REVENUE RECOGNITION

QUESTION 1
Identify IFRS 15’s five steps which need to be followed by entities when recognising revenue
from contracts with a customer.
ANSWER 1
IFRS 15 sets out a five-step framework when recognizing revenue from contracts with
customer:
1. Identify the contract(s) with the customer: A contract is an agreement between two or
more parties that creates enforceable rights and obligations.
2. Identify the performance obligations in the contract: A contract includes promises to
transfer goods or services to a customer. If those goods or services are distinct, the
promises are performance obligations and are accounted for separately.
3. Determine the transaction price: The transaction price is the amount of consideration to
which an entity expects to be entitled in exchange for transferring promised goods or
services to a customer.
4. Allocate the transaction price: An entity typically allocates the transaction price to each
performance obligation on the basis of the relative standalone selling prices of each
distinct good or service. If a standalone selling price is not observable, the entity
estimates it.
5. Recognize revenue when a performance obligation is satisfied: An entity recognizes
revenue when (or as) it satisfies a performance obligation by transferring a promised
good or service to a customer (which is when the customer obtains control of that good
or service).

QUESTION 2
Explain how IFRS 15 is expected to improve the financial reporting of revenue.

ANSWER 2
1. Enhancements to Quality and Consistency: IFRS 15 is designed to provide substantial
enhancements to the quality and consistency of how revenue is reported. It
addresses the previous lack of detail in IFRS revenue recognition requirements and
the overly prescriptive and conflicting nature of U.S. GAAP, aiming for a balanced
and improved set of rules. The previous standard IAS 18 was subjective. It was quite
difficult to verify the accuracy of reported revenues.
2. Five-Step Framework for Revenue Recognition: IFRS 15 establishes a five-step
framework for revenue recognition, providing a systematic approach to recognize
revenue in a manner that reflects the transfer of promised goods or services to
 customers. This framework includes steps such as identifying the contract,
performance obligations, determining transaction price, allocating the price, and
recognizing revenue when a performance obligation is satisfied. The framework
helps to base revenue recognition decision, thus increasing the verifiability of the
revenue figures.
3. Convergence of IFRS and U.S. GAAP: The new standard is fully converged, meaning
that it provides consistent and unified requirements for revenue recognition in both
IFRS and U.S. GAAP. This convergence is expected to reduce the divergence in
accounting treatments for economically similar transactions, enhancing
comparability between companies reporting under different standards.
4. Scope of IFRS 15: The standard applies to all contracts with customers, excluding
specific types such as lease contracts, insurance contracts, financial instruments,
and certain guarantees. This broader scope ensures that revenue recognition
principles are consistently applied to a wide range of transactions, contributing to a
more comprehensive understanding of a company's financial performance.
5. Disclosure Requirements: IFRS 15 introduces detailed disclosure requirements
intended to provide users of financial statements with a clear understanding of the
nature, amount, timing, and uncertainty of revenue and related cash flows. These
disclosures cover qualitative and quantitative information about contracts with
customers, significant judgments made in applying the revenue guidance, and assets
recognized from the costs to obtain or fulfill a contract.

QUESTION 3
Johnny enters into a 12-month telecom plan with the local mobile operator ABC. The terms of
plan are as follows:

• Johnny’s monthly fixed fee is CU 100.

• Johnny receives a free handset at the inception of the plan.

• ABC sells the same handsets for CU 300 and the same monthly prepayment plans
without handset for CU 80/month.
Required:
How should ABC recognise the revenues from this plan in line with IAS 18 and IFRS 15?

ANSWER 3
IAS 18
According to IAS 18, revenue should be recognised when it meets two criteria: a) it is probable
that any future economic benefit associated with the item of revenue will flow to the entity; b)
the amount of revenue can be measured reliably. Therefore, at the inception, ABC should
recognise revenue of CU 100 each month (CU 1200/year) when the service is delivered. (when
the significant risks and rewards of ownership have been transferred to the buyer). As for the
handset, it should be treated separately when the good is delivered. however in this case the
handset is given for free thus no revenue recognition for the headset.

IFRS 15
Under IFRS 15, the revenue recognition should follow the five-step model framework.

1) Identify the contract with customers: contract between ABC and Johny, sale of handset and
telecom plan – 12 months plan with Johnny

2) Identify separate performance obligations in the contract - obligation to deliver the handset
and to perform telecom service for 12 months

3) Determine transaction price - CU 100 per month (CU 1200/year)

4) Allocate the transaction price to the separate performance obligation - The transaction price
should be allocated to each performance obligation based on the relative standalone selling
prices of the goods or services being provided to the customer.
In this case, ABC sells the same handset for CU 300 (standalone price for handset) and ABC
provides the same monthly plan without the handset CU 80/month (standalone price of the
plan). Therefore, according to IFRS 15, ABC needs to allocate the transaction price to each
performance obligation on a relative standalone price.

