Impact of MFRS 16 on AirAsia Group Bhd

Disclaimer: The content in this blog post contains my own opinion and it should not be relied upon for making any decisions.

Recently, while I was browsing Facebook, I saw this news by The Borneo Post Online in Facebook:

AirAsia Group Bhd slipped into the red with a net loss of RM303.72 million for the financial year ended Dec 31, 2019 (FY19) compared with a net profit of RM1.97 billion in the preceding year.
Posted by Borneo Post Online on Thursday, February 27, 2020

According to the news, the reasons for AirAsia Group Bhd to suffer net loss in the financial year 2019 were partly due to the following:

"The weaker bottom-line, despite a 17 per cent jump in revenue to RM12.45 billion, was partly attributed to accounting treatment of the restructured aircraft ownership, moving from owning to leasing aircraft, despite recording similar cash outflow in either financing method, the low-cost airline said."

"According to the company, the adoption of Malaysian Financial Reporting Standard (MFRS) 16 reduced its net operating profit by RM130.9 million while the MFRS 137 accounting treatment led to a 43 per cent jump in maintenance and overhaul costs."

"The airline’s bottom-line was partly weighed down by a depreciation of right-of-use assets of RM1.76 billion and finance costs (lease liabilities) of RM505.87 million following the adoption of MFRS 16."

I thought it will be interesting to analyse the accounting treatments in this news as it will be relevant to ACCA students (especially SBR students as it will be good for you to apply what you learnt in the class to the actual business world). Hence, I write this post which contains my opinion on the impact of the above accounting treatments.

IFRS 16 Treatment

According to IFRS 16 Leases, when an entity leases an asset, the entity is required to recognise a right-of-use asset and a lease liability.

Generally, the right-of-use asset will be depreciated whereas finance cost will be recognised on lease liability.

This is in contrast with the previous IAS 17 Leases where an entity may have finance lease and operating lease. The accounting treatment of finance lease is similar to the current IFRS 16 treatment (hence there isn't much impact for finance lease under IFRS 16). However, for operating lease, the treatment was to expense off the lease payment in Statement of Profit or Loss (SOPL).

Refer to the table below for a comparison between IAS 17's operating lease and IFRS 16's treatment:

	IAS 17 Operating Lease	IFRS 16
Expenses	Lease payment  (rental paid)	Depreciation of right-of-use asset Finance cost on lease liability
Asset	None	Right-of-use asset
Liability	None	Lease liability

As we can see from the above, under IFRS 16, the entity may have potentially more expenses as well as having a higher asset and liability figure.

Let's have a look at AirAsia's recent fourth quarter report ended 31 December 2019 (the relevant results are summarised in the table below):

	Cumulative
	Year Ended 31/12/2019 RM’000	Year Ended 31/12/2018 RM’000
Aircraft operating lease expenses	-	(1,155,680)
Depreciation of right of use asset	(1,762,663)	-
Finance costs - lease liabilities	(505,873)	-
Total expenses related to IFRS 16 / IAS 17	(2,268,536)	(1,155,680)

As we can see from the above, there have been around 96% increase in the expenses once IFRS 16 is adopted.

Whereas for the increase in right-of-use asset and lease liability:

	As At 31/12/2019 RM’000	As At 31/12/2018 RM’000
Right of use assets	12,219,457	-
Lease liabilities – current liabilities	2,104,702	-
Lease liabilities – non-current liabilities	10,156,869

A full 100% increase. 

However, it should be noted that AirAsia Group Bhd did not apply full retrospective adjustment under IAS 8. It was mentioned in the notes to the unaudited financial statements that:

"On the date of initial application (of MFRS 16), the Group applied the simplified transition approach and did not restate comparative amounts for the period prior to first adoption."

In any case, with the increase in right-of-use assets (i.e. increase in capital employed), the return on capital employed (ROCE) of the company will definitely be impacted (i.e. reduced).

Not only that, the lease liabilities will also increase the gearing ratio of the company.

As such, we can now see that IFRS 16 might cause some impact on the financial statements which might be perceived as negative as investors (despite the fact that all these are just accounting adjustments).

Restructured Aircraft Ownership

Next, we shall explore the issue on the restructuring in the aircraft ownership of AirAsia Group Bhd. In the news, it was mentioned that the company was "moving from owning to leasing aircraft".

To understand this, it is necessary for us to understand what was happening to AirAsia Group Bhd in the year 2019. Let's look at one news on AirAsia in year 2019:

The company plans to fully shift to the new model by completely withdrawing from aircraft ownership.
Posted by The Star on Sunday, June 2, 2019

In short, AirAsia Group Bhd had decided to went into sales and leaseback agreements.

Image from IFRS Box.

