E-14 Advanced Accounting and Financial Reporting - PowerPoint Presentation

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E-14 Advanced Accounting and Financial Reporting

Lecture 02IAS 8 Accounting Policies, Changes in Estimates and Correction of ErrorsIAS 18 RevenueIAS 37 Provisions, Contingent Liabilities and Contingent Assets

Sajid

Shafiq, ACASlide2

IAS-8 Overview

Objectives, Scope and DefinitionsSelection and Application of Accounting PoliciesChanges in Accounting PoliciesChanges in Accounting EstimatesPrior Period ErrorsImpracticability in respect of Retrospective Application and Retrospective RestatementClass Practice Questions

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03- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors

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Objectives, Scope and Definitions

30-Dec-1003- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors

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Objective & Scope

To enhance the relevance, reliability and comparability of financial statements

Should be applied by an entity to select and apply its accounting policies.

In addition, IAS 8 should be applied where an entity

changes

its accounting policies or estimates, and for the

correction

of errors arising in prior periods.

Definitions

Accounting policies

are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements.

A change in accounting estimate

is an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors.

Prior Period Errors

are omissions from, and misstatements in, the entity’s FS for one or more prior periods arising from a failure to use, or misuse of, reliable information that:

was available when financial statements for those periods were

authorised

for issue; and

could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements.

Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud.Slide4

Selection and Application of Accounting Policies

When an IFRS specifically applies to a transaction, other event or condition, the accounting policy or policies applied to that item shall be determined by applying the IFRS and considering any relevant Implementation Guidance issued by the IASB for the IFRS.In the absence of an IFRS that specifically applies to a transaction, other event or condition, management shall use its

judgement

in developing and applying an accounting policy that results in information that is:

relevant to the economic decision-making needs of users; and

reliable, in that the financial statements:

represent faithfully the financial position, financial performance and cash flows of the entity;

reflect the economic substance of transactions, other events and conditions, and not merely the legal form;

are neutral,

ie

free from bias;

are prudent; and

are complete in all material respects.

In making the

judgement

described above, management shall refer to, and consider the applicability of, the following sources in descending order:

the requirements and guidance in IFRSs dealing with similar and related issues; and the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the

Framework.30-Dec-1003- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors4Slide5

Changes in Accounting Policies

An existing accounting policy should only be changed where a new accounting standard requires such a change or where the new policy will result in reliable and more relevant information being presented.IAS 8 requires changes in accounting policies to be accounted for retrospectively except where it is not practicable to determine the effect in prior periods.

Retrospective application

is where the FS of the current period and each prior period presented are adjusted so that it appears as if the new policy had always been followed. This is achieved by restating the profits in each period presented and adjusting the opening position by restating retained earnings (i.e. cumulative profits held in the statement

Where it is

not practicable

to determine either the specific effect in a particular period or the cumulative effect of applying a new policy to past periods, the new policy should be applied from the earliest date that it is practicable to do so. of financial position as part of equity).

The reasons for and effects of a change in accounting policy should be disclosed

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03- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors

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Illustration 1

Multi Ltd commenced trading two years ago, on 1 January 2006, and adopted the accounting policy (then allowed by IAS 23 )of recognising all interest costs in profit or loss.Its draft statement of financial position at 31 December 2007, and its final statement of financial position for the previous year are as follows: 2007 2006 CUm

CUm

Property, plant and equipment 284 241

Other assets

899 900

1,183

1,141

Share capital 100 100

Retained earnings

year ended 2006 41 41

year ended 2007 42 -Liabilities 1,000 1,000

1,183

1,141Borrowing costs attributable to qualifying assets of CU10 million have been recognised in P/L in each year.The revised IAS 23 requires borrowing costs attributable to qualifying assets to be recognised as part of the cost of those assets. Multi Ltd has designated 1 January 2006as the date on which the new standard should be adopted.

30-Dec-1003- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors6This change in accounting policy should be applied retrospectively as follows (the tax implications as a consequence of this change and the potential impact on depreciation have been ignored for the purposes of this illustration):

Restated

2007 2006

Cum

CUm

Property, plant & equip

(284+10+10) / (241+10) 304 251

Other assets

899

900

1,203

1,151

Share capital 100 100

Retained earnings

year ended 2006 (41+10) 51 51

year ended 2007 (42+10) 52 -

Liabilities

1,000 1,000 1,203 1,151

Changes in Accounting PoliciesSlide7

Changes in Accounting Estimates

The preparation of FS requires many estimates to be made on the basis of the latest available, reliable information. Key areas in which estimates are made include, for example, the recoverability of amounts owed by customers, the obsolescence of inventories and the useful lives of non-current assets.

As more up-to-date information becomes available estimates should be revised to reflect this new information. These are changes in estimates and

are not

changes in accounting policies or the correction of errors

By its very nature the revision of an estimate to take account of more up to date information does not relate to prior periods. Instead such a revision is based on the latest information available and therefore should be

recognised

in the period in which that change arises. The effect of a change in an accounting estimate should therefore be

recognised

prospectively

, i.e. by

recognising

the change in the current and future periods affected by the change.