Transaction price: CU100/month (CU 1200/year)

standaolne price for monthly plan - CU 80 (CU 960)
standaolne price for handset - CU 300

Therefore,
CU 300 + CU 960 = CU 1260

allocation ratio:
CU 300/CU 1260= 23.8%
CU 960/CU 1260= 76.2%

Revenue:
23.8% x CU 1200 = CU 285.6
76.2% X CU 1200 = CU 914.40

So, under this method, ABC would recognise revenue of approximately CU285.60 for the
handset and CU914.40 for the plan service.
QUESTION 4
In software development or telecommunications, where customers usually buy a prepayment
plans with a handset or software development comes with implementation and post-delivery
service in 1 package, or any similar arrangements.
Required:
How would IAS 18 and IFRS 15 treat this?

ANSWER 4
Under IAS 18, the revenue is defined as a gross inflow of economic benefits arising from
ordinary operating activities of an entity. It means that if the operator gives a handset for free
with the prepayment plan, then the revenue from handset is 0.
Under new IFRS 15, the transaction price must be allocated to the individual performance
obligations in the contract and recognised when these obligations are delivered or fulfilled. It
means that under new IFRS 15, telecom operator must allocate a part of the revenue from
prepayment plan with free handset to the sale of handset, too.

QUESTION 5
Kappa prepares financial statements to 30 September each year. During the year ended 30
September 2015, Kappa entered into the following transactions:
(i) On 1 September 2015, Kappa sold a machine to a customer. Kappa also agreed to service the
machine for a two-year period from 1 September 2015 for no additional charge. The total
amount payable by the customer for this arrangement was agreed to be:
– $800,000, if the customer paid by 31 December 2015.
– $810,000, if the customer paid by 31 January 2016.
– $820,000, if the customer paid by 28 February 2016.
The directors of Kappa consider that it is highly probable the customer will pay for the products
in January 2016. The stand-alone selling price of the machine was $700,000 and Kappa would
normally expect to receive $140,000 in consideration for providing two years’ servicing of the
machine. The alternative amounts receivable are to be treated as variable consideration.
(ii) On 20 September 2015, Kappa sold 100 identical items to a customer for $2,000 each. The
items cost Kappa $1,600 each to manufacture. The terms of sale are that the customer has the
right to return the goods for a full refund within three months. After the three-month period
has expired the customer can no longer return the goods and payment becomes immediately
due. Kappa has entered into transactions of this type with this customer previously and can
reliably estimate that 4% of the products are likely to be returned within the three-month
period.
Required:
Explain and show how both these transactions would be reported in the financial statements of
Kappa for the year ended 30 September 2015.

ANSWER 5
PART 1:
Kappa has TWO performance obligations – to provide the machine and provide the servicing.
The total transaction price consists of a fixed element of $800,000 and a variable element of
$10,000 or $20,000.
The variable element should be included in the transaction price based on the probability of its
occurrence. Therefore, a variable element of $10,000 should be included and the total
transaction price will be $810,000.
The transaction price should be allocated to the performance obligations based on their stand-
alone fair values. In this case, these are $700,000: $140,000 or 5:1.
Therefore $675,000 ($810,000 x 5/6) should be allocated to the obligation to supply the
machine and $135,000 ($810,000 x 1/6) to the obligation to provide two years’ servicing of the
machine.
The obligation to supply the machine is satisfied fully in the year ended 30 September 2015 and
so revenue of $675,000 in respect of this supply should be recognised.
Only 1/24 of the obligation to provide the servicing is satisfied in the year ended 30 September
2015 and so revenue of $5,625 ($135,000 x 1/24) in respect of this supply should be
recognised.
On 30 September 2015, Kappa will recognise a receivable of $810,000 based on the expected
transaction price. This will be reported as a current asset.
On 30 September 2015, Kappa will recognise deferred income of $129,375 ($810,000 –
$675,000 – $5,625). $67,500 ($129,375 x 12/23) of this amount will be shown as a current
liability. The balance of $61,875 ($129,375 – $67,500) will be non-current.

PART 2
When the customer has a right to return products, the transaction price contains a variable
element.
Since this can be reliably measured, t is taken account of in measuring the revenue and the
total revenue will be $192,000 (96 x $2,000).
$200,000 (100 x $2,000) will be recognised as a trade receivable.
$8,000 ($200,000 – $192,000) will be recognised as a refund liability. This will be shown as a
current liability.
The total cost of the goods sold is $160,000) (100 x $1,600). Of this amount, only $153,600 (96 x
$1,600) will be shown as a cost of sale. The other $6,400 ($160,000 – $153,600) will be shown
as a right of return asset under current assets.

QUESTION 6
Valvey is a major property developer which buys land for the construction of housing. One
aspect of its business is to provide low-cost homes through the establishment of a separate
entity, known as a housing association. Valvey purchases land and transfers ownership to the
housing association before construction starts. Valvey sells rights to occupy the housing units to
members of the public, but the housing association is the legal owner of the building. The
housing association enters into loan agreements with the bank to cover the costs of building
the homes. However, Valvey negotiates and acts as guarantor for the loan, and bears the risk of
increases in the loan’s interest rate above a specified rate. Currently, the housing rights are
normally all sold out on the completion of a project.
Valvey enters discussions with a housing contractor regarding the construction of the housing
units, but the agreement is between the housing association and the contractor. Valvey is
responsible for any construction costs in excess of the amount stated in the contract and is
responsible for paying the maintenance costs for any units not sold. Valvey sets up the board of
the housing association, which comprises one person representing Valvey and two independent
board members.
Valvey recognises income for the entire project when the land is transferred to the housing
association. The income recognised is the difference between the total sales price for the
finished housing units and the total estimated costs for construction of the units. Valvey argues
that the transfer of land represents a sale of goods which fulfils the revenue recognition criteria
in IAS 18 Revenue.

