• Accruals method

    The accruals method allocates gains and losses from a financial arrangement to income years according to an implicit rate of return. This is known commercially as the internal rate of return.

    The accruals method applies to a financial arrangement when there is:

    • an overall gain or loss from the arrangement that is sufficiently certain at the time an entity starts to have the arrangement
    • a particular gain or loss from the arrangement that is either sufficiently certain at the time an entity starts to have the arrangement or that becomes sufficiently certain during the life of the arrangement.

    To work out whether an entity has a sufficiently certain gain or loss (overall or particular), consider only the financial benefits the entity is sufficiently certain to provide or receive.

    Sufficiently certain gain or loss

    In deciding whether an entity has a sufficiently certain gain or loss from a financial arrangement, only financial benefits that the entity is sufficiently certain to receive and provide can be considered.

    Under section 230-115, a financial benefit is treated as sufficiently certain only if both of the following apply:

    • it is reasonably expected that the entity will receive or provide the financial benefit, assuming the entity will continue to have the financial arrangement for the rest of its life
    • at least some of the amount or value of the benefit is, at that time, fixed or determinable with reasonable accuracy.

    When working out whether a financial benefit is sufficiently certain, an entity must look at the:

    • terms and conditions of the financial arrangement
    • accepted pricing and valuation techniques
    • economic or commercial substance and effect of the arrangement
    • contingencies attached to the other financial benefits that are to be provided or received under the arrangement, and any interaction these contingencies may have with the financial benefits under consideration.

    See also:

    Sufficiently certain overall gain or loss

    An entity will have a sufficiently certain overall gain or loss from a financial arrangement if at the time it started to have the arrangement, it is sufficiently certain that it will make an overall gain or loss of at least a particular amount.

    In determining whether the gain or loss is sufficiently certain, regard must be had to the risk that the receipt or provision of financial benefits that are not sufficiently certain might reduce that gain or loss.

    Therefore, a contingent financial benefit that may reduce the amount of gain or loss may affect whether there is a sufficiently certain overall gain or loss.

    The particular gain or loss approach is the default approach. If, at the time an entity starts to have a financial arrangement, the entity is sufficiently certain of both an overall gain or loss and particular gains or losses from the arrangement, the entity can only apply the accruals method to the overall gain or loss if it chooses to do so. If the entity chooses to apply the accruals method to the overall gain, it cannot apply the accruals method to the particular gains or losses arising from the financial arrangement.

    Sufficiently certain particular gain or loss

    An entity will have a sufficiently certain particular gain or loss from a financial arrangement if, at that time, it is sufficiently certain that it will make a gain or loss of at least a particular amount.

    In determining whether the gain or loss is sufficiently certain, regard must be had to the risk that the receipt or provision of a financial benefit under the financial arrangement that is not sufficiently certain might reduce that gain or loss.

    If a financial benefit to be received or provided under the financial arrangement is not sufficiently certain but is not reasonably attributable in working out the particular gain or loss, this has no bearing on whether the particular gain or loss is sufficiently certain.

    Example: Particular gains on an index bond

    Dan Co holds a bond that pays annual interest coupons. In addition, on maturity, Dan Co will either pay or receive an additional payment depending on the performance of a certain equity index.

    Dan Co does not have an overall gain or loss under this arrangement, as on maturity Dan Co may be required to pay an amount that would reduce the amount of the gain. This payment is not sufficiently certain due to the contingency attached. However, the possible payment on maturity is not a cost attributable to the annual coupon payments.

    Accordingly, Dan Co will have sufficiently certain particular gains, being the interest coupons, which are to be spread over the period to which they relate.

    End of example
    Financial benefits dependent on a variable

    Under some financial arrangements, periodic returns are calculated with reference to a variable such as an interest rate or consumer price index.

    In working out whether a financial benefit is sufficiently certain at a particular time (reference time), where the financial benefit depends on a variable based on an interest rate or a rate that solely or primarily reflects the time value of money, a consumer price index or an index prescribed by regulations, it must be assumed that the variable will continue to have the value it has at the reference time.

    This allows the accruals method to apply to arrangements such as fixed-term variable-rate loans.

    Any discrepancy between the assumed variable and the actual variable rate will be brought to account under running balancing adjustments, provided the difference is immaterial.

