MAH, Chartered Accountants

Author: Mohammed Haque

  • Estimating fair value of unlisted shares

    The fair value of unlisted shares is the price at which the shares would be bought or sold between knowledgeable, willing parties in an arm’s length transaction. Estimating the fair value of unlisted shares can be challenging, as there is no readily available market price for the shares and the fair value must be determined using other methods.

    One method for estimating the fair value of unlisted shares is the income approach, which values the shares based on the present value of future cash flows. The income approach involves estimating the future cash flows that the shares are expected to generate, and then discounting those cash flows at a rate that reflects the risks associated with the cash flows.

    Another method for estimating the fair value of unlisted shares is the market approach, which values the shares based on comparable listed shares. The market approach involves identifying similar listed shares and comparing their market prices to the unlisted shares. The market approach can be challenging if there are no comparable listed shares, or if the listed shares are not sufficiently similar to the unlisted shares.

    A third method for estimating the fair value of unlisted shares is the cost approach, which values the shares based on the cost of reproducing or replacing the assets of the company. The cost approach involves estimating the cost of reproducing or replacing the assets of the company, and then adjusting the cost for any changes in the value of the assets since they were acquired.

    Overall, estimating the fair value of unlisted shares is a complex and uncertain process that requires careful analysis and judgment. The fair value of unlisted shares can be sensitive to the assumptions and methodologies used, and can vary significantly depending on the approach and the specific circumstances of the company.

  • Accounting for a convertible loan

    A convertible loan is a type of loan that can be converted into shares of the borrower’s common stock at the option of the lender. In accounting, a convertible loan is typically accounted for as a liability, with the potential conversion option being accounted for as a separate instrument, either as a liability or as equity.

    According to International Accounting Standard (IAS) 32, “Financial Instruments: Presentation,” a convertible loan should be initially recognized at fair value, with any difference between the loan’s fair value and the proceeds received from the lender being recognized as a gain or loss in the income statement. The loan should then be subsequently measured at amortized cost, using the effective interest method, with any difference between the loan’s amortized cost and its redemption value being recognized as a gain or loss in the income statement.

    The potential conversion option should be accounted for separately from the loan. If the conversion option is classified as a liability, it should be initially recognized at fair value, with any difference between the option’s fair value and the proceeds received from the lender being recognized as a gain or loss in the income statement. The option should then be subsequently measured at fair value, with any changes in fair value being recognized in the income statement.

    If the conversion option is classified as equity, it should be initially recognized at fair value, with any difference between the option’s fair value and the proceeds received from the lender being recognized as a contribution to equity. The option should then be subsequently measured at fair value, with any changes in fair value being recognized directly in equity.

    For example, if a company borrows £100,000 from a lender and the loan includes a conversion option that allows the lender to convert the loan into shares of the company’s common stock at a conversion price of £10 per share, the company would initially recognize the loan at fair value. If the fair value of the loan is £105,000, the company would recognize a gain of £5,000 in the income statement. The loan would then be subsequently measured at amortized cost using the effective interest method, with any difference between the amortized cost and the redemption value being recognized as a gain or loss in the income statement.

    If the conversion option is classified as a liability, it would be initially recognized at fair value. If the fair value of the option is £10,000, the company would recognize a gain of £10,000 in the income statement. The option would then be subsequently measured at fair value, with any changes in fair value being recognized in the income statement.

    If the conversion option is classified as equity, it would be initially recognized at fair value. If the fair value of the option is £10,000, the company would recognize a contribution to equity of £10,000. The option would then be subsequently measured at fair value, with any changes in fair value being recognized directly in equity.

  • IFRS 15 Revenue recognition

    International Financial Reporting Standard 15 (IFRS 15) is a new accounting standard that provides guidance on how to account for revenue from contracts with customers. IFRS 15 replaces the previous revenue recognition standards, including IAS 18, “Revenue,” and IAS 11, “Construction Contracts,” and is effective for annual periods beginning on or after January 1, 2018.