Required:
Discuss how the above items should be dealt with in the financial statements of Valvey.

ANSWER 6
Valvey needs to consider whether its revenue recognition policy is in compliance with IAS 18
Revenue.
The criteria for revenue recognition required by paragraph 14 of IAS 18 do not appear to be
met, and no revenue should be accounted for as of the date of the transfer of land to the
housing association. Revenue arising from the sale of goods should be recognised when all of
the following criteria have been satisfied (IAS 18.14):
(a) the seller has transferred to the buyer the significant risks and rewards of ownership;
(b) the seller retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold;
(c) the amount of revenue can be measured reliably;
(d) it is probable that the economic benefits associated with the transaction will flow to the
seller; and
(e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.
It is important to consider whether the risks for the project have been transferred to the
association and whether Valvey has control over the project during the construction period.
Even if the risk associated with the land is different to the risk associated with the project
directly. Valvey should assess the risks for the entire project since it is exposed to material risks
during the construction period. Valvey provides a guarantee as regards the maintenance costs,
is liable for certain increases in the interest rate over expectations, and is responsible for
financing variations in the procurement and construction contract which the contractor would
not cover.
Further, Valvey guarantees the payment for the housing association’s debt on the building loan.
Valvey is exposed to risk as if it had built the housing units itself because it gives guarantees in
respect of the construction process.
Valvey also determines the membership of the board of the housing association and thus there
is a question mark over whether the board is independent from Valvey. Valvey guarantees that
the housing association would not be liable if budgeted construction costs are exceeded, so the
entity is exposed to financial risk in the construction process.
Valvey has retained the significant risks and had effective control of the land it had sold and
also the entire construction process. Consequently, the revenue recognition criteria in
paragraph 14 of IAS 18 are not met on the transfer of the land and Valvey should account for
the whole project as if it had built the housing units itself. Accordingly, revenue should be
recognised when the housing units are finished and delivered to the buyer of the rights in
accordance with IAS 18 which appears to be when the project is completed.
QUESTION 7
Yling entered into a construction contract on 1 January 2014 which is expected to last 24
months.
The agreed price for the contract is $5 million.
At 30 September 2014, the costs incurred on the contract were $1·6 million and the estimated
remaining costs to complete were $2·4 million.
On 20 September 2014, Yling received a payment from the customer of $1·8 million which was
equal to the full amount of the progress billings.
Yling calculates the stage of completion of its construction contracts on the basis of progress
billings to the contract price.
Required:
What amount would be reported in Yling’s statement of financial position as at 30 September
2014 for the amount due from the customer for the above contract?

ANSWER 7
$160,000

QUESTION 8
An entity negotiates with major airlines to purchase tickets at reduced rates.
It agrees to buy a specific number of tickets and must pay even if unable to resell them.
The entity then sets the price for these ticket for its own customers and receives cash
immediately on purchase. The entity also assists the customers in resolving complaints with the
service provided by airlines. However, each airline is responsible for fulfilling obligations
associated with the ticket, including remedies to a customer for dissatisfaction with the service.
Required:
How would this be dealt with under IFRS 15?
ANSWER 8
Step 1: Identify the contract(s) with a customer
This is clear here when the ticket is purchased
Step 2: Identify the performance obligations in the contract
This is tricky - is it to arrange for another party provide a flight ticket - or is it - to provide the
flight ticket themselves?
Well - look at the risks involved. If the flight is cancelled the airline pays to reimburse,
If the ticket doesn't get sold - the entity loses out
Look at the rewards - the entity can set its own price and thus rewards
On balance therefore the entity takes most of the risks and rewards here and thus controls the
ticket - thus they have the obligation to provide the right to fly ticket

Step 3: Determine the transaction price

This is set by the entity

Step 4: Allocate the transaction price to the performance obligations in the contract
The price here is the GROSS amount of the ticket price (they sell it for)

Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation
Recognise the revenue once the flight has occurred

QUESTION 9
An entity has a customer loyalty programme that rewards a customer with one customer
loyalty point for every $10 of purchases. Each point is redeemable for a $1 discount on any
future purchases. Customers purchase products for $100,000 and earn 10,000 points. The
entity expects 9,500 points to be redeemed, so they have a stand-alone selling price $9,500.
Required:
How would this be dealt with under IFRS 15?