    Financial benefits denominated in a foreign currency

    Where all the financial benefits provided and received under a financial arrangement are denominated in a particular foreign currency, they must not be translated into Australian currency (or other applicable functional currency) to determine whether the financial benefit is sufficiently certain (subsection 230-115(8)).

    This allows the accruals method to apply to certain arrangements denominated in a particular foreign currency, where the gain or loss would be sufficiently certain, but for potential changes in foreign exchange rates.

    See also:

    Applying the accruals method

    In applying the accruals method, entities must determine the period over which the gain or loss is to be spread, and allocate amounts of gain or loss to intervals.

    Period to spread gain or loss over

    Where there is a sufficiently certain overall gain or loss from the financial arrangement, and the entity chooses to apply the overall method, the gain or loss is spread over a period that begins when the entity starts to have the financial arrangement and ends when the entity ceases to have the financial arrangement.

    Where there is a sufficiently certain particular gain or loss from the financial arrangement, the gain or loss is spread over the period to which the gain or loss relates. This period must not start earlier than the time at which the entity starts to have the financial arrangement.

    This spreading or smoothing principle reflects the financial concept of interest on interest or compound interest.

    Allocation of gain or loss to intervals

    Under the accruals method, the gain or loss must be allocated to intervals that are the same length and do not exceed 12 months – however, the first and last interval may be shorter than the other intervals.

    If the relevant interval starts in one income year and ends in the next income year, the part of the gain or loss that relates to that interval must be allocated between the income years on a reasonable basis.

    How the gain or loss is spread

    Once the period over which the relevant gain or loss should be spread is determined, the method used to spread that gain or loss over that period must be established. Where the accruals method applies to gains or losses the taxpayer makes from a financial arrangement, the gain or loss is spread using:

    • compounding accruals (paragraph 230-135(2)(a))
    • a different method, the results of which approximate those obtained using compounding accruals (paragraph 230-135(2)(b)).

    Generally, to apply the compounding accruals method, a taxpayer estimates the rate of return (the discount rate) that equates the net present value of all relevant cash flows (financial benefits) to zero. An entity applies that rate to the initial investment, to provide an estimated period-by-period gain or loss that forms the basis of taxation.

    Example: Zero coupon bonds

    Iron Co acquires a three-year zero-coupon bond for $100 on 1 January 2011, with a face value of $133.10. Iron Co has not chosen an elective method. As there is a sufficiently certain overall gain of $33.10, the accruals method will apply to the zero-coupon bond.

    Iron Co's gain of $33.10 is spread across the three years. Applying the internal rate of return of 10% to the cost of the financial arrangement on a compounding basis, Iron Co makes a gain of $10.00, $11.00 and $12.10 respectively during the three-year term.

     

     

    Year 1

    Year 2

    Year 3

    Acquisition cost

    $100.00

     

     

     

    Value through term

     

    $110.00

    $121.00

     

    Face value at end

     

     

     

    $133.10

    Tax treatment under the accruals method

     

    $10.00 gain

    $11.00 gain

    $12.10 gain*

    * Subdivision 230-G balancing adjustment applies when the financial arrangement ceases

    End of example

    See also:

    Financial arrangements with a notional principal

    A notional principal arrangement is a financial arrangement under which financial benefits to be provided or received are calculated by referring to a notional, rather than actual, principal amount, regardless of whether that amount is actually paid or received.

    The notional principal amount and financial benefits calculated are known commercially as a leg of the arrangement. There are two legs to such an arrangement.

    Under section 230-120, the accruals and realisation methods apply to certain notional principal arrangements by calculating the gains and losses on each leg separately, as if the notional principal amount is a financial benefit actually paid or received at a time, and in a manner that reflects the way in which the other financial benefits for that leg are calculated.

    A common example of a financial arrangement where section 230-120 could apply is a swap. In general terms, a swap is an agreement between two parties under which they exchange cash flows over time. The value of the cash flows is often calculated based on a notional principal. For example, under an interest rate swap, the gain or loss on the variable leg and the fixed leg is calculated separately. The accruals method could then apply to each leg of the interest rate swap as if they were separate financial arrangements.

    See also:

    Spreading prepayments

    A gain or loss from a prepayment generally relates to the period after a payment is made. The gain or loss should be spread across the period to which it relates. This period to which the gain or loss relates may start earlier than the time when the gain or loss becomes sufficiently certain, and may continue until the entity ceases to have the financial arrangement.

