Common errors in financial reporting and audit quality: Dealing with complex and judgemental transactions and arrangements

Previously, we looked at some common errors in the application of IFRS® Accounting Standards and Australian Accounting Standards (AAS) that typically arise from the failure to properly apply the scope and definition criteria. In this article, we examine the types of complex and judgemental accounting transactions that should be documented in accounting position papers and the risks of failing to do so. 

Transactions with multiple components and alternative accounting treatments

Complex financial instruments, such as convertible notes, simple agreements for future equity (SAFE) notes, and preference shares, are often incorrectly accounted for. This is invariably because they comprise at least two components that may need to be accounted for separately on different measurement bases, subject to their contractual terms and the relevant accounting requirements.

Finance teams involved in issuing debt instruments typically understand that they should account for such instruments as financial liabilities, particularly when the instrument has a specified repayment date. Some finance teams, however, still regard conversion features that enable the instrument to be settled by the issuer issuing ordinary shares as equity in nature, irrespective of the conversion terms.

Conversion features that typically fail the ‘fixed for fixed’ criteria in IAS 32 Financial Instruments: Presentation (and therefore do not qualify for classification as equity) include:

• A conversion ‘price’ based on the issuer’s share price on the conversion date
• A conversion price based on the issuer’s share price, but subject to a ‘cap’ and/or a ‘floor’ price, and
• ‘Down round’ features that adjust the conversion ratio (number of ordinary shares issued per convertible note) subject to the issuer issuing ordinary shares at a price that is less than the conversion price.

All of these features, and their accounting implications, are discussed further in our BDO Global publication IFRS Accounting Standards in Practice – Accounting for convertible notes.

The failure to correctly account for complex financial statements can have significant impacts on the following items:

• Total debt, total equity and therefore debt-to-equity ratios
• Interest expense, and
• Fair value gains and losses.

Given the complexity of some financial instruments and the potential for some components to be separately accounted for at fair value through profit or loss, it’s important for entities to agree with their auditors:

• The classification of complex financial instruments and their individual components (such as conversion features and embedded derivatives), and
• The measurement requirements applicable to those separately identifiable components (amortised cost or fair value through profit or loss).

The most effective way of achieving this is through a well-researched and well-constructed accounting position paper.

Transactions involving multiple written agreements

It’s not unusual to find an entity has entered into more than one written agreement with the same counterparty for the provision of related goods and services. Various IFRS Accounting Standards and AAS anticipate such circumstances by requiring entities to assess and, if applicable, account for two or more separate legal contracts as a single unit of account.

Similar guidance can be found in paragraph B2 of IFRS 16 Leases and the Implementation Guidance to IFRS 9 Financial Instruments.

In addition to facilitating accounting for the substance of the transaction, combining related contracts and treating them as a single transaction can reduce the risks that transactions are structured to achieve accounting outcomes that wouldn’t otherwise have been achievable. The following example demonstrates this.

Example

Company A has engaged Company B to construct an outdoor entertainment area on the head office grounds for staff functions. This will involve Company B providing seats and tables, installing cooking facilities, and undertaking landscaping works. The work will commence in early June, and Company B has a 30 June reporting date.

To maximise the revenue Company B reports in the current reporting period, Companies A and B agree that the relevant written agreement will attribute an amount to the seats and tables that is greater than the amount Company A would otherwise pay for them (because they will be delivered before 30 June) and the other written agreements will attribute lesser amounts to the installation of the cooking facilities and landscaping (which is expected to be delivered after 30 June). Nevertheless, the payment milestones will remain as originally agreed.

Documentation in an accounting position paper of the proposed accounting treatment of the contract as a whole can facilitate the identification and explanation of:

• The relevant written contracts and the relationships between them
• The reasons for treating all the relevant written contracts as a single unit of account, and
• How the ‘Five Step’ model in IFRS 15 would apply to ensure that Company B recognises revenue to depict the transfer of the promised goods and services in an amount that reflects the consideration to which Company B expects to be entitled in exchange for those goods or services.

Substance over form

For various reasons, some of which are unrelated to the accounting implications, transactions might be conducted in ways that are not representative or reflective of their underlying substantive purpose or features. For instance, in 2019, the IASB’s Interpretation Committee (IFRIC) considered a submission about the sale of a single asset containing real estate. The submission outlined the following fact pattern:

Company A builds and sells real estate as part of its ordinary activities

• Company A establishes a legal entity (‘RE entity’) for each real estate asset (i.e. land and buildings) when it acquires the land and before it enters into contracts with customers for the sale of the land
• RE entity only holds the real estate asset and any related tax asset or liability
• At the time the RE entity is established, Company A determines that the RE entity is a subsidiary in accordance with IFRS 10 Consolidated Financial Statements
• In selling the real estate to a customer, the entity transfers its 100% equity interest in the RE entity to the customer. That is, legally, Company A sells shares in the RE entity, not the underlying real estate asset, to the customer, and
• As a consequence of the transaction, Company A loses control of the real estate.

The main accounting issue the IFRIC addressed was whether Company A should account for the sale of an RE entity under IFRS 10 (i.e. as a sale of a subsidiary) or IFRS 15 (i.e. as a sale of a good as part of Company A's ordinary activities).

The submission was subsequently referred to the IASB, and in June 2020, the IASB decided not to add a narrow-scope project to its work plan on the matter at that time. Following the Post-Implementation Review of IFRS 10, the IASB decided to take no further action on this topic.

Notwithstanding that neither the IFRIC nor the IASB provided any substantive guidance on how the sale of a single asset containing real estate should be accounted for, the submitter avoided the key missteps that we identified in last month’s article, being:

• Overlooking other potentially relevant standards and focusing only on the one that appears to apply, and  
• Failing to fully explore and evaluate the specific context of the transaction or event, the nature and objectives of the entity, and the purpose and consequences of the transaction. 

This is because the submitter clearly documented the fact pattern and assessed the applicability of all the relevant IFRS Accounting Standards and AAS.

New and evolving transactions and arrangements

As noted in our March and April 2025 articles, changes in products and markets over time undermine the capacity of IFRS Accounting Standards and AAS to provide unambiguous accounting guidance. Evidence of this can be found in recent pronouncements and announcements by the profession on:

• Accounting for cryptocurrencies and other digital assets
• Accounting for costs incurred in ‘software as a service’
• Accounting for the costs of artificial intelligence (AI), and
• Accounting for power purchase arrangements.

In order to demonstrate financial reporting hygiene, and good governance more broadly, entities should prepare robust accounting position papers to support their accounting treatment of any accounting transactions or events for which there are no directly applicable accounting pronouncements.

Looking ahead 

Next month, we’ll explore what a good accounting position paper looks like and examine the value proposition of a good accounting position paper.

Need help? 

BDO provides expert support for entities preparing for audits or drafting accounting position papers. For assistance contact BDO’s IFRS & Corporate Reporting team.