ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 17: Provisions and events after the balance sheet date

IAS 37: Applications and future developments

 IFRIC Interpretation 1: changes in existing decommissioning, restoration and

similar liabilities

 IFRIC Interpretation 5: rights to interests in an environmental rehabilitation

fund Disclosures about contingent liabilities and contingent assets

 IFRIC Interpretation 13: customer loyalty programmes

 IAS 37: The problems

4 IAS 37: Applications and future developments

A number of IFRIC Interpretations have been issued that relate to the application of

IAS 37. These are summarised in this section.

4.1 IFRIC Interpretation 1: changes in existing decommissioning,

restoration and similar liabilities

It was explained earlier that when an entity has an obligation to incur

decommissioning costs, site restoration costs or environmental clean-up costs in the

future, the present value of this future obligation should be recognised as a liability

(a provision) and it should be added to the cost of the asset.

Debit: Asset

Credit: Provision for decommissioning costs.

The discount ‘unwinds’ each year (by the opening amount of the liability multiplied

by the discount rate) and is reported as a finance cost expense in profit or loss and

added to the liability (Debit: Expense, Credit: Liability).

IFRIC 1 deals with a situation where there is a change in the estimate of the present

value of the decommissioning or restoration liability. A change in the estimate

might occur because:

 the estimate of the actual future cost is changed, or

 the appropriate interest rate/discount rate changes

 there is a change in the estimated period of time remaining to when the costs

will be incurred.

IFRIC 1 states that if the asset is measured using the cost model, any increase in the

liability should be added to the cost of the asset and any decrease in the liability

should be deducted. (However a deduction in the liability cannot reduce the asset to

a negative carrying amount, and any excess should be taken to profit or loss for the

period.)

The depreciation of the asset should be based on its revised cost of the asset and

estimated remaining life. The finance cost for the unwinding of the discount should

be based on the adjusted amount of the provision/liability.

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If the change means an increase in the carrying cost of the asset, it might be

appropriate to consider whether there has been any impairment to the asset.

(If the asset has been measured using the revaluation model, the basic rule is that

any increase in the liability/provision should be recognised in profit or loss; and

any reduction in the liability should be reported as other comprehensive income

and added to the revaluation reserve for the asset.)



Example

Entity STV established an operating plant on 1 January Year 1. The initial cost of the

plant was $12 million and it has a 40-year expected life. This initial cost included a

provision for future decommissioning costs at the end of 40 years. These costs were

estimated at $7.4 million, and had a present value of $1 million when discounted at

the applicable rate of 5%.

After 10 years, the estimated costs of decommissioning have been revised and the

present value of these future liabilities is now only $0.8 million.

By the end of 10 years, the provision for future decommissioning costs has risen,

with the unwinding of the discount, to $1.63 million (= $1 million × 1.05)

). The

change on the estimated liability therefore means that the liability is reduced by

$0.83 million.

The carrying amount of the asset after 10 years, assuming straight line depreciation

and a nil residual value, is $9 million (= $12 million × 30/40). The reduction in the

provision/liability of $0.83 million should be deducted from this carrying amount,

so that the revised carrying amount is $8.17 million.

 The asset should now be depreciated at the rate of $8.17 million/30 years =

$272,000 per year.

 In the next year, the finance cost for unwinding the discount on the

provision/liability will be $0.8 million × 0.05 = $40,000.

4.2 IFRIC Interpretation 5: rights to interests in an environmental

rehabilitation fund

IFRIC 5 (Rights to interests arising from decommissioning, restoration and

environmental rehabilitation funds) deals with a situation in which a fund is

established by an entity or a number of different entities to provide for future

decommissioning or environmental rehabilitation costs. Money is paid into the fund

and invested. The entity or entities are subsequently able to draw on money from

the fund to meet their future obligations when these arise.

IFRIC 5 states that in such a situation, an entity that is a contributor to such a fund

should report the liability for the future obligation separately from its interest in the

benefits from the fund.

 The future obligation is reported as a provision and valued at present value

(with the discount unwinding each year).

Chapter 17: Provisions and events after the balance sheet date

 The entity’s interest in the fund should be reported separately under the

provisions of IAS 37. If it is virtually certain that the entity will receive benefits

from the fund, these should be reported as an actual asset.