ANSWER 9
Step 1: Identify the contract(s) with a customer
This is when goods are purchased

Step 2: Identify the performance obligations in the contract

The promise to provide points to the customer is a performance obligation along with, of
course, the obligation to provide the goods initially purchased

Step 3: Determine the transaction price

$100,000

Step 4: Allocate the transaction price to the performance obligations in the contract
The entity allocates the $100,000 to the product and the points on a relative stand-alone
selling price basis as follows:
So the standalone selling price total is 100,000 + 9,500 = 109,500
Now we split this according to their own standalone prices pro-rata
Product $91,324 [100,000 x (100,000 / 109,500]
Points $8,676 [100,000 x 9,500 /109,500]

Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation
Of course, the products get recognised immediately on purchase but now let’s look at the
points. Let’s say at the end of the first reporting period, 4,500 points (out of the 9,500) have
been redeemed.
The entity recognises revenue of $4,110 [(4,500 points ÷ 9,500 points) × $8,676] and recognises
a contract liability of $4,566 (8,676 – 4,110) for the unredeemed points.

QUESTION 10
Indicate True or False.
a. The new revenue recognition standard adopted a liability approach as the basis for
revenue recognition. FALSE
b. Revenue is recognised in the accounting period when the performance obligation is
satisfied. TRUE
c. The first step in the revenue recognition process is to identify the separate performance
obligations in the contract. FALSE
d. Revenue from a contract with a customer cannot be recognised until a contract exists. TRUE
e. Whether a contract modification is treated as a separate performance obligation or
prospectively, the same amount of revenue is recognised before and after the modification.
TRUE
f. If the performance obligation is not highly dependent on, or interrelated with, other
promises in the contract, then each performance obligation should be accounted for
separately. TRUE
g. A performance obligation is a written guarantee in a contract to provide a product or
service to a customer. FALSE
h. Companies always use the expected value, a probability-weighted amount, to estimate
variable consideration. FALSE
i. When a sales transaction involves a significant financing component, the fair value is
determined either by measuring the consideration received or by discounting the payment
using an imputed interest rate. TRUE
j. Companies rarely have to allocate the transaction price to more than one performance
obligation in a contract. FALSE
k. When a company sells a bundle of goods at a discount, the discount should be allocated to
the product that caused the discount and not to the entire bundle. TRUE
LEASING
QUESTION 1
Differentiate finance lease from operating lease.

ANSWER 1
Under a finance lease, the lessee has substantially all of the risks and reward of ownership.
Situations that would normally lead to a lease being classified as a finance lease include the
following:

• the lease transfers ownership of the asset to the lessee by the end of the lease term
• the lease term is for the major part of the economic life of the asset, even if title is
not transferred
• at the inception of the lease, the present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset
• the leased assets are of a specialised nature such that only the lessee can use them
without major modifications being made
• if the lessee is entitled to cancel the lease, the lessor's losses associated with the
cancellation are borne by the lessee
• gains or losses from fluctuations in the fair value of the residual fall to the lessee
• the lessee has the ability to continue to lease for a secondary period at a rent that is
substantially lower than market rent
All other leases are operating leases.

QUESTION 2
On 1 April 2009 Bush Co entered into an agreement to lease a machine that had an estimated
life of four years. The lease period is also four years, at which point the asset will be returned to
the leasing company. Annual rentals of $5,000 are payable in arrears from 31 March 2010. The
machine is expected to have a nil residual value at the end of its life. The machine had a fair
value of $14,275 at the inception of the lease. The lessor includes a finance cost of 15% per
annum when calculating annual rentals. How should the lease be accounted for in the financial
statements of Bush for the year end 31 March 2010?

ANSWER 2
The lease should be classified as a finance lease as the estimated life of the asset is four years
and Bush retains the right to use this asset for four years in accordance with the lease
agreement therefore enjoying the rewards of the asset.
Recognise the asset and the lease liability:
Dr Property, plant and equipment 14,275
Cr Finance lease obligations 14,275

Dr Depreciation expense ($14,275/4 years) 3,568

Cr Accumulated depreciation 3,568

QUESTION 3
How do we recognise finance lease and operating lease in financial statement?

ANSWER 3
Finance lease – to be recognised in the income statement and balance sheet
Operating lease – to be recognised in the income statement