Note: I have written the accounting treatment of sales and leaseback agreement previously. You can read more at the link below if you are interested to know more:

1. https://tysonspeaks.blogspot.com/2019/08/ifrs-16-sales-and-leaseback-part-1.html
2. https://tysonspeaks.blogspot.com/2019/08/ifrs-16-sales-and-leaseback-part-2.html

Borneo Post had mentioned that "MFRS 137 accounting treatment led to a 43 per cent jump in maintenance and overhaul costs". MFRS 137 is similar to IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

If you look into AirAsia's recent fourth quarter report ended 31 December 2019, you will realise the following:

	Cumulative
	Year Ended 31/12/2019 RM’000	Year Ended 31/12/2018 RM’000
Maintenance and overhaul	(1,320,820)	(938,369)

An increase of around 41% in expense, which is similar to what was being reported in Borneo Post.

In relation to the provision balance we see that provision balance has also increased, as shown below:

	As At 31/12/2019 RM’000	As at 31/12/2018 RM’000
Aircraft maintenance provisions / payables
-          Current liabilities	1,861,748	878,941
-          Non-current liabilities	3,547,776	4,049,068
Total	5,409,524	4,928,009

According to the notes to the unaudited financial statements, it is mentioned that:

"Aircraft maintenance provision/ payables relates to maintenance costs that needs to be incurred for maintaining the aircraft as long as it is currently still in use and on the return of lease aircraft."

It seems like the Borneo Post's news is implying that maintenance and overhaul expenses had increased because of the sales and leaseback transactions which happened during the year 2019 and the increase is due to requirement in MFRS 137 (or IAS 37).

Hence the question - why is it that when a company start to lease asset, they may need to recognise more expenses as well as more provision?

Well, here is my opinion on the possible reason (Note: this is only my own opinion and guess as I do not have the details of the sales and leaseback agreement).

Owning Aircraft

Look at the beautiful sky!

If an airline company owns aircraft, the aircraft is accounted for under IAS 16 Property, Plant and Equipment (PPE). In relation to the repair and maintenance cost of the aircraft, it is stated in IAS 16, paragraph 14 that:

"A condition of continuing to operate an item of property, plant and equipment (for example, an aircraft) may be performing regular major inspections for faults regardless of whether parts of the item are replaced. When each major inspection is performed, its cost is recognised in the carrying amount of the item of property, plant and equipment as a replacement if the recognition criteria are satisfied. Any remaining carrying amount of the cost of the previous inspection (as distinct from physical parts) is derecognised."

In short, major inspection (or overhaul) of aircraft is recognised as part of the PPE and the previous carrying amount of the inspection or overhaul will be derecognised.

Apart from that, under IAS 37, paragraph 14, it is mentioned that provision shall be recognised when:

(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.

As such, if an airline company owns aircraft, they may not be able to recognise provision on future maintenance or overhaul due to the reason that they may not be having present obligation as a result of past event to conduct the repair (unless they can demonstrate otherwise).

Instead, a major overhaul will be capitalised as PPE and minor repair will be expensed off as and when it occurs. Provision is generally not recognised for future repair or overhaul if the entity owns the aircraft.

Leasing Aircraft

If an aircraft is leased, there is a contract in place. The contract may stipulate that the airline has to conduct regular maintenance and overhaul on the leased aircraft. This means that the airline company will have a present obligation (i.e. legal obligation) under the lease contract to perform the regular maintenance and overhaul.

As such, if wear and tear occurs to the aircraft (i.e. past event has occurred), the entity is obliged to perform the maintenance and overhaul under the lease contract. Thus, provision needs to be recognised when the wear and tear occurs.

Note: It is important to know that a provision can only be created if it results from a past event. If there is no wear and tear, provision cannot be recognised. In other words, provision can only be created if there is a "present obligation" (i.e. the lease contract which gives rise to legal obligation) and a "past event" has occurred (known as obligating event, i.e. the wear and tear event which makes the company to be obliged to pay for the repair cost).

Hence, if a company moves from owning aircraft to leasing aircraft, it is possible for more provision to be recognised. This could explain the reason for the increase in maintenance and overhaul cost of AirAsia Group Bhd.

Conclusion

As we can see from the above, new accounting standard (i.e. IFRS 16) can impact financial statements in several ways and it is important for us to understand these impacts so as to be able to explain these impacts to the users of financial statements.

We can also see that a change in the ways of conducting business will have some accounting impacts. For AirAsia Group Bhd, sales and leaseback of aircraft might be a good way to raise finance, but it may result in lower profitability due to increase in provision as well as increase in expenses related to IFRS 16.

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IAS 36 - Is Liability Considered in The Measurement of Recoverable Amount?

Today we shall look into the case of whether liability is considered in the measurement of recoverable amount for impairment testing purpose.