4.3 IFRIC Interpretation 13: customer loyalty programmes

An entity might offer incentives to its customers to buy its goods and services by

offering credits or points. The customers might then be able to use the points they

have earned to claim free goods or price discounts on goods when they make future

purchases. The rewards for customer loyalty might be provided:

 By the entity itself, for example when a supermarket company gives points to

customers for purchases they make in its stores

 By a third party, such as free air miles provided by an airline company. The

airline company provides the rewards, but the air miles are earned for purchases

by customers from other entities.

IFRIC 13 deals with the problem of how to account for rewards granted to

customers under such schemes, including when to recognise the revenue from sales

under IAS 18.

In principle, when an entity gives its customers points for purchasing its goods, the

money that it receives now from current sales is partly related to future purchases

by customers when they claim their reward in the future.

 One method of accounting for this would be to defer recognition of some of the

revenue earned ‘now’ until the customers claim their rewards, and recognise the

deferred revenue as revenue associated with those rewards.

 A second approach would be to recognise the cost of future purchases by

customers under a reward scheme as part of the cost of the sales where the

points or credits are originally earned.

IFRIC 13 opts for the first method.

When an entity gives its customers points or credits for a sale, a part of the

consideration received from the sale should be deferred as a liability or provision

for the cost of the future rewards:

Debit: Cash

Credit: Provision for future rewards

Credit: Revenue (balance).

The amount of the deferred consideration at a ‘fair value’.

When customers claim their rewards, the provision can be released to revenue. The

amount recognised as revenue =:

Total provision × (Credits or points claimed in the period/Total number of credits

or points expected to be redeemed).

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

Example

A supermarket has a customer loyalty programme, and customers are given loyalty

points when they make purchases. Customers can use the points to claim price

reductions on future purchases.

In one period, the entity grants 100,000 loyalty points and it estimates the value of

each loyalty point to be $0.01. The entity believes that only 80% of these loyalty

points will actually be claimed. Actual consideration received from sales in the

period was $100,000. For this period, a provision of $800 for future rewards should

be recognised (= 80% × $100,000 × 0.01), and revenue for the period should be

$99,200.

Suppose that in the next period 30 points are redeemed. There should be a transfer

of $300 from the provision to revenue (= $800 × 30/80) and the provision will be

reduced to $500.

Suppose that in the following year, 51 points are redeemed and the entity now

believes that 90% of the points will be redeemed. The cumulative deferred

compensation recognised to date should now be $800 × 81/90 = $720. In the

previous period $300 was recognised, so $420 should be recognised as revenue in

this period. The provision is now reduced from $500 to $80.



Example

A car dealer operates a customer loyalty scheme by giving free air miles to

customers when they buy cars. The car dealer pays an airline company $0.009 for

each air mile, but estimates that the fair value of each air mile is $0.01.

During one period, the car dealer issues 1,000,000 air miles under the loyalty

scheme.

 Since the airline company accepts an obligation to offer the free air miles to

customers of the car dealer, the car dealer is entitled to recognise the fair value of

the air miles awarded ($10,000) as soon as the cars are sold.

 The car dealer also incurs a liability to pay the airline $90,000 for the air miles.

 The profit from the customer loyalty scheme in the period is therefore $10,000.

4.4 IAS 37: The problems

Although IAS 37 has gone a considerable way towards reducing the use of

provisions to ‘manipulate’ reported profits in the accounts, there is still occasional

abuse of the rules.

Chapter 17: Provisions and events after the balance sheet date



Example

A report was released in 2005 on Nortel Networks Corporation in the US which

revealed that companies were still using provisioning to manipulate profits. In 2001

Nortel reported a large liability for restructuring costs as it dramatically down-sized

its operations in 2001 and 2002. In 2002 senior management realised that they had

an excess of $303 million in the restructuring provision, which it reversed back to

increase profits. They chose to wait to release the provision until the first half of

2003 as employees had the opportunity to earn large bonuses if Nortel reported

profits in 2003, but a similar incentive did not exist in 2002.

Another problem with IAS 37 is the distinction between provisions and contingent

liabilities. Provisions have to be recognised in the financial statements, whereas

contingencies are simply disclosed in a note.

The IASB has therefore carried out a review of IAS 37, but this is not currently in the

exam syllabus for P2.

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Paper P2 (INT)

Corporate Reporting

CHAPTER

Other accounting standards

Contents

1 IAS 2: Inventories

2 IAS 11: Construction contracts

3 IAS 41: Agriculture

4 IFRIC 17 : Distribution of non cash assets to

owners

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IAS 2:

Inventories

 Definition of inventory

 Valuation: lower of cost and net realisable value

 Measuring the cost of inventory

 Disclosure requirements for inventory

1 IAS 2: Inventories

You should already be familiar with IAS 2: Inventories from your previous studies.

