Concepts, Rules, and Examples | WILEY IAS 2003: Interpretation and Application of International Accounting Standards

Alternative Concepts of Interim Reporting

The argument is often made that interim reporting is generically different than financial reporting for a full fiscal year. Two distinct views of interim reporting have developed. Under the first view, the interim period is considered to be an integral part of the annual accounting period. Annual operating expenses are estimated and then allocated to the interim periods based on forecasted annual activity levels such as sales volume. When this approach is employed, the results of subsequent interim periods must be adjusted to reflect estimation errors.

Under the second view, the interim period is considered to be a discrete accounting period with status equal to a fiscal year. Thus, there are no estimations or allocations different from those used for annual reporting. The same expense recognition rules apply as under annual reporting, and no special interim accruals or deferrals are applied. Annual operating expenses are recognized in the interim period in which they are incurred, irrespective of the number of interim periods benefited.

Proponents of the integral view argue that the unique expense recognition procedures are necessary to avoid creating possibly misleading fluctuations in period-to-period results. Using the integral view results in interim earnings which are indicative of annual earnings and, thus, useful for predictive purposes. Proponents of the discrete view, on the other hand, argue that the smoothing of interim results for purposes of forecasting annual earnings has undesirable effects. For example, a turning point in an earnings trend that occurred during the year may be obscured.

Yet others have noted that the distinction between the integral and the discrete approaches is arbitrary and, in fact, rather meaningless. These critics note that interim periods bear the same relationship to full years as fiscal years do to longer intervals in the life cycle of a business, and that all periodic financial reporting necessitates the making of estimates and allocations. Direct costs and revenues are best accounted for as incurred and earned, respectively, which equates a discrete approach in most instances, while many indirect costs are more likely to require that an allocation process be applied, which is suggestive of an integral approach. In short, a mix of methods will be necessary as dictated by the nature of the cost or revenue item being reported upon, and neither a pure integral nor a pure discrete approach could be utilized in practice. The International Accounting Standard on interim financial reporting, IAS 34, does, in fact, adopt a mix of the discrete and the integral views, as described more fully below.

Objectives of Interim Financial Reporting: The IASC Perspective

The purpose of interim financial reporting is to provide information which will be useful in making economic decisions (as, of course, is annual financial information). Furthermore, interim financial reporting is expected to provide information specifically about the financial position, performance, and change in financial position of an enterprise. The objective is general enough to embrace the preparation and presentation of either full financial statements or condensed information.

While accounting is often criticized for looking at an entity's performance through the rearview mirror, in fact it is well understood by standard setters that to be useful, such information must provide insights into future performance. As outlined in the objective of the IASC's standard on interim financial reporting, IAS 34, the primary, but not exclusive, purpose of timely interim period reporting is to provide interested parties (e.g., investors and creditors) with an understanding of the enterprise's earnings-generating capacity and its cash-flow-generating capacity, which are clearly future-oriented. Furthermore, the interim data is expected to give interested parties not only insights into such matters as seasonal volatility or irregularity, and provide timely notice about changes in patterns or trends, both as to income or cash-generating behavior, but also into such balance-sheet-based phenomena as liquidity.

In reaching the positions set forth in the standard, the IASC had considered the importance of interim reporting in identifying the turning points in an enterprise's earnings or liquidity. It was concerned that the integral approach to interim reporting can mask these turning points and thereby prevent users of the financial statements from taking appropriate actions. If this observation is correct, this would be an important reason to endorse the discrete view. In fact, the extent to which application of an integral approach masks turning points is probably related to the extent of "smoothing" applied to revenue and expense data. It seems quite feasible that interim reporting in accordance with the integral view, if done sensitively, would reveal turning points as much as reports prepared under the contrary approach. As proof of this, one can consider national economic statistics, which are most commonly reported on seasonally adjusted bases, which is analogous to the consequence of utilizing an integral approach to interim reporting of enterprise financial information. Such economic data is often quite effective at highlighting turning points and is accordingly employed far more typically than is unadjusted monthly data.

While the objectives of interim reporting are highly consistent with those of annual financial reporting, there are, in the IASC's view, further concerns. These were identified in the DSOP on interim financial reporting as involving matters of cost and timeliness, as well as questions of materiality and measurement accuracy. In general, the conclusion is that to be truly useful, the information must be produced in a more timely fashion than is often the case with annual reports (although other research suggests that users' tolerance for delayed information is markedly declining in all arenas), and that some compromises in terms of accuracy may be warranted in order to achieve greater timeliness.

Basic Conclusions about Application of Accounting Principles to Interim Financial Reports

Although a cursory reading of the standard may give the impression that the IASC has favored a pure discrete view, some of the examples given in Appendix 2 to IAS 34 (e.g., those explaining the accounting treatment of income taxes and employer payroll taxes, or the example which explains the application of the standard to the treatment of contingent lease payments) lead one to believe that, in fact, the IASC has pursued an approach which is a combination of both the discrete view and the integral view.