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03- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors

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Illustration 2

An entity’s accounting policy is to recognise assets at no more than their recoverable amounts. Consistent with this and based upon experience it has always provided in full against trade receivables which have been outstanding for five months or more.Because the economy is entering a period of recession, it reconsiders the recoverability of its receivables and decides to provide in full for amounts outstanding for four months or more. This is not a change in accounting policy. What has changed is the level of the receivables that are thought to be recoverable. This is a change in estimate.

Illustration 3

A machine tool with an original cost of CU100,000, has an originally estimated useful life of ten years, and residual value of nil. The annual straight-line depreciation charge will be CU10,000 per annum and the carrying amount after three years will be CU70,000.

If in the fourth year it is decided that, as a result of changes in market conditions, the remaining useful life is only three years (so a total of six years), then the depreciation charge in that year (and in the next two years) will be the carrying amount brought forward divided by the revised remaining useful life, CU70,000/3 = CU23,333. There should be no change to the depreciation charged for the past three years.

The effect of the change (in this case an increase in the annual depreciation charge from CU10,000 to CU23,333) in the current year, and the next two years, should be disclosed.

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03- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors

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Changes in Accounting EstimatesSlide9

Prior Period Errors

Examples of such errors are:mathematical errors; mistakes in applying an accounting policy;oversights or misinterpretation of facts; and

Fraud.

IAS 8 requires that these errors are adjusted in those

past periods

in which the error arose rather than in the current period. Adjustment in the current period would lead to a distorted result in the period in which the error was identified.

Retrospective

restatement corrects the FS as if the prior period error had never occurred.

If it is

impracticable

to determine the effect on an individual period of an error, then the adjustment should be made to the opening balance of the earliest period in which it is possible to identify such information.

It is important to

distinguish

between prior period errors and changes in accounting estimates. Accounting

estimates are best described as approximations, being the result of considering what is likely to happen in the future, for example how many customers will pay their outstanding invoices and the period over which non-current assets can be used productively within the business. By their very nature estimates result from judgments made on the basis of information available at the time they are made, so they may need to be adjusted in the future, in the light of additional information becoming available.

Prior period errors, on the other hand, result from

discoveries which undermine the reliability of the previously published FS, for example unrecorded income and expenditure, fictitious inventory or the incorrect application of accounting policies such as classifying maintenance expenses as part of the cost of non-current assets. Prior period errors should be rare.

30-Dec-1003- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors9Slide10

Prior Period Errors

Illustration 4During 20X2, Beta Co discovered that some products that had been sold during 20X1 were incorrectly included in inventory at 31 December 20X1 at CU6,500.Beta’s accounting records for 20X2 show sales of CU104,000, cost of goods sold of CU86,500 (including CU6,500 for the error in opening inventory), and income taxes of CU5,250.

In 20X1, Beta reported:

CU

Sales 73,500

Cost of goods sold

(53,500)Profit before income taxes 20,000

Income taxes

(6,000)

Profit

14,000

20X1 opening retained earnings was CU20,000 and closing retained earnings was CU34,000.

Beta’s income tax rate was 30 per cent for 20X2 and 20X1. It had no other income or

expenses.

Beta had CU5,000 of share capital throughout, and no other components of equity except for retained earnings. Its shares are not publicly traded and it does not disclose earnings per share.

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03- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors10Slide11

Prior Period Errors

Illustration 4Beta CoExtract from the Statement of Comprehensive Income (restated) 20X2 20X1

CU

CU

Sales 104,000 73,500

Cost of goods sold

(80,000) (60,000)

Profit before income

taxes 24,000 13,500

Income taxes

(7,200)

(4,050)

Profit

16,800 9,450

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03- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors11

Beta CoStatement of changes in equity

Share

Capital

CU

Retained

Earnings

CU

Total

CU

Balance at 31.12. X0

5,000

20,000

25,000

Profit for the year 31.12.X1 (

restated

)

9,450

9,450

Balance at 31.12.X1

5,000

29,450

34,450Profit for the year 31 .12. X216,80016,800

Balance at 31.12.X2

5,000

46,250

51,250Slide12

Prior Period Errors

Illustration 4Beta CoExtracts from the notesSome products that had been sold in 20X1 were incorrectly included in inventory at 31 December 20X1 at CU6,500. The financial statements of 20X1 have been restated to correct this error. The effect of the restatement on those financial statements is

summarised

below. There is no effect in 20X2.

Effect on

20X1

CU

(Increase) in cost of goods sold (6,500)

Decrease in income tax expense

1,950

(Decrease) in profit

(4,550)

(Decrease) in inventory (6,500)

Decrease in income tax payable

1,950(Decrease) in equity (4,550)

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03- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors12Slide13

Impracticability

Impracticable Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so. For a particular prior period, it is impracticable to apply a change in an accounting policy retrospectively or to make a retrospective restatement to correct an error if:the effects of the retrospective application or retrospective restatement are not determinable;

the retrospective application or retrospective restatement requires assumptions about what management’s intent would have been in that period; or

the retrospective application or retrospective restatement requires significant estimates of amounts and it is impossible to distinguish objectively information about those estimates that:

provides evidence of circumstances that existed on the date(s) as at which those amounts are to be

recognised

, measured or disclosed; and

would have been available when the financial statements for that prior period were authorized for issue

from other information.

