Ten Common Mistakes in Preparing IFRS Financial Statements

The following is a list of ten common errors & omissions in financial statements prepared under the International Financial Reporting Standards (IFRS) framework.

Several represent differences between Canadian Accounting Standards for Private Enterprises (ASPE) and IFRS. Others relate to questions that are omitted from the accounting and financial reporting process.

These items should be on your To-Do list for 2018, as we come into the new reporting season.

  1. Concept of “conditions that existed at the end of the reporting period” not applied

For those events occurring after the reporting period, IFRS differentiates between events that are recognized (that is, adjusted in the financial statements) and events that are not recognized but may require disclosure. The basis for making the determination is whether the event reflected conditions at the balance sheet date – if it did not, it is considered for disclosed only.

A commonly overlooked example is long term debt where there has been a breach of financial covenants making the debt repayable on demand. Such a breach is often fixed after the reporting period by either amendment to the agreement or by an injection of cash by a shareholder or other related party. On this basis it is still presented as long-term debt on the balance sheet when financial statements are prepared under ASPE.

Under IFRS, however, the “conditions at the balance sheet date” concept is strictly applied, so, since the debt was due on demand at the date of the financial statements it should be presented as a current liability.  The fact that the breach was cured after the reporting period would be disclosed.

A similar presentation difference arises between private and international frameworks where there is demand debt owed to the shareholder or to another related party. Under ASPE, a representation is often obtained by the auditor to justify presenting the debt as long term on the balance sheet.

  1. Classification of financial instruments as debt or as equity ignored

Plain vanilla loans and plain vanilla common shares are presented as debt and equity respectively on the statement of financial position. However, all of the characteristics of a financial instrument should be analysed in detail to ensure the correct presentation. Those that have characteristics of both debt and equity are often required to be split with the respective components accounted for and presented as debt and as equity.

Similarly, some features of an instrument mean it is automatically treated as either debt or as equity, regardless of its other characteristics. For example, an instrument that is automatically repaid in cash on the occurrence of some future event (a so-called, puttable instrument) is presented as a liability on the statement of financial position. This can arise, for example, where the terms of a unanimous shareholders’ agreement require shares held by a member of management to be automatically redeemed by the company in the event of his/her death.

Note that this is the case even though the future event has not yet occurred, because the feature of the instrument existed at the reporting date.

Distributions made on shares presented as debt are expensed through the income statement as a financing cost. Therefore, incorrectly presenting these instruments can have a significant impact on financial covenants and on operating results.

  1. “Income before the undernoted” or similar subtotals used in the income statement

The phrase extraordinary item has long since been disallowed in financial reporting.  Recently, however, the heading “Income before the undernoted” is used to achieve a similar objective. When this subtotal is used, whether items of expense are placed above it or below it is often arbitrary and usually inconsistent.

Undernoted items can be one off costs (such as impairment losses), non-cash expenses (stock option expense) or be related to acquisitions (acquisition costs and depreciation of intangible assets).  Companies would like the reader to exclude such items from the analysis of performance.

An income statement prepared in accordance with IFRS needs to comply with certain minimum disclosures. Additional subtotals can be included, provided they are necessary to understand the performance of the entity.  The most common additional subtotal is Income before tax, which is often included (but is not required as a minimum disclosure) on the grounds that the income tax expense is to some extent outside the control of the company. In this case, income before tax is considered a more appropriate measure of performance.

Meaningless subtotals and the arbitrary presentation of expenses should be avoided.

  1. Incorrectly accounting for related party transactions

This often arises due to a misunderstanding of the standard on related party transactions: it defines the disclosures required with respect to related party transactions only. It does not prescribe their accounting treatment. Any transactions with related parties are accounted for in accordance with the appropriate standard for such transactions.

For example, a term loan with a non-market interest rate between the entity and a related party would be accounted for in accordance with the financial instrument standard. That standard requires that the loan be recognized at its fair value on the date it is advanced with interest recognized over the term.

  1. Accounting for certain debits

An entity applying ASPE has accounting policy choices available to it, for example: choosing to capitalize borrowing costs to a qualifying asset or expense them as incurred; and to capitalize the costs of developing internally created intangible assets or to expense them as incurred.

Conversely, IFRS requires an entity to capitalize:

  • borrowing costs where the construction or development of an asset takes a substantial period of time. The requirement would also apply to inventory where the ‘substantial period of time’ criterion is met.


  • the costs of developing an intangible asset where defined conditions are met.

For entities considering adopting IFRS, these considerations need to be identified at an early stage of the decision-making process because the accounting consequences can be time consuming to resolve.

  1. Failing to ask if an acquisition represents a business combination

A business is defined as a combination of inputs and processes applied to those inputs that are able to generate outputs, even though outputs are not necessary to meet the definition.

