ACCA Paper F7. Financial Management. theexpgroup.com

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1 Thank you for downloading this extract from our ExPedite notes to accompany your free online Course in a Coffee Break. To download a free complete set of our ExPress notes please visit Good luck with your F7 studies. ACCA Paper F7 Financial Management For exams in 2010

2 Chapter 3 Substance and IAS 18 Revenue START The Big Picture Substance over Form The Framework document and IAS 1 both state that for information to be reliable, it must be reported in accordance with its commercial substance, rather than strictly in adherence to its legal form. We have already encountered one example of substance over form in the context of finance leases, where a reporting entity records assets held under a finance lease in the SOFP, although it s not owned by them. In substance, the degree of control means it s their asset although legally it quite possibly never is. There are a wide range of transactions where identifying the true commercial substance may be difficult. The most common types of transactions in the exam are: Inventory sold on a sale or return basis ( consignment inventory ) Debt factoring Page 3.1

3 Loans secured on assets that will be repurchased. In order to reach a sensible conclusion in any substance over form scenario, it is necessary to identify: What assets are in question? What are the intrinsic risks and rewards of holding that asset? Which party to the transaction is, on balance, more exposed to the risks and rewards of that asset? The asset with the greater exposure to risks and rewards recognises the asset on its SOFP. If it involves initial recognition of an asset, this often generates recognition of a gain also. EXAMPLE Sale or return inventory Bookworm is a book store. It takes delivery of books from publishers on the condition that it can return books at any time to the publisher, at the cost of Bookworm. Bookworm does not charge publishers a fee for displaying their books. The agreements with publishers are that Bookworm buys the books from the publisher at the moment when they are sold on to a customer, or when 24 months passes from delivery; whichever is the sooner. Bookworm has an inventory management system that monitors which books have been in inventory for a long time and it returns almost all books before the 24 months expires. Bookworm s accounting policy is to recognise all books as purchases at cost at the time of delivery from the publisher. Any returns to the publishers are then recorded as purchase returns. At 30 June 20x4, Bookworm conducts a physical inventory count and determines that it has inventory at a purchase price of $459,500. Page 3.2

4 Required Determine whether Bookworm s accounting policy complies with IFRS. Solution to example Intrinsic risk/ return of books Borne mostly by Reason Obsolescence Publishers Obsolete inventory can be returned with no penalty. Theft Bookworm Stolen inventory could not be returned within 24 months, so must be purchased by Bookworm. Ability to sell at a profit Bookworm Bookworm has physical custody. Physical damage, eg fire Bookworm Damaged goods would not be returnable. Slow moving inventory Publishers Bookworm can return underperforming inventory for no penalty. Although Bookworm bears most of the identified risks, the biggest risk is obsolescence and slow moving inventory. The others are risks, but not ones that are likely to cause nearly the same level of losses as obsolescence. Consequently, Bookworm should only recognise the purchase of inventory at either the point of sale to a customer, or passage of 24 months. This means that the current accounting policy does not comply with IFRS. The inventory should be derecognised by Bookworm and recognised by the relevant publishers. Page 3.3

5 Review and self-test 1 Shaky has trade receivables of $1.6 million. It has decided that it will be beneficial to request a debt factoring company to collect these receivables on its behalf. It has split the receivables into two groups of $800,000 each and given one block of receivables to Stephen Co and the other $800,000 to Fry Co. The terms of each agreement are: Stephen Co: Stephen Co advanced $600,000 to Shaky Co upon legal transfer of the right to receive the receivable s payment. Stephen Co will contact receivables and take legal action where necessary to recover payment. Stephen Co bears all such costs itself. In the event that receivables never pay, Stephen Co has no right to recover any of the $600,000 advanced to Shaky, nor is it under any obligation to pay Shaky any greater amount if all the receivables pay quickly. Fry Co: Fry Co advanced $700,000 to Shaky Co upon legal transfer of the right to receive the receivable s payment. Fry Co will contact receivables and take legal action where necessary to recover payment. Fry Co charges Shaky Co an administration fee of 1% of the receivable s book value for each month before payment is received. This administration fee is also increased by any legal costs incurred. In the event that receivables do not pay Fry Co within six months from the start of the agreement, Fry Co has a put option to sell the receivable s debt back to Shaky Co for the original value of the debt. Required Analyse each of the above agreements and determine an appropriate treatment, both in SOFP and SOCI for each transaction. Review and self-test 2 Pretence Co is a maker of brandy. It sells premium mature brandy as its main brand that is aged for ten years before sale. At 30 September 20x1, it sold inventory with a work-in-progress value (correctly according to IAS 2) of $458,000 to a bank. The bank bought the inventory for $458,000 in cash. The inventory had an average age of two years at the date of sale. The bank has a put option to sell the brandy back to Pretence at any date before 30 September 20x7 at a price equal to $458,000 plus a mark-up, which is calculated on a Page 3.4