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03- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors

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Class Practice Questions

30-Dec-1003- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors

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Mohani

Manufacturing Limited is engaged in manufacturing of spare parts for motor car assemblers. The audited financial statements for the year ended December 31, 2007 disclosed that the profit and retained earnings were Rs. 21 million and Rs. 89 million respectively. The draft financial statements for the year show a profit of Rs. 15 million. However, following adjustments are required to be made:

The management of the company has decided to change the method for valuation of raw materials form FIFO to weighted average. The value of inventory under each method is as follows:

In 2007, the company purchased a plant for Rs. 100 million. Depreciation on plant was recorded at Rs. 25 million instead of Rs. 10 million. This error was discovered after the publication of financial statements for the year ended December 31, 2007. The error is considered to be material.

Required:

Produce an extract showing the movement in retained earnings, as would appear in the statement of changes in equity for the year ended December 31, 2008.

FIFO

WEIGHTED AVERAGE

Rupees in million

December

31, 2006

37.0

35.5

December

31, 2007

42.3

44.5December 31, 200858.4

54.4Slide15

Class Practice Questions

30-Dec-1003- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors

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Winter

2006, Question No 4

XLS

Limited is a listed company and engaged in the assembling of

electrical appliances

. During the year,

the company

changed its accounting policies in respect

of the

following:

It

has started to capitalize the borrowing costs directly attributable to

the qualifying assets.

Upto June 30, 2005, the company recognized the borrowing costs as an expense in the year in which they were incurred.Provision for bad debts shall be provided at 3% instead of 2%.

The management feels that change of above policies will reflect a fair view of the company’s financial position to the shareholders. Extracts from the financial statements of the company before incorporation of above changes are given below: 2006 2005 Rs. in million Gross profit 486 410 General and administration expenses (231) (225) Selling and distribution expense (

110) (98)

Financial charges (32) (31) Profit

before tax 113 56 Income taxes (30) (14) Profit after tax

83 42

Retained earnings – opening 452 410 Retained earnings – closing 535 452Slide16

Class Practice Questions

30-Dec-1003- IAS 8 Accounting Policies, Changes in Estimates and Correction of Errors

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Winter

2006, Question No

4

Following

additional information is also available:

Details

of borrowing costs expensed out in current and prior periods which

are directly

attributable to the qualifying assets are as follows

:

The change in the rate of provision for bad debts has been made on the recommendation of Recovery Department. The company has not yet made the provision as of June 30, 2006. The details of accounts receivables are as

follows:

Accounts receivable as at June 30, 2005 Rs. 100 million

Accounts

receivable as at June 30, 2006 Rs. 123 millionProvision as at June 30, 2004 was Rs. 1.6 million.Income tax rate was 25% for both years.Required:Present the above changes in the Profit and Loss Account and Statement of Changes in Equity in accordance with the requirements of IAS-8 “Accounting Policies, Changes in Accounting Estimates and Errors”.Draft an accounting policy about the borrowing costs for disclosure in the financial statements.

(17)

Year

Amount Rs. in million

June 30, 2006

16

June 30, 2005

12

June 30, 2004 and before

8Slide17

IAS 18-Overview

Objectives, Scope and DefinitionsMeasurement of RevenueRecognition of Revenue:Sale of GoodsRendering of ServicesRevenue Generated on Entity AssetsPractical Application and ExamplesClass Practice Questions

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02- IAS 18 Revenue

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Objectives, Scope and Definitions

30-Dec-1002- IAS 18 Revenue18

Objective

Revenue is simply income that arises in the course of the ordinary activities of the entity and is often known by different names, including sales, turnover, fees, interest, dividends and royalties.

The primary issue in accounting for revenue is one of timing. When should an entity

recognise

revenue? The timing of the recognition is critical to the timing of profits.

IAS 18 states that revenue should be

recognised

when it is probable that the economic benefits associated with the transaction will flow to the entity and these benefits can be measured reliably.

Scope

Applies to:

the sale of goods, which includes both goods produced by the entity for sale and goods purchased directly for resale;

the rendering of services, which typically involves the performance of a contractually agreed task over an agreed period of time, except construction contracts which are dealt with in IAS 11; and

revenue earned from the use by others of the entity’s assets including interest, royalties and dividends earned by the entity.

Definitions

Revenue

is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.

Fair value

is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

Amounts collected on behalf of others, including sales taxes, value added taxes and amounts collected as agent on behalf of a principal, are excluded from the revenue figure.Slide19

Measurement of Revenue

IAS 18 sets out that revenue should be measured at the fair value of the payment, which may take a number of different forms (i.e. it is not limited to cash), received or receivable.The amount of the payment will normally be expressed in the agreement between the buyer and the seller. Revenue is measured

net of trade discounts

or

volume rebates

that are given.

Generally cash will be paid on receipt of the goods or services, or within a short credit period of, say, 30 days. However, where payment is deferred for a long period

of time to provide the buyer with an interest-free credit period, the deferred cash payment includes a form of financing. A typical example is a retail outlet selling furniture or household electrical equipment on a year’s interest-free credit. In such cases the entity will need to assess what the fair value of the payment is. This is determined by estimating what value the debt could be exchanged for between willing parties. The difference between the fair value and the actual amount paid will be classified as interest revenue. (

Present Value concept

)

Where the entity receives

similar

goods or services as payment this is essentially a ‘swap’ transaction. The entity is replacing one asset with another similar asset. In such cases

no revenue

is generated, with no additional cost reported. Such transactions are quite common in the sale of commodities, for example milk, with suppliers exchanging inventories to fulfill demand in a particular location.

