IFRS 15 (ACCA)

December 2015

There has been significant divergence in practice over recognition of revenue mainly because International
Financial Reporting Standards (IFRS) have contained limited guidance in certain areas. The International
Accounting Standards Board (IASB) as a result of the joint project with the US Financial Accounting Standards
Board (FASB) has issued IFRS 15 Revenue from Contracts with Customers. IFRS 15 sets out a five-step model,
which applies to revenue earned from a contract with a customer with limited exceptions, regardless of the
type of revenue transaction or the industry. Step one in the five-step model requires the identification of the
contract with the customer and is critical for the purpose of applying the standard. The remaining four steps in
the standard’s revenue recognition model are irrelevant if the contract does not fall within the scope of IFRS
15.

Required:
(a) (i) Discuss the criteria which must be met for a contract with a customer to fall within the
scope of IFRS 15. (5 marks)
(ii) Discuss the four remaining steps which lead to revenue recognition after a contract has been
identified as falling within the scope of IFRS 15. (8 marks)

(b) (i) Tang enters into a contract with a customer to sell an existing printing machine such that control of the
printing machine vests with the customer in two years’ time. The contract has two payment options. The
customer can pay $240,000 when the contract is signed or $300,000 in two years’ time when the customer
gains control of the printing machine. The interest rate implicit in the contract is 11·8% in order to adjust for
the risk involved in the delay in payment. However, Tang’s incremental borrowing rate is 5%. The customer paid
$240,000 on 1 December 2014 when the contract was signed. (4 marks)

(ii) Tang enters into a contract on 1 December 2014 to construct a printing machine on a customer’s premises
for a promised consideration of $1,500,000 with a bonus of $100,000 if the machine is completed within 24
months. At the inception of the contract, Tang correctly accounts for the promised bundle of goods and services
as a single performance obligation in accordance with IFRS 15. At the inception of the contract, Tang expects
the costs to be $800,000 and concludes that it is highly probable that a significant reversal in the amount of
cumulative revenue recognised will occur. Completion of the printing machine is highly susceptible to factors
outside of Tang’s influence, mainly issues with the supply of components. At 30 November 2015, Tang has
satisfied 65% of its performance obligation on the basis of costs incurred to date and concludes that the variable
consideration is still constrained in accordance with IFRS 15. However, on 4 December 2015, the contract is
modified with the result that the fixed consideration and expected costs increase by $110,000 and $60,000
respectively. The time allowable for achieving the bonus is extended by six months with the result that Tang
concludes that it is highly probable that the bonus will be achieved and that the contract still remains a single
performance obligation. Tang has an accounting year end of 30 November. (6 marks)

Required:
Discuss how the above two contracts should be accounted for under IFRS 15. (In the case of
(b)(i), the discussion should include the accounting treatment up to 30 November 2016 and in
the case of (b)(ii), the accounting treatment up to 4 December 2015.)

ANSWER

4 (a) (i) The definition of what constitutes a contract for the purpose of applying the standard is critical. The
definition of contract is based on the definition of a contract in the USA and is similar to that in IAS 32 Financial
Instruments: Presentation. A contract exists when an agreement between two or more parties creates
enforceable rights and obligations between those parties. The agreement does not need to be in writing to be
a contract but the decision as to whether a contractual right or obligation is enforceable is considered within
the context of the relevant legal framework of a jurisdiction. Thus, whether a contract is enforceable will vary
across jurisdictions. The performance obligation could include promises which result in a valid expectation that
the entity will transfer goods or services to the customer even though those promises are not legally enforceable.

The first criteria set out in IFRS 15 is that the parties should have approved the contract and are committed to
perform their respective obligations. It would be questionable whether that contract is enforceable if this were
not the case. In the case of oral or implied contracts, this may be difficult but all relevant facts and
circumstances should be considered in assessing the parties’ commitment. The parties need not always be
committed to fulfilling all of the obligations under a contract. IFRS 15 gives the example where a customer is
required to purchase a minimum quantity of goods but past experience shows that the customer does not
always do this and the other party does not enforce their contract rights. However, there needs to be evidence
that the parties are substantially committed to the contract.