QUESTION 4
Leasing is important to Holcombe, a public limited company as a method of financing the
business. The Directors feel that it is important that they provide users of financial statements
with a complete and understandable picture of the entity’s leasing activities. They believe that
the current accounting model is inadequate and does not meet the needs of users of financial
statements.
Holcombe has leased plant for a fixed term of six years and the useful life of the plant is 12
years. The lease is non-cancellable, and there are no rights to extend the lease term or
purchase the machine at the end of the term. There are no guarantees of its value at that point.
The lessor does not have the right of access to the plant until the end of the contract or unless
permission is granted by Holcombe.
Fixed lease payments are due annually over the lease term after delivery of the plant, which is
maintained by Holcombe. Holcombe accounts for the lease as an operating lease but the
directors are unsure as to whether the accounting treatment of an operating lease is
conceptually correct.
Required: Discuss the reasons why the current lease accounting standards may fail to meet the
needs of users and could be said to be conceptually flawed.
ANSWER 4
The existing accounting model for leases has been criticised for failing to meet the needs of
users of financial statements. It can be argued that operating leases give rise to assets and
liabilities that should be recognised in the financial statements of lessees. Consequently, users
may adjust the amounts recognised in financial statements in an attempt to recognise those
assets and liabilities and reflect the effect of lease contracts in profit or loss. The information
available to users in the notes to the financial statements is often insufficient to make reliable
adjustments to the financial statements.
The existence of two different accounting methods for finance leases and operating leases
means that similar transactions can be accounted for very differently. This affects the
comparability of financial statements. Also, current accounting standards provide opportunities
to structure transactions so as to achieve a specific lease classification. If the lease is classified
as an operating lease, the lessee obtains a source of financing that can be difficult for users to
understand, as it is not recognised in the financial statements.
Existing accounting methods have been criticised for their complexity. In particular, it has
proved difficult to define the dividing line between the principles relating to finance and
operating leases. As a result, standards use a mixture of subjective judgments and rule-based
criteria that can be difficult to apply.
The existing accounting model can be said to be conceptually flawed. On entering an operating
lease contract, the lessee obtains a valuable right to use the leased item. This right meets the
Framework’s definition of an asset. Additionally, the lessee assumes an obligation to pay rentals
that meet the Framework’s definition of a liability. However, if the lessee classifies the lease as
an operating lease, that right and obligation are not recognised.
There are significant and growing differences between the accounting methods for leases and
other contractual arrangements. This has led to inconsistent accounting for arrangements that
meet the definition of a lease and similar arrangements that do not. For example, leases are
financial instruments but they are scoped out of IAS 32/39.

QUESTION 5
On January 1, 2017, XYZ Company signed an 8-year lease agreement for equipment. Annual
payments are $28,500 at the beginning of each year. At the end of the lease, the equipment will
revert to the lessor. The equipment has a useful life of 8 years and has no residual value. At the
time of the lease agreement, the equipment has a fair value of $166,000. An interest rate of
10.5% and straight-line depreciation are used.

1. Identify the type of lease

2. Prepare the schedule for lease amortisation
 3. Prepare the journal entries

ANSWER 5
1. Identify the type of lease
There is no bargain purchase option because the equipment will revert back to the lessor. The
life of the lease is 8 years and the economic life of the asset is 8 years. This is 100%. Using a
financial calculator, calculate for the PV of the minimum lease payments:
N=8
I/YR = 10.5
FV = 0
PMT = 28,500
PV = 164,995
Therefore, 164,995/166,000 = 99%
Conclusion: This is a financing/capital lease because at least one of the above criteria is met and
during the lease, the risks and rewards of the asset have been fully transferred. We have
satisfied the criteria for proper lease accounting.

2. Lease amortization schedule

3. Journal entries
January 1, 2017
DR Equipment 164,995
CR Cash 28,500
CR Lease Liability 136,495
The equipment account is debited by the present value of the minimum lease payments and
the lease liability account is the difference between the value of the equipment and cash paid
at the beginning of the year.

December 31, 2017

DR Depreciation Expense 20,624
CR Accumulated Depreciation 20,624

Depreciation expense must be recorded for the equipment that is leased.

DR Interest Expense 14,332
CR Interest Payable 14,332

January 1, 2018
DR Interest Payable 14,332
DR Lease Liability 14,168
CR Cash 28,500

QUESTION 6
Leasing is important to Holcombe, a public limited company as a method of financing the
business. The Directors feel that it is important that they provide users of financial statements
with a complete and understandable picture of the entity’s leasing activities. They believe that
the current accounting model is inadequate and does not meet the needs of users of financial
statements.
Holcombe has leased plant for a fixed term of six years and the useful life of the plant is 12
years. The lease is non-cancellable, and there are no rights to extend the lease term or
purchase the machine at the end of the term. There are no guarantees of its value at that point.
The lessor does not have the right of access to the plant until the end of the contract or unless
permission is granted by Holcombe.
Fixed lease payments are due annually over the lease term after delivery of the plant, which is
maintained by Holcombe. Holcombe accounts for the lease as an operating lease but the
directors are unsure as to whether the accounting treatment of an operating lease is
conceptually correct.
Required: Discuss whether the plant operating lease in the financial statements of Holcombe
meets the definition of an asset and liability as set out in the ‘Framework for the Preparation
and Presentation of Financial Statements.’

ANSWER 6
An asset 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. Holcombe has the right to use the leased
plant as an economic resource because the entity can use it to generate cash inflows or reduce
cash outflows. Similarly, Holcombe controls the right to use the leased item during the lease
term because the lessor is unable to recover or have access to the resource without the
consent of the lessee or unless there is a breach of contract. The control results from past
events, which is the signing of the lease contract and the receipt of the plant by the lessee.
Holcombe also maintains the asset.
Unless the lessee breaches the contract, Holcombe has an unconditional right to use the leased
item. Future economic benefits will flow to the lessee from the use of the leased item during
the lease term. Thus, it could be concluded that the lessee’s right to use a leased item for the
lease term meets the definitions of an asset in the Framework.
A liability is a present obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources embodying economic benefits.
The obligation to pay rentals is a liability. Unless Holcombe breaches the contract, the lessor
has no contractual right to take possession of the item until the end of the lease term. Equally,
the entity has no contractual right to terminate the lease and avoid paying rentals. Therefore,
the lessee has an unconditional obligation to pay rentals. Thus, the entity has a present
obligation to pay rentals, which arises out of a past event, which is the signing of the lease
contract and the receipt of the item by the lessee. Finally, the obligation is expected to result in
an outflow of economic benefits in the form of cash.
Thus, the entity’s obligation to pay rentals meets the definition of a liability in the Framework.