Most noteworthy is the fact that this approach is very different from the position under certain leading national accounting standards, such as that imposed under US GAAP, which mandates the integral view. It is interesting to note, however, that neither position is pure in the sense that not all measures are consistent with the stated overall philosophy. Thus, the IASC's approach seems quite balanced. For example, while in IAS 34 the discrete view is endorsed in many situations, the method of accounting for income taxes prescribed is clearly compliant with an integral view, not a discrete view.

Further, IAS 34 states that interim financial data should be prepared in conformity with accounting policies used in the most recent annual financial statements. The only exception noted is when a change in accounting principle has been adopted since the last year-end financial report was issued. The standard also stipulates that the definitions of assets, liabilities, income, and expenses for the interim period are to be identical to those applied in annual reporting situations.

While IAS 34, in many instances, is quite forthright about declaring its allegiance to the discrete view of interim financial reporting, it does incorporate a number of important exceptions to the principle. These matters are discussed in greater detail below.

Statements and Disclosures to Be Presented in Interim Financial Reports

Content of an interim financial report.

Instead of repeating information previously presented in annual financial statements, interim financial reports should preferably focus on new activities, events, and circumstances that have occurred since the date of publication of the latest complete set of financial statements. IAS 34 has recognized the need to keep financial statement users abreast with the latest financial condition of an enterprise and has thus softened the presentation and disclosure requirements in the case of interim financial reports. Thus, in the interest of timeliness and cost considerations and to avoid repetition of information previously reported, the standard allows an enterprise, at its option, to provide information relating to its financial position in a condensed format, in lieu of comprehensive information provided in a complete set of financial statements prepared in accordance with IAS 1. The minimum requirements as to the components of the interim financial statements to be presented (under this option) and their content are discussed later.

IAS 34, paragraph 7, clarifies the following three important aspects of interim financial reporting.

That the above concession extended by the standard to interim financial reports is in no way intended to either prohibit or discourage an enterprise from presenting a complete set of interim financial statements, as defined by IAS 1;
That even in the case of condensed interim financial statements, if an enterprise chooses to add line items or additional explanatory notes to the condensed financial statements, over and above the minimum prescribed by this standard, the standard does not, in any way, prohibit or discourage the addition of such extra information to the prescribed minimum basic requirements; and
That the recognition and measurement guidance in IAS 34 applies to a complete set of interim financial statements as they apply to condensed interim financial statements. (Thus, a complete set of interim financial statements would include not only the disclosures specifically prescribed by this standard, but also disclosures required by other IAS. For example, disclosures required by IAS 32, such as interest rate risk or credit risk, would need to be incorporated in a complete set of interim financial statements, in addition to the selected footnote disclosures prescribed by IAS 34.)

Minimum components of an interim financial report.

IAS 34 sets forth minimum requirements in relation to condensed interim financial reports. The standard mandates that the following financial statements components be presented when an enterprise opts for the condensed format:

A condensed balance sheet
A condensed income statement
A condensed statement showing either all changes in equity or changes in equity other than those arising from capital transactions with owners and distributions to owners
A condensed cash flow statement
A selected set of footnote disclosures

Form and content of interim financial statements.

IAS 34, paragraph 9, mandates that if an enterprise chooses the "complete set of (interim) financial statements" route instead of opting for the short-cut method of presenting only "condensed" interim financial statements, then the form and content of those statements should conform to the requirements of IAS 1 for a complete set of financial statements.
However, if an enterprise opts for the condensed format of interim financial reporting, then IAS 34, paragraph 10, requires that, at a minimum, those condensed financial statements should include each of the headings and the subtotals that were included in the enterprise's most recent annual financial statements, along with selected explanatory notes, as prescribed by the standard.

It is interesting to note that in paragraph 10, IAS 34 mandates expansiveness in certain cases. The Standard notes that extra line items or notes may need to be added to the minimum disclosures prescribed above, if their omission would make the condensed interim financial statements misleading. This concept can be best explained through the following illustration:

At December 31, 2002, an enterprise's comparative balance sheet had trade receivables that were considered doubtful, and hence, were fully reserved as of that date. Thus, on the face of the balance sheet as of December 31, 2002, the amount disclosed against trade receivables, net of provision, was a zero balance (and the comparative figure disclosed as of December 31, 2001, under the prior year column was a positive amount, since at that earlier point of time, that is, at the end of the previous year, a small portion of the receivable was still considered collectible). At December 31, 2002, the fact that the receivable (net of the provision) ended up being presented as a zero balance on the face of the balance sheet was well explained in the notes to the annual financial statements (which clearly showed the provision being deducted from the gross amount of the receivable that caused the resulting figure to be a zero balance that was then carried forward to the balance sheet). If at the end of the first quarter of the following year the trade receivables were still doubtful of collection, thereby necessitating creation of a 100% provision against the entire balance of trade receivables as of March 31, 2003, and the enterprise opted to present a condensed balance sheet as part of the interim financial report, it would be misleading in this case to disclose the trade receivables as of March 31, 2003, as a zero balance, without adding a note to the condensed balance sheet explaining this phenomenon.