Scenario

Let's look at the following example (this is extracted directly from the example in paragraph 78 of IAS 36):

"A company operates a mine in a country where legislation requires that the owner must restore the site on completion of its mining operations. The cost of restoration includes the replacement of the overburden, which must be removed before mining operations commence. A provision for the costs to replace the overburden was recognised as soon as the overburden was removed. The amount provided was recognised as part of the cost of the mine and is being depreciated over the mine’s useful life. The carrying amount of the provision for restoration costs is CU500, which is equal to
the present value of the restoration costs.

The entity is testing the mine for impairment. The cash‑generating unit for the mine is the mine as a whole. The entity has received various offers to buy the mine at a price of around CU800. This price reflects the fact that the buyer will assume the obligation to restore the overburden. Disposal costs for the mine are negligible. The value in use of the mine is approximately CU1,200, excluding restoration costs. The carrying amount of the mine is CU1,000."

A picture of a mine.

Note: CU stands for currency units. It is just a term to replace currency such as $ or RM.

To summarise,

Carrying amount (CA) of the mine = CU1,000
CA of the provision for restoration costs = CU500
Fair value less cost of disposal (FVLCOD) of the mine = CU800
Value in use (VIU) of the mine (excluding restoration costs) = CU1,200

To understand how to solve this issue, we will need to understand some rules in IAS 36. After you understand the rule, then you can come back to this case again.

Back to Basic

According to IAS 36, impairment happens when the CA exceeds recoverable amount (RA). RA is the higher of VIU and FVLCOD.

Image from IFRS box.

VIU means present value of the future cash flows expected to be derived from an asset or cash‑generating unit.

FVLCOD means the price that would be received to sell an asset in an orderly transaction between market participants (refer to IFRS 13) minus the incremental costs directly attributable to the disposal of an asset or cash-generating unit.

Cash-generating unit (CGU) is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.

Rules in Measuring Fair Value Less Costs of Disposal

IAS 36 also mentions that when we measure the cost of disposal in FVLCOD, we should not include in costs that have been recognised as liabilities. Refer to below (paragraph 28 of IAS 36):

"Costs of disposal, other than those that have been recognised as liabilities, are deducted in measuring fair value less costs of disposal."

For example, if we have already recognised a provision for dismantling or restoration cost, we need not minus such dismantling or restoration cost when we calculate FVLCOD. The reason is to prevent double counting as the liability has already been recognised in the financial statements.

Rules in Measuring Value In Use

IAS 36 also mentions that in the measurement of VIU, we do not include the cash outflows relating to obligations that have been recognised as liabilities. Refer to below (paragraph 43(b) of IAS 36):

"To avoid double‑counting, estimates of future cash flows do not include cash outflows that relate to obligations that have been recognised as liabilities (for example, payables, pensions or provisions)."

This is basically the same rule for measuring FVLCOD. If we have already recognised a provision for dismantling or restoration cost, we need not minus such dismantling or restoration cost when we calculate VIU.

Reasons for The Rules of Not Minus Costs That Have Been Recognised as Liabilities

We can see that for both the rules in measuring FVLCOD and VIU, we do not minus costs or cash outflows that have been recognised as liabilities.

To understand the logic behind this rule, we need to understand what does it mean by "cost / cash outflows that have been recognised as liabilities".

A good example would be provision for dismantling cost. Such provision is recognised as liability in the financial statements. It will also be capitalised as part of the asset (e.g. PPE). Subsequently, the asset value (together with the capitalised dismantling cost) will be depreciated and it will be charged to SOPL.

In other words, we can say that the provision for dismantling cost will ultimately be charged to SOPL as expense. This makes profit figure to be lower.

For impairment loss, generally we charge impairment loss to SOPL. This also reduces profit.

Consider the following:

If we minus the cost of dismantling when we calculate FVLCOD and VIU, it will cause the FVLCOD and VIU to be lower. This will increase impairment loss and profit will be reduced (e.g. if CA is 100 and VIU is 80, impairment is 20. However, if VIU is lowered to 60, impairment will be increased to 40 and profit will be reduced).

Therefore, if we have already recognised provision for dismantling cost, our profit would have been reduced by the dismantling cost. If we minus cost of dismantling again in FVLCOD and VIU, this makes impairment loss amount to be larger, and hence profit will be reduced by the cost of dismantling again.

In other words, we would have double counted the impact on dismantling in our profit (i.e. it is charged to SOPL twice). Hence, to prevent such double counting, the rule is that we are not to minus such cost or cash outflows in FVLCOD and VIU.

Exception to the Above Rules

There is an exception to the rules mentioned above. This happen if a buyer wishes to buy over the asset together with the associated liability. Consider the following case:

Let say we have an asset with fair value of $1,000 and a buyer want to buy this asset from us. However, this asset comes with a liability to dismantle it at the end of the useful life. Let's say this liability is having the present value of $200.

(Note: We have also recognised a provision for dismantling cost in our financial statements.)