    Where the period to which the gain or loss relates starts before the time the financial benefit becomes sufficiently certain, this may result in amounts being allocated to income years prior to when the amount became sufficiently certain. This is inconsistent with the forward looking accruals approach, and accordingly under section 230-170, any gain or loss allocated to previous income years in these circumstances is deemed to have been made in the income year where the gain or loss became sufficiently certain.

    See also:

    Spreading single financial benefits

    When applying the accruals method, a taxpayer must determine an amount to which to apply the rate of return. Where the financial arrangement consists of a single financial benefit to be received or provided, it can be unclear what the relevant amount should be.

    In these circumstances, taxpayers must have regard to a notional principle from which the amount of the financial benefit giving rise to the gain or loss is calculated, or which is otherwise reasonably related to the financial benefit.

    For example, the notional principle may be the amount that is effectively invested by the taxpayer to make the amount of gain or loss.

    Election for portfolio treatment

    Generally, if it is established that there is a sufficiently certain overall gain or loss from a financial arrangement, that gain or loss is spread over a period that commences when the taxpayer starts to have the financial arrangement and ends when the taxpayer ceases to have the financial arrangement under the accruals method.

    If eligible, an entity can make an irrevocable election under section 230-150 to modify this rule where the overall gain or loss from the financial arrangement arises in part from fees (referred to as portfolio fees), or from a discount/premium for acquiring a portfolio of similar financial arrangements.

    In these cases, the portfolio fees, and any gain or loss to the extent that it arises in part from the premium or discount in acquiring the portfolio, are spread over the expected life of the portfolio rather than the period of the financial arrangement. An example of a portfolio of similar financial arrangements is a portfolio of similar home loans held by a bank.

    See also:

    Running balancing adjustments

    A running balancing adjustment is made under section 230-175 to correct any underestimation or overestimation of financial benefits resulting from applying the accruals method throughout the life of the financial arrangement.

    A running balance adjustment does not arise if the amount of the financial benefit received is either:

    • less than the estimated amount, and the difference is the result of the writing off of a bad debt or impairment
    • more than the estimated amount and the difference is the result of a reversal of an impairment loss.

    See also:

    Reassessment

    Under section 230-185, an entity must reassess which gains and losses from a financial arrangement the accruals method should apply to, and which gains and losses from the financial arrangement the realisation method should apply to, if both the following apply:

    • The accruals or realisation method applies to the gains and losses from the arrangement.
    • There has been a material change to the terms and conditions of the arrangement or the circumstances that affect the arrangement.

    See also:

    Re-estimation

    Under section 230-190, an entity may have to re-estimate a gain or loss if both the following apply:

    • the accruals method applies to the gain or loss
    • circumstances arise that materially affect the amount, value, or timing of financial benefits that were taken into account in working out the amount of the gain or loss.

    An entity may also have to re-estimate a gain or loss if the:

    • gain or loss is being spread using the effective interest method
    • gain or loss is spread using this method, and the entity recalculates the effective interest rate in accordance with accounting principles
    • terms and conditions of the arrangement provides for reset dates to occur no more than 12 months apart (section 230-190(3A)).

    This re-estimation involves two parts:

    • a fresh determination of the amount of the gain or loss
    • a reallocation of the remaining part of that revised amount over the remaining part of the accrual period.

    See also:

    Impairments

    If a financial arrangement (or financial asset or financial liability that forms part of the financial arrangement) is impaired (within the meaning of the accounting principles as defined in subsection 995-1(1)), a taxpayer must reassess, in accordance with section 230-185, whether there is a sufficiently certain gain or loss to which the accruals method can apply.

    Where it is determined that the accruals method will apply, a re-estimation is required under section 230-190.

    Where the re-estimation results in the entity making a loss from the financial arrangement, the loss will not be deductible to the extent that it is made as a result of the impairment (subsection 230-172(2)). An impairment will only give rise to a deduction upon the writing off of a bad debt.

    See also:

    Reversal of impairments

    Reassessment to realisation

    When an impairment arises, it may be determined (pursuant to the reassessment under section 230-185) that the realisation method applies to the arrangement (see Realisation method).

    Upon reversal of the impairment, an entity must again reassess under section 230-185 whether the accruals or realisation method will apply to the financial arrangement. As a result, it may be determined that there is a sufficiently certain gain or loss to which the accruals method will apply.