When the payment is receivable in the form of

dissimilar goods or services, revenue is generated and costs should be recognised. In such cases the transaction is measured based on the fair value of what will be received. If it is not possible to measure the value of the goods or services received reliably, then the revenue should be based on the fair value of the goods or services supplied.

30-Dec-1002- IAS 18 Revenue19Slide20

Measurement of Revenue

Illustration 1A company sells goods to a customer for CU2,500 on 5 July 2007. Although delivery will take place as soon as possible, the company has given the customer an interest-free credit period of 12 months.The fair value of the consideration receivable is CU2,294. In other words, if

the company tried

to sell this in cash, it would expect to receive CU2,294 rather than CU2,500.

The balance of CU206 represents interest revenue.

Therefore the company should split the CU2,500 between revenue and interest.

Revenue of CU2,294 should be

recognised

on 5 July 2007, with the balance of CU206 being

recognised

as interest revenue over the 12-month credit period.

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02- IAS 18 Revenue

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Recognition of Revenue- Sale of Goods

IAS 18 sets out five conditions that need to be met before revenue from the sale of goods should be recognised. These five conditions are that: [IAS 18.14]The significant ‘

risks and rewards

’ of ownership have been transferred from the seller to the buyer. In a simple scenario this will be when the legal title or actual possession of the goods passes between the two parties. The retention of insignificant risks and rewards would not necessarily prevent the recognition of the revenue. This might be the case in the retail industry where an item may be returned and a refund provided;

The seller no longer has management involvement or effective control over the goods;

The amount of the revenue can be measured reliably;

It is probable that payment for the goods will be received by the entity. The effect of this is that the revenue in relation to credit sales is

recognised

before actual payment is received; and

The costs incurred, or to be incurred, in relation to the transaction can be measured reliably. It may be difficult to estimate the costs in relation to a transaction in certain circumstances; however that does not prevent a reliable estimate being made, and therefore should not stop revenue being

recognised

. The provision of a warranty is an example of this. If, however, it is not possible to estimate reliably the costs to be incurred, this precludes the recognition of revenue and therefore any payment received should be

recognised

as a liability.

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02- IAS 18 Revenue

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Recognition of Revenue- Sale of Goods

Continuing from condition 1 earlier, revenue should not be recognised until the ‘risks and rewards’ of ownership have been transferred to the buyer. The seller may retain significant risks and rewards of ownership in a number of ways. Examples of these are as follows:when the entity retains an obligation for unsatisfactory performance not covered by normal warranty provisions;

when the receipt of the revenue from a particular sale is contingent on the derivation of revenue by the buyer from its sale of the goods;

when the goods are shipped subject to installation and the installation is a significant part of the contract which has not yet been completed by the entity; and

when the buyer has the right to rescind the purchase for a reason specified in the sales contract and the entity is uncertain about the probability of return.

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02- IAS 18 Revenue

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Recognition of Revenue- Sale of Goods

Illustration 2A motor car is sold for CU20,000 on 1 March 2007, and includes a two-year manufacturer’s warranty. As a special promotion a deferred payment option is being offered by the manufacturer – ‘buy now, pay in 12 months’ time’. The dealer has a 31 December year end.The following steps are needed to account for the sale:

split the CU20,000 payment between the cash sale price and the effective interest;

recognise

the cash sale price as revenue on 1 March;

recognise

interest income for the 10 months’ credit given in the accounting period in which the sale is

recognised

;

recognise

the remaining 2 months’ interest in the following period;

production and selling costs will be

recognised

in the same period that the revenue relating to the sale of the motor car is

recognised;

a warranty provision will be set up in the period in which the revenue relating to the sale of the motor car is

recognised for expected costs under the warranty provision (in accordance with IAS 37 Provisions, contingent liabilities and contingent assets); andcosts incurred under the warranty provision will be charged to the warranty provision to the extent that the provision covers the costs. Any excess costs incurred will be recognised

in profit or loss and any balance remaining on the provision at the end of the second year will be released to profit or loss..30-Dec-1002- IAS 18 Revenue23Slide24

Recognition of Revenue- Rendering of Services

The criteria for the recognition of revenue in relation to the rendering of services are similar to those for the sale of goods. However, the criteria which refer to ownership (1&2) are clearly not relevant where services are being provided. Criteria 3 to 5 above are, however, equally relevant to the rendering of services. In addition, the entity should be able to assess accurately the stage of completion of the transaction. [IAS 18.20]IAS 18 specifically mentions three methods

of assessing the stage of completion but does not prohibit the use of other methods. The three methods are:

Surveys of work performed;

Assessing the services performed to date against the total services to be performed under the contract; and

Assessing the costs incurred to date against the total costs to be incurred under the contract.

It is generally not appropriate to

recognise

revenue based on payments received under the contract, as often stage payments set out under the terms of the contract bear little resemblance to the actual services performed.

If the overall outcome of a service transaction cannot be estimated reliably, then revenue is only

recognised

to the extent that costs incurred to date are recoverable from the customer.

