Accounting news 04 IFRS. 02 Czech Accounting 06 US GAAP

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1 Who helps you handle the pressure? Accounting news Czech Accounting, IFRS and US GAAP February 2011, Deloitte Czech Republic 02 Czech Accounting Report on Related Party Transactions Brief Guidance for the Finance Department and Common Difficulties of this Report 04 IFRS IFRS EU Endorsement Process New IFRS Publication by Deloitte IFRS Tips 06 US GAAP Less common revenue recognition methods under US GAAP: Installment and Cost Recovery Methods of Revenue Recognition Revenue Recognition on Sales to Distributors

2 Czech Accounting Report on Related Party Transactions Brief Guidance for the Finance Department and Common Difficulties of this Report The objective of the Report on Related Party Transactions (full title: Report on the Transactions between the Controlling and the Controlled Entities and between the Controlled Entity and Other Entities Controlled by the Same Controlling Entity (hereinafter the Related Parties )) is to inform creditors and other owners of the controlled entity about whether the controlling entity uses its influence (and if so, how) and whether it fulfils the obligations to settle detriment, if any. If you take a look at the Reports on Related Party Transactions of random companies that are filed in the Collection of Deeds, you will find that they differ in content, as well as in the amount of detail included. The Report on Related Party Transactions and the content thereof are defined in Section 66a (9) of Act No. 513/1991 Coll., the Commercial Code. While the content is outlined in detail, the definition regarding the level of concreteness of individual information that should be included is much vaguer. The reason for this could be to protect business secrets and personal data, or, with regard to particular entities, such as financial institutions, to maintain confidentiality with regard to certain data. This article has been prepared in order to provide guidance to the Finance department on how to prepare the report. The Finance department is often directly charged with preparing the Report on Related Party Transactions, since it usually has the greatest understanding of the transactions between related parties during the reporting period, despite the fact that it often lacks sufficient knowledge of the law to describe the relations in the way that is required by the Commercial Code. It is not, however, the Finance department but the statutory body of the controlled entity that is responsible for preparing the Report on Related Party Transactions. First of all, the controlling entity must be defined as the: Majority owner; Owner with a majority of voting rights; or Owner who can enforce appointment or election, recall the majority of persons who form the statutory body, the Company s Supervisory Board. This means that a shareholder with, for example, only 40% ownership can also act as a controlling entity, assuming that no one else has a greater percentage of ownership and that other shareholders do not act in concert. A situation can also occur when the controlled entity does not know who its controlling entity is or, in a related issue, who the entities controlled by the same controlling entity are. In brief, the company does not know the structure of the entities related at the same level or at the level above. Can, in such case, the company s statutory body state that it is not aware of these facts and that it is therefore unable to include them? Pursuant to the commentaries on the Commercial Code, the statutory body must in such case carry out an investigation in order to find out the missing information, since the Commercial Code imposes an obligation on the statutory body to act with due care. Nevertheless, Czech legislation does not impose the obligation on the controlling entity to disclose such information to the controlled entity. Another situation that may occur is when the controlled entity is familiar with the related party structure but it does not know the exact equity interest in the companies concerned. Neither the Commercial Code nor any other legislation has determined that the exact equity interest must be stated in the Report on Related Party Transactions; only information on whether the entity is a controlling entity or an entity controlled by the same controlling entity needs to be included. Pursuant to Section 66a (9) of Act No. 513/1991 Coll., the Commercial Code, the Report on Related Party transactions should always be prepared within three months after the end of the reporting period. Some companies, however, do not have to prepare a Report on Related Party Transactions at all: these include companies that have concluded a controlling agreement, companies that are organisational branches, or companies that are not controlled. As mentioned earlier, a detailed description of what should be included in a Report on Related Party Transactions is included in Section 66a (9) of Act No. 513/1991 Coll., the Commercial Code. The Report on Related Party Transactions must include at least the following information: Agreements that were concluded in the last reporting period. It is understood that an agreement need not always be made in writing, but can also be concluded orally. Examples include agreements on the purchase or sale of assets, inventory, services (various fees paid to the controlling entity), agreements on the purchase or sale of securities, equity interests, etc. Other legal acts that were taken on behalf of these entities. These include, for example, lease contracts, loans, collateral, an assignment or remission of receivables, contractual fines and default interest, compensation for damage, dividends, etc, as well as other business contracts, such as mandate, consignment, association, silent partnership, merger and other contracts. All other measures on behalf or at the initiative of these entities taken or realised by the controlling entity. One example may be a decision of the general meeting, measures taken in order to decrease production or to abandon a certain part of the market etc. The advantages and disadvantages related to this measure must always be stated. 02 continues on next page