6 compound basis at EURIBOR + 4% per annum. Pretence has a call option that it can buy the brandy back at this same price on 30 September 20x7 only. Pretence has recorded the sale of brandy as revenue and derecognised the inventory from its SOFP. Required Analyse the above transaction and determine whether Pretence s accounting treatment complies with IFRS. If not, suggest a better treatment. IAS 18: Revenue Revenue recognition is clearly a key issue in preparation of financial statements. The rules are different depending upon whether a sale is for goods or for services. This means that the first step in the exam is to identify whether a transaction is for goods or services. If it s for a construction contract, follow the rules specifically of IAS 11. Recognition of revenue: goods Recognise revenue when most of the more important inherent risks and rewards of the goods have passed from the seller to the buyer. This might well be earlier or later than when legal title passes or when payment occurs. Recognition of revenue: services Recognise revenue as the costs of providing the service are incurred. Where a service is paid for up front, revenue often must be deferred as a liability in the SOFP until the revenue is earned. Valuation of revenue If sales are made with long-term payment terms, recognise the sale and the receivable at its net present value using an appropriate discount rate. This then shows finance income over time. Page 3.5

7 Bundled sales Where goods are sold with serviced bundled (eg after-sales servicing for two years), then unbundle into separate components. EXAMPLE If a car is sold for $30,000 with three years of free servicing, recognise this as: $ Total sales value 30,000 Less: Market value of three year servicing agreement (to be recognised over 3 years) (3,000) Value of goods sold (recognise immediately) 27,000 Review and self-test 3 FlyHigh Co is an airline. It generally receives bookings for customers flights one month before the flight takes place. During the year to 31 December 20x7, it received bookings, and simultaneous payment for flights, of $1.2 million per month. The previous year, it had received bookings and payments of $800,000 per month. Bookings are not seasonal. Required What would be the opening balance on deferred revenue? What would be the closing balance on deferred revenue? What revenue would be recognised for the year ended 31 December 20x7? Page 3.6

8 Solution to review and self-test 1 Applying the model of risk and rewards to Stephen Co Intrinsic risk/ return of receivables Borne mostly by Reason Slow payment Stephen Co Shaky is unaffected by how quickly Stephen collects the receivables. Non-payment Stephen Co If receivables do not pay, there is no adjustment to the amount paid by Stephen to Shaky to recover the debt. Creating administration costs eg by disputing balances in a petty way Stephen Co Once the legal transfer of debts is complete, there is no recourse to Shaky for any problems in collection of the debt. An appropriate accounting presentation of the transfer of the debts from Shaky to Stephen is therefore to derecognise the debts from Shaky s SOFP and recognise them in Stephen s SOFP. Shaky will derecognise an asset of $800,000 in return for cash of $600,000 so recognise a loss on derecognition of $200,000. This will be presented as a finance cost or as a distribution cost, depending on Shaky s accounting policy. Applying the model of risk and rewards to Fry Co Intrinsic risk/ return of receivables Borne mostly by Reason Slow payment Shaky Fry has a right to charge an additional cost to Shaky for the time taken to recover payment. The slower the payment, the greater the income of Fry and the greater the expenses of Shaky. Non-payment Shaky Fry has a put option to give the nonrecovered debts back to Shaky, including amounts due for the 1% monthly charge. Creating administration costs eg by disputing balances in a petty way Shaky Legal costs incurred are passed onto Shaky by Fry. Page 3.7

9 An appropriate accounting presentation for this transaction is to continue to recognise the receivables on the SOFP of Shaky, since Shaky is exposed to the risks and rewards associated with these receivables. The cash advanced by Fry to Shaky should be presented as a secured loan and the finance costs charged to Shaky by Fry should be presented as a cost of collecting debts, however that is classified in the financial statements by the accounting policy of Shaky. Page 3.8

10 Solution to review and self-test 2 Applying the model of risk and rewards to Stephen Co Intrinsic risk/ return of long-term inventory WIP Physical deterioration and abnormal losses Gains from market price increases Losses from market price falls Borne mostly by Pretence Co Pretence Co Pretence Co Reason The bank s put option means that if the inventory physically deteriorates, its value will fall. This loss can be avoided by the bank by putting the inventory back onto Pretence. P s call option means that if prices increase, it will be able to call the inventory back into its ownership and sell it at a profit. Same reasoning as physical deterioration. The existence of a put and call option at the same price means that ownership will revert to the legal seller, whatever happens to prices. This means that Pretence retains the risks and rewards of ownership. An appropriate accounting treatment is therefore to continue to recognise the inventory on Pretence s SOFP, despite the legal transfer of ownership. The cash received from the bank should be presented as a loan, secured on the inventory WIP. The imputed interest each period at EURIBOR + 4% should be added to the loan each period and presented as a finance cost. Although this is described as a mark up, in substance it is a finance cost, as evidenced by the mention of EURIBOR. Page 3.9

11 Solution to review and self-test 3 The opening balance on deferred revenue would be the sales in the month of December 20x6, being $800,000 The closing balance on deferred revenue would be the sales in the month of December 20x7, being $1,200,000. Revenue recognised in the year ended x6 would be: $ 000 Reversal of opening deferred revenue to profit 800 Cash received in the current year (12 x $1.2m) 14,400 Less: Deferred revenue at end of year (1,200) Revenue recognised 14,000 Page 3.10