If costs are not recoverable under the contract, revenue should not be

recognised

although costs incurred should be expensed.

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02- IAS 18 Revenue

24Slide25

Recognition of Revenue- Rendering of Services

Illustration 3An entity enters into a CU210,000 fixed price contract for the provision of services. At the end of 2007, the first accounting period, the contract is assessed as being one-third complete, and costs incurred to date are CU45,000.If costs to complete can be estimated reliably at CU90,000, the overall contract is profitable, as the total revenue of CU210,000 exceeds total costs (CU45,000 plus CU90,000). Revenue to be

recognised

in the first accounting period will be CU70,000, calculated as one-third of the total contract revenue. Costs of one-third of total estimated costs i.e. CU45,000 would also be

recognised

and matched against the related revenue.

If the costs to complete cannot be estimated reliably, then the outcome of the total contract cannot be estimated reliably, and revenue is

recognised

to the extent that the costs incurred are believed to be recoverable from the client.

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02- IAS 18 Revenue

25Slide26

Recognition of Revenue Generated on Entity Assets

Where an entity is able to measure reliably the revenue and that it expects to receive payment, the recognition of revenue generated on the use by others of the entity’s assets should be recognised as follows: [IAS 18.30]

Interest should be

recognised

on using effective interest rate method(IAS 39);

Dividends should be

recognised when the entity, as a shareholder, has a right to receive payment. This is usually when the dividends are approved in AGM; andRoyalties should be

recognised

on an accrual basis, i.e. they should be

recognised

as they fall due under the terms of the relevant agreement.

Important

[18.32]

When unpaid interest has accrued before the acquisition of an interest-bearing investment, the subsequent receipt of interest is allocated between

pre-acquisition and post-acquisition periods; only the post-acquisition portion is recognised as revenue.

30-Dec-10

02- IAS 18 Revenue26Slide27

Practical Applications and Examples

A- Consignment salesUnder such arrangements, the buyer takes delivery of the goods and undertakes to sell them on, on behalf of the original seller. Although the buyer takes delivery of the goods, he is in such circumstances really acting as an agent on behalf of the original seller. The original seller only recognises his sale when his buyer sells the goods on to a third party, since it is only at this point that the seller passes on the significant risks and rewards of ownership.

This treatment is also relevant in sale and return transactions, i.e. revenue should not be

recognised

until the goods are sold to third parties.

B- Subscriptions to publications

Where a series of publications are subscribed to and each publication distributed is of similar value, revenue should be

recognised

on a straight-line basis over the period of the subscription.

Where the value of each publication varies, revenue is

recognised

based on the value of the individual publication compared with the total subscription paid.

C- Advertising commissions

Revenue should be

recognised

for media commissions, for example running a series of advertisements, when the related advertising appears before the public.

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02- IAS 18 Revenue27Slide28

Practical Applications and Examples

D-Franchise feesFees which are received for the use of continuing rights, granted as part of a franchise agreement, should be recognised as revenue as the services are provided, or the rights are used.E- Agency transactions

No revenue is

recognised

when the party is acting as agent for another (the principal). In such transactions, the sale does not represent revenue of the agent who is, in fact, acting as

‘intermediary’ for another party. The agent is often paid a commission in such transactions,

and it is this commission receivable which is, instead, recorded as revenue for the agent.

F- Servicing fees included in the price of the product

When the sale price for goods includes an amount in relation to the ongoing servicing of the product, and the servicing element is identifiable, it should be deferred and

recognised

as revenue over the period of the service contract.

‘Bill and hold’ sales,

Goods shipped subject to installation and inspection.

Goods shipped subject to approval

Lay away sales

Sale and repurchase agreements

30-Dec-1002- IAS 18 Revenue

28Slide29

Class Practice Questions

30-Dec-1002- IAS 18 Revenue29

The Grand Company placed an order with The Little Company for new specialist machinery. The order was non-cancellable once signed and Grand agreed to pay for the machinery at the time the order was signed on 1 February 20X7. little held the machinery to Grand’s order form 1 June 20X7, the date on which it was completed.

Grand commenced using the machinery on 1 August 20X7 when Little completed the installation process. Little had staff on standby to deal with any operating problems until the warranty period ended on 1 November 20X7.

Under IAS 18 Revenue, Little should

recognise

the revenue from the sale of this specialist machinery on

A

1 February 20X7

B

1 June 20X7

C

1 August 20X7

D

1 November 20X7

________________________________________________________________________________

The

Marfak

Company provides service contracts to customers for maintenance of their electrical systems. On 1 October 20X8 it agrees a four-year contract with a major customer for CU154,000.

Costs over the period of the contract are reliably estimated at CU51,333.

Under IAS 18 Revenue, how much revenue should the company

recognise

in profit or loss in the year ended 31 December 20X8?

A

CU9,625

B

CU38,500

C

CU3,208

D

CU12,833 Slide30

Class Practice Questions

30-Dec-1002- IAS 18 Revenue30

On 1 January 20X8 The Violet Company signs a four-year fixed-price contract to provide services for a customer. The contract value is CU550,000.

At 31 December 20X8 the contract is thought to be 30% complete. Costs to complete the contract cannot be reliably estimated and costs incurred to date of CU152,000 are recoverable from the customer.

What is the revenue to be

recognised

in profit or loss for the year ended 31 December 20X8, according to IAS 18 Revenue?