3 Czech Accounting Counter-performance if the controlled entity provided performance. Whether the controlled entity suffered any detriment from the described relationships and whether the detriment was settled in the reporting period, and if not, whether a contract for the settlement of the detriment was concluded. We would like to point out common discrepancies between the financial statements and the Report on Related Party Transactions. Some companies describe intercompany transactions in their financial statements, including the amount of individual performances. They, however, make reference to business secrecy restrictions in the Report on Related Party Transactions and do not state the amount of performance therein. Given that both documents are part of the Annual Report, it is easy to identify the amount of performance from the Annual Report or the financial statements. In conclusion, let us consider the publishing of the Report on Related Party Transactions. The report must be published in the Collection of Deeds pursuant to Section 27a (2c) of Act No. 513/1991 Coll., the Commercial Code. This report is published either independently or as part of the Annual Report, if the company is obligated to prepare and publish its Annual Report. The Accounting Act imposes an obligation to have the annual report audited; pursuant to the Commercial Code, and the Report on Related Party Transactions must also be audited. 03

4 IFRS IFRS EU Endorsement Process New IFRS Publication by Deloitte IFRS tips The European Financial Reporting Advisory Group (EFRAG) updated its report showing the status of endorsement of each IFRS, including standards, interpretations, and amendments, most recently on 17 January The following six IASB pronouncements are awaiting European Commission endorsement for use in the EU: Standards IFRS 9 Financial Instruments (issued in November 2009) Amendments Improvements to IFRSs (Issued in May 2010) Amendments to IFRS 7 Financial Instruments: Disclosures (issued in October 2010) Amendments to IFRS 1 Removal of Fixed Dates for First-Time Adopters (issued in December 2010) Amendments to IFRS 1 Severe Hyperinflation (issued in December 2010) Amendments to IFRS 12 Deferred Tax: Recovery of Underlying Assets Amendments to IAS 12 (issued in December 2010) The endorsement status report can be found at IFRS Presentation and Disclosure Checklist for 2010 in Czech language The Czech version of the Presentation and Disclosure Checklist for 2010 is available on The purpose of Deloitte s IFRS Presentation and Disclosure Checklist for 2010 is to assist users in determining whether they complied with the presentation and disclosure requirements specified in IFRS standards and interpretations. The checklist is formatted to allow the recording of a review of financial statements, with a place to indicate yes/no/ irrelevant for each presentation and disclosure item. Today, IFRS Tips cover questions from our clients relating to IAS 11 Construction contracts. Application of IAS 11 to contracts with a duration of less than one year Question Should IAS 11 be applied to construction contracts with a duration of less than one year? Answer IAS 11 applies to construction contracts accounted for in the financial statements of contractors. The term 'contractors' is not defined in IAS 11, and therefore, can be taken to refer to reporting entities engaged in contracting activity. Construction contracts are defined in IAS 11.3 as contracts "specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use". IAS 11 does not provide for a minimum duration for the construction period (such as one year) for construction contracts falling within its scope. Nor does it refer to 'long-term contracts'. The principles of IAS 11 will need to be applied for all construction contracts under which the contract activity starts in one reporting period and ends in another, thus creating an allocation problem for contract income and expenses. continues on next page 04