It is essential that each party’s rights and the payment terms can be identified regarding the goods or services
to be transferred. This latter requirement is the key to determining the transaction price.

The contract must have commercial substance before revenue can be recognised, as without this requirement,
entities might artificially inflate their revenue and it would be questionable whether the transaction has
economic consequences. Further, it should be probable that the entity will collect the consideration due under
the contract. An assessment of a customer’s credit risk is an important element in deciding whether a contract
has validity but customer credit risk does not affect the measurement or presentation of revenue. The
consideration may be different to the contract price because of discounts and bonus offerings. The entity should
assess the ability of the customer to pay and the customer’s intention to pay the consideration. If a contract
with a customer does not meet these criteria, the entity can continually re-assess the contract to determine
whether it subsequently meets the criteria.

Two or more contracts which are entered into around the same time with the same customer may be combined
and accounted for as a single contract, if they meet the specified criteria. The standard provides detailed
requirements for contract modifications. A modification may be accounted for as a separate contract or a
modification of the original contract, depending upon the circumstances of the case.

(ii) Step one in the five-step model requires the identification of the contract with the customer. After a contract
has been determined to fall under IFRS 15, the following steps are required before revenue can be recognised.

Step two requires the identification of the separate performance obligations in the contract. This is often
referred to as ’unbundling’, and is done at the beginning of a contract. The key factor in identifying a separate
performance obligation is the distinctiveness of the good or service, or a bundle of goods or services. A good
or service is distinct if the customer can benefit from the good or service on its own or together with other
readily available resources and is separately identifiable from other elements of the contract. IFRS 15 requires
a series of distinct goods or services which are substantially the same with the same pattern of transfer, to be
regarded as a single performance obligation. A good or service, which has been delivered, may not be distinct
if it cannot be used without another good or service which has not yet been delivered. Similarly, goods or
services which are not distinct should be combined with other goods or services until the entity identifies a
bundle of goods or services which is distinct. IFRS 15 provides indicators rather than criteria to determine when
a good or service is distinct within the context of the contract. This allows management to apply judgement to
determine the separate performance obligations which best reflect the economic substance of a transaction.

Step three requires the entity to determine the transaction price, which is the amount of consideration which
an entity expects to be entitled to in exchange for the promised goods or services. This amount excludes
amounts collected on behalf of a third party, for example, government taxes. An entity must determine the
amount of consideration to which it expects to be entitled in order to recognise revenue.

The transaction price might include variable or contingent consideration. Variable consideration should be
estimated as either the expected value or the most likely amount. Management should use the approach which
it expects will best predict the amount of consideration and should be applied consistently throughout the
contract. An entity can only include variable consideration in the transaction price to the extent that it is highly
probable that a subsequent change in the estimated variable consideration will not result in a significant
revenue reversal. If it is not appropriate to include all of the variable consideration in the transaction price, the
entity should assess whether it should include part of the variable consideration. However, this latter amount
still has to pass the ’revenue reversal’ test.
Additionally, an entity should estimate the transaction price taking into account non-cash consideration,
consideration payable to the customer and the time value of money if a significant financing component is
present. The latter is not required if the time period between the transfer of goods or services and payment is
less than one year. If an entity anticipates that it may ultimately accept an amount lower than that initially
promised in the contract due to, for example, past experience of discounts given, then revenue would be
estimated at the lower amount with the collectability of that lower amount being assessed. Subsequently, if
revenue already recognised is not collectable, impairment losses should be taken to profit or loss.

Step four requires the allocation of the transaction price to the separate performance obligations. The allocation
is based on the relative standalone selling prices of the goods or services promised and is made at inception
of the contract. It is not adjusted to reflect subsequent changes in the standalone selling prices of those goods
or services. The best evidence of standalone selling price is the observable price of a good or service when the
entity sells that good or service separately. If that is not available, an estimate is made by using an approach
which maximises the use of observable inputs. For example, expected cost plus an appropriate margin or the
assessment of market prices for similar goods or services adjusted for entity-specific costs and margins or in
limited circumstances a residual approach. When a contract contains more than one distinct performance
obligation, an entity allocates the transaction price to each distinct performance obligation on the basis of the
standalone selling price.

