the landlord to maintain the facilities in an appealing fashion so that tenants will be successful in attracting customers.
Only the base amount of the periodic rental is a true liability, unless and until the higher rent becomes payable as defined sales targets are actually achieved. If contingent rents are payable based on a sliding scale (e.g., 1% of sales volume up to $500,000, then 2% of amounts up to $1.5 million, etc.), the projected level of full-year sales should not be used to compute rental accruals in the early periods; rather, only the contingent rents payable on the actual sales levels already achieved should be so recorded.
The foregoing examples were clearly categories of costs that, while often fairly predictable, would not constitute a legal obligation of the reporting entity until the associated conditions were fully met.
There are, however, other examples that are more ambiguous. Paid vacation time and holiday leave are often enforceable as legal commitments, and if this is so, provision for these costs should be made in the interim financial statements.
In other cases, as when company policy is that accrued vacation time is lost if not used by the end of a defined reporting year, such costs might not be subject to accrual under the discrete view. The facts of each such situation would have to be carefully analyzed to make a proper determination.
Revenues Received Seasonally, Cyclically, Or Occasionally
IAS 34 is clear in stipulating that revenues such as dividend income and interest earned cannot be anticipated or deferred at interim dates, unless such practice would be acceptable under IFRS at year-end.
Thus, interest income is typically accrued, since it is well established that this represents a contractual commitment. Dividend income, on the other hand, is not recognized until declared, since even when highly predictable based on past experience, these are not obligations of the paying corporation until actually declared.
Furthermore, seasonality factors should not be smoothed out of the financial statements. For example, for many retail stores a high percentage of annual revenues occur during the holiday shopping period, and the quarterly or other interim financial statements should fully reflect such seasonality. That is, revenues should be recognized as they occur.
The fact that income taxes are assessed annually by the taxing authorities is the primary reason for reaching the conclusion that taxes are to be accrued based on the estimated average annual effective tax rate for the full fiscal year.
Further, if rate changes have been enacted to take effect later in the fiscal year (while some rate changes take effect in midyear, more likely this would be an issue if the entity reports on a fiscal year and the new tax rates become effective at the start of a calendar year), the expected effective rate should take into account the rate changes as well as the anticipated pattern of earnings to be experienced over the course of the year.
Thus, the rate to be applied to interim period earnings (or losses, as discussed further below) will take into account the expected level of earnings for the entire forthcoming year, as well as the effect of enacted (or substantially enacted) changes in the tax rates to become operative later in the fiscal year.
In other words, and as the standard puts it, the estimated average annual rate would “reflect a blend of the progressive tax rate structure expected to be applicable to the full year’s earnings including enacted or substantially enacted changes in the income tax rates scheduled to take effect later in the financial year.”
IAS 34 addresses in detail the various computational aspects of an effective interim period tax rate which are summarized in the following paragraphs.
Multiplicity Of Taxing Jurisdictions And Different Categories Of Income
Many entities are subject to a multiplicity of taxing jurisdictions, and in some instances the amount of income subject to tax will vary from one to the next, since different laws will include and exclude disparate items of income or expense from the tax base. For example, interest earned on government-issued bonds may be exempted from tax by the jurisdiction that issued them, but be defined as fully taxable by other tax jurisdictions the entity is subject to.
To the extent feasible, the appropriate estimated average annual effective tax rate should be separately ascertained for each taxing jurisdiction and applied individually to the interim period pretax income of each jurisdiction, so that the most accurate estimate of income taxes can be developed at each interim reporting date. In general, an overall estimated effective tax rate will not be as satisfactory for this purpose as would a more carefully constructed set of estimated rates, since the pattern of taxable and deductible items will fluctuate from one period to the next.
Similarly, if the tax law prescribes different income tax rates for different categories of income (such as the tax rate on capital gains which usually differs from the tax rate applicable to business income in many countries), then to the extent practicable, a separate tax rate should be applied to each category of interim period pretax income. The standard, while mandating such detailed rules of computing and applying tax rates across jurisdictions or across categories of income, recognizes that in practice such a degree of precision may not be achievable in all cases.