IAS 34 requires disclosure of earnings per share (both basic EPS and diluted EPS) on the face of the interim income statement. This disclosure is applicable whether condensed or complete interim financial statements are presented.
IAS 34, paragraph 13, mandates that an enterprise should follow the same format in its interim statement showing changes in equity as it did in its most recent annual financial statements.
IAS 34, paragraph 14, requires that an interim financial report be prepared on a consolidated basis if the enterprise's most recent annual financial statements were consolidated statements. Regarding presentation of separate interim financial statements of the parent company in addition to consolidated interim financial statements, if they were included in the most recent annual financial statements, this standard neither requires nor prohibits such inclusion in the interim financial report of the enterprise.

Selected explanatory notes.

While a number of notes would potentially be required at an interim date, there could clearly be far less disclosure than is prescribed under other enacted IAS. IAS 34, paragraph 15, reiterates that it is superfluous to provide the same notes in the interim financial report that appeared in the most recent annual financial statements, since financial statement users have access to those statements in any case. On the contrary, at an interim date it would be meaningful to provide an explanation of events and transactions that are significant to an understanding of the changes in financial position and performance of the enterprise since the last annual reporting. In keeping with this line of thinking, IAS 34, paragraph 16, provides a list of minimum disclosures required to accompany the condensed interim financial statements, which are outlined below.

A statement that the same accounting policies and methods of computation are applied in the interim financial statements compared with the most recent annual financial statements, or if those policies or methods have changed, a description of the nature and effect of the change
Explanatory comments about seasonality or cyclicality of interim operations
The nature and magnitude of significant items affecting interim results that are unusual because of nature, size, or incidence
Dividends paid, either in the aggregate or on a per share basis, presented separately for ordinary (common) shares and other classes of shares
Revenue and operating result for business segments or geographical segments, whichever has been the entity's primary mode of segment reporting
Any significant events occurring subsequent to the end of the interim period
Issuances, repurchases, and repayments of debt and equity securities
The nature and quantum of changes in estimates of amounts reported in prior interim periods of the current financial year, or changes in estimates of amounts reported in prior financial years, if those changes have a material effect in the current interim period
The effect of changes in the composition of the enterprise during the interim period, like business combinations, acquisitions, or disposal of subsidiaries, and long-term investments, restructuring, and discontinuing operations
The changes in contingent liabilities or contingent assets since the most recent annual financial statements

IAS 34, paragraph 17, provides examples of the kinds of disclosures that are required. For instance, an example of unusual items might be (as given by IAS 34, paragraph 17a): ". . .the write-down of inventories to net realizable value and the reversal of such a writedown."

Finally, in the case of a complete set of interim financial statements, the standard allows additional disclosures mandated by other IASC standards. However, if the condensed format is used, then additional disclosures required by other IAS standards are not required.

Comparative interim financial statements.

IAS 34 endorses the concept of comparative reporting, which is generally acknowledged to be more useful than is the presentation of information about only a single period. This is consistent with the position that has been taken by the accounting profession around the globe for many decades (although comparative reports are not an absolute requirement in some jurisdictions, most notably in the US). The IASC furthermore mandates not only comparative (condensed or complete) interim income statements (e.g., the second quarter of 2003 together with the second quarter of 2002), but the inclusion of year-to-date columns as well (e.g., the first half of 2003 and also the first half of 2002). Thus, an interim income statement would comprise four columns of data. On the other hand, in the case of the remaining components of interim financial statements, the presentation of two columns of data would suffice, as mandated by IAS 34. For example, the other components of the interim financial statements should present the following data for the two periods:

The balance sheet as of the end of the current interim period and a comparative balance sheet as of the end of the immediately preceding financial year;
The cash flow statement cumulatively for the current financial year to date, with a comparative statement for the comparable year-to-date period of the immediately preceding financial year; and
The statement showing changes in equity cumulatively for the current financial year to date, with a comparative statement for the comparable year-to-date period of the immediately preceding financial year.

The following illustration should amply explain the above requirements of IAS 34.