Logically, the buyer will not offer us $1,000 to buy the asset from us. The buyer may offer $800 only because the buyer will need to pay for the future dismantling cost.

(Note: when deciding the offer price, the buyer will deduct dismantling cost and give us the net offer price of $800.)

FVLCOD is thus $800. However, this figure is derived after the buyer deducts dismantling cost. Notice that this FVLCOD of $800 is not consistent with the measurement rule as explained above.

According to the rule as mentioned above, we are not supposed to minus dismantling cost from FVLCOD if we have already recognised a provision.

IAS 36 acknowledges this issue, and this was mentioned in paragraph 78:

"It may be necessary to consider some recognised liabilities to determine the recoverable amount of a cash‑generating unit. This may occur if the disposal of a cash‑generating unit would require the buyer to assume the liability. In this case, the fair value less costs of disposal (or the estimated cash flow from ultimate disposal) of the cash‑generating unit is the price to sell the assets of the cash‑generating unit and the liability together, less the costs of disposal. To perform a meaningful comparison between the carrying amount of the cash‑generating unit and its recoverable amount, the carrying amount of the liability is deducted in determining both the cash‑generating unit’s value in use and its carrying amount."

In short, because the FVLCOD of $800 is derived after minus the dismantling cost, therefore when we perform impairment testing, we should also minus dismantling cost when we calculate the carrying amount as well as the value in use.

Application to the Scenario

After you understand the exception to the rule, you can now go back and read the case at the beginning of this post again.

As a recap:

CA of the mine = CU1,000
CA of the provision for restoration costs = CU500
FVLCOD of the mine = CU800
VIU of the mine (excluding restoration costs) = CU1,200

In this case, the FVLCOD of CU800 is a net offer price by the buyer (meaning the buyer has already deducted the restoration cost in arriving at CU800).

As such, to achieve apple with apple comparison, we need to minus the provision for restoration cost when we calculate carrying amount and VIU:

CA = CU1,000 - CU500 = CU500

VIU = CU1,200 - CU500 = CU700
FVLCOD = CU800 (Note: buyer already minus dismantling cost)

RA = CU800 (higher of VIU and FVLCOD)

In this case, there is no impairment because the CA is less than RA.

Refer to the following for the explanation by IAS 36:

"The cash‑generating unit’s fair value less costs of disposal is CU800. This amount considers restoration costs that have already been provided for. As a consequence, the value in use for the cash‑generating unit is determined after consideration of the restoration costs and is estimated to be CU700 (CU1,200 less CU500). The carrying amount of the cash‑generating unit is CU500, which is the carrying amount of the mine (CU1,000) less the carrying amount of the provision for restoration costs (CU500). Therefore, the recoverable amount of the cash‑generating unit exceeds its carrying amount."

Conclusion

In conclusion, whenever we make comparison, it is important to compare apple with apple. The illustration above demonstrate the importance of comparing apple with apple. 

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The Quest for the Perfect Story

Have you ever heard of addiction to story? Apparently this is a real addiction, as shown below:

If you are not convinced that this addiction is real, watch this video:

See this cute little baby, so addicted to story until the point that he cried when the story has ended. Poor baby. I will buy you lots of books next time ok? 😂

As a matter of fact, I think I am addicted to stories. I crave for stories that can make me reflect on my life as well as story that managed to leave an impact in my heart.

I guess the reason why so many of us are addicted to stories is that stories allow us to experience a different life (especially a life that you can't have in the real life). All you need to do is to simply imagine yourself as one of the characters in the story.

For example, you could be flying in the sky, if you imagine yourself as Peter Pan.

Or you could go for an adventure in the Pacific Ocean, by imagining yourself as the little mermaid.

Or if you longed for the perfect love story (well in my opinion, this story is perfect enough), just imagine yourself as Cinderella.

I mean, what else can you ask for, if your love story is full of magic and a pumpkin carriage?

See my point? Life seems to be perfect, if we were to live in such a story. Story allows us to live a multiple life, if you like.

Stories are also useful tools for us to understand our life better. It trains us to be an empathy person. I believe that if you want to understand human being, you will need to read more stories and try to be empathy, i.e. try to understand the feelings of the characters in the story.

As such, I started to wonder about what makes a good story. To be exact, I want to know why certain stories stayed with us for a long period of time.

Thus, I decided to embark on a soul searching journey. Perhaps you can call it "The Quest for the Perfect Story".

To answer this question, I decided to go through three stories that have changed my life (i.e. stories that have change my world view or stories that allow me to understand our life better). I will explain why these stories have touched my heart, and I hope that we can find some common similarities between these stories.

1. Sword Art Online

Sword Art Online (SAO) is a Japanese anime which was introduced to me by one of my students (if you are reading this, thank you for introducing this anime to me because this anime had changed my life).