Where the transaction price includes a variable amount and discounts, consideration needs to be given as to
whether these amounts relate to all or only some of the performance obligations in the contract. Discounts and
variable consideration will typically be allocated proportionately to all of the performance obligations in the
contract. However, if certain conditions are met, they can be allocated to one or more separate performance
obligations.

Step five requires revenue to be recognised as each performance obligation is satisfied. An entity satisfies a
performance obligation by transferring control of a promised good or service to the customer, which could occur
over time or at a point in time. The definition of control includes the ability to prevent others from directing the
use of and obtaining the benefits from the asset. A performance obligation is satisfied at a point in time unless
it meets one of three criteria set out in IFRS 15. Revenue is recognised in line with the pattern of transfer.

If an entity does not satisfy its performance obligation over time, it satisfies it at a point in time and revenue
will be recognised when control is passed at that point in time. Factors which may indicate the passing of
control include the present right to payment for the asset or the customer has legal title to the asset or the
entity has transferred physical possession of the asset.

(b) (i) The contract contains a significant financing component because of the length of time between when
the customer pays for the asset and when Tang transfers the asset to the customer, as well as the prevailing
interest rates in the market. A contract with a customer which has a significant financing component should be
separated into a revenue component (for the notional cash sales price) and a loan component. Consequently,
the accounting for a sale arising from a contract which has a significant financing component should be
comparable to the accounting for a loan with the same features. An entity should use the discount rate which
would be reflected in a separate financing transaction between the entity and its customer at contract inception.
The interest rate implicit in the transaction may be different from the rate to be used to discount the cash flows,
which should be the entity’s incremental borrowing rate. IFRS 15 would therefore dictate that the rate which
should be used in adjusting the promised consideration is 5%, which is the entity’s incremental borrowing rate,
and not 11·8%.

Tang would account for the significant financing component as follows:

Recognise a contract liability for the $240,000 payment received on 1 December 2014 at the contract inception:

Dr Cash $240,000
Cr Contract liability $240,000

During the two years from contract inception (1 December 2014) until the transfer of the printing machine,
Tang adjusts the amount of consideration and accretes the contract liability by recognising interest on $240,000
at 5% for two years.

Year to 30 November 2015

Dr Interest expense $12,000
Cr Contract liability $12,000
Contract liability would stand at $252,000 at 30 November 2015.

Year to 30 November 2016

Dr Interest expense $12,600
Cr Contract liability $12,600

Recognition of contract revenue on transfer of printing machine at 30 November 2016 of $264,600 by debiting
contract liability and crediting revenue with this amount.

(ii) Tang accounts for the promised bundle of goods and services as a single performance obligation satisfied
over time in accordance with IFRS 15. At the inception of the contract, Tang expects the following:

Transaction price $1,500,000

Expected costs $800,000
Expected profit (46·7%) $700,000
At contract inception, Tang excludes the $100,000 bonus from the transaction price because it cannot
conclude that it is highly probable that a significant reversal in the amount of cumulative revenue recognised
will not occur. Completion of the printing machine is highly susceptible to factors outside the entity’s
influence. By the end of the first year, the entity has satisfied 65% of its performance obligation on the basis
of costs incurred to date. Costs incurred to date are therefore $520,000 and Tang reassesses the variable
consideration and concludes that the amount is still constrained. Therefore at 30 November 2015, the
following would be recognised:

Revenue $975,000
Costs $520,000
Gross profit $455,000

However, on 4 December 2015, the contract is modified. As a result, the fixed consideration and expected costs
increase by $110,000 and $60,000, respectively. The total potential consideration after the modification is
$1,710,000 which is $1,610,000 fixed consideration + $100,000 completion bonus. In addition, the allowable
time for achieving the bonus is extended by six months with the result that Tang concludes that it is highly
probable that including the bonus in the transaction price will not result in a significant reversal in the amount
of cumulative revenue recognised in accordance with IFRS 15. Therefore the bonus of $100,000 can be included
in the transaction price. Tang also concludes that the contract remains a single performance obligation.
Thus,Tang accounts for the contract modification as if it were part of the original contract. Therefore, Tang
updates its estimates of costs and revenue as follows:

Tang has satisfied 60·5% of its performance obligation ($520,000 actual costs incurred compared to $860,000
total expected costs). The entity recognises additional revenue of $59,550 [(60·5% of $1,710,000) – $975,000
revenue recognised to date] at the date of the modification as a cumulative catch-up adjustment. As the
contract amendment took place after the year end, the additional revenue would not be treated as an adjusting
event.
March/June 2017 Sample Question

Question:

3 (c) Carsoon Co is a company which manufactures and retails motor vehicles. It also constructs premises for
third parties. It has a year end of 28 February 2017.