XYZ Enterprise presents quarterly interim financial statements and its financial year ends on December 31 each year. For the second quarter of 2003, the XYZ Enterprise should present the following financial statements (condensed or complete) as of June 30, 2003:
1. An income statement with four columns presenting information for the 3-month periods ended June 30, 2003, and June 30, 2002; and for the 6-month periods ended June 30, 2003, and June 30, 2002
2. A balance sheet with two columns presenting information as of June 30, 2003. and as of December 31, 2002
3. A cash flow statement with two columns presenting information for the 6-month periods ended June 30, 2003, and June 30, 2002
4. A statement of changes in equity with two columns presenting information for the 6-month periods ended June 30, 2003, and June 30, 2002

Furthermore, IAS 34, paragraph 21, observes that for highly seasonal businesses, the inclusion of additional income statement columns for the twelve months ending on the date of the most recent interim report (also referred to as rolling twelve-month statements) would be very useful. The objective of rolling twelve-month statements is that seasonality concerns are eliminated, since by definition each rolling period contains all the seasons of the year. (Rolling statements cannot correct cyclicality that encompasses more than one year, such as business recessions.) Accordingly, the IASC encourages companies affected by seasonality to consider including these additional statements, which could result in an interim income statement comprising six or more columns of data.

Accounting Policies in Interim Periods

Consistency.

The standard logically states that interim period financial statements should be prepared using the same accounting principles that had been employed in the most recent annual financial statements. This is consistent with the idea that the latest annual report provides the frame of reference that will be employed by users of the interim information. The fact that interim data is expected to be useful in making projections of the forthcoming full-year's reported results of operations makes consistency of accounting principles between the interim period and prior year important, since the projected results for the current year will undoubtedly be evaluated in the context of year-earlier performance. Unless the accounting principles applied in both periods are consistent, any such comparison is likely to be less than fully valid.

The decision to require consistent application of accounting policies across interim periods and in comparison with the earlier fiscal year is not only an implication of the view of interim reporting as being largely a means of predicting the coming fiscal year results, it is also driven by the conclusion that interim reporting periods stand alone (rather than being merely an integral portion of the full year). To put it differently, when an interim period is seen as an integral part of the full year, it is easier to rationalize applying different accounting policies to the interim periods, if doing so will more meaningfully present the results of the portion of the full year within the boundaries of the annual reporting period. For example, deferral of certain costs at interim balance sheet dates, notwithstanding the fact that such costs could not validly be deferred at year-end, might theoretically serve the purpose of providing a more accurate predictor of full-year results.

On the other hand, if each interim period is seen as a discrete unit to be reported upon without having to serve the higher goal of providing an accurate prediction of the full-year's expected outcome, then a decision to depart from previously applied accounting principles is less easily justified. Given the IASC's stated clear preference for the discrete view of interim financial reporting, its requirement regarding consistency of accounting principles is entirely logical.

Consolidated reporting requirement.

The standard also requires that, if the enterprise's most recent annual financial statements were presented on a consolidated basis, then the interim financial reports in the immediate succeeding year should also be presented similarly. This is entirely in keeping with the notion of consistency of application of accounting policies. The rule does not, however, preclude or require publishing additional "parent company only" interim reports, even if the most recent annual financial statements did include such additional data.

Materiality As Applied to Interim Financial Statements

Materiality is one of the most fundamental concepts underlying financial reporting. At the same time, it has largely been resistant to attempts at definition. A number of international accounting standards do require that items be disclosed if material or significant or are of "such size" as would warrant separate disclosure. For example, IAS 8 requires that items of income and expense within profit or loss from ordinary activities which are of such size and nature or incidence that their disclosure is relevant to explain the performance of an enterprise are to be separately disclosed. However, guidelines for performing an arithmetical calculation of a threshold for materiality (in order to measure "such size") is not prescribed in IAS 8, or for that matter in any other IAS, but rather, is left to the devices of each individual charged with responsibility for financial reporting to determine.

IAS 34 puts forward the notion that materiality for interim reporting purposes will differ from that defined in the context of an annual period. This follows from the decision to endorse the discrete view of interim financial reporting, generally. Thus, for example, discontinuing operations or extraordinary items would have to be evaluated for disclosure purposes against whatever benchmark, such as gross revenue, is deemed appropriate, as that item is being reported in the interim financial statements, and not in the prior year's financial statements or projected current full-year's (period's) results. The effect would normally be to lower the threshold level for reporting such items: some items separately set forth in the interim financials might not be so presented in the full-year's annual report that later includes that same interim period. The objective is not to mislead the user of the information by failing to include a disclosure that might appear to be material within the context of the interim report, since that is the user's immediate frame of reference. If later the threshold is raised and items previously presented are no longer deemed worthy of such attention, this is not thought to create a risk of misleading the user, in contrast to a failure to disclose an item in the interim financial statements that measured against the performance parameters of the interim period might appear significant.

To illustrate, assume that Xanadu Corp. has gross revenues of $2.8 million in the first fiscal quarter and will, in fact, go on to earn revenues of $12 million for the full year. Traditionally, materiality is defined as 5% of revenues. If in the first quarter an extraordinary gain of $200,000 is incurred, this should be separately set forth in the quarterly financial statements since it exceeds the defined 5% threshold for materiality. If there are no other extraordinary losses for the balance of the year, it might validly be concluded that disclosure in the year-end financials may be omitted, since a $200,000 loss is not material in the context of $12 million of revenues. Thus, Xanadu's first quarter report might include an item defined as extraordinary that is later redefined as not being extraordinary.