Basically, SAO is about VRMMORPG (virtual reality massively multiplayer online role-playing game). If you are not so familiar with this term, VRMMORPG means a virtual reality online game in which it allows a lots of player to play the game together at the same time.

I find this anime interesting because instead of facing computer screen when we play computer game, SAO allows the player to enter the gaming world via a technology called NerveGear.

All you need to do is to install the NerveGear on your head (as shown in the diagram above) and the NerveGear will reroute all your brain signal into the game server. As such, you can enter the gaming world (Aincrad) which looks like this:

SAO is a floating castle which houses 100 floors. Inside each floor, you get to see something like this:

Imagine that you can live inside such a world. How perfect life would be.

However, there is a twist.

On the first day of official launch of SAO, many enthusiastic players entered the game. However, they realised that they can't log out the game.

Yes, you did not read that wrong. The players are trapped inside the game, with no ability to log out. There is also no way for you to control your body in the real life because NerveGear has rerouted all your brain signal to the game server.

Thereafter, we learn that this was done on purpose by the developer of the game, Kayaba Akihiko.

For no specific reason, he trapped 10,000 people in the game and he mentioned that the only way they can log out is to clear the 100 floors in Aincrad. However, if any player accidentally die in the game, the player will also be killed in the real life because NerveGear will automatically emit high-powered microwaves which can fry your brain. Any attempt to disconnect NerveGear by anyone in the real life will also have similar consequences.

10,000 people were trapped in such a game with no obvious reason. For no reason, they were forced to live in the game. For no reason, they were forced to try to clear the games in order to be able to return to the real world. The worst thing is that they may die trying.

Imagine if you were the players trapped inside the game, how would you feel? How would you react? Can life still be meaningful if you were one of them?

Well if you find this story to be absurd, let me tell you that our life can be very absurd too. For no reason, we were born into this world. For no reason, we were forced to go to school, get a degree, and start working. Similarly, in our life, we may also die accidentally if we were not careful. Well eventually, we are going to die anyway. So what is the meaning of life then?

I will try to answer this question at a later part. But since we are on the topic of death, let's talk about the second story that has forever changed my life.

2. Tuesday with Morrie

Tuesday with Morrie is one of the best books that I have read in my life. It is always said that movie can make us shed tears due to the background music. However, I shed lots of tears after I read this book (even without any background music).

This is a story about an old man (Morrie), a teacher, who was diagnosed with amyotrophic lateral sclerosis (ALS) which has no known cure. And yes, death is inevitable for him.

It is funny isn't it? All these while when we were living, we never really thought of dying. It was only until the time when the doctor delivered the death sentence to us then we were hit by the reality - our days are numbered. Although we are going to die, the sun still shines brightly and other people will still continue on with their life. The world will not stop for us.

Read this quote from this book:

Perhaps it is very pessimistic for me to say this, but since we will die eventually, why should we study so hard for our exam? Why should we climb the corporate ladder in order to get a higher pay? Why should we torture ourselves so much?

My point is that after we worked so hard in our life, we will still die anyway. Why not we just enjoy our life to the max since our life is so meaningless after all?

Again, I will try to answer this question at a later part. Let's look into another story that made me think a lot about our life.

3. Lord of the Rings

I guess I have watched Lord of the Rings for around 5 times. I must say that each time I watched the movie, I learnt something different.

This is a story about two hobbits, Frodo and Sam attempting to take the One Ring to a volcano (Mount Doom) in hope of destroying the ring.

Both of them were not involved in the forging of the evil ring, but somehow they were tasked to embark on the journey to Mount Doom to destroy the ring.

To put things into perspective, this is the route that Frodo and Sam had taken in the Middle Earth:

According to this website, Frodo and Sam had walked a total of 1,350 miles (roughly 2,170km+) over a period of 6 months. This is roughly equivalent to travelling from Kuching to Sabah and from Sabah back to Kuching (on foot!).

Despite Frodo and Sam had no role in forging the evil one ring, they still had to bear the burden of the ring. They may get killed in the process too. True enough, they were captured or were almost captured multiple times in their journey.

What's the point of suffering so much for other people's mistake? Were there any hope at all for two small hobbits to actually reach Mount Doom and to destroy the ring? Well, Gandalf the wizard in Lord of the Rings had said this:

Perhaps what he said is true. Sometimes in life, we need to be a fool. We need to be foolish enough to believe that there are still some hope, despite everyone telling us to give up.

Similarities in the Three Stories

By now you may have realised some recurring questions - is our life meaningless after all? Why must we suffer so much in our life? We will be dead at the end of the day anyway.

My friend, if you are still reading, I hope you realised that these stories are sharing a common plot - the characters were in a situation in which there weren't much hope. However, you should also realised that these characters never give up in these stories.

