General Concepts
The definitions of assets, liabilities, income and expense are the same for interim period reporting as for annual reporting. These items are defined in the IASB's Conceptual 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 capitalised at year end because of a failure to meet this definition could similarly not be capitalised at interim dates. 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.
While the overall implication is that identical recognition rules are to be applied to interim financial statements, there is a requirement that measurements of the interim reporting purposes are made on a year‐to‐date basis. This means that specific measurements such as fair value, impairment and estimates would be applied at the interim period as if were applied by the annual year end. Changes in the measurement amount in the next interim period would be a change of estimate in that period. However, expenses such as income tax that are payable on a yearly basis would be measured in the interim reports on the yearly weighted‐average income tax rate expected for the full financial year. The recognition and measure at each interim report are based on the information when the interim report is prepared and only updated in the next interim report.
Application of the Recognition and Measurement Basis
Recognition is based on the general recognition guidance for assets, liabilities, income and expenses. The year‐to‐date measurement basis means that items are measured on a specific interim date if a measure is available on that date, but are measured on a yearly basis if the measurements are related to a year assessment of the total amount receivable or payable. The illustrative examples provide the following examples to explain the general recognition and measurement guidance:
Major planned periodical maintenance and overhaul, and other planned but irregular costs. The cost of such maintenance and overhaul or other seasonal expenditure expected to be incurred late in the year is not anticipated for an interim period, unless an event occurred that creates a legal or constructive obligation at the interim ending date.
Provisions. Provisions are only recognised when the entity has no realistic alternative but to make the transfer as a result of a past event that creates a legal or constructive obligation. Estimated changes in measurement of recognised provisions are updated in each interim report.
Year‐end bonuses. The nature of bonuses might differ significantly. A year‐end bonus is only anticipated in an interim period if the bonus is:
(a) a legal or constructive obligation that the entity has no realistic alternative to avoid the payment and (b) a realistic estimate could be made. Specifically, the guidance in IAS 19 should be applied (see Chapter 19). The assessment will be based on the expectation whether a bonus will be paid at year end based on the performance until the end of the interim period.
Contingent lease payments. Contingent leases based on a required level of annual sales will be recognised pro rata in the interim report based on the expectation that the annual level will be achieved, based on the information available in the interim period. This is based on the fact that the entity has no realistic alternative to making the future lease payment.
Intangible assets. All costs incurred in an interim period on an intangible asset are expensed if the criteria for capitalisation is not met at the end of the interim period.
Pensions cost. Pension cost in an interim period is based on a year‐to‐date basis based on the actuarial determined pension rate anticipated at the end of the year, adjusted for significant market fluctuations and events, which might change that rate.
Short‐term compensation absence. In terms of the requirements of IAS 19 the amount outstanding at the end of the interim period will only be recognised if the short‐term compensation is accumulating.
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. Interest income is typically accrued, since it is well established that this represents a contractual commitment. Dividend income, on the other hand, is not recognised until declared, 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 recognised as they occur.
Recognition of Annual Costs Incurred Unevenly during the Year
IAS 34 clarifies that cost incurred unevenly during an entity's financial year shall not be anticipated or deferred for interim reporting purposes, unless anticipation or deferral would be appropriate at the end of the financial year. The illustrated examples provide the following examples to demonstrate this principle:
1. Employer payroll tax and insurance contributions. If such contributions are assessed on an annual basis the expense recognised in the interim reports is estimated using an estimated annual effective payroll tax or contribution rate. If a progressive tax rate is applied for individuals, it means that the rate will be based on the total expected remuneration of the employee for the year.
Income Taxes
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. Furthermore, 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 summarised in the following paragraphs.
Difference in Financial Reporting Year and Tax Year
When the financial reporting year and the income tax year differ, the tax expense is calculated at a different average estimated tax rate for each portion of a tax year falling in the interim period.