There are no practical differences between the two frameworks in this respect: the ASPE standard was copied from the international standard prior to Canada’s adoption of IFRS to avoid creating unnecessary accounting differences on transition to IFRS.

A business combination can arise where an entity purchases assets and some processes, so addressing this question should not be overlooked.

  1. Going concern issues

An entity is no longer a going concern where management intends to cease operations or has no realistic alternative but to do so. In this case some other basis of accounting needs to be applied which will require consideration of many other issues, such as: the write down of assets to recoverable amounts; recognition of provisions for staff terminations and onerous leases; and so on.

The fact that management’s intention to cease operations means the entity is no longer a going concern can often go unnoticed.

More frequently an entity’s continued operation will depend on one or more factors, typically ramping up revenues and/or sourcing refinancing or additional financing rounds. Where that is the case, the financial statements need to include disclosures sufficient to paint an accurate picture for users.  Including a clear reference to that disclosure on the statement of financial position is required under IFRS.

  1. Boilerplate language used in disclosures

The IFRS and ASPE frameworks have the same roots and therefore have many similarities. However, many differences exist and these are often ignored when an entity reporting under ASPE changes to reporting under IFRS. For professional accounting firms that are preparing financial statements on behalf of their clients, problems can arise when an ASPE financial statement template is used for a client reporting under IFRS.

Some can be very subtle and depend on a detailed understanding of the standards. For example, under ASPE, where operating losses are available for carry forward for tax purposes but are unlikely to be used by the entity they are recognized for accounting purposes but with an allowance of equal value against them. Under IFRS such a deferred tax asset is recognized only ‘to the extent’ that it is likely to be used.

Similarly, accounting policies and other disclosures are often based on boilerplate language which is frequently borrowed from the continuous disclosures of public companies.

A financial statement prepared under IFRS should be convincing: it should look and feel like an IFRS financial statement. In addition, standard disclosures should be avoided. Instead they should be specific to the company and its business.

  1. Accounting for financial instruments

The current rules on accounting for financial instruments require an impairment loss on a financial instrument asset accounted for at amortized cost to be calculated as the difference between the present value of the cash expected to be collected and the carrying amount of the asset. The corollary of which is that interest revenue on the instrument is still earned after the impairment loss has been recognized.

Furthermore, that impairment loss can only be recognized where there is objective evidence that a loss has arisen at the date of the reporting period.  Any event occurring after that date that gives rise to a loss is not an adjusting event.

These accounting requirements are often misapplied.

  1. Failing to consider the question of functional versus reporting currency

The reporting currency can be any currency selected at the option of the entity.  The functional currency, however, must be identified based on the facts and circumstances.

A company is required to determine the functional currency by applying a list of criteria to the company’s operations and environment. In some cases that application and the resulting decision of functional currency is readily apparent.  In other cases, for example where the company earns significant revenues and is financed in other currencies, the decision can come down to a judgement call based on the weighting of the various criteria.

A Question Not to be Underestimated: Asset or Business Acquisition?

A transaction is either accounted for as a business acquisition under IFRS 3, Business Combinations, or, if it is not a business combination, in accordance with the appropriate standard for an asset purchase (for example: IAS 16 Property, Plant and Equipment; IAS 38 Intangible Assets; or IAS 40 Investment Property).

The question is important (and there are significant consequences to getting the answer wrong or not considering the question at all!), because in a business combination:

  • Goodwill or a gain on bargain purchase is accounted for;
  • Assets acquired and liabilities assumed are accounted for at their fair values rather than being recognized at their relative fair values in an asset purchase;
  • Directly attributable acquisition costs are expensed versus capitalized as part of the asset purchased;
  • Deferred tax assets and liabilities are recognized in a business combination;
  • IFRS provides guidance on recognizing contingent consideration but there is no guidance in the standards applicable to asset purchases;
  • The disclosure requirements are considerable in the financial statements for a period in which a business combination is completed, and the same disclosure applies in any year where an acquisition is made subsequent to the report date but before the financial statements are issued; and
  • Also note that some of these differences continue in future periods, such as impairment and depreciation/amortization.

An entity first needs to determine whether the assets acquired and liabilities assumed constitute a business (IFRS 3.3). If they do not meet the definition of a business, then the default is to account for the transaction an asset purchase.

Appendix A to IFRS 3 defines a business as, ‘an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return…to investors or other owners, members or participants.’  A business therefore consists of inputs and processes applied to those inputs that have the ability to generate outputs. Therefore, outputs themselves are not required.

Input: are economic resources, such as intellectual property, access to necessary materials, employees and non-current assets such as intangible assets or the rights to use non-current assets.

Process: is any system, standard, protocol, convention or rule, such as strategic management processes, operational or resource management processes. Administrative processes are specifically excluded.