Thus, in all such cases, IAS 34 softens its stand and allows usage of a “weighted-average of rates across jurisdictions or across categories of income” provided “it is a reasonable approximation of the effect of using more specific rates.”
In computing an expected effective tax rate for a given tax jurisdiction, all relevant features of the tax regulations should be taken into account. Jurisdictions may provide for tax credits based on new investment in plant and machinery, relocation of facilities to backward or underdeveloped areas, research and development expenditures, levels of export sales, and so forth, and the expected credits against the tax for the full year should be given consideration in the determination of an expected effective tax rate.
Thus, the tax effect of new investment in plant and machinery, when the local taxing body offers an investment credit for qualifying investment in tangible productive assets, will be reflected in those interim periods of the fiscal year in which the new investment occurs (assuming it can be forecast to occur later in a given fiscal year), and not merely in the period in which the new investment occurs. This is consistent with the underlying concept that taxes are strictly an annual phenomenon, but it is at variance with the purely discrete view of interim financial reporting.
The interim reporting standard notes that, although tax credits and similar modifying elements are to be taken into account in developing the expected effective tax rate to apply to interim earnings, tax benefits which will relate to onetime events are to be reflected in the interim period when those events take place.
This is perhaps most likely to be encountered in the context of capital gains taxes incurred in connection with occasional dispositions of investments and other capital assets; since it is not feasible to project the rate at which such transactions will occur over the course of a year, the tax effects should be recognized only as the underlying events transpire.
While in most cases tax credits are to be handled as suggested in the foregoing paragraphs, in some jurisdictions tax credits, particularly those that relate to export revenue or capital expenditures, are in effect government grants.
The accounting for government grants is set forth in IAS 20; in brief, grants are recognized in income over the period necessary to properly match them to the costs which the grants are intended to offset or defray. Thus, compliance with both IAS 20 and IAS 34 would necessitate that tax credits be carefully analyzed to identify those which are, in substance, grants, and then accounting for the credit consistent with its true nature.
Tax Loss Tax Credit Carrybacks And Carryforwards
When an interim period loss gives rise to a tax loss carryback, it should be fully reflected in that interim period. Similarly, if a loss in an interim period produces a tax loss carryforward, it should be recognized immediately, but only if the criteria set forth in IAS 12 are met.
Specifically, it must be deemed probable that the benefits will be realizable before the loss benefits can be given formal recognition in the financial statements. In the case of interim period losses, it may be necessary to assess not only whether the entity will be profitable enough in future fiscal years to utilize the tax benefits associated with the loss, but, furthermore, whether interim periods later in the same year will provide earnings of sufficient magnitude to absorb the losses of the current period.
IAS 12 provides that changes in expectations regarding the realizability of benefits related to net operating loss carryforwards should be reflected currently in tax expense.
Similarly, if a net operating loss carryforward benefit is not deemed probable of being realized until the interim (or annual) period when it in fact becomes realized, the tax effect will be included in tax expense of that period.
Appropriate explanatory material must be included in the notes to the financial statements, even on an interim basis, to provide the user with an understanding of the unusual relationship between pretax accounting income and the provision for income taxes.
Volume Rebates Or Other Anticipated Price Changes In Interim Reporting Periods
IAS 34 prescribes that where volume rebates or other contractual changes in the prices of goods and services are anticipated to occur over the annual reporting period, these should be anticipated in the interim financial statements for periods within that year.
The logic is that the effective cost of materials, labor, or other inputs will be altered later in the year as a consequence of the volume of activity during earlier interim periods, among others, and it would be a distortion of the reported results of those earlier periods if this were not taken into account.
Clearly this must be based on estimates, since the volume of purchases, etc., in later portions of the year may not materialize as anticipated.
As with other estimates, however, as more accurate information becomes available this will be adjusted on a prospective basis, meaning that the results of earlier periods should not be revised or corrected. This is consistent with the accounting prescribed for contingent rentals and is furthermore consistent with IAS 37’s guidance on provisions.