In SAO, despite knowing that they may die in real life, the players still try their very best to clear the games. The front line players (the players with high levels who were fighting very hard to clear the game) felt that they owe the other non-front line players a duty to clear the games so that everyone can be released from this nightmare.

In Tuesday with Morrie, despite knowing that he would die eventually, he still wanted to try to help as many people as possible. This including sharing the life lessons with one of his ex-student (the author) so that the author can write a book about life and death. According to Morrie,

Morrie also said this:

To fully understand the meaning of offering others what you have to give, you will have to experience it yourself by reading the book. Allow me to share with you one part of the novel that really made me shed tears:

In other words, the help by Morrie transcends life and death. He is still helping us after he is dead. Although he can't talk to us face to face, his story will always remain in the book and it will continue to inspire lots of people. He is really a true teacher to the end.

What about Lord of the Rings? I will let Sam to explain to you the significance of this story. Watch this video (a very touching speech by him).

“It's like in the great stories, Mr. Frodo. The ones that really mattered. Full of darkness and danger they were. And sometimes you didn't want to know the end. Because how could the end be happy? How could the world go back to the way it was when so much bad had happened? But in the end, it’s only a passing thing, this shadow. Even darkness must pass. A new day will come. And when the sun shines it will shine out the clearer. Those were the stories that stayed with you. That meant something, even if you were too small to understand why. But I think, Mr. Frodo, I do understand. I know now. Folk in those stories had lots of chances of turning back, only they didn’t. They kept going, because they were holding on to something. That there is some good in this world, and it's worth fighting for.”

Lessons Learnt

I think Sam has summarised the lessons learnt well. Our life is indeed meaningless (or hopeless if you want). Sometimes we were in the situation where we can't even see the light at the end of the tunnel. How could the ending be happy, when our life sucks to the max?

However, these stories appeal to me because in the end, there will be a happy ending (spoilers alert!). 

In SAO, despite the sacrifice of some players who will never come back to life, the game was finally cleared.

In Tuesday with Morrie, even though Morrie passed away eventually, he left us with an invaluable gift, i.e. life lessons in the book.

In Lord of the Rings, the ring was successfully destroyed after so much of struggles and hardship.

So is life really meaningless? I guess not. Let's be a fool to believe that there are still some hope in our life. Let's be a fool to believe that there are still something good in this world which is worth fighting for, and believe me, whatever sufferings that you and I are facing now are temporary. It will not last forever and a better tomorrow will definitely come.

It is true that we are going to die at the end of our life, but this doesn't render our life meaningless. Why not we try our best to create an interesting life? Why not we try our best to create something permanent in this temporary life? 

The Perfect Story

Coming back to the quest for the perfect story. After all the analysis above, I hope you realised that each story is unique in its own way. Perhaps we shouldn't make this quest as our number one priority in life.

Instead of hoping that you exist in a perfect story, why not we try our best to create one ourselves? After all, you are living your own life. You only live once (YOLO). Make it meaningful, and I guess that shall be our ultimate quest for the perfect story.

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IAS 12 - How To Determine Tax Base (Part 3)

This is the third part of how to determine tax base. For the previous posts, you can refer to the following link:

Part 1 - https://tysonspeaks.blogspot.com/2019/08/ias-12-how-to-determine-tax-base-part-1.html

Part 2 - https://tysonspeaks.blogspot.com/2019/09/ias-12-how-to-determine-tax-base-part-2.html

For Part 3, I am going to discuss about how to determine the tax base for liability as well as tax base for some specific scenarios involving the accounting standards in the Financial Reporting (FR) paper of ACCA.

Tax Base of Liability

Before we go into the details, let's look again at the definition of tax base of liability according to IAS 12:

The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods. In the case of revenue which is received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods.

In general, there are two points:

(a) Generally, the tax base of the liability will be equal to its carrying amount unless the liability represents an expense which will only be deductible in the future when it is paid. In this case, the tax base is the carrying amount minus the amount that will be deductible in the future (e.g accrued expenses in which deduction is given in the future when the liability is paid - deduction on cash basis).

(b) If the liability represents an income received in advance, then the tax base is the carrying amount minus any revenue that is not taxable in the future (e.g. an income received in advance which is taxed in this year on receipt basis. This income will not be taxable in the future).

You will understand more after going through the following illustrations:

1. Trade Payables

The entity incurs an expense of $100 on credit. The accounting double entry is:

Dr Expenses (SOPL) $100
Cr Trade payables $100

In this case, the carrying amount of the liability is $100.

Tax treatment: Assuming that the tax rule provides that such expense is deductible on an accrual basis (i.e. deduction is given even though the entity has not paid for the expense).

The imaginary tax double entry in the imaginary tax financial statements will be:

Dr Deductible expenses $100
Cr Trade payables $100

As we can see from the above, the tax base of the liability is also $100 because $100 is deductible in this year.