(c) Carsoon constructs retail vehicle outlets and enters into contracts with customers to construct buildings on
their land. The contracts have standard terms, which include penalties payable by Carsoon if the contract is
delayed, or payable by the customer, if Carsoon cannot gain access to the construction site.

Due to poor weather, one of the projects was delayed. As a result, Carsoon faced additional costs and
contractual penalties. As Carsoon could not gain access to the construction site, the directors decided to make
a counter-claim against the customer for the penalties and additional costs which Carsoon faced. Carsoon felt
that because claims had been made against the customer, the additional costs and penalties should not be
included in contract costs but shown as a contingent liability. Carsoon has assessed the legal basis of the claim
and feels it has enforceable rights.

In the year ended 28 February 2017, Carsoon incurred general and administrative costs of $10 million, and
costs relating to wasted materials of $5 million.

Additionally, during the year, Carsoon agreed to construct a storage facility on the same customer’s land for $7
million at a cost of $5 million. The parties agreed to modify the contract to include the construction of the
storage facility, which was completed during the current financial year. All of the additional costs relating to the
above were capitalised as assets in the financial statements.

The directors of Carsoon wish to know how to account for the penalties, counter claim and additional costs in
accordance with IFRS 15 Revenue from Contracts with Customers. (7 marks)

Required:
Advise Carsoon on how the above transactions should be dealt with in its financial statements
with reference to relevant International Financial Reporting Standards.

Answer:

(c) IFRS 15 Revenue from Contracts with Customers specifies how to account for costs incurred in fulfilling a
contract which are not in the scope of another standard. Costs to fulfil a contract which is accounted for under
IFRS 15 are divided into those which give rise to an asset and those which are expensed as incurred. Entities
will recognise an asset when costs incurred to fulfil a contract meet certain criteria, one of which is that the
costs are expected to be recovered.

For costs to meet the ‘expected to be recovered’ criterion, they need to be either explicitly reimbursable under
the contract or reflected through the pricing of the contract and recoverable through the margin.

The penalty and additional costs attributable to the contract should be considered when they occur and Carsoon
should have included them in the total costs of the contract in the period in which they had been notified.

As regards the counter claim for compensation, Carsoon accounts for the claim as a contract modification in
accordance with IFRS 15. The modification does not result in any additional goods and services being provided
to the customer. In addition, all of the remaining goods and services after the modification are not distinct and
form part of a single performance obligation. Consequently, Carsoon should account for the modification by
updating the transaction price and the measure of progress towards complete satisfaction of the performance
obligation.

A contract modification may exist even though the parties to the contract have a dispute about the scope or
price (or both) of the modification or the parties have approved a change in the scope of the contract but have
not yet determined the corresponding change in price. In determining whether the rights and obligations which
are created or changed by a modification are enforceable, an entity should consider all relevant facts and
circumstances including the terms of the contract and other evidence. On the basis of information available, it
is possible to feel that the counter claim had not reached an advanced stage, so that claims submitted to the
client could not be included in total revenues.