A

CU13,000

B

CU152,000

C

CU137,500

D

CU165,000

______________________________________________________________________________

On 1 July 20X7 The

Otakamiro

Company handed over to a client a new computer system. The contract price for the supply of the system and after-sales support for 12 months was CU800,000.

Otakamiro

estimates the cost of the after-sales support at CU120,000 and it normally marks up such costs by 50% when tendering for support contracts.

Under IAS 18 Revenue, the revenue

Otakamiro

should

recognise

in its financial year ended 31 December 20X7 is

A

CU620,000

B

CU800,000

C

CU710,000

D

NilSlide31

Class Practice Questions

30-Dec-1002- IAS 18 Revenue31

Model Security Limited (MSL) is a supplier of high quality security systems. The company also provides services for maintenance of the systems. Following are some of the transactions which were carried out in January, 2007:

Two systems were delivered to a customer on January 05, 2007. According to the terms of sale, MSL was required to install the systems within three months. The installation work was completed on February 28, 2007. Sale price and installation charges of Rs. 60,000 and Rs. 25,000, respectively, had been paid by the customer in advance.

A service contract was signed under which MSL was required to provide repair and maintenance with parts and accessories. A non-refundable annual fee amounting to Rs. 60,000 was received as advance on January 01, 2007.

A firm contract was signed, for supply of sixty systems at a price of Rs. 55,000 each. The systems were required to be altered for the customer’s specific requirement. It was agreed that in case of cancellation, the customer will have to pay a compensation equal to 25% of the total agreed price. MSL has estimated that it would have to bear a cost of Rs. 12,000 to bring the systems in general saleable condition. According to the agreement, the customer had paid 25% advance on January 17, 2007.

Three systems have been delivered and installed at the office premises of Mr. Fine, a close friend of Chief Executive Officer (CEO), on January 08, 2007. The accountant has not recorded the sale, as the amount of discount has not been decided by the CEO. List price of each system is Rs. 2.5 million.

Required:

With reference to IAS 18 (Revenue) explain how and when the sale should be recorded in each of the above case.Slide32

32

02- IAS 18 RevenueSlide33

IAS-37 Overview

Objectives, Scope and DefinitionsRecognition of ProvisionsContingent Liabilities and Contingent AssetsMeasurementReimbursements and other mattersAppendix C and D(not included)Class Practice Questions

30-Dec-10

07- IAS 37 Provisions, Contingent Liabilities and Contingent Assets

33Slide34

30-Dec-10

07- IAS 37 Provisions, Contingent Liabilities and Contingent Assets34Objectives, Scope and Definitions

Objective

The objective of this Standard is to ensure that appropriate

recognition

criteria and

measurement

bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is

disclosed

in the notes to enable users to understand their nature, timing and amount.

Scope

This Standard shall be applied by all entities in accounting for provisions, contingent liabilities and contingent assets, except:

those resulting from

executory

contracts, except where the contract is onerous; and

those covered by another Standard. (IAS 11, 12, 17, 19, IFRS 4)

Some amounts treated as provisions may relate to the recognition of revenue, for example where an entity gives guarantees in exchange for a fee. This Standard does not address the recognition of revenue.

This Standard defines provisions as liabilities of uncertain timing or amount. At times ‘provision’ is also used in the context of items such as depreciation, impairment of assets and doubtful debts: these are adjustments to the carrying amounts of assets and are not addressed in this Standard.

This Standard applies to provisions for restructurings (including discontinued operations).

Definitions

Executory

contracts

are contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent

A

provision

is a liability of uncertain timing or amount.

A

liability

is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.Slide35

30-Dec-10

07- IAS 37 Provisions, Contingent Liabilities and Contingent Assets35

Definitions

An

obligating event

is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.

A

legal obligation

is an obligation that derives from:

a contract (through its explicit or implicit terms);

legislation; or

other operation of law.

A

constructive obligation

is an obligation that derives from an entity’s actions where:

by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; &

as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

A

contingent liability

is:

a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or

a present obligation that arises from past events but is not

recognised

because:

it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or

the amount of the obligation cannot be measured with sufficient reliability.

A

contingent asset

is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

An

onerous contract

is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.

A

restructuring

is a programme that is planned and controlled by management, and materially changes either:

the scope of a business undertaken by an entity; or

the manner in which that business is conducted.Slide36

Recognition of Provisions

A provision shall be recognised when:an entity has a present obligation (legal or constructive) as a result of a

past event

;

it is probable that an

outflow

of resources embodying economic benefits will be required to settle the obligation; anda

reliable estimate

can be made of the amount of the obligation .

If these conditions are not met, no provision shall be

recognised

.

30-Dec-10

07- IAS 37 Provisions, Contingent Liabilities and Contingent Assets

36

Future operating losses

A provision should

NOT

be

recognised

in respect of future operating losses since there is no present obligation arising from a past event. However, an expectation that the entity will incur future operating losses may indicate that there has been an impairment (a reduction in value) of assets, and an impairment review should be carried out.

Onerous contracts

The excess unavoidable costs should be provided for at the time the contract becomes onerous. The entity has an obligation to meet these future costs as a result of signing the original contract, it will be required to pay them and they can be measured reliably.

