ACCA F7 (INT) Financial Reporting - Study text - 2010

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Chapter 2: Recognition and measurement

 offsetting reflects the economic substance of a transaction. An example specified

in IAS1 is reporting of a gain or loss on disposal of a non-current asset at sale

value minus the carrying value of the asset and the related selling expenses.

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Recognition in the financial statements: IASB Framework

 Probability of future economic benefit flowing in or out

 Reliability of measurement

 Recognition of assets, liabilities, income and expenses

 Measurements of elements of financial statements

2 Recognition in the financial statements: IASB

Framework

The IASB Framework states that an element (asset, liability, equity, income or

expense) should be recognised in the statement of financial position or income

statement when it:

 meets the definition of an element, and also

 satisfies certain criteria for recognition.

Items that fail to meet the criteria for recognition should not be included in the

financial statements. However, some if these items may have to be disclosed as

additional details in a note to the financial statements.

The criteria for recognition are as follows:

 It must be probable that the future economic benefit associated with the item

will flow either into or out of the entity.

 The item should have a cost or value that can be measured reliably.

2.1 Probability of future economic benefit flowing in or out

The concept of probability relates to the degree of certainty or uncertainty that the

future economic benefit associated with the item will flow into or out of the entity.

The degree of certainty or uncertainty should be assessed on the basis of the

evidence available at the time the financial statements are prepared.

For example, if it is considered fairly certain that a trade receivable will be paid at a

future date, it is appropriate to recognise the receivable as an asset in the statement

of financial position. However, there is probably a reasonable degree of certainty

that some trade receivables will become bad debts and the economic benefit will not

flow into the entity. It would then be appropriate to recognise an ‘expense’ for the

expected reduction in economic benefits (as an allowance for doubtful debts).

2.2 Reliability of measurement

An item should be recognised in the financial statements only if it has a cost or

value that can be measured with reliability.

Chapter 2: Recognition and measurement

In many cases, the value of an item has to be estimated because its value is not

known with certainty. Using reasonable estimates is an essential part of preparing

financial statements, and provided that the estimates are reasonable, it is

appropriate to recognise items in the financial statements.

However, if it is not possible to make a reasonable estimate, the item should be

excluded from the statement of financial position and income statement.

An item that cannot be estimated with reliability at one point in time might be

estimated with greater certainty at a later time, when it would then be appropriate

to include it in the financial statements.

2.3 Recognition of assets, liabilities, income and expenses

Recognition of assets

An asset is recognised in the statement of financial position when there is an

increase in future economic benefits relating to an increase in an asset (or a

reduction in a liability) which can be measured reliably.

An asset should not be recognised when expenses have been incurred but it is

unlikely that any future economic benefits will flow to the entity. Instead, the item

should be treated as an expense, and its cost should be ‘written off’.

Recognition of liabilities

A liability is recognised when it is probable that an outflow of resources that

embody economic benefits will result from the settlement of a present obligation,

and the amount of the obligation can be measured reliably.

Recognition of income

Income is recognised in the income statement when an increase in future economic

benefits arises from an increase in an asset (or a reduction in a liability) and this can

be measured reliably.

Note that this is approach to income recognition is based on changes in assets or

liabilities in the statement of financial position. It is what has been called a ‘balance

sheet approach’ to income and expense recognition. Income is recognised as an

increase in an asset (for example, cash or trade receivables) or a simultaneous

reduction in a liability (for example a bank overdraft).

Recognition of expenses

Expenses are recognised in the income statement when a decrease in future

economic benefits arises from a decrease in an asset or an increase in a liability,

which can be measured reliably.

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Again, note that this is a ‘balance sheet approach’ to the recognition of expenses. An

expense is recognised at the same time as an increase in a liability (for example,

trade payables) or a reduction in an asset (for example, cash).

Expenses are recognised in the income statement by means of a direct association

between items of income and the expenses incurred in creating that income.

 Matching of costs and income involves the simultaneous recognition of

revenues and related expenses.

 When economic benefits arise over several accounting periods, and the

association with income can only be decided in broad terms, expenses should be

recognised in the income statement of each accounting period on the basis of

‘systematic and rational allocation procedures’. For example, depreciation

charges for a non-current asset are allocated between accounting periods on a

systematic and rational basis, by means of an appropriate depreciation policy

and depreciation method.

 When an item of expenditure is not expected to provide any future economic

benefits, it should be recognised immediately as an expense in the income

statement. When the future economic benefits associated with an asset are no

longer expected to arise, the value of the asset is written off, and the write-off is

treated as an expense.

 An expense may also be recognised when a liability arises without the

recognition of any matching asset. For example, a liability might arise when an

entity recognises that it will have to make a payment to settle a legal dispute.

The cost of the future liability is treated as an expense in the period when the

liability is recognised.

2.4 Measurements of elements of financial statements

The IASB Framework states that several measurement bases are used for the

elements in financial statements. These include:

 Historical cost. Assets are measured at the amount of cash paid, or at the fair

value of the consideration given to acquire them. Liabilities are measured at:

− the amount of proceeds received in exchange for the obligation (for example,

bank loan or a bank overdraft), or

− the amount of cash that will be paid to satisfy the liability.