    IFRS 15 establishes a single, principles-based five-step model for recognizing revenue from contracts with customers. The five steps are:

    1. Identify the contract with the customer.
    2. Identify the performance obligations in the contract.
    3. Determine the transaction price.
    4. Allocate the transaction price to the performance obligations in the contract.
    5. Recognize revenue when (or as) the entity satisfies a performance obligation.

    The first step in applying IFRS 15 is to identify the contract with the customer. A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. A contract with a customer exists when the entity has approved the contract and the customer has accepted the offer to enter into the contract.

    The second step is to identify the performance obligations in the contract. A performance obligation is a promise to transfer a good or service to the customer in the contract. The entity should assess the contract to determine which promises are performance obligations, and which promises are not.

    The third step is to determine the transaction price. The transaction price is the amount of consideration to which the entity expects to be entitled in exchange for transferring the goods or services to the customer. The transaction price should be determined based on the contract, using the expected value of the consideration that the entity expects to receive from the customer.

    The fourth step is to allocate the transaction price to the performance obligations in the contract. The transaction price should be allocated to each performance obligation in the contract based on the relative standalone selling prices of the goods or services promised in the contract. The standalone selling price is the price at which the entity would sell the good or service separately to the customer.

    The fifth and final step is to recognize revenue when (or as) the entity satisfies a performance obligation. The entity should recognize revenue when it satisfies a performance obligation by transferring a good or service to the customer. This means that the entity should recognize revenue when it completes the performance obligation, or when it receives payment from the customer, whichever comes first.

    IFRS 15 includes detailed guidance on how to apply the five-step model in various situations, including contracts with multiple performance obligations, contracts with variable consideration, and contracts with non-cash consideration.

  • Accruals concept

    The accruals concept is a fundamental principle of accounting that states that income and expenses should be recognized in the period in which they are earned or incurred, rather than in the period in which they are paid or received. The accruals concept is based on the idea that the financial statements should reflect the economic substance of transactions, rather than their legal form.

    The accruals concept is applied through the use of accrual-based accounting, in which income and expenses are recognized based on the underlying economic events that give rise to them. This means that income is recognized when it is earned, and expenses are recognized when they are incurred, regardless of whether the cash has been received or paid.

    The accruals concept is applied in a number of ways in accounting, including the recognition of revenue, the recognition of expenses, and the matching of revenue and expenses.

    One example of the application of the accruals concept is the recognition of revenue. According to the accruals concept, revenue should be recognized in the period in which it is earned, rather than in the period in which it is received. This means that if a company performs a service or sells a product in one period, but does not receive payment until the next period, the revenue should be recognized in the first period, rather than the second period.

    For example, if a company provides consulting services to a client in December and issues an invoice for £10,000, but does not receive payment until January, the company would recognize the £10,000 of revenue in December, rather than in January. This is because the revenue was earned in December, when the consulting services were provided, rather than in January, when the cash was received.

    Another example of the application of the accruals concept is the recognition of expenses. According to the accruals concept, expenses should be recognized in the period in which they are incurred, rather than in the period in which they are paid. This means that if a company incurs an expense in one period, but does not pay the cash until the next period, the expense should be recognized in the first period, rather than the second period.

    For example, if a company purchases office supplies in December for £500 and receives an invoice, but does not pay the cash until January, the company would recognize the £500 of expense in December, rather than in January. This is because the expense was incurred in December, when the office supplies were purchased, rather than in January, when the cash was paid.

  • Useful economic life

    The useful economic life of an asset is the period over which the asset is expected to generate economic benefits for the entity. In other words, it is the period of time during which the asset is expected to be used by the entity to generate revenue or other economic benefits.

    The useful economic life of an asset is an important concept in accounting, as it is used to determine the amount of depreciation or amortization that should be recognized for the asset. Depreciation is the systematic allocation of the depreciable amount of a tangible asset over its useful life, while amortization is the systematic allocation of the amortizable amount of an intangible asset over its useful life.