5 IFRS Application of IAS 11 to service transactions Question Does IAS 11 apply to service transactions? Answer IAS 11.5 clarifies that construction contracts will include contracts for the rendering of services that are directly related to the construction of an asset (e.g. those for the services of project managers and architects). Other examples include design, engineering, construction management that are essential to the construction of the asset. The general criteria for revenue recognition for service transactions are established in paragraph 20 of IAS 18 Revenue. The general principle established in IAS is that revenue should be recognised by reference to the stage of completion of a service transaction at the end of the reporting period, which is consistent with IAS 11. Therefore, although service contracts do not fall generally within the scope of IAS 11, they will be dealt with under IAS 18 using principles consistent with those established in IAS 11, and IAS 11 provides useful guidance in this regard. In some circumstances, careful judgement may be required to determine whether a contract should be regarded as being for the supply of construction services or simply for the supply of goods. In particular, merely because a contract requires items to be supplied that have not yet been constructed, it does not necessarily follow that the contract is for construction services. In July 2008, IFRIC 15 Agreements for the Construction of Real Estate was issued. It addresses whether an agreement is within the scope of IAS 11 or IAS 18, and when revenue from the construction of real estate should be recognised. IAS 11 and software development contracts Question Are software development contracts within the scope of IAS 11? Answer Yes, if they meet the definition of a construction contract in IAS 11. IAS 11 defines a construction contract as "a contract specifically negotiated for the construction of an asset". Whether the asset under construction is tangible or intangible is not relevant to this definition; therefore, it is possible for contracts for the construction of intangible assets, such as software, to be within the scope of IAS 11. An entity should carefully assess each software development contract to determine whether it meets this definition. Software development contracts for fully bespoke products meet the definition of a construction contract in IAS 11 and should be accounted for in accordance with IAS 11, including all of the disclosure requirements. Contracts for the supply of software products already developed in-house or with minimal customisation fall into the scope of IAS 18 Revenue as the supply of goods. Pre-contract costs Background Company Z is a software design company that develops software specifically suited for a particular entity. In order to secure a contract with a particular entity, Company Z incurs costs as part of its bid on a project. Such costs may include labour costs, general administration costs, research and development costs, etc. Many of these costs are incurred prior to securing the contract (and are referred to below as 'pre-contract costs'). Question How should Company Z account for pre-contract costs? Answer Paragraph 89 of the Framework for the Preparation and Presentation of Financial Statements states that an "asset is recognised in the statement of financial position when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably". General administration costs for which reimbursement is not specified in the contract are identified in IAS 11.20, among others, as examples of costs that should be excluded from contract costs because they cannot be attributed to contract activity or allocated to a contract. Therefore, any overhead costs incurred in the 'pre-contract' period should be expensed when incurred (unless the contract specifies that they are to be reimbursed). IAS specifies that other pre-contract costs should be included as part of contract costs if: they relate directly to the contract; they were incurred in securing the contract; they can be separately identified; they can be measured reliably; and it is probable that the contract will be obtained. A great deal of care should be taken when determining whether precontract costs should be capitalised. If pre-contract costs have been capitalised, and it subsequently transpires that it is no longer considered probable that the contract will be obtained, the costs should be recognised in profit or loss immediately. 05

6 US GAAP Less common revenue recognition methods under US GAAP: Installment and Cost Recovery Methods of Revenue Recognition US GAAP is very prescriptive and a lot more specific as to the application of revenue recognition methods compared to IFRS or Czech Accounting Standards. Revenue should ordinarily be accounted for at the time a transaction is completed, with appropriate provision for uncollectible accounts. Paragraph (a) of the FASB Accounting Standards Codification states that revenue and gains generally are not recognized until being realized or realizable and until earned. Accordingly, unless the circumstances are such that the collection of the sale price is not reasonably assured, the installment method of recognizing revenue is not acceptable. There may be exceptional cases where receivables are collectible over an extended period of time and, because of the terms of the transactions or other conditions, there is no reasonable basis for estimating the degree of collectibility. When such circumstances exist, and as long as they exist, either the installment method or the cost recovery method of accounting may be used. As defined in paragraph FASB Accounting Standards Codification through 55-9, the installment method apportions collections received between cost recovered and profit. The apportionment is in the same ratio as total cost and total profit bear to the sales value. Under the cost recovery method, which is to be used in cases when even installment method of revenue recognition would not be adequate, equal amounts of revenue and expense are recognized as collections are made until all costs have been recovered, postponing any recognition of profit until that time. Profit would be recognized at only when value of cost of asset sold plus the interest revenue resulting from delayed cash collection would be fully recovered. 06 Principal collections reduce the related receivable, and interest collections on such receivables increase the unrecognized gross profit on the balance sheet. Gross profit is presented as a separate item of revenue on the income statement when it is recognized as earned when respective collection received. In the absence of the circumstances mentioned above the installment or cost recovery methods are not acceptable, nevertheless we should be aware of those and consider in cases where doubts on collectibility exists. If, after the adoption of the installment or cost recovery method, the transaction meets the requirements for the full accrual method, the seller may then change to the full accrual method. The remaining profit that was not recognized is recognized in income at that time. A change from the cost recovery method or installment method to the full accrual method as a result of changed conditions is a change in estimate, not a change in accounting principle. However, if the change has a material effect on the seller's financial position or results of operations, the seller's financial statements should disclose the effect of, and the reason for, recognizing the profit on the uncollected portion of the sales value. The following two examples illustrate the use of the installment method of accounting: 1. Company A has developed a new telecommunications technology that has not been previously introduced to the market. To create a viable market for this product, A will ease credit restrictions and sell product inventory to numerous unrelated start-up entities. Payment for these sales will be long-term, probably more than two years. Because A has no experience with marketing this product or with long-term collections from buyers with weaker credit, collection of the purchase price is not reasonably assured and it may be appropriate for A to use the installment method or another delayed recognition method to recognize revenue. 2. Company B has entered into a written agreement with Company C under which C is obligated to make royalty payments to B for six years on the basis of C's total sales of Product X. Company B recognizes the royalty payments when earned using accrual method of accounting (as Product X is sold by C) throughout each year. In 1999, C made all payments to B within 30 days as stipulated in the contract. However, B learned in late 2000 that because of financial constraints, it is not reasonably assured that C will be able to make its royalty payments. How should B account for the revenue under this contract? Company B should account for the revenue in accordance with SEC Staff Accounting Bulletin Topic 13-A.1, which establishes four criteria that are required to be met in order for revenue to be recognized. They are: 1. Persuasive evidence of an arrangement exists. The written agreement between B and C meets the requirement of persuasive evidence of an arrangement. 2. Delivery has occurred or services have been rendered. Company C is obligated to make royalty payments on the basis of sales of Product X. Thus, the delivery or services requirement seems to be met. 3. The seller's price to the buyer is fixed or determinable. The price is contractually determinable on the basis of C's sales of Product X; therefore, that portion of the arrangement meets this criterion. 4. Collectibility is reasonably assured. Because C is potentially unable to honor its obligation to make the royalty payment to B, collectibility is not reasonably assured, and therefore, the collectibility criterion is not met.