 Current cost or current value is the basis used in current value

accounting/current cost accounting. Assets are measured at the amount that

would be paid to purchase the same or a similar asset at the current time.

Liabilities are measured at the amount that would be required to settle the

obligation at the current time.

 Realisable value (or settlement value). This method of measurement is relevant

when an entity is not a going concern, and is faced with liquidation (and a

forced sale of its assets). Assets are measured at the amount that could be

obtained by selling them. Liabilities are measured at the amount that would be

required to settle them at the current time.

 Present value. Assets might be measured at the value of the future net cash

inflows that the item is expected to generate, discounted to a present value.

Chapter 2: Recognition and measurement

Similarly, a liability might be measured at the discounted present value of the

expected cash outflows that will be made to settle the liability.

Historical cost is the most commonly-used measurement basis. However, the other

bases of measurement are often used to modify historical cost. For example,

inventories are measured at the lower of cost and net realisable value.

The IASB Framework does not favour one measurement base over the others.

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IAS18: Revenue

 The purpose of IAS18

 Measurement of revenue

 Sale of goods: revenue recognition

 Rendering of services: revenue recognition

 Interest, royalties and dividends: revenue recognition

 IAS18: disclosure requirements

3 IAS18: Revenue

3.1 The purpose of IAS18

The IASB Framework has a so-called ‘balance sheet approach’ to revenue

recognition. It states that revenue is recognised in the income statement when:

 there is an increase in future economic benefits related to an increase in an asset

or a decrease in a liability, and

 this increase in economic benefits can be reliably measured.

Revenue is income that arises in the ordinary course of activities and it is referred to by

a variety of different names including sales, fees, interest, dividends and royalties.

IAS18 Revenue deals in more detail than the Framework with the measurement and

recognition of revenue. It defines revenue as ‘the gross inflow of economic benefits

during the period 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.’

It adds that revenue relates only to economic benefits receivable by the entity for its

own account. Amounts collected on behalf of a third party, such as sales tax

collected on behalf of the government, must be excluded from revenue because they

do not result in an increase in equity.

3.2 Measurement of revenue

IAS18 states that revenue must be measured at ‘the fair value of the consideration

received or receivable’. Broadly speaking, this is the fair market price less any

volume rebates (discount allowed for buying in large quantities) or ‘trade discount

allowed’.

 If a sale is a cash sale, the revenue is the immediate proceeds of the sale.

 If a sale is a normal credit sale, the revenue is the expected future receipt.

However, in some cases when the payment is deferred, the fair value might be less

than the amount of cash that will eventually be received. For example, a company

Chapter 2: Recognition and measurement

might sell goods and give the customer interest-free credit. Giving interest-free

credit is a financing transaction, and the revenue recognised should be the

discounted present value of the future receipts.

The difference between the nominal sale value and the fair value of the

consideration is recognised as interest income.

Example

An entity sells an item to a customer for $55,000. The customer is allowed 12 months

of interest-free credit. The sale is made on the last day of the entity’s financial year.

The discount rate appropriate for the transaction is 10%, and the discounted present

value of the future receipt is $50,000.

In this situation, the revenue from the sale will be recorded as $50,000 in the year of

the sale. In the following year, there will be additional interest income of $5,000.

3.3 Sale of goods: revenue recognition

IAS18 specifies when revenue should be recognised for the sale of goods. An entity

may recognise revenue from the sale of goods only when all of the following

conditions have been met:

 The entity has transferred to the buyer the ‘significant risks and rewards of

ownership of the goods’. This normally occurs when legal title to the goods or

possession of the goods passes to the buyer.

 The entity does not retain effective control over the goods sold, or retain a

continuing management involvement to the degree usually associated with

ownership.

 The amount of revenue can be measured reliably.

 It is probable that economic benefits associated with the transaction will flow to

the entity.

 The costs incurred (or to be incurred) for the transaction can be measured

reliably.

Examples

(1) Goods are sold by a manufacturer to a retailer, who has the right to return the

goods if it is unable to sell them. (The goods are supplied on a ‘sale or return’

basis.)

Revenue should not be recognised by the manufacturer if receipt of payment

from the customer is contingent on the customer being able to sell the goods.

The manufacturer still retains significant risks of ownership. Revenue should

be recognised when the customer sells the goods, and not before.

(2) A manufacturer of machinery ships machine parts to a business customer for

installation. The machine has not yet been installed. The manufacturer will do

the installation work and the cost of the installation work will be a significant

part of the total cost of the contract.

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Revenue should not yet be recognised because the seller still retains

significant risks and rewards of ownership.

(3) Goods have been sold on credit to a customer in a country where there has

been a major political change, and there is now a ban in that country on

payments to other countries.

Revenue should not yet be recognised. It is not yet probable that the economic

benefits associated with the transaction (payment by the customer) will flow to

the seller.

(4) An entity receives $25,000 as an advance payment for goods that have not yet

been manufactured.