    The useful economic life of an asset is determined by the entity based on its expected use of the asset. The useful economic life of an asset may be shorter than its physical life, if the entity expects to dispose of the asset before the end of its physical life. For example, a vehicle may have a physical life of 15 years, but the entity may expect to dispose of the vehicle after 5 years, in which case the useful economic life of the vehicle would be 5 years.

    The useful economic life of an asset may also be affected by obsolescence or technological changes. If an asset becomes obsolete or is replaced by a newer technology, the useful economic life of the asset may be shorter than its physical life. For example, a computer may have a physical life of 5 years, but if it becomes obsolete after 3 years, the useful economic life of the computer would be 3 years.

  • Acquisition with contingent consideration

    Contingent consideration is a type of payment that is dependent on the occurrence of a future event. In accounting, contingent consideration is recognized and measured when it is probable that the event will occur and the amount of the payment can be reasonably estimated.

    According to International Financial Reporting Standard 3 (IFRS 3), “Business Combinations,” contingent consideration is recognized as a liability in the acquirer’s balance sheet at the acquisition date. The liability is measured at fair value, which is the best estimate of the amount of the future payment at the acquisition date.

    The fair value of contingent consideration is determined using a valuation technique, such as a discounted cash flow analysis or a probability-weighted expected return calculation. The fair value of the liability is then adjusted for the passage of time and changes in the probability of the event occurring, until the event is no longer probable or the amount of the payment can no longer be reasonably estimated.

    Once the event has occurred and the amount of the payment has been determined, the acquirer is required to remeasure the liability at the amount of the payment. The difference between the original measurement of the liability and the remeasurement of the liability is recognized in the acquirer’s income statement as a gain or loss on the contingent consideration.

    For example, if a company acquires another company and agrees to pay a contingent consideration of £1 million if the acquired company achieves certain financial targets, the company would recognize a liability of £1 million at the acquisition date, measured at fair value. If the acquired company achieves the financial targets and the amount of the payment is determined to be £1 million, the company would remeasure the liability at £1 million and recognize any difference between the original measurement and the remeasurement as a gain or loss on the contingent consideration.

  • Share based payments

    Share-based payment is a method of compensating employees or other parties using the entity’s own equity instruments, such as shares or share options. International Financial Reporting Standard 2 (IFRS 2), “Share-Based Payment,” provides guidance on the accounting treatment of share-based payment transactions.

    According to IFRS 2, a share-based payment arrangement is a contract between an entity and the recipient of the share-based payment, in which the entity agrees to provide the recipient with equity instruments of the entity, or cash in lieu of the equity instruments, in exchange for goods or services received. The equity instruments may be shares, share options, or other instruments that will be settled in the entity’s own shares or share options.

    IFRS 2 requires entities to recognize the fair value of the goods or services received under a share-based payment arrangement as an expense in the income statement. The fair value of the goods or services is determined at the date at which the recipient completes the performance of the services or other conditions for vesting of the equity instruments.

    The fair value of the equity instruments issued under a share-based payment arrangement is also recognized as an expense in the income statement. The fair value of the equity instruments is determined at the date at which the recipient completes the performance of the services or other conditions for vesting of the equity instruments.

    IFRS 2 includes guidance on the measurement of the fair value of the goods or services received under a share-based payment arrangement. The fair value of the goods or services may be determined using either a fair value model or an attribution model.

    The fair value model is based on the fair value of the equity instruments issued or to be issued under the share-based payment arrangement. The fair value of the equity instruments is determined using a valuation technique, such as a Black-Scholes option pricing model. The fair value of the goods or services is then determined by multiplying the number of equity instruments issued or to be issued by the fair value of the equity instruments.

    The attribution model is based on the grant-date fair value of the goods or services received by the recipient. The grant-date fair value of the goods or services is determined using a valuation technique, such as a present value calculation based on the expected cash flows from the goods or services. The fair value of the goods or services is then determined by allocating the grant-date fair value of the goods or services to the vesting period of the equity instruments.