7 US GAAP Revenue Recognition on Sales to Distributors Because the collectibility criterion is not met, B should cease recording revenue associated with the royalty payment amounts from C. Bad debt expense would be charged for amounts that B had previously recorded but had not yet received payment for and for which collectibility was determined to be doubtful. Going forward, as both parties continue to operate under the contract with collectibility of B's obligation to C in doubt, no revenue should be recognized until cash is received. It is not appropriate under the revenue recognition guidance to record revenue (assuming all other revenue recognition criteria have been met) and related bad debt expense for amounts for which collectibility is not reasonably assured. Although both methods of revenue recognition mentioned above are rather exceptional, they should be followed if transaction does not fulfill the criteria listed above and if US GAAP shall be followed. What factors should companies consider in determining whether a transaction with a distributor is a sale at the moment of sale to the distributor or a consignment transaction and therefore sale shall be realized at the moment when sold by distributor to an end customer? Several SEC enforcement actions have related to companies that recognized revenue on products transferred to distributors under arrangements theoretically structured to comply with the normal terms and conditions of sales, where the distributor effectively received the goods on consignment. In some situations, the distributors received the product, but paid the seller only if the product had been ultimately sold to the end user. This is characteristic of a consignment and not a sale to a distributor. Sales to distributors may require special consideration, especially when such sales occur at or near the end of a quarter or fiscal year. When evaluating the proper accounting for such transactions, it may be helpful to consider the patterns of sales to the distributor and payments made by the distributor. Side agreements that amend or supersede the actual contractual sales terms may exist that substantively change the terms of the arrangement. If goods are shipped on consignment, the goods are considered inventory of the seller. Assessing whether inventory transferred to a distributor is, in substance, on consignment can require a significant amount of judgment. The following list highlights a number of factors that, if present, might indicate that a transfer represents a consignment rather than a sale: The manufacturer dictates the number of units and type purchased by the distributor under a "quota" system. The distributor is very thinly capitalized and is, for all practical purposes, "carried" by the manufacturer. Merchandise transferred to one distributor may, at the discretion of the manufacturer, be subsequently transferred to another distributor to fill a need. The manufacturer takes a very active interest in the internal management of the distributor. The manufacturer has taken over many of its distributorships as a result of the distributor's failure to pay for or sell previously delivered products. Distributors are allowed to return or exchange merchandise "purchased." The sale is completely financed by the manufacturer. The sales price ultimately received by the manufacturer is contingent upon the amount the distributor receives when the product is resold. The distributor is not able to pay for the merchandise purchased until it is resold to a third party. Legal transfer of title does not pass to the distributor when the product is delivered to the distributor. Extended payment terms are granted that are substantially different from those given to normal buyers. The existence of one or more of the above factors alone may not necessarily preclude the recognition of a sale to a distributor; however, when considered with other factors, the transaction may represent a consignment arrangement rather than a sale. 07

8 If you have any questions regarding any of the articles in this publication, please contact one of the following audit experts: Czech Accounting IFRS and US GAAP Romana Pojslová: Stanislav Staněk: Michal Brandejs: Martin Tesař: Soňa Plachá: Pavel Kodýtek: Deloitte Advisory s.r.o. Nile House Karolinská 654/ Prague 8 - Karlín Czech Republic Tel.: Fax: This publication contains general information only, and none of Deloitte Touche Tohmatsu Limited, any of its member firms or any of the foregoing s affiliates (collectively the Deloitte Network ) are, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your finances or your business. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person who relies on this publication. *** Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. With a globally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and deep local expertise to help clients succeed wherever they operate. Deloitte's approximately 170,000 professionals are committed to becoming the standard of excellence Deloitte Czech Republic