Payment in advance is not recognised as revenue. The money received should

be included as a current liability in the balance sheet. (Debit Cash $25,000,

Credit Payments received in advance $25,000).

Revenue recognition and substance

Financial statements must present fairly the effects of the transactions entered into by

an entity. This means that preparers must observe the principle of ‘substance over form’

by recognising the economic substance of transactions where this is different from their

legal form.

Example

Alpha sells an asset to Beta for $100,000. However, Alpha continues to use the asset in

exactly the same way as before, even though Beta is now its legal owner. Alpha has

received $100,000 but IAS 18 does not allow Alpha to recognise this amount as sales

revenue. The significant risks and rewards of ownership have not yet passed to Beta.

Alpha still controls the asset and can use it in its business (a reward of ownership). No

sale has taken place.

The substance of the transaction is that Alpha has raised a loan which is secured on the

asset. Therefore Alpha must recognise a liability for $100,000.

3.4 Rendering of services: revenue recognition

When an entity provides a service to a customer, and the outcome of the transaction can

be estimated reliably, revenue should be recognised by reference to the stage of

completion of the transaction at the balance sheet date. (This means that revenue may

be recognised for a service that has not yet been completed at the balance sheet date).

The recognition of revenue by reference to the stage of completion of a transaction

may be referred to as the ‘percentage of completion method’.

IAS18 states that the outcome of a service transaction can be estimated reliably

when all the following conditions apply.

 The amount of revenue can be measured reliably.

 It is probable that the economic benefits associated with the transaction will flow

to the service provider.

Chapter 2: Recognition and measurement

 The stage of completion of the transaction at the balance sheet can be measured

reliably.

 The costs already incurred for the transaction and the costs that will be incurred

to complete the transaction can be measured reliably.

When these conditions are not met, revenue should be recognised only to the extent

of the expenses recognised that are recoverable.

For example, suppose that a contract to develop new computer software for a

customer has not been completed by the balance sheet date. The revenue from the

transaction will be $70,000 and costs of $12,000 have been incurred to date. It is not

yet certain what stage of completion has been reached, nor what the further costs to

completion will be. Revenue in the current period should be $12,000 and matching

costs should be $12,000, so that there is neither a profit nor a loss in the current

financial period.

3.5 Interest, royalties and dividends: revenue recognition

Revenue from interest, royalties and dividends should be recognised when it is

probable that the benefits will flow to the entity and the amount of the revenue can

be measured reliably.

IAS18 states that revenue from these sources should be recognised as follows.

 Interest. Interest income should be recognised on a time proportion basis that

takes into account the effective yield on the interest-earning asset.

 Royalties. Revenue from royalties should be recognised on an accruals basis, in

accordance with the terms of the royalty agreement.

 Dividends. Revenue from dividends should be recognised when the right to

receive the dividend is established.

3.6 IAS18: disclosure requirements

Accounting standards commonly include disclosure requirements, setting out the

information that entities must disclose. IAS18 requires disclosure of:

 the accounting policies adopted for recognising revenue, and

 each significant category of revenue in the period, including revenue from:

− the sale of goods

− the rendering of services

− interest

− royalties

− dividends.

In addition, there should be disclosure, for each significant category of income, of

the amount of revenue arising from the exchange of goods or services.

Paper F7: Financial reporting (International)

Alternatives to historical cost accounting

 Deficiencies in historical cost accounting (HCA)

 Current value accounting

 Constant purchasing power accounting

 The IASB Framework and concepts of capital maintenance

 International accounting standards and measurement

 Fair value

4 Alternatives to historical cost accounting

4.1 Deficiencies in historical cost accounting (HCA)

Traditionally, historical cost accounting (HCA) has been used to prepare financial

statements, but with some exceptions. In historical cost accounting:

 assets and liabilities are shown in the statement of financial position at their

historical cost (less accumulated depreciation, in the case of non-current assets)

and

 income and expenses are recorded at their historical amount.

The main advantage of historical cost accounting is that it provides objective

measurements of many values. There is often objective evidence for the historical

cost of an asset or liability, or the historical amount of income or expenses.

The other significant advantage of historical cost accounting is that it is

understandable and easy to apply.

However, historical cost accounting has many weaknesses, particularly when there

is a high rate of inflation, and there is a significant rise over time in selling prices

and costs. The main weaknesses with HCA during a period of price inflation are as

follows:

 The carrying value (net book value) of non-current assets is often significantly

lower than their current fair value or market value. For example, an item of land

and buildings bought 20 years ago for $5 million would be worth substantially

more now, and to report the asset at its historical cost is misleading.

 The value of inventory in the statement of financial position is its value at the

date of purchase or manufacture, not its value at the end of the reporting period.

For slow-moving items of inventory, in a period of high inflation the historical

cost of the inventory might be substantially different from its current value.

 The cost of sales measured at historical cost does not represent the current value

of the assets consumed. The replacement cost of the assets consumed could be

much higher than their historical cost, due to a high rate of inflation.

 The income statement therefore under-states the ‘real’ value of the cost of sales,

and so over-states profit. It fails to show the profit in ‘real’ economic terms.

ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing

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