Recognition Issues

General concepts.

The draft statement of principles holds that definitions of assets, liabilities, income, and expense should be the same for interim period reporting as at year-end. These items are defined in the IASC's Framework for the Preparation and Presentation of Financial Statements. 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 enterprise, expenditures that could not be capitalized at year-end because of a failure to meet this definition could similarly not be given deferred recognition at interim dates. Thus, by applying the same definitions at interim dates, the IASC has mandated the same recognition rules as are applicable at the end of full annual reporting periods.

However, while the overall implication is that identical recognition and measurement rules are to be applied to interim financial statements, the draft statement does go on to set forth a number of modifications to the general rule. Some of these are in simple acknowledgment of the limitations of certain measurement techniques, and the recognition that applying those definitions at interim dates might necessitate interpretations different from those useful for annual reporting. In other cases, the standard clearly departs from the discrete view, since such departures are not only wise, but probably fully necessary. These specific recognition and measurement issues are addressed below.

Recognition of annual costs incurred unevenly during the year.

It is frequently observed that certain types of costs are incurred in uneven patterns over the course of a fiscal year, while not being driven strictly by variations in volume of sales activity. For example, major expenditures on advertising may be prepaid at the inception of the campaign; tooling for new product production will obviously be heavily weighted to the preproduction and early production stages. Certain discretionary costs, such as research and development, will not bear any predictable pattern or necessary relationship with other costs or revenues.

If an integral view approach had been elected by the IASC, there would be potent arguments made in support of the accrual or deferral of certain costs. For instance, if a major expenditure for overhauling equipment is scheduled to occur during the final interim period, logic could well suggest that the expenditure should be anticipated in the earlier interim periods of the year. Under the discrete view adopted by the standard, however, such an accrual would be seen as an inappropriate attempt to smooth the operating results over all the interim periods constituting the full fiscal year. Accordingly, such anticipation of future expenses is prohibited, unless the future expenditure gives rise to a true liability in the current period, or meets the test of being a contingency which is probable and the magnitude of which is reasonably estimable.

For example, many business enterprises grant bonuses to managers only after the annual results are known; even if the relationship between the bonuses and the earnings performance is fairly predictable from past behavior, these remain discretionary in nature and need not be given. Such a bonus arrangement would not give rise to a liability during earlier interim periods, inasmuch as the management has yet to declare that there is a commitment that will be honored. (Compare this with the situation where managers have contracts specifying a bonus plan, which clearly would give rise to a legal liability during the year, albeit one which might involve complicated estimation problems. Also, a bonus could be anticipated for interim reporting purposes if it could be considered a constructive obligation, for example, based upon past practice for which the enterprise has no realistic alternative and a realistic estimate of that obligation can be made).

Another example involves contingent lease arrangements. Often in operating leases the lessee will agree to a certain minimum or base rent, plus an amount that is tied to some variable such as sales revenue. This is typical, for instance, in retail rental contracts, such as for renting space in shopping malls, since it encourages the landlord to maintain the facilities in an appealing fashion such that tenants are successful in attracting customers. Only the base amount of the periodic rental is a true liability, until the higher rent becomes payable as sales targets are achieved. If contingent rents are payable based on a sliding scale (e.g., 1% of sales volume up to $500,000, then 2% of amounts up to $1.5 million, etc.), the projected level of full-year sales should not be used to compute rental accruals in the early periods; rather, only the contingent rents payable on the actual sales levels already achieved should be so recorded.

While the foregoing examples were clearly categories of costs that, while often fairly predictable, would not constitute a legal obligation of the reporting enterprise until the associated conditions were fully met, there are other examples that are more ambiguous. Paid vacation time and holiday leave would often be enforceable as legal commitments, and if so, provision for these should be made in interim financial statements. In other cases, as when accrued vacation time is lost if not used by the end of a defined reporting year, such costs might not be subject to accrual under the discrete view. The facts of each such situation would have to be carefully analyzed to make such a determination.

Revenues received seasonally, cyclically, or occasionally.

The standard is clear that revenues such as dividend income and interest earned cannot be anticipated or deferred at interim dates, unless such practice would be acceptable at year-end. Thus, interest income is typically accrued for, since it is well established that this represents a contractual commitment. Dividend income, on the other hand, is not recognized until declared, since even when highly predictable based on past experience, these are not obligations of the paying corporation until actually declared.

Furthermore, seasonality factors should not be smoothed out of the financial statements. For example, retail stores typically have a high percentage of annual revenues occurring in the holiday shopping period, and the quarterly or other interim financial statements should fully reflect such seasonality; thus, recognize it as it occurs.

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. Further, if rate changes have been enacted to take effect later in the fiscal year (while some rate changes take effect in midyear, more likely this would be an issue if the enterprise 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, as the standard puts it, the estimated average annual rate would "reflect a blend of the progressive tax rate structure expected to be applicable to the full year's earnings including enacted or substantially enacted changes in the income tax rates scheduled to take effect later in the financial year."