Where an onerous contract has been identified, an impairment review should be carried out before a provision is

recognised

.

When making a best estimate of the provision for an onerous contract the entity should take into account an estimate of any likely income that will be received under the contract.

Restructuring

A constructive obligation to restructure an entity only arises when:

a detailed formal plan has been made. (location, number of employees , cost, time; and

an announcement to those to be affected made.

A restructuring provision should only include direct expenditure arising from the restructuring. Costs which relate to the future activities of the entity should not be provided for as part of the restructuring, for example relocating or retraining staff.Slide37

Recognition of Provisions- Onerous Contracts

Illustration 1An entity entered into a 10 year lease of a building. The annual rent under the lease agreement is CU36,000. The entity has decided to relocate its head office with 5 years still to run on the original lease. The entity is permitted to sublet the building and believes that, although market rentals have decreased, it should be able to sublet the building for the full 5 years. The expected rental is CU24,000 per annum.

A provision should be

recognised

for the excess costs under the lease contract above the expected benefits to be received. The obligating event was the signing of the lease

agreement and CU36,000 is required to be paid in each of the remaining 5 years.

A provision for the following amount should be

recognised

:

Annual outflow CU36,000

Annual expected inflow

CU24,000

Excess annual outflow expected

CU12,000

A provision of CU60,000 (CU12,000 x 5 years) should be recognised.

Note: all other costs and the time value of money have been ignored.

30-Dec-1007- IAS 37 Provisions, Contingent Liabilities and Contingent Assets

37Slide38

Contingent liabilities and contingent assets

A contingent liability or asset should be disclosed in the financial statements rather than being recognised in the statement of financial position. A contingent liability

should be

disclosed

unless

the possible outflow of resources to meet the liability is remote. If the outflow is thought to be remote, no disclosure is required.

A contingent asset

should be disclosed when the expected inflow of economic benefits is probable. An example of a contingent asset is a legal claim that the entity is pursuing, where the outcome is uncertain although it is probable that the entity will gain some financial benefit from it.

Where the outflow of resources is

probable

, a provision should be

recognised

rather than a contingent liability disclosed. However, in relation to assets a ‘probable’ inflow of economic benefits only results in the disclosure of a contingent asset; for an asset to be

recognised

, the inflow of benefits should be ‘virtually certain

’.

30-Dec-1007- IAS 37 Provisions, Contingent Liabilities and Contingent Assets

38Slide39

Measurement

30-Dec-1007- IAS 37 Provisions, Contingent Liabilities and Contingent Assets

39

Best Estimate

This is the amount an entity would

rationally

pay to settle the obligation or to transfer it to a third party.

Management will generally be required to make a number of

judgements

to arrive at a best estimate for a provision.

Judgements

should be supplemented by experience of similar transactions and, where appropriate, by advice from independent

experts

.

The outcome of events occurring after the reporting period should be taken into account in making estimates,

Where there are a number of possible outcomes probability weightings should be used. If the best estimate for a single obligation is CU10,000, and there is a 55% chance of the expenditure being incurred, then the best estimate is CU10,000, not 55% of CU10,000.

When making an estimate management will need to take into account the risks and uncertainties surrounding the likely outcome

Present Value

The expenditure required to settle an obligation may occur within a

short period

after the end of the reporting period, in which case the time value of money can be ignored.

However, if the outflow of resources is expected to occur a

significant time

after the obligation itself arose, the effect of the time value of money should be taken into account in estimating the provision.

A

pre-tax rate

discount rate should be used

reflecting the current assessments of the time value of money and the risks specific to the liability. The unwinding of the discount each period should be

recognised

as a finance cost in profit or loss.

Other Points

It is possible that the amount required to settle an obligation will be dependent on a number of future events.

For example, where it is expected that there will be technological advances that will reduce, say, future clean up costs, the expected effect of these future events should be taken into account in assessing the provision.

Gains from the expected disposal of assets should not be taken into account in measuring a provision.

IAS 37 does not override other standards, so such gains should be dealt with under the relevant standard. For plant and equipment the relevant standard is IAS 16Slide40

Measurement

Illustration 2A business sells goods which carry a one-year repair warranty. If minor repairs were to be required on all goods sold in 2007, the repair cost would be CU100,000. If major repairs were needed on all goods sold, the cost would be CU500,000.It is estimated that 80% of goods sold in 2007 will have no defects, 15% will have minor defects, and 5% will have major defects.The provision for repairs required at 31 December 2007 is:

CU

80% of the goods will require no repairs -

15% will require minor repairs 15% x CU100,000 15,000

5% will require major repairs 5% x CU500,000

25,000

Best estimate of provision required

40,000

30-Dec-10

07- IAS 37 Provisions, Contingent Liabilities and Contingent Assets

40Slide41

Reimbursement and Other Matters

ReimbursementsAn entity may be able to look to another party, such as an insurance company or a supplier under a warranty, for reimbursement of all or part of the entity’s expenditure to settle a provision. IAS 37 requires that the reimbursement should be

recognised

only when it is

virtually certain

that the amount will be received. If it is only probable that a reimbursement will be received then the amount is considered to be a contingent asset and will be disclosed.

A reimbursement asset should be reported as a separate asset

in the SFP and

not netted

against any outstanding provision. The recognition of any reimbursement asset is

restricted

to the amount of the related provision.