For P2 you do not need to learn anything new about inventories, but IAS 2 is an

examinable document. A brief revision of the requirements of the standard is

therefore given here.

1.1 Definition of inventory

Inventories are:

 Assets held for sale. For a retailer, these are items that the business sells – its

stock-in trade. For a manufacturer, assets held for sale are usually referred to as

‘finished goods’

 Assets in the process of production for sale (‘work-in-progress’ for a

manufacturer)

 Assets in the form of materials or supplies to be used in the production process

(‘raw materials’ in the case of a manufacturer).

There are several rules in IAS 2 dealing with the valuation (measurement) of

inventory in the statement of financial position.

1.2 Valuation: lower of cost and net realisable value

IAS 2 Inventories states that inventories should be valued at the lower of:

 cost and

 net realisable value.

Cost consists of all the costs of purchase, plus the costs of conversion and other costs

incurred in bringing the inventories to their present location and condition.

 Costs of purchase include the cost of the item itself (less any trade discounts)

plus import duties, transport costs and other handling costs.

 Costs of conversion are the ‘internal costs’ incurred in getting the inventory into

its current state, such as the internal costs incurred in producing finished goods.

They include both direct costs (such as labour and expenses) and a share of

production overheads, where production overhead absorption rates are based

on normal levels of activity.

Chapter 18: Other accounting standards

Net realisable value (NRV) is the estimated selling price of the item minus:

 all the (estimated) costs to make the item ready for sale, and

 all the (estimated) costs necessary to make the sale.

IAS 2 comments that the practice of writing down inventories below cost to their net

realisable value is consistent with the view that assets should not have a carrying

value in the statement of financial position that exceeds the amount expected to be

realised from their sale or use.

1.3 Measuring the cost of inventory

IAS 2 allows three methods for measuring the cost of inventories.

 Actual cost

 First-in, first-out (FIFO)

 Weighted average cost (AVCO).

Actual cost is used where items can be individually traced. This is usual for high-

value items. For example, cars for sale in a car dealer’s showroom will normally be

valued at actual cost in the financial statements of the car dealer.

Where it is not possible to identify actual cost, a choice is allowed between FIFO or

AVCO. The chosen method should be applied consistently to all similar types of

inventories.

1.4 Disclosure requirements for inventory

IAS 2 requires the following disclosures in notes to the financial statements.

 The accounting policy adopted for measuring inventories, including the cost

valuation method used.

 The total carrying amount of inventories, classified appropriately. (For a

manufacturer, appropriate classifications will be raw materials, work-in-

progress and finished goods.)

 The amount of inventories carried at net realisable value or NRV (‘fair value

minus costs to sell’).

 The amount of inventories written down in value, and so recognised as an

expense during the period.

 Details of any circumstances that have led to the write-down of inventories to

NRV.

Paper P2 INT: Corporate Reporting

IAS 11:

Construction contracts

 Definition of a construction contract

 The accounting problem with construction contracts

 Recognising revenue and costs of a contract in the financial statements

 IAS 11: Disclosure requirements

 IFRIC Interpretation 12: Service concession arrangements

2 IAS 11: Construction contracts

2.1 Definition of a construction contract

A construction contract is a contract specifically negotiated with a client for the

construction of:

 a single asset such as a bridge, building, pipeline or road, or

 a number of related assets. For example, an oil refinery might be made up of

several assets, such as buildings, pipelines, oil tanks and so on.

2.2 The accounting problem with construction contracts

IAS 11: Construction contracts sets out how an entity that is constructing an asset

under a construction contract should deal in its financial statements with the

revenues and costs arising from that contract.

The work on a major construction contract is likely to cover at least two accounting

periods (and is often more than two accounting periods). The main problem with

the accounting for construction contracts is therefore to decide how to allocate the

revenue and costs of the contracts between the different accounting periods.

IAS 11 states that revenue and costs should be matched to accounting periods. This

means that in each accounting period, a proportion of the overall (estimated) profits

on the contract are taken to profit or loss.

Provided that estimates are made on a reasonable basis, then the amounts taken to

profit or loss in each year, in accordance with IAS 11, will reflect the underlying

position – which is that profits are earned over the life of the construction contract,

not on the date that the contract is finally completed.

2.3 Recognising revenue and costs of a contract in the financial statements

The following rules apply to the recognition of the revenue and costs for a

construction contract in the financial statements of the contractor.

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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