When the contract is modified for the construction of the storage facility, an additional $7 million is added to
the consideration which Carsoon will receive. The additional $7 million reflects the stand-alone selling price of
the contract modification. The construction of the separate storage facility is a distinct performance obligation;
the contract modification for the additional storage facility would be, in effect, a new contract which does not
affect the accounting for the existing contract. Therefore the contract is a performance obligation which has
been satisfied as assets are only recognised in relation to satisfying future performance obligations. General
and administrative costs cannot be capitalised unless these costs are specifically chargeable to the customer
under the contract. Similarly, wasted material costs are expensed where they are not chargeable to the
customer. Therefore a total expense of $15 million will be charged to profit or loss and not shown as assets.
December 2017

Question

2 (b) Formatt has entered into a contract with a customer to supply specialised medical equipment. Formatt
has developed the equipment in conjunction with the customer but has contracted with a supplier for its
manufacture. The supplier delivers the equipment to the customer. Formatt pays the supplier directly and
invoices the customer with the agreed selling price which is cost plus 25%. Any equipment defects are the
responsibility of Formatt.

The directors of Formatt are unsure as to whether they should account for the whole transaction as a principal
or just the profit margin as if an agent. (7 marks)

Answer:

2 (b) IFRS 15 Revenue from Contracts with Customers states that an entity is a principal where the entity controls
the promised good before transfer to the customer. However, the entity is an agent where the performance
obligation is to arrange provision of the goods by another party. Although Formatt has subcontracted the
manufacturing of the equipment to a supplier, the development of the specification, the manufacturing of the
equipment, and the overall management of the contract are not distinct because they are not separately
identifiable and thus there is a single performance obligation. The customer has contracted with Formatt so
that the various elements of the contract are integrated as one obligation.

Therefore, Formatt controls the specialised equipment before the equipment is transferred to the customer and
is therefore the principal in this transaction. Formatt is also responsible for any defects. The supplier cannot
decide to use the specialized equipment for another purpose as the equipment must be delivered to the
customer to fulfil the promise in the contract. Formatt has the responsibility for fulfilling the contract, determines
the price of the contract, is not paid on a commission basis and has the credit risk.
Question

3 (a) (i) Darlatt is a public limited company with a year end of 31 August 2017. It sells wind turbines as part
of a combined contract which includes a standard two-year warranty term and maintenance services for a ten-
year period. In addition, Darlatt offers the option of a ten-year extension to the warranty for an additional fee
which is paid at the time of the initial sale. The sales price for the combined contract is $3·6 million and the
customer will pay an additional fee of $0·8 million for the extended warranty. If sold separately, the selling price
of the wind turbine would be $3·2 million and the selling price of the two-year warranty and ten-year
maintenance service contract would be $0·9 million. The extended warranty has a separate selling price of $1
million.

The directors of Darlatt would like to know how the above transactions should be accounted for under IFRS 15
Revenue from Contracts with Customers. (8 marks)

Required:
Discuss the advice which should be given to Dalatt in each of the cases with reference to relevant
International Financial Reporting Standards.

Answer

3 (a) (i) IFRS 15 Revenue from Contracts with Customers sets out the core principle that an entity will recognise
revenue to depict the transfer of promised goods or services to customers in an amount which reflects the
consideration to which the entity expects to be entitled in exchange for those goods or services. This principle
is delivered through a five-step model. Once the contract with the customer has been identified, step 2 of the
model identifies those elements of the contract which should be accounted for separately. The performance
obligations should be identified at the beginning of the contract by identifying distinct goods or services in the
contract. To do so, the entity should identify all the goods and services which have been promised. The distinct
performance obligations are the units of account which determine when and how revenue is recognised. A
good or service is distinct only if the customer can benefit from the good or service either on its own or together
with other resources available to the customer and the good or service is separately identifiable from other
promises in the contract.

A customer can benefit from a good or service on its own if it can be used, consumed, or sold to generate
economic benefits. Determining whether a good or service is distinct within the context of the contract requires
assessment of the contract terms and the intent of the parties.
Thus in the case of Darlatt, the entity is required to assess whether the deliverables it has promised to the
customer give rise to separate performance obligations. The purchase of the wind turbine and the maintenance
contract are obviously separate performance obligations. However, the two warranties require further
consideration. The nature of the warranty will determine the accounting impact. IFRS 15 states that an entity
accounts for a warranty as a separate performance obligation if the customer has the option to purchase the
warranty separately. An entity accounts for a warranty as a cost accrual if it is not sold separately, unless the
warranty is to provide the customer with a service in addition to assurance that the product complies with
agreed specifications. The free warranty simply provides the customer with the assurance that the wind turbine
meets the agreed specification and thus is not a separate performance obligation. Where the warranty provides
an additional service as is the case with the ten-year warranty, then the income will be treated as deferred
revenue.