The two amounts may be netted off in the SCI.

Illustration 3

An entity has received a claim for damaged goods from a customer. The entity’s legal advisors believe that it is probable that a settlement will need to be made of CU10,000 in favour

of the customer. However, in their opinion it is also probable that a counterclaim by the entity against their supplier for contributory negligence would successfully recover the damages.

A provision should be made for CU10,000 as the outflow of economic benefits is probable. The counterclaim asset is not recognised since it is only probable that it will be received. It can only be recognised when it is virtually certain to be received. It should be disclosed as a contingent asset.

30-Dec-1007- IAS 37 Provisions, Contingent Liabilities and Contingent Assets41Other mattersIAS 37 requires provisions to be reviewed at the end of each reporting period and adjusted to reflect the most up to date information about the estimate. If at the end of the reporting period it is assessed that a transfer of economic benefits is no longer probable, the provision should be reversed. A provision should only be utilised against the expenditure which it was originally set up for. Slide42

Class Practice Question

30-Dec-1007- IAS 37 Provisions, Contingent Liabilities and Contingent Assets

42

You are the Chief Financial Officer of Breeze Limited, a newly incorporated company which manufactures portable air conditioners. The company has started commercial production on September 01, 2006. While reviewing the financial statements on July 31, 2007 before presentation to the board of directors for approval, you found that the following information has not been dealt with in the financial statements:

While constructing the factory building it was agreed with the Union Council of the area that any damage caused to a nearby school will be restored by the company. As a gesture of goodwill the company had also offered that a donation of Rs. 500,000 would be given to the school provided the Union Council also gives a similar grant. On the balance sheet date, it was almost certain that the Union Council would pay the grant. The damage caused by construction was restored at a cost of Rs. 650,000 in July 2007. The Union Council paid the grant of Rs. 500,000 to the school in July 2007.

Within six months from the start of commercial production, the company was required to maintain an in-house workers' canteen and provide subsidized meals to its workers. The cost of construction of such canteen was Rs. 800,000; whereas cost for running the canteen was Rs. 142,000 per month. The company failed to comply with the requirement of the law. The concerned authority took a serious note of the situation and issued a show cause notice on July 18, 2007. To avoid adverse consequences the company decided to start construction of the canteen immediately. It was also decided that during the construction period, the company would reimburse the full amount of meal expenses of its workers. The construction is expected to be completed on August 30, 2007.

The company allows full refund if the goods sold by it are returned within two months from the date of sale. According to the best estimate, the goods return ratio is 10 percent. The returned goods can be sold in second hand market at cost which is 60% of the selling price. The accounts were appropriately adjusted on June 30, 2007 based on the above estimates. The actual returns and the relevant information is summarized below:

Required:

Discuss each event in the light of the relevant International Accounting Standards and suggest how these should be dealt in the financial statements for the year ended June 30, 2007.Slide43

Gold Shoes Limited, a company engaged in manufacturing of pure and artificial leather shoes has been facing a sharp decline in their profits for few years due to severe competition from shoes imported from China. The board of directors of the company formed a committee of executives to look into the matter. A detailed plan was submitted by the committee, which was considered and approved by the board on May 08, 2006. The approved plan has been circulated to members and other stakeholders. The following activities have taken place subsequently:

Production of artificial leather shoes was discontinued and new designs of leather shoes were introduced from July 06.Some processing units having book value of Rs. 35 million (m)have been sold, at a price of Rs. 31 m in July 2006.

Some employees were terminated in June 2006 for which payment of compensation of Rs. 10.5 m is agreed with the union in July 2006.

Co.’s legal advisor has been asked to prepare various sale agreements of fixed assets and stocks, preparation of memorandums of understanding with the distributor and worker union etc. related to discontinued business. The legal advisor charged Rs. 0.2 m as fee in addition to his monthly

retainership

fee amounting to Rs. 0.05 m in July 2006.

Stock of artificial leather shoes available in Co’s store on June 30, 2006 was sold in 1

st

week of July 2006 to the sole distributor of the company at an agreed price of Rs. 12 m as against the cost incurred by the Co. amounting to Rs. 11 m.

In July 2006 total assets of

Peshawer

office, having carrying value of Rs. 1.8 m on June 30, 2006 were agreed to be sold to a party for Rs. 2 m.

Purchase of additional machinery costing Rs. 3 m was approved in July 2006, for which a valid and firm quotation was received from the supplier in June 2006.

Manager of

Peshawer

office was transferred to Islamabad due to closure of

Peshawer office in July 2006. A relocation compensation of Rs. 0.5 m is agreed.Certain workers of the discontinued unit were given the option to continue their employment subject to successful completion of a specific training. They completed the required training in June 06. In July 06 the company as a gesture of good relations reimbursed 75% of their training expenditure, which amounted to Rs. 0.50 m.

It has been estimated, with reasonable accuracy, that as a result of the sale promotion and marketing costs of new designs of shoes, there will be an operating loss of Rs. 8 m by the time the whole process is completed (around Dec06).Required:Describe with reasons how each of the above activity would be recorded or disclosed in the financial statements for the year ended June 30, 2006. (You are not required to give journal entries.)30-Dec-1007- IAS 37 Provisions, Contingent Liabilities and Contingent Assets43

Class Practice Question