IAS 34 addresses in detail the various computational aspects of an effective interim period tax rate which are summarized in the following paragraphs.

Multiplicity of taxing jurisdictions and different categories of income.

Most enterprises are subject to a multiplicity of taxing jurisdictions, and in some instances the amount of income subject to tax will vary from one to the next, since different laws will include and exclude disparate items of income or expense from the tax base. For example, interest earned on government-issued bonds may be exempted from tax by the jurisdiction that issued them, but be defined as fully taxable by other tax jurisdictions the entity is subject to. To the extent feasible, the appropriate estimated average annual effective tax rate should be separately ascertained for each taxing jurisdiction and applied individually to the interim period pretax income of each jurisdiction, so that the most accurate estimate of income taxes can be developed at each interim reporting date. In general, an overall estimated effective tax rate will not be as satisfactory for this purpose as would a more carefully constructed set of estimated rates, since the pattern of taxable and deductible items will fluctuate from one period to the next.

Similarly, if the tax law prescribes different income tax rates for different categories of income (such as the tax rate on capital gains which usually differs from the tax rate applicable to business income in many countries), then to the extent practicable, a separate tax rate should be applied to each category of interim period pretax income. The standard, while mandating such detailed rules of computing and applying tax rates across jurisdictions or across categories of income, recognizes that in practice such a degree of precision may not be achievable in all cases. Thus, in all such cases, IAS 34 softens its stand and allows usage of a "weighted-average of rates across jurisdictions or across categories of income" provided "it is a reasonable approximation of the effect of using more specific rates."

Tax credits.

In computing an expected effective tax rate for a given tax jurisdiction, all relevant features of the tax regulations should be taken into account. Jurisdictions may provide for tax credits based on new investment in plant and machinery, relocation of facilities to backward or underdeveloped areas, research and development expenditures, levels of export sales, and so forth, and the expected credits against the tax for the full year should be given consideration in the determination of an expected effective tax rate. Thus, the tax effect of new investment in plant and machinery, when the local taxing body offers an investment credit for qualifying investment in tangible productive assets, will be reflected in those interim periods of the fiscal year in which the new investment occurs (assuming it can be forecast to occur later in a given fiscal year), and not merely in the period in which the new investment occurs. This is consistent with the underlying concept that taxes are strictly an annual phenomenon, but it is at variance with the purely discrete view of interim financial reporting.

The interim reporting standard notes that, although tax credits and similar modifying elements are to be taken into account in developing the expected effective tax rate to apply to interim earnings, tax benefits which will relate to onetime events are to be reflected in the interim period when those events take place. This is perhaps most likely to be encountered in the context of capital gains taxes incurred in connection with occasional dispositions of investments and other capital assets; since it is not feasible to project the rate at which such transactions will occur over the course of a year, the tax effects should be recognized only as the underlying events transpire.

While in most cases tax credits are to be handled as suggested in the foregoing paragraphs, in some jurisdictions tax credits, particularly those that relate to export revenue or capital expenditures, are in effect government grants. The accounting for government grants is set forth in IAS 20; in brief, grants are recognized in income over the period necessary to properly match them to the costs which the grants are intended to offset or defray. Thus, compliance with both IAS 20 and IAS 34 would necessitate that tax credits be carefully analyzed to identify those which are, in substance, grants, and then accounting for the credit consistent with its true nature.

Tax loss tax credit carrybacks and carryforwards.

When an interim period loss gives rise to a tax loss carryback, it should be fully reflected in that interim period. Similarly, if a loss in an interim period produces a tax loss carryforward, it should be recognized immediately, but only if the criteria set forth in IAS 12 are met. Specifically, it must be deemed probable that the benefits will be realizable before the loss benefits can be given formal recognition in the financial statements. In the case of interim period losses, it may be necessary to assess not only whether the enterprise will be profitable enough in future fiscal years to utilize the tax benefits associated with the loss, but, furthermore, whether interim periods later in the same year will provide earnings of sufficient magnitude to absorb the losses of the current period.

IAS 12 provides that changes in expectations regarding the realizability of benefits related to net operating loss carryforwards should be reflected currently in tax expense. Similarly, if a net operating loss carryforward benefit is not deemed probable of being realized until the interim (or annual) period when it in fact becomes realized, the tax effect will be included in tax expense of that period. Appropriate explanatory material must be included in the notes to the financial statements, even on an interim basis, to provide the user with an understanding of the unusual relationship between pretax accounting income and the provision for income taxes.

Volume rebates or other anticipated price changes in interim reporting periods.