QUESTION 7
Discuss the advantages and disadvantages of leasing to both lessors and lessees, resulting from
IFRS 16 application.

ANSWER 7
Advantage to Lessor:
1. Steady Revenue Stream: With IFRS 16, lessors now have a more standardized method of
reporting lease income. This can lead to more predictable and steady revenue streams as lease
payments are recognized over the lease term.
2. Reduced Risk of Obsolescence: With IFRS 16, lessors may find it easier to attract lessees due
to the more transparent and standardized lease accounting. This can reduce the risk of having
assets sit idle or become obsolete.

Advantages to Lessee:
1. Improved Balance Sheet: Under IFRS 16, operating leases are now recognized on the balance
sheet as Right-of-Use (ROU) assets and lease liabilities. This can improve the lessee's financial
ratios and make the balance sheet more reflective of the company's true financial position.
2. Greater Transparency: Lessees have clearer visibility into their lease obligations and
commitments, which can help in better financial planning and decision-making.

Disadvantages to Lessor:
1. Increased Administration: IFRS 16 requires more detailed reporting and documentation,
which can increase administrative burdens for lessors. Additionally, compliance costs may also
rise.
2. Impact on Financial Ratios: Lease accounting changes under IFRS 16 may affect how lessors'
financial ratios are viewed by investors and creditors. This could impact perceptions of financial
health and borrowing capacity.

Disadvantages to Lessee:
1. Increased Liability: The elimination of operating and finance lease in IFRS16 has increased
liability since operating lease is no longer an off-balance sheet item. While having leased assets
on the balance sheet can improve transparency, it also means recognizing lease liabilities. This
can impact financial ratios and debt levels, affecting how creditors and investors perceive the
company.
2. Complexity in Implementation: Implementing IFRS 16 can be complex and time-consuming,
requiring adjustments to systems, processes, and reporting.
3. The agency cost problem: In a lease, the lessor will transfer all rights to the lessee for a
specific period of time, creating a moral hazard issue. Because the lessee who controls the asset
is not the owner of the asset, the lessee may not exercise enough care as if it’s his/her own
asset. This separation between the asset’s ownership (lessor) and control of the asset (lessee) is
referred to as the agency cost of leasing.

QUESTION 8
Smith Limited entered into the following contract during the year ended 31 July 2008. Items of
specialised equipment were leased at a cost of €8,000 per month payable in advance. The lease
term is for two years from 1 October 2007 and can be cancelled at any time by either party to
the lease. Any maintenance is to be carried out by the lessor. The equipment would have a cost
of €300,000 if purchased in the open market and is expected to have a useful life of seven
years. Compute the amount of rental to be included in the financial statements.

ANSWER 8
This is an operating lease as it applies only to part of assets useful life and present value of lease
payments does not constitute substantially all of fair value.
Equipment (operating lease): 10 months rental to be included in the financial statements: 10 X
€8,000 = €80,000. Under income statement, profit from operations is stated after charging
“Operating lease payments €80,000”

QUESTION 9
Smith Limited entered into a six-year finance lease for an item of plant on 1 August 2007. The
agreement requires Smith Limited to pay a deposit of €80,000 to be followed by five equal
annual installments of €120,000 on 1 August in each subsequent year. The purchase price of
the asset if purchased outright would be €620,000. Smith Limited has just recently paid the
insurance bill for the machine. Smith Limited uses the sum of digits to allocate the finance
charge for this lease. Calculate the finance charge and current liability.
ANSWER 9

QUESTION 10
a. What are the effects of finance lease and operating lease on the balance sheet, income
statement and cash flow statement?
b. Which of the following options would you consider as operating lease? Explain.

Option 1
Company Leasing has approached Company ABC to lease equipment from it for five years (non-
cancelable lease). The annual payment would be $20,000. The discount rate implied in the
lessor's implied rate is 6%. Company ABC has an incremental borrowing rate of 7%. After the
five-year period, the asset will be transferred to the lessor, which it will sell for scrap.
Option 2
Company L&R has also approached Company ABC to rent equipment from it. Under the term of
the rental agreement, Company ABC will rent the equipment from Company L&R for an annual
fee of $20,000. This equipment has an estimated useful life of 10 years.