Once the separate performance obligations have been identified, then the transaction price is allocated to them
based on the relative stand-alone selling prices of the goods or services promised. This allocation is made at
contract inception and not adjusted to reflect subsequent changes in the stand-alone selling prices of those
goods or services. The best evidence of stand-alone selling price is the observable price of a good or service
when the entity sells that good or service separately.

Therefore, the wind turbine will be allocated with ($3·2m/$4·1m x $3·6m), i.e. $2·8 million and the maintenance
contract with ($0·9m/$4·1m x $3·6m), i.e. $0·8 million of the total revenue. Thus, the maintenance contract
and additional warranty will be recognised over time and the sale of the wind turbine and free warranty will be
recognised at a point in time. Where revenue is recognised over time, a method should be used which best
reflects the pattern of transfer of goods or services to the customer. In this case, it would appear that both of
the above elements would be recognized over 10 years.
March/June Sample Question 2018

Question

3 (a) Medsupply operates in the medical supply industry and has a financial year end of 31 May 2018.
Medsupply sells technology needed to perform highly complex operations. When a hospital purchases
equipment from Medsupply, it provides a very specialised piece of instrumentation, which is an integral part of
the surgical process, free of charge.

The legal ownership of the instruments remains with Medsupply. The instruments are returned to Medsupply
if they become faulty or at the end of their useful life, which is normally 1·5 years. At this point, Medsupply
replaces them with new instruments but retains the right to be reimbursed if the instruments are not returned.
The instruments are nearly always returned at the end of their useful life and disposed of as clinical waste.

The directors of Medsupply would like advice on the accounting treatment for the instruments loaned to
hospitals. (8 marks)

Answer:

3 (a) Evaluating the economic ownership of the instruments loaned to customers is quite judgemental with all
factors needing to be evaluated separately. The use of ‘substance over form’ should always be a priority in this
situation. The existing asset definition states that it is a resource controlled by the entity as a result of past
events and from which future economic benefits are expected to flow to the entity. Thus an asset is a resource
rather than the inflow of economic benefits which the resource may generate. An asset must be capable of
producing economic benefits, although these economic benefits need not be certain nor is there any minimum
threshold before that resource meets the definition of an asset.

It is therefore important to determine whether the customer or Medsupply has the right to obtain substantially
all of the economic benefits arising from use and the right to direct the use of the identified asset throughout
the period. A customer has control of an asset if it has the right to operate the asset or has designed the asset
in a way that predetermines its use.

The rewards associated with ownership would include the unrestricted ability to use the asset as well as to
participate in any potential increases in value. Risks include the possibility of impairment, the risk of loss and
usage restrictions. There are several factors which will help to determine who enjoys the economic benefits.
On the return of the instruments, they are disposed of as clinical waste and, hence, it would appear that the
instruments have no value on return. Additionally, the instruments are
nearly always returned at the end of their useful life and hence the economic benefit has remained with the
hospital throughout the life of the instrument. It appears from the above discussion that the hospital has the
right to obtain substantially all the economic benefits and therefore no assets should appear in the financial
statements of Medsupply. This conclusion is despite the fact that Medsupply retains the legal ownership.

Lessors are required to apply IFRS 15 Revenue from Contracts with Customers to allocate the consideration in
the contract. Where a contract has multiple performance obligations, an entity will allocate the transaction price
to the performance obligations in the contract by reference to their relative standalone selling prices. Thus it
could be argued that the contract of sale contains a lease from the viewpoint of the instruments and that the
transaction price should be split accordingly between the value of the devices and the instrumentation.

The costs incurred to fulfil a contract are recognised as an asset if and only if all of the following criteria are
met:

– the costs relate directly to a contract (or a specific anticipated contract);

– the costs generate or enhance resources of the entity which will be used in satisfying performance obligations
in the future; and
– the costs are expected to be recovered.