IAS 34 prescribes that where volume rebates or other contractual changes in the prices of goods and services are anticipated to occur over the annual reporting period, these should be anticipated in the interim financial statements for periods within that year. The logic is that the effective cost of materials, labor, or other inputs will be altered later in the year as a consequence of the volume of activity during earlier interim periods, among others, and it would be a distortion of the reported results of those earlier periods if this were not taken into account. Clearly this must be based on estimates, since the volume of purchases, etc., in later portions of the year may not materialize as anticipated. As with other estimates, however, as more accurate information becomes available this will be adjusted on a prospective basis, meaning that the results of earlier periods should not be revised or corrected. This is consistent with the accounting prescribed for contingent rentals and is furthermore consistent with IAS 37's guidance on provisions.

The requirement to take volume rebates and similar adjustments into effect in interim period financial reporting applies equally to vendors or providers, as well as to customers or consumers of the goods and services. In both instances, however, it must be deemed probable that such adjustments have been earned or will occur, before giving recognition to them in the financials. This high a threshold has been set because the definitions of assets and liabilities in the IASC's Framework for the Preparation and Presentation of Financial Statements require that they be recognized only when it is probable that the benefits will flow into or out from the enterprise. Thus, accrual would only be appropriate for contractual price adjustments and related matters. Discretionary rebates and other price adjustments, even if typically experienced in earlier periods, would not be given formal recognition in the interim financials.

Depreciation and amortization in interim periods.

The rule regarding depreciation and amortization in interim periods is more consistent with the discrete view of interim reporting. Charges to be recognized in the interim periods are to be related to only those assets actually employed during the period; planned acquisitions for later periods of the fiscal year are not to be taken into account.

While this rule seems entirely logical, it can give rise to a problem that is not encountered in the context of most other types of revenue or expense items. This occurs when the tax laws or financial reporting conventions permit or require that special allocation formulas be used during the year of acquisition (and often disposition) of an asset. In such cases, depreciation or amortization will be an amount other than the amount that would be computed based purely on the fraction of the year the asset was in service. For example, assume that convention is that one-half year of depreciation is charged during the year the asset is acquired, irrespective of how many months it is in service. Further assume that a particular asset is acquired at the inception of the fourth quarter of the year. Under the requirements of IAS 34, the first three quarters would not be charged with any depreciation expense related to this asset (even if it was known in advance that the asset would be placed in service in the fourth quarter). However, this would then necessitate charging fourth quarter operations with one-half year's (i.e., two quarters') depreciation, which arguably would distort that final period's results of operations.

IAS 34 does address this problem area. It states that an adjustment should be made in the final interim period so that the sum of interim depreciation and amortization equals an independently computed annual charge for these items. However, since there is no requirement that financial statements be separately presented for a final interim period (and most enterprises, in fact, do not report for a final period), such an adjustment might be implicit in the annual financials, and presumably would be explained in the notes if material (the standard does not explicitly require this, however).

The alternative financial reporting strategy, that is, projecting annual depreciation, including the effect of asset dispositions and acquisitions planned for or reasonably anticipated to occur during the year, and then allocating this ratably to interim periods, has been rejected. Such an approach might have been rationalized in the same way that the use of the effective annual tax rate was in assigning tax expense or benefits to interim periods, but this has not been done.

Inventories.

Inventories represent a major category for most manufacturing and merchandising enterprises, and some inventory costing methods pose unique problems for interim financial reporting. In general, however, the same inventory costing principles should be utilized for interim reporting as for annual reporting. However, the use of estimates in determining quantities, costs, and net realizable values at interim dates will be more pervasive,

Three particular difficulties are addressed in IAS 34. These are the matters of determining net realizable values at interim dates, the use of the LIFO costing method, and the allocation of manufacturing variances.

Regarding net realizable value determination, the standard expresses the belief that the determination of NRV at interim dates should be based on selling prices and costs to complete at those dates. Projections should therefore not be made regarding conditions which possibly might exist at the time of the fiscal year-end. Furthermore, write-downs to NRV taken at interim reporting dates should be reversed in a subsequent interim reporting period only if it would be appropriate to do so at the end of the financial year.

LIFO inventory costing poses unique problems because it is almost solely driven by tax regulations (although in a few industries a case can be made that the physical flow of goods follows a last-in, first-out pattern) that provide an economic incentive to use the method. As a tax-driven accounting procedure, annual measurement is usually prescribed, and certain adjustments required at year-end can potentially interfere with meaningful financial reporting if made at interim dates. The most commonly encountered issue is that of liquidation of lower cost LIFO layers at interim dates, only to have the physical quantity restored before year-end.

To avoid distorting the operating results of the interim period in which the liquidation occurs (overstating interim profits by expensing lower cost inventory through cost of sales), as well as that of the later period when the inventory volume is restored (having the reverse effect), common practice has long been to provide a reserve for temporary liquidations of inventory, effectively charging current period cost of sales for the higher level of costs, which it is expected will be incurred when the temporary liquidation is reversed. This is the method sanctioned under US GAAP as well.