Output: is a return in the form of dividends, lower costs or other economic benefits

You should note the following in applying the definition:

  • If the transaction does not include both inputs and processes then it is not a business combination.
  • Some processes must be included in the transaction, but all processes used by the vendor need not be included. Some necessary processes may be provided by the acquirer on integrating the business with their own operations.
  • A business need not have liabilities.
  • The set of assets and activities must be capable of being conducted and managed as a business by a market participant. Whether the seller operated the set as a business and whether the acquirer intends to operate it as a business is not relevant.
  • There is a rebuttable presumption that an asset that includes goodwill is a business.
  • The elements of a business vary by both industry and structure of an entity.
  • New businesses often have few inputs and processes and only one (or no) outputs. In this situation, other factors must be considered, including whether the set:
    • Has begun planned principal activities;
    • Is pursuing a plan to produce outputs; and
    • Is expected to obtain access to customers to purchase those outputs.

The determination of whether a transaction is a business acquisition or an asset purchase is a judgement call that must be disclosed.

The Application Guidance provides more detail that is useful in applying IFRS 3, including the following.

The definition of a business includes inputs and processes and may also result in outputs, although outputs are not necessary for a business to exist. A process is defined as, ‘any system, standard, protocol, convention or rule’ (IFRS 3.B7) that when applied to inputs creates, or has the ability to create, outputs. Examples of processes include strategic management, operational and resource management. Inputs are economic resources that create, or have the ability to create, outputs when one or more processes are applied, and include intangible assets or the rights to use non-current assets.

‘To be capable of being conducted and managed for the purposes defined, an integrated set of activities and assets requires two essential elements – inputs and processes’. Therefore both assets and processes must be included in the acquisition, even though all necessary processes need not be acquired (some processes may be contributed by the acquirer) (IFRS 3.B8). If no processes are included, then the transaction is an asset purchase; if this was not the case, then any asset purchased for use in an existing business would meet the definition of a business, which would be non-sense.

Furthermore, processes are described as ‘activities’ in IFRS 3.B8, which is consistent with the English language definitions of the word: (i) as a noun, ‘a series of actions or steps taken’ and (ii) as a verb, ‘perform a series of mechanical or chemical operations on something in order to change or preserve it.’ The purchase of in-place leases, for example, represents economic inputs and not a process; the leases represent a right to benefit from non-current assets. There are no activities inherent in a rent-roll, instead leasing and other management processes are applied to it.

Where the acquisition includes both inputs and some level of process (over and above administrative functions, which are specifically excluded by the definition) the determination can involve significant judgement. The IFRS Interpretations Committee White Paper of May 2013 addressed the application of this principle in practice by different sectors, including the real estate sector, and in different jurisdictions.

One view in practice is that the processes acquired must have a level of sophistication that involves a degree of knowledge unique to the assets being acquired for a business to exist. Common themes in the responses received include:

(a)    Examples of significant management processes that management views as being integral for a business to exist, include marketing, tenancy management, financing, development operations and other functions that are typically undertaken by the parent company or external management.

(b)    The acquisition of an investment property together with the employment of key management personnel of the vendor is a strong indicator of a business.

(c)     Other processes such as cleaning, security and maintenance are generally not considered to be significant processes. Therefore, a transaction that only includes those or similar processes is generally treated as an asset purchase.

Note that these necessary processes meet both the definition in IFRS 3 and the English language definition, while in-place leases acquired do not.

The view that a level of sophistication is required is predominant in Europe and Australia and is consistent with the requirement that processes be at a more supervisory or management level (as per the definition: strategic management, operational and resource management).

The view from respondents using US GAAP (which is nearly identical to IFRS guidance) is that ‘any process that, when applied to an input or inputs, create or have the ability to create outputs, gives rise to a business.’  Therefore, transactions are more likely to result in business acquisitions than asset purchases in the US GAAP world.

Under Canadian Accounting Standards for Private Enterprises (ASPE) the relevant standard is 1582 Business Combinations, which is a copy of IFRS 3 Business Combinations. Therefore, the guidance surrounding IFRS can also be applied to the same asset or business combination question under ASPE. In applying the GAAP hierarchy in ASPE (standard 1100 Generally Accepted Accounting Principles), the first consideration would be IFRS and not US GAAP. This is logical given the fact that 1582 and IFRS 3 are identical.

The International Accounting Standards Board (IASB) carried out a Post Implementation Review (PIR) of IFRS 3 in 2014/2015. The review found that stakeholders find it difficult to apply the definition of a business in practice. The IASB issued an exposure draft in June 2016 which proposes: amending the language used in the standard, adding illustrative examples and simplifying the application of the standard in some situations. The comment period closed on October 31, 2016. Watch this space for an IFRS Condensed piece on the final amendments to the standard.