ANSWER 10
a. What are the effects of finance lease and operating lease on the balance sheet, income
statement and cash flow statement?
For finance lease:

• Balance sheet (Lessee) = Lease recognition affects non-current asset and non-
current liability of the lessee.
• Balance sheet (Lessor) = Lease recognition affects the assets (right-of-use assets)
and receivable of the lessor.
• Income statement (lessee): Depreciation expenses and interest expenses of the
asset borne by lessee.
• Cash flow (lessee): Depreciation and interest expenses deducted out of profit in
operating activity, and lease prepayment recorded in financing activity
For operating lease:

• Balance sheet = unaffected

• Income statement (lessee) = lease recognition recorded as an expense
• Income statement (lessor) = lease recognition recorded as an income
• Cash flow statement (lessee) = lease prepayment recognized as an outflow in
operating activities.

b. Which of the following options would you consider as operating lease? Explain.
If Company ABC accepts Company Leasing's offer, the lease agreement has to be classified as a
capital lease because the non-cancelable lease term is equal to 75% or more of the expected
economic life of the asset. (At the end the five years, the equipment is sold for scrap). The
second option can be classified as an operating lease.
PROVISIONS AND CONTINGENCIES
QUESTION 1
During 2020, Smart Co gives a guarantee of certain borrowings of Peace Co, whose financial
condition at that time is sound. During 2021, the financial condition of Peace Co deteriorates
and at 30 June 2021 Peace Co files for protection from its creditors.
What accounting treatment is required:
(a) At 31 December 2020?
(b) At 31 December 2021?

ANSWER 1
What accounting treatment is required:

• At 31 December 2020?
Present obligation as a result of a past obligating event – The obligating event is the giving of
the guarantee, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement – No outflow of benefits is
probable at 31 December 20X0.
Conclusion – The guarantee is recognised at fair value.

• At 31 December 2021?
Present obligation as a result of a past obligating event – The obligating event is the giving of
the guarantee, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement – At 31 December 20X1, it
is probable that an outflow of resources embodying economic benefits will be required to settle
the obligation.
Conclusion – The guarantee is subsequently measured at the higher of (a) the best estimate of
the obligation (see paragraphs 14 and 23), and (b) the amount initially recognised less, when
appropriate, cumulative amortisation in accordance with SB-FRS 18 Revenue.
QUESTION 2
a. After a wedding in 2020 ten people died, possibly as a result of food poisoning from products
sold by Carb Co. Legal proceedings are started seeking damages from Carb but it disputes
liability. Up to the date of approval of the financial statements for the year to 31 December
2020, Carb's lawyers advise that it is probable that it will not be found liable. However, when
Carb prepares the financial statements for the year to 31 December 2021 its lawyers advise
that, owing to developments in the case, it is probable that it will be found liable.
What is the required accounting treatment?
(i) At 31 December 2020?
(ii) At 31 December 2021?
b. Water Co gives warranties at the time of sale to purchasers of its products. Under the terms
of the warranty the manufacturer undertakes to make good, by repair or replacement,
manufacturing defects that become apparent within a period of three years from the date of
the sale. Should a provision be recognised?

ANSWER 2
(a) What is the required accounting treatment?

• At 31 December 2020?
Present obligation as a result of a past obligating event – On the basis of the evidence available
when the financial statements were approved, there is no obligation as a result of past events.
Conclusion – No provision is recognised (see paragraphs 15 and 16). The matter is disclosed as a
contingent liability unless the probability of any outflow is regarded as remote (paragraph 86).

• At 31 December 2021?
Present obligation as a result of a past obligating event – On the basis of the evidence available,
there is a present obligation.
An outflow of resources embodying economic benefits in settlement – Probable.
Conclusion – A provision is recognised for the best estimate of the amount to settle the
obligation (paragraphs 14–16).

(b) On past experience, it is probable (ie more likely than not) that there will be some claims
under the warranties.
Present obligation as a result of a past obligating event – The obligating event is the sale of the
product with a warranty, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement – Probable for the
warranties as a whole (see paragraph 24).
Conclusion – A provision is recognised for the best estimate of the costs of making good under
the warranty products sold before the end of the reporting period (see paragraphs 14 and 24).

QUESTION 3
IAS 37 Provisions, contingent liabilities and contingent assets prescribes the accounting and
disclosure for those items named in its title. Define provisions and contingent liabilities. Briefly
explain how IAS 37 improves consistency in financial reporting.

ANSWER 3
IAS 37 Provisions, contingent liabilities and contingent assets defines provisions as liabilities of
uncertain timing or amount that should be recognised where there is a present obligation (as a
result of past events), it is probable (assumed to be more than a 50% chance) that there will be
an outflow of economic benefits (to settle the obligation) and the amounts can be estimated
reliably. The obligation may be legal or constructive.
A contingent liability has more uncertainty in that it is a possible obligation (assumed to be less
than a 50% chance) whose existence will be confirmed only by one or more future uncertain
events that are not wholly within the control of the entity. An existing obligation where the
amount cannot be reliably measured is also treated as a contingent liability.
The Standard seeks to improve consistency in the reporting of provisions. In the past some
entities created ‘general’ (rather than specific) provisions for liabilities that did not really exist
(known as ‘big bath’ provisions); equally many entities did not recognise provisions where there
was a present obligation. The latter often related to deferred liabilities such as future
environmental costs. The effect of such inconsistencies was that comparability was weakened
and profit was frequently manipulated.