The last of the special issues related to inventories that are addressed by IAS 34 concerns allocation of variances at interim dates. When standard costing methods are employed, the resulting variances are typically allocated to cost of sales and inventories in proportion to the dollar magnitude of those two captions, or according to some other rational system. IAS 34 requires that the price, efficiency, spending, and volume variances of a manufacturing enterprise are recognized in income at interim reporting dates to the extent those variances would be recognized at the end of the financial year. It should be noted that some standards have prescribed deferral of such variances to year-end based on the premise that some of the variances will tend to offset over the course of a full fiscal year, particularly if the result of volume fluctuations due to seasonal factors. When variance allocation is thus deferred, the full balance of the variances are placed onto the balance sheet, 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.

Foreign Currency Translation Adjustments at Interim Dates

Given the IASC's adoption of the discrete view regarding interim reporting, it is not surprising that the same approach to translation gains or losses as is mandated at year-end would be adopted in IAS 34. IAS 21 prescribes rules for translating the financial statements for foreign operations into the reporting currency and also includes guidelines for using historical, average, or closing foreign exchange rates. It also lays down rules for either including the resulting adjustments in income or in equity. IAS 34 requires that consistent with IAS 21, the actual average and closing rates for the interim period be used in translating financial statements of foreign operations at interim dates. In other words, the future changes to exchanges rates (in the current financial year) are not allowed to be anticipated by IAS 34.

Where IAS 21 provides for translation adjustments to be recognized in the income statement in the period it arises, IAS 34 stipulates that the same approach be applied during each interim period. If the adjustments are expected to reverse before the end of the financial year, IAS 34 requires that enterprises not defer some foreign currency translation adjustments at an interim date.

Adjustments to Previously Reported Interim Data

While year-to-date financial reporting is not required, although the standard does recommend it in addition to normal interim period reporting, the concept finds some expression in the standard's position that adjustments not be made to earlier interim periods' results. By measuring income and expense on a year-to-date basis, and then effectively backing into the most recent interim period's presentation by deducting that which was reported in earlier interim periods, the need for retrospective adjustment of information that was reported earlier is obviated. However, there may be the need for disclosure of the effects of such measurement strategies when this results effectively in including adjustments in the most current interim period's reported results.

Accounting Changes in Interim Periods

IAS 34, paragraph 43, requires that a change in accounting policy other than one for which the transition is specified by a new IAS should be reflected either

By restating the financial statements of prior interim periods of the current year and the comparable interim periods of the prior financial year, if the enterprise follows the benchmark treatment under IAS 8, or
By restating the financial statements of prior interim periods of the current financial year, without restating the comparable interim periods of the prior financial years (i.e., when the enterprise follows the allowed alternative treatment under IAS 8).

The first option would be more informative because of the salutary effects on comparability of financial data for the current and preceding years. If the second option is adopted and the allowed alternative treatment is followed, then the entire cumulative adjustment is to be made prospectively in the determination of the profit or loss for the period in which the accounting policy is changed.

One of the objectives of the above requirement of IAS 34 is to ensure that a single accounting policy is applied to a particular class of transactions throughout the entire financial year. To allow differing accounting policies to be applied to the same class of transactions within a single financial year would be disastrous since it would, as pointed out by the standard, result in "interim allocation difficulties, obscured operating results, and complicated analysis and understandability of interim period information."

Use of estimates in interim periods.

IAS 34, paragraph 41, recognizes that preparation of interim financial statements will require a greater use of estimates than annual financial statements. Appendix 3 to the standard provides examples of use of estimates to illustrate the application of this standard in this regard. The Appendix provides nine examples covering areas ranging from inventories to pensions. For instance, in the case of pensions, the Appendix states that for interim reporting purposes, reliable measurement is often obtainable by extrapolation of the latest actuarial valuation, as opposed to obtaining the same from a professionally qualified actuary, as would be expected at the end of a financial year. Readers are advised to read the other illustrations contained in Appendix 3 of IAS 34 for further guidance on the subject.

Impairment of assets in interim periods.

IAS 34, paragraph 36, stipulates that an enterprise should apply the same impairment testing, recognition, and reversal criteria at an interim period as it would at the end of its financial year. However, this does not mean that a detailed impairment calculation as prescribed by IAS 36 would automatically need to be used at interim periods; instead, an enterprise would need to review for indications of significant impairments since the date of the most recent financial year to determine whether such a calculation is required.

Interim financial reporting in hyperinflationary economies.

IAS 34, paragraph 32, requires that interim financial reports in hyperinflationary economies be prepared using the same principles as at the financial year-end. Thus, the provisions of IAS 29 would need to be complied with in this regard. IAS 34 stipulates that in presenting interim data in the measuring unit, enterprises should report the resulting gain or loss on the net monetary position in the interim period's income statement. IAS 34 also requires that enterprises do not need to annualize the recognition of the gain or loss or use estimated annual inflation rates in preparing interim period financial statements in a hyperinflationary economy.