    Some amount of the gain or loss to which the accruals method applies may relate to a period before the time the gain or loss became sufficiently certain. In such a situation, section 230-130 applies to allow the entity to spread the gain or loss earlier than the time the gain or loss became sufficiently certain.

    Parts of the gain or loss allocated to intervals ending prior to or during the income year in which the gain or loss became sufficiently certain are deemed to have been made in that income year (subsection 230-170(2A)).

    Reassessment to accruals

    When an impairment arises, it may be determined pursuant to the reassessment under section 230-185 that the accruals method continues to apply to the arrangement

    Upon reversal of the impairment, a re-estimation is again required under section 230-190, which may result in the entity making a gain from the financial arrangement. Some part of this gain may reflect the previous impairment loss that was not deductible.

    When determining the allocation of a gain to intervals ending after the re-estimation, the amount to be reallocated is reduced by the non-deductible amount (subsection 230-192(5)).

    Example: Impairment on a loan

    Chris Co is a TOFA entity that has not made any TOFA tax-timing method elections.

    On 1 July 2013, Chris Co lends $10,000. Chris Co expects to receive that $10,000, plus annual interest of 20% compounding annually, on 30 June 2017 (a total of $10,736 interest).

    When Chris Co starts to have the financial arrangement, there is a sufficiently certain gain or loss of $10,736 to which the accruals method will apply.

    Chris Co would spread the gain on the following basis:

    Year ending

    Gain or loss

    Balance

     

     

    $10,000

    30 June 2014

    $2,000 ($10,000 x 20%) gain

    $12,000

    30 June 2015

    $2,400 ($12,000 x 20%) gain

    $14,400

    30 June 2016

    $2,880 ($14,440 x 20%) gain

    $17,280

    30 June 2017

    $3,456 ($17,280 x 20%) gain

    $20,736

     

    $10,736 gain

     

    Impairment

    On 1 July 2014, the loan is impaired for accounting purposes. Chris Co does not write the debt off as bad, but now only expects to receive $8,748 on 30 June 2017.

    Chris Co's freshly determined loss is $1,252 ($10,000 – $8,748). Following the impairment, Chris Co must reassess whether the accruals method will continue to apply to the arrangement.

    Chris Co has already allocated a $2,000 gain to the first period. Consequently, the loss required to be spread is $3,252 (to offset the initial $2,000 gain, and to recognise the difference between amounts provided and amounts expected to be received under the arrangement of $1,252). Chris Co uses the accruals method to spread this loss over the remaining life of the loan.

    Chris Co must determine the effective interest rate to apply to reduce the balance from the current $12,000. The effective interest rate is 10%.

    Chris Co therefore spreads the loss on the following basis:

    Year ending

    Gain or loss

    Balance

     

     

    $12,000

    30 June 2015

    $1,200 ($12,000 x 10%) loss (non-deductible)

    $10,800

    30 June 2016

    $1,080 ($10,800 x 10%) loss (non-deductible)

    $9,720

    30 June 2017

    $972 ($9,720 x 10%) loss (non-deductible)

    $8,748

     

    $3,252 loss

     

    Partial reversal of impairment

    Chris Co cannot deduct these losses because they are the result of an impairment.

    On 1 July 2015, Chris Co partially reverses the impairment, as it now expects to receive an amount of $14,520 on 30 June 2017.

    Chris Co's freshly determined gain is $4,520 ($14,520 – $10,000). Chris Co must again reassess whether the accruals method will apply to the arrangement.

    Chris Co has already allocated a $2,000 gain and $1,200 loss to previous periods. Accordingly, the remaining amount to be allocated is a $3,720 gain ($4,520 – $2,000 + $1,200). However, Chris Co was unable to deduct the $1,200 loss as it was the result of an impairment. Accordingly, the gain is reduced by this amount to $2,520.

    Chris Co spreads this gain on the following basis:

    Year ending

    Gain or loss

    Balance

     

     

    $12,000

    30 June 2016

    $1,200 ($12,000 x 10%)

    $13,200

    30 June 2017

    $1,320 ($13,200 x 10%)

    $14,520

     

    $2,520 gain

     

    When the arrangement comes to an end, a Subdivision 230-G balancing adjustment is required to be calculated under section 230-445. The $1,200 impairment loss that was not deductible is not included at paragraph (c) of step one of the method statement in section 230-445.

    End of example
      Last modified: 10 Jun 2016QC 27222