Since the CA and TB are the same, there will be no deferred tax because the accounting rule and tax rule are the same.

Note: Referring back to the definition, as none of the $100 liability is deductible in the future (the full $100 has already been deducted in the current year), the tax base is equal to its carrying amount of $100.

2. Accrued Expenses Which Is Deducted on Cash Basis

An entity has accrued water and electricity expenses of $100 for the month of December. Such expense has not been paid by year end. The accounting double entry is:

Dr Expenses (SOPL) $100
Cr Accrued expenses $100

In this case, the carrying amount of the liability is $100.

Tax treatment: Assuming that tax rule provides that the deduction for such expenses can only be made when the entity has paid for the expenses.

As the entity has not paid for the expenses, there will be no tax double entry. Accordingly, it follows that there is no tax base because the expense is not deductible in this year.

As such, CA = $100 and TB = $0. As CA > TB and this is a liability, this represents a DTD of $100.

Reason for DTD: The entity will pay higher tax this year because deduction is not given this year. However, the entity will pay lesser tax in the future when deduction is given (hence DTD).

Note: Referring back to the definition, as the $100 liability will only be deducted in the future, the tax base is equal to its carrying amount ($100) less the amount that will be deductible in the future ($100). This will result in tax base to be equal to zero ($100 - $100).

3. Deferred Income Which Is Taxed on Cash / Receipt Basis

An entity receives $100 advance payment for services to be rendered in the future. As the performance obligation has not been satisfied, according to IFRS 15 Revenue from Contracts with Customers, revenue cannot be recognised. Instead, a deferred revenue (liability) should be recognised as follows:

Dr Bank $100
Cr Deferred revenue (liability) $100

In this case, the carrying amount of the liability is $100.

Tax treatment: Assuming that the tax rule mentions that the income will be taxed if the entity has received the income.

As the income is subject to tax in this year (since the entity has received the income), the imaginary tax double entry in the imaginary tax financial statements will be as follows:

Dr Bank $100
Cr Taxable income $100

In other words, in the tax SOFP, there will be no liability because the income has already been taxed this year. As such, tax base is equal to zero.

As CA = $100 and TB = 0 and this is a liability, there will be a DTD of $100 since CA > TB.

Reason for DTD: The entity will pay more tax in this year because the deferred income is subject to tax in this year. However, the entity need not pay tax again in the future (hence the future tax is lesser and it is DTD).

Note: Referring back to the definition, as the $100 income received in advance has already been taxed in this year, there will be no tax to be paid in the future. As such the tax base is the carrying amount ($100) less the revenue that will not be taxable in the future ($100). This will result in the tax base to be equal to $0 ($100 - $100).

4. Deferred Income Which Is Taxed in the Future

Assuming that the scenario is the same as scenario no.3 above, except that the tax treatment is that the income will not be taxed now, but it will only be taxed in the future when services are rendered.

In this case, the imaginary tax double entry in the imaginary tax financial statements will be similar to the accounting double entry:

Dr Bank $100
Cr Deferred revenue (liability) $100

As such, tax base of the liability is equal to $100 because we have not paid the tax.

As CA = $100 and TB = $100, it follows that there is no deferred tax. This is because the accounting rule and tax rule are the same.

Note: Referring back to the definition, as the $100 income received in advance will be taxed in the future, the tax base is the carrying amount ($100) less the revenue that will not be taxable in the future ($0). This will result in the tax base to be equal to $100 ($100 - $0).

5. Loan Payable

An entity borrowed $100 from the bank. The accounting double entry is as follows:

Dr Bank $100
Cr Loan payable $100

As such, the carrying amount of the liability is $100.

Tax treatment: When the entity receives the borrowing from the bank, there is no tax implication. When the entity makes repayment of loan to the bank, there is also no tax implication.

The imaginary tax double entry in the imaginary tax financial statements will be similar to the accounting double entry:

Dr Bank $100
Cr Loan payable $100

As the CA and TB are the same, it follows that there is no deferred tax. This is because the accounting rule and tax rule are the same.

Note: Referring back to the definition, as the $100 liability will not be deductible in the future, the tax base is equal to its carrying amount ($100) less the amount that will be deductible in the future ($0). This will result in tax base to be equal to $100 ($100 - $0).

6. Accrued Fines and Penalties

An entity accrues fines and penalties amounting to $100. The accounting double entry is as follows:

Dr Expenses (SOPL) $100
Cr Accrued fines and penalties $100

As such, the carrying amount of the liability is $100.

Tax treatment: Assuming that fines and penalties are not deductible for tax purposes.

The imaginary tax double entry in the imaginary tax financial statements will be similar to the accounting double entry:

Dr Non-deductible expenses $100
Cr Accrued fines and penalties $100

As such, the tax base of the liability is also $100.

As the CA and TB are the same, it follows that there is no deferred tax.