The requirement to take volume rebates and similar adjustments into effect in interim period financial reporting applies equally to vendors or providers, as well as to customers or consumers of the goods and services. In both instances, however, it must be deemed probable that such adjustments have been earned or will occur, before giving recognition to them in the financials. This high a threshold has been set because the definitions of assets and liabilities in the IASB’s Framework require that they be recognized only when it is probable that the benefits will flow into or out from the entity.
Thus, accrual would only be appropriate for contractual price adjustments and related matters. Discretionary rebates and other price adjustments, even if typically experienced in earlier periods, would not be given formal recognition in the interim financials.
Depreciation And Amortization In Interim Periods
The rule regarding depreciation and amortization in interim periods is more consistent with the discrete view of interim reporting. Charges to be recognized in the interim periods are to be related to only those assets actually employed during the period; planned acquisitions for later periods of the fiscal year are not to be taken into account.
While this rule seems entirely logical, it can give rise to a problem that is not encountered in the context of most other types of revenue or expense items.
This occurs when the tax laws or financial reporting conventions permit or require that special allocation formulas be used during the year of acquisition (and often disposition) of an asset. In such cases, depreciation or amortization will be an amount other than the amount that would be computed based purely on the fraction of the year the asset was in service. For example, assume that convention is that one-half year of depreciation is charged during the year the asset is acquired, irrespective of how many months it is in service.
Further assume that a particular asset is acquired at the inception of the fourth quarter of the year. Under the requirements of IAS 34, the first three quarters would not be charged with any depreciation expense related to this asset (even if it was known in advance that the asset would be placed in service in the fourth quarter). However, this would then necessitate charging fourth quarter operations with one-half year’s (i.e., two quarters’) depreciation, which arguably would distort that final period’s results of operations.
IAS 34 does address this problem area. It states that an adjustment should be made in the final interim period so that the sum of interim depreciation and amortization equals an independently computed annual charge for these items. However, since there is no requirement that financial statements be separately presented for a final interim period (and most entities, in fact, do not report for a final period), such an adjustment might be implicit in the annual financials, and presumably would be explained in the notes if material (the standard does not explicitly require this, however).
The alternative financial reporting strategy, that is, projecting annual depreciation, including the effect of asset dispositions and acquisitions planned for or reasonably anticipated to occur during the year, and then allocating this ratably to interim periods, has been rejected. Such an approach might have been rationalized in the same way that the use of the effective annual tax rate was in assigning tax expense or benefits to interim periods, but this has not been done.
Inventories represent a major category for most manufacturing and merchandising entities, and some inventory costing methods pose unique problems for interim financial reporting. In general, however, the same inventory costing principles should be utilized for interim reporting as for annual reporting. However, the use of estimates in determining quantities, costs, and net realizable values at interim dates will be more pervasive.
Determining net realizable values and the allocation of manufacturing variances
Regarding net realizable value determination, the standard expresses the belief that the determination of NRV at interim dates should be based on selling prices and costs to complete at those dates. Projections should therefore not be made regarding conditions which possibly might exist at the time of the fiscal year-end. Furthermore, write-downs to NRV taken at interim reporting dates should be reversed in a subsequent interim reporting period only if it would be appropriate to do so at the end of the financial year.
The last of the special issues related to inventories that are addressed by IAS 34 concerns allocation of variances at interim dates. When standard costing methods are employed, the resulting variances are typically allocated to cost of sales and inventories in proportion to the dollar magnitude of those two captions, or according to some other rational system. IAS 34 requires that the price, efficiency, spending, and volume variances of a manufacturing entity are recognized in income at interim reporting dates to the extent those variances would be recognized at the end of the financial year.
It should be noted that some standards have prescribed deferral of such variances to year-end based on the premise that some of the variances will tend to offset over the course of a full fiscal year, particularly if the result of volume fluctuations due to seasonal factors.
When variance allocation is thus deferred, the full balance of the variances are placed onto the statement of financial position, typically as additions to or deductions from the inventory accounts. However, IAS 34 expresses a preference that these variances be disposed of at interim dates (instead of being deferred to year-end) since to not do so could result in reporting inventory at interim dates at more or less than actual cost.