Thus utilising the above criteria from IFRS 15, it would indicate that the cost of the instrumentation should not
be shown as an asset of Medsupply as it will not be recovered. The instruments form an integral part of an
overall surgical process and are part of a multiple-component arrangement between Medsupply and the
hospital. However, in this case, the instruments are simply a cost of sale. The instruments should be initially
recorded at their acquisition and/or production cost in accordance with IAS 2 Inventory. Subsequent to initial
recognition, the instruments should be measured at the lower of cost and net realisable value and when the
instrument is loaned to the hospital, the manufacturer should reduce its inventory and recognise costs of sales
accordingly, as Medsupply is not receiving proceeds for the usage of the instrument.

Question

3 (c) Medsupply conducts clinical trials to gain regulatory approvals for the development of its products. The
majority of these clinical trials are carried out by contract research organisations (CRO). The CROs help with
medical discovery, clinical development and commercialisation of products. The terms of the contracts require
Medsupply to make advanced payments before the CROs will perform the clinical trial management services.
These advance payments are normally non-refundable and made up to six months before the activity
commences.
Medsupply has recently paid $4 million as an advanced payment to Clinical Unit Trials (CUT) who has been
contracted to aid and support research in the field of tropical disease. They provide advice on the early
development and design of research proposals. The research is to start in four months’ time. In addition,
Medsupply has received a non-refundable fee of $2 million as an advanced payment from a government
department who has contracted with Medsupply to provide a vaccine in the same field of tropical disease. The
contract has a total value of $10 million and the non-refundable fee of $2 million is not a government grant
under IAS 20 Accounting for Government Grants and Disclosure of Government Assistance.

The directors of Medsupply would like advice on the accounting treatment of the above advanced payments
both made by and received by Medsupply. (6 marks)

Required:
Advise the directors of Medsupply on how each of the above issues should be dealt with in its
financial statements with reference to relevant International Financial Reporting Standards (IFRSs).

Answer:

3 (c) The International Accounting Standard Board’s (IASB’s) Conceptual Framework states that expenses are
recognised when a decrease in future economic benefits related to a decrease in an asset or an increase of a
liability has arisen which can be measured reliably. This means, in effect, that recognition of expenses occurs
simultaneously with the recognition of an increase in liabilities or a decrease in assets. Essentially, this
recognition should occur when the related goods or services are consumed, irrespective of the timing of funds
being paid.

IAS 38 Intangible Assets provides guidance on internally generated intangible assets which are recognised only
if, amongst other criteria, the technical feasibility of a development project can be demonstrated.

Initially, Medsupply should record the pre-payment to CUT as an asset. Then, as the research services are
performed by CUT, Medsupply must continue to determine if the criteria for the capitalisation of an intangible
asset have been met. The services being performed by CUT appear to be of a research nature and not
development work as CUT has been contracted to aid and support the development of knowledge in the field
of tropical disease. Additionally, CUT provides advice on the early development of research proposals and
design. Thus almost certainly the costs incurred will be classed as research expenditure. Therefore, Medsupply
should expense the related costs as services rendered.

The Framework states that income is recognised when an increase in future economic benefits related to an
increase in an asset or a decrease of a liability has arisen which can be measured reliably. IFRS 15 Revenue
from Contracts with Customers states that entities must evaluate whether non-refundable upfront fees relate to
the transfer of a good or service. In many situations, an upfront fee represents an advance payment for future
goods or services. Medsupply will need to assess if the non-refundable fee relates to a separate performance
obligation. The upfront fee appears to represent an advance payment for future goods or services and it appears
that these services will not commence for at least four months as that is the date when the contract with CUT
commences. Such fees would be recognised as revenue only when those future goods or services are provided,
that is in four months’ time.
September 2018 SBR

Question:

3 (a) Skizer is a pharmaceutical company which develops new products with other pharmaceutical companies
that have the appropriate production facilities.

Stakes in development projects

When Skizer acquires a stake in a development project, it makes an initial payment to the other pharmaceutical
company. It then makes a series of further stage payments until the product development is complete and it
has been approved by the authorities. In the financial statements for the year ended 31 August 20X7, Skizer
has treated the different stakes in the development projects as separate intangible assets because of the
anticipated future economic benefits related to Skizer’s ownership of the product rights. However, in the year
to 31 August 20X8, the directors of Skizer decided that all such intangible assets were to be expensed as
research and development costs as they were unsure as to whether the payments should have been initially
recognised as intangible assets. This write off was to be treated as a change in an accounting estimate.