    IFRS 2 also includes guidance on the accounting for modifications of share-based payment arrangements. A modification of a share-based payment arrangement is a change to the original terms of the arrangement that results in a change in the fair value of the goods or services received, or the number or fair value of the equity instruments issued or to be issued.

    If a modification of a share-based payment arrangement results in a change in the fair value of the goods or services received, or the number or fair value of the equity instruments issued or to be issued, the entity is required to recognize the incremental fair value of the goods or services received as an expense in the income statement. The incremental fair value of the goods or services is determined by comparing the fair value of the goods or services received before and after the modification.

    If a modification of a share-based payment arrangement does not result in a change in the fair value of the goods or services received, or the number or fair value of the equity instruments issued or to be issued, the entity is not required to recognize the modification as an expense in the income statement.

    Black-Scholes model

    The Black-Scholes model is a mathematical model used to determine the fair value of a European call or put option, using the current market price of the underlying asset, the option’s exercise price, the option’s time to expiration, the underlying asset’s volatility, and the risk-free interest rate.

    To use the Black-Scholes model, the user inputs the current market price of the underlying asset, the option’s exercise price, the option’s time to expiration, the underlying asset’s volatility, and the risk-free interest rate. The model then uses a set of equations to calculate the fair value of the option.

  • Intangible assets (UK)

    Intangible assets are non-physical assets that are identifiable and have a useful life that extends beyond one year. Examples of intangible assets include trademarks, copyrights, patents, and customer relationships. FRS 102, the financial reporting standard that applies in the United Kingdom, includes detailed guidance on the accounting treatment of intangible assets.

    According to FRS 102, intangible assets are initially recognized in the financial statements at their cost, which is the amount paid to acquire the assets, plus any directly attributable costs of bringing the assets to their present location and condition. The cost of an intangible asset may include various components, such as the purchase price, any legal or professional fees, and any directly attributable costs of development or registration.

    Once assets are recognized, FRS 102 requires entities to apply the amortization method to allocate their cost over their useful lives. Amortization is the systematic allocation of the amortizable amount of an intangible asset over its useful life. The useful life of an intangible asset is the period over which it is expected to generate economic benefits for the entity. The amortizable amount of an intangible asset is its initial cost, less its residual value.

    The residual value of an intangible asset is the estimated amount that the entity expects to receive from the sale or disposal of the asset at the end of its useful life. FRS 102 requires entities to review the assumptions used to determine the useful lives and residual values of their intangible assets on an annual basis, and to make any necessary adjustments. For example, if an entity expects a patent to have a useful life of 10 years, but it is only granted protection for 8 years, the entity would need to adjust the useful life and residual value of the asset.

    The maximum permitted useful life of intangibles is generally 10 years.

    FRS 102 also includes guidance on the disclosure of intangible assets in the financial statements. Entities are required to disclose the carrying amount of their intangible assets, as well as the methods and assumptions used in determining their useful lives and residual values. They are also required to disclose any impairments of their intangible assets, and any changes in the methods or assumptions used to determine their useful lives and residual values.

    In addition, FRS 102 includes specific guidance on the accounting treatment of internally generated intangible assets. These are intangible assets that are developed or acquired by an entity through its own efforts, rather than through a purchase or acquisition. Examples of internally generated intangible assets include software developed in-house, and customer lists developed through marketing activities.

    FRS 102 requires entities to recognize internally generated intangible assets only if they meet the same recognition criteria as other intangible assets. This means that the intangible asset must be expected to provide future economic benefits, must be controlled by the entity, and must have a cost that can be measured reliably. In addition, the entity must be able to demonstrate that it has incurred eligible development costs, and that it has a plan to complete the development and use the intangible asset.