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 pre‐tax 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 (e.g., the tax rate on capital gains may differ 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 pre‐tax income. The standard, while mandating such detailed rules of computing and applying tax rates across jurisdictions or across categories of income, recognises 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.”
Tax Credits
In calculating 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, etc. and the expected credits against the tax for the full year should be given consideration in the determination of an expected effective tax rate. 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.
IAS 34 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 disposal 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 recognised 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 recognised in income over the period necessary to properly match them to the costs which the grants are intended to offset or defray. To ensure compliance with both IAS 20 and IAS 34, tax credits will need to be carefully analysed 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 recognised immediately, but only if the criteria set forth in IAS 12 are met. It must be deemed probable that the benefits will be realisable 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 utilise 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 realisability 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 realised until the interim (or annual) period when it in fact becomes realised, the tax effect will be included in tax expense of that period. Appropriate explanations 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 pre‐ tax 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, labour 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 materialise 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 financial statements. This high threshold has been set because the definitions of assets and liabilities in the IASB's Conceptual Framework require that they be recognised only when it is probable that the benefits will flow into or out from the entity. An 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 financial statements.
Depreciation and Amortisation in Interim Periods
The rule regarding depreciation and amortisation in interim periods is more consistent with the discrete view of interim reporting. Charges to be recognised in the interim periods are to be related only to 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 amortisation 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 the 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 amortisation equals an independently computed annual charge for these items. However, 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 rationalised 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
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 utilised for interim reporting as for annual reporting. The use of estimates in determining quantities, costs and NRVs at interim dates will be more pervasive.
Two particular difficulties are addressed in IAS 34. These are the matters of determining NRVs at interim dates and the allocation of manufacturing variances.
Regarding NRV 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 monetary 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 recognised in income at interim reporting dates to the extent those variances would be recognised at the end of the financial year. It should be noted that some national 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 is due to seasonal factors.
When variance allocation is thus deferred, the full balances 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.
Example of interim reporting of product costs
Dakar Corporation encounters the following product cost situations as part of its quarterly reporting:
It only conducts inventory counts at the end of the second quarter and end of the fiscal year. Its typical gross profit is 30%. The actual gross profit at the end of the second quarter is determined to have been 32% for the first six months of the year. The actual gross profit at the end of the year is determined to have been 29% for the entire year.
It determines that, at the end of the second quarter, due to peculiar market conditions, there is an NRV adjustment to certain inventory required in the amount of €90,000. Dakar expects that this market anomaly will be corrected by year‐end, which indeed does occur in late December.
It suffers a decline of €65,000 in the market value of its inventory during the third quarter. This inventory value increases by €75,000 in the fourth quarter.
It suffers a clearly temporary decline of €10,000 in the market value of a specific part of its inventory in the first quarter, which it recovers in the second quarter.
Dakar uses the following calculations to record these situations and determine quarterly cost of goods sold:
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Full Year
Sales €10,000,000 €8,500,000 €7,200,000 €11,800,000 €37,500,000
(1—Gross profit percentage) 70% 70%
Cost of goods, gross profit method 7,000,000 5,040,000
Cost of goods, based on actual physical count 5,580,0001 9,005,0002 26,625,000
Temporary NRV decline in specific inventory3 90,000 (90,000) 0
Decline in inventory value with subsequent increase465,000 (65,000) 0
Temporary decline in inventory value5 10,000 (10,000) 0 0 0
Total cost of goods sold 7,010,000 5,660,000 5,105,000 8,850,000 26,625,000
1Calculated as [€18,500,000 sales × (1 – 32% gross margin)] − €7,000,000 (quarter 1 cost of sales). 2Calculated as [€37,500,000 sales × (1 – 29% gross margin)] − €17,620,000 (quarters 1–3 cost of sales). 3Even though anticipated to recover, the NRV decline must be recognised.
4Full recognition of market value decline, followed by recognition of market value increase, but only in the amount needed to offset the amount of the initial decline.
5No deferred recognition to temporary decline in value.