Sale of development project

On 1 September 20X6, Skizer acquired a development project as part of a business combination and correctly
recognised the project as an intangible asset. However, in the financial statements to 31 August 20X7, Skizer
recognised an impairment loss for the full amount of the intangible asset because of the uncertainties
surrounding the completion of the project. During the year ended 31 August 20X8, the directors of Skizer judged
that it could not complete the project on its own and could not find a suitable entity to jointly develop it. Thus,
Skizer decided to sell the project, including all rights to future development. Skizer succeeded in selling the
project and, as the project had a nil carrying value, it treated the sale proceeds as revenue in the financial
statements. The directors of Skizer argued that IFRS 15 Revenue from Contracts with Customers states that
revenue should be recognised when control is passed at a point in time. The directors of Skizer argued that
the sale of the rights was part of their business model and that control of the project had passed to the
purchaser.

(iii) Discuss whether the proceeds of the sale of the development project above should be treated
as revenue in the financial statements for the year ended 31 August 20X8. (4 marks)

Answer:

3 a (iii) Gains arising from derecognition of an intangible asset cannot be presented as revenue as IAS 38
explicitly forbids it. There is no indication that Skizer’s business model is to sell development projects but,
rather, it undertakes the development of new products in conjunction with third party entities. Skizer’s business
model is to jointly develop a product, then leave the production to partners. As Skizer has recognised an
intangible asset in accordance with IAS 38, and fully impaired the asset, it cannot argue that it has thereafter
been held for sale in the ordinary course of business. Therefore, according to IAS 38, the gain from the
derecognition of the intangible asset cannot be classified as revenue under IFRS 15 Revenue from Contracts
with Customers but as a profit on the sale of the intangible asset.
Question:

4 (b) Daveed is a car retailer who leases vehicles to customers under operating leases and often sells the cars
to third parties when the lease ends.

Net cash generated from operating activities for the year ended 31 August 20X8 for the Daveed Group is as
follows:

Year ended 31 August 20X8 $m

Cash generated from operating activities 345
Income taxes paid (21)
Pension deficit payments (33)
Interest paid (25)
Associate share of profits 12
––––
Net cash generated from operating activities 278
––––
Net cash flows generated from investing activities included interest received of $10 million and net capital
expenditure of $46 million excluding the business acquisition at (iii) below.

There were also some errors in the presentation of the statement of cash flows which could have an impact
on the calculation of net cash generated from operating activities.

The directors have provided the following information as regards any potential errors:

(iii) Daveed also acquired a digital mapping business during the year ended 31 August 20X8. The statement of
cash flows showed a loss of $28 million in net cash inflow generated from operating activities as the effect of
changes in foreign exchange rates arising on the retranslation of this overseas subsidiary. The assets and
liabilities of the acquired subsidiary had been correctly included in the calculation of the cash movement during
the year.

Answer:

(iii) Purchase and sale of cars

Daveed’s presentation of cash flows from the sale of cars as being from investing activities is incorrect as cash
flows from the sale of cars should have been presented as cash flows from operating activities ($30 million).
IAS 16 Property, Plant and Equipment (PPE) states that an entity which normally sells items of PPE which are
held for rental to others should transfer such assets to inventories at their carrying amount when they cease to
be rented and become held for sale. Subsequent proceeds from the sale of such assets should be recognised
as revenue in accordance with IFRS 15 Revenue from Contracts with Customers and thus shown as cash flows
from operating activities.

Purchase of associate
$m
Balance at 31 August 20X8 23
Less profit for period $16m x 25% (4)
Add dividend received $4m x 25% 1
–––
Cost of acquisition (cash) 20
–––
Therefore, cash paid for the investment is $20 million, and cash received from the dividend is $1 million.

In order to arrive at the correct figure for net cash generated from operating activities, the incorrect treatment
of the profit for the year for the associate must be eliminated ($12 million) and the correct adjustment of $4
million shown in net cash generated by operating activities