    The key criteria for recognising internal development as an asset if an entity can demonstrate all of the following:
    (a) The technical feasibility of completing the intangible asset so that it will be available for use or sale.
    (b) Its intention to complete the intangible asset and use or sell it.
    (c) Its ability to use or sell the intangible asset.
    (d) How the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.
    (e) The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.
    (f) Its ability to measure reliably the expenditure attributable to the intangible asset during its development.

  • Property, plant and equipment

    Property, plant, and equipment (PP&E) are long-term assets that are used in the production or supply of goods and services. They include a wide range of assets, such as land and buildings, machinery and equipment, and vehicles and other vehicles. FRS 102, the financial reporting standard that applies in the United Kingdom, includes detailed guidance on the accounting treatment of PP&E.

    According to FRS 102, PP&E are initially recognized in the financial statements at their historical cost, which is the amount paid to acquire the assets, plus any directly attributable costs of bringing the assets to their present location and condition. Historical cost is generally determined using the cost model, which values assets at their original purchase price, less any accumulated depreciation and impairment losses.

    The cost of an asset may include various components, such as the purchase price, any import duties or taxes, and any directly attributable costs of installation or modification. FRS 102 requires entities to recognize any directly attributable costs as part of the initial cost of the assets. For example, if a company purchases a new machine and incurs costs to install it, these costs would be recognized as part of the initial cost of the machine.

    Once assets are recognized, FRS 102 requires entities to apply the depreciation method to allocate their cost over their useful lives. Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. The useful life of an asset is the period over which it is expected to generate economic benefits for the entity. The depreciable amount of an asset is its initial cost, less its residual value.

    The residual value of an asset is the estimated amount that the entity expects to receive from the sale or disposal of the asset at the end of its useful life. FRS 102 requires entities to review the assumptions used to determine the useful lives and residual values of their PP&E on an annual basis, and to make any necessary adjustments. For example, if an entity expects a machine to have a useful life of 10 years, but it becomes obsolete after 8 years, the entity would need to adjust the useful life and residual value of the asset.

    FRS 102 also includes guidance on the disclosure of PP&E in the financial statements. Entities are required to disclose the carrying amount of their PP&E, as well as the methods and assumptions used in determining their useful lives and residual values. They are also required to disclose any impairments of their PP&E, and any changes in the methods or assumptions used to determine their useful lives and residual values.

    Overall, the guidance on PP&E in FRS 102 provides a comprehensive and transparent framework for the recognition, measurement, and disclosure of these assets in the financial statements. It helps to ensure that the financial statements of entities accurately reflect the value of their PP&E, and provide useful information to users of the financial statements.

  • Inventories

    Inventory is a term used in accounting to refer to the raw materials, unfinished goods, and finished goods that a business holds for sale or use in the production of other goods. FRS 102, the financial reporting standard that applies in the United Kingdom, includes guidance on the accounting treatment of inventory.

    According to FRS 102, inventory is measured at the lower of cost and net realizable value. Cost is defined as the expenditure incurred in bringing the inventory to its present location and condition, and includes such items as direct materials, direct labor, and overhead. Net realizable value is the estimated selling price of the inventory, less the estimated costs of completion and the estimated costs necessary to make the sale.

    Inventory is recorded in the balance sheet at the lower of cost and net realizable value. If inventory is valued at cost, it is typically determined using the weighted average cost method, which takes into account the quantities and costs of all units of inventory on hand. If inventory is valued at net realizable value, any excess of cost over net realizable value is recognized as a loss in the income statement.

    FRS 102 also includes guidance on the disclosure of inventory in the financial statements. Entities are required to disclose the carrying amount of inventory, as well as the methods and assumptions used in valuing inventory. They are also required to disclose any write-downs of inventory, and any changes in the methods or assumptions used to value inventory.

    Overall, the guidance on inventory in FRS 102 provides a consistent and transparent framework for the measurement and disclosure of inventory in the financial statements. It helps to ensure that the financial statements of entities accurately reflect the value of the inventory they hold.