Note: Referring back to the definition, as the $100 liability will not be deductible in the future, the tax base is equal to its carrying amount ($100) less the amount that will be deductible in the future ($0). This will result in tax base to be equal to $100 ($100 - $0).

Alternatively, you can also argue that as fines and penalties are not deductible, the difference represents a permanent difference and deferred tax should be ignored. Both analysis will result in no deferred tax calculation.

There you go! This is the idea of how do we determine tax base for liability.

Next, I am going to cover about some specific scenarios involving the accounting standards in the Financial Reporting (FR) paper of ACCA.

Specific Scenarios

In this part, I will cover some scenarios involving the following:

1. Unutilised tax losses or unutilised tax credits
2. Leasing (IFRS 16)
3. Convertible loan note (IAS 32)

1. Unutilised Tax Losses / Unutilised Tax Credits

Unutilised tax losses (in Malaysia, this is known as unabsorbed business losses) refer to the tax losses that can be carried forward to the future so that it can be used to offset against taxable income that an entity will earn in the future. In other words, future tax can be reduced by these unutilised tax losses.

As the entity will pay lesser tax in the future, unutilised tax losses will result in deferred tax asset (DTA).

For example, if an entity is having unutilised tax losses of $100,000 and the tax rate is 25%, there will DTA of $25,000 ($100,000 x 25%).

However, do take note that paragraph 34 of IAS 12 mentions that such deferred tax asset can be recognised "to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised."

In other words, using the same example as above, if the entity only expects that it can earn $70,000 taxable profit in the future, the entity can only recognise DTA of $21,000 ($50,000 x 25%) instead of the full $25,000 DTA.

The remaining DTA of $4,000 ($25,000 - $21,000) will not be recognised because the entity is not able to earn the extra $30,000. In other words, the entity will not be able to use the tax losses of $30,000 because the entity cannot earn the extra $30,000. As such, the DTA of $4,000 will only be disclosed in the notes to the financial statements.

2. Leasing

Under IFRS 16, a lessee (an entity who lease an asset) will recognise right-of-use asset as well as lease liability (the detailed accounting treatment under IFRS 16 is not covered in this post). Let's just say:

Right-of-use asset - $100
Lease liability - $90
Net CA of lease (asset) - $10

Tax treatment: Assuming that the tax rule provides that lease rental is treated as a deductible expense.

The imaginary tax double entry for the lease rental in the imaginary tax financial statements will be as follows:

Dr Deductible expenses $100
Cr Bank $100

As such, under the tax rule, there will be no asset because we just claim a deductible expense on lease rental. Tax base will be equal to zero.

As CA = 10 and TB = $0 and this is an asset, the difference of $10 represents TTD.

Reason for TTD: If there is a positive net asset of lease in the accounting SOFP, it means that there will be higher profit in the accounting SOPL (due to double entry). In other words, accounting profit is more than taxable profit for this year. As we only claim lease rental as deductible expenses for tax purpose, we will actually pay lesser income tax this year. In the future, our tax might be higher after we have claimed all the lease rental deduction (hence TTD).

Note: If the net CA of the lease is a liability, then the difference shall be DTD.

Reason for DTD: If there is a net liability of lease in the accounting SOFP, it means that there will be higher expenses (thus lower profit) in the accounting SOPL (due to double entry). In other words, accounting profit is lower than taxable profit for this year. We will pay more income tax in this year. In the future, our tax might be lower (hence DTD).

3. Convertible Loan Note (IAS 32)

Under IAS 32, convertible loan note needs to be split into loan component and equity component (the detailed accounting treatment under IAS 32 is not covered in this post). Let's just say we have a convertible loan note of $100 and upon initial recognition, the entity has determined that

Loan element - $90
Equity element - $10

The double entry upon initial recognition is

Dr Bank $100
Cr Convertible loan note $90
Cr Equity component $10

As such, the CA of the convertible loan note (liability) is $90.

Tax treatment: Assuming that we do not split the loan into loan and equity component as per tax rule.

As such, TB will be $100.

As CA = $90 and TB = $100 and this is a liability, the difference of $10 represents TTD.

Notes:

1. The deferred tax liability arising on initial recognition (as explained above) is not charged to SOPL. Instead, it is charged directly to the equity component. Remember, the deferred tax treatment should follow the accounting treatment. Since in accounting we credit equity component $10, we have to charge the deferred tax to the equity component too.

2. On subsequent accounting, when we apply amortised cost method to the carrying amount of convertible loan note, the carrying amount of convertible loan note will be increased by finance cost and reduced by actual interest paid. The subsequent changes in deferred tax liability as a result of this will be charged to SOPL because the finance cost on convertible loan note is charged to SOPL.

Congratulations! You have reached the end of this post!

In my next post on IAS 12, I will talk about some specific scenarios relevant for SBR students. So stay tuned!

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