QUESTION 4
The following items have arisen during the preparation of Borough’s draft financial statements
for the year ended 30 September 2019:
(i) On 1 October 2018, Borough commenced the extraction of crude oil from a new well on the
seabed. The cost of a 10-year licence to extract the oil was $50 million. At the end of the
extraction, although not legally bound to do so, Borough intends to make good the damage the
extraction has caused to the seabed environment. This intention has been communicated to
parties external to Borough. The cost of this will be in two parts: a fixed amount of $20 million
and a variable amount of 2 cents per barrel extracted. Both of these amounts are based on
their present values as at 1 October 2018 (discounted at 8%) of the estimated costs in 10 years’
time. In the year to 30 September 2019 Borough extracted 150 million barrels of oil.
(ii) Borough owns the whole of the equity share capital of its subsidiary Hamlet. Hamlet’s
statement of financial position includes a loan of $25 million that is repayable in five years’
time. $15 million of this loan is secured on Hamlet’s property and the remaining $10 million is
guaranteed by Borough in the event of a default by Hamlet. The economy in which Hamlet
operates is currently experiencing a deep recession, the effects of which are that the current
value of its property is estimated at $12 million and there are concerns over whether Hamlet
can survive the recession and therefore repay the loan.
Required: Describe, and quantify where possible, how items (i) and (ii) above should be treated
in Borough’s statement of financial position for the year ended 30 September 2019.
In the case of item (ii) only, distinguish between Borough’s entity and consolidated financial
statements and refer to any disclosure notes. Your answer should only refer to the treatment of
the loan and should not consider any impairment of Hamlet’s property or Borough’s investment
in Hamlet.
Note: the treatment in the income statement is NOT required for any of the items.

ANSWER 4
(i) Although the information in the question says the environmental provision is not a legal
obligation, it implies that it is a constructive obligation (Borough has created an expectation
that it will pay the environmental costs) and therefore these costs should be provided for. The
obligation for the fixed element of the cost arose as soon as the extraction commenced,
whereas the variable element accrues in line with the extraction of oil. The present value of the
environmental cost is shown as a non-current liability (credit) with the debit added to the cost
of the licence and (effectively) charged to income as part of the annual amortisation charge.
(ii) From Borough’s perspective, as a separate entity, the guarantee for Hamlet’s loan is a
contingent liability of $10 million. As Hamlet is a separate entity, Borough has no liability for the
secured amount of $15 million, not even for the potential shortfall for the security of $3 million.
The $10 million contingent liability would normally be described and disclosed in the notes to
Borough’s entity financial statements.
In Borough’s consolidated financial statements, the full liability of $25 million would be
included in the statement of financial position as part of the group’s consolidated non-current
liabilities – there would be no contingent liability disclosed.
The concerns over the potential survival of Hamlet due to the effects of the recession may
change the disclosure in Borough’s entity financial statements. If Borough deems it probable
that Hamlet is not a going concern the $10 million loan, which was previously a contingent
liability, would become an actual liability and should be provided for on Borough’s entity
statement of financial position and disclosed as a current (not a non-current) liability.

QUESTION 5
The current version of IAS 37 requires the recognition of a restructuring provision at the earlier
of the commencement of the restructuring and its public announcement. This requirement has
led some critics to suggest that the IAS 37 approach countenances ‘big-bath’ provisioning – the
very practice the standard was produced to avoid. Assess the validity of the arguments of such
critics. The exposure draft proposing changes to IAS 37 was originally issued in 2005 and then
added to in 2010.
Explain the clarifications that were made in the 2010 draft and outline why the 2005 draft was
deficient in these areas.

ANSWER 5
Big-bath provision practice is an act to manipulate provision recognised, this practice allows
preparers to record higher provision and therefore higher expense, and in turn record lower
profit.
The 2010 amendments are made to;
1. Align the criteria in IAS 37 for recognizing a liability only if it is probable.
2. Clarify the measurements of liability in IAS 37 which was previously vague in the 2005 draft.
The 2010 amendments make the 'big-bath' provision preventable as the draft provides more
specific guidelines on how to recognize and measure provision.
As of 2010 amendment, measurement objective is to measure the amount that the entity
would rationally pay at the end of the reporting period to be relieved of the obligation. This
fixes the shortcoming of the 2005 draft to measure the amount required to 'settle' the liability,
which is vague and open to misinterpretation on what preparers deem of 'settling' and what
costs are supposed to be included. This poses a risk of overstating the provision due to wrong
addition of costs.
Furthermore, the 2010 draft provide a better guideline on how to measure provisions and
contingencies reliably. Whereby estimates take into account expected outflow of resources,
time value for money, and risk that actual outflows might ultimately differ from those
expected. This clarifies the 2005 shortcomings of unclear definition of "measuring a liability at
the best estimate amount" which is open to misinterpretation and subject to miscalculation of
provisions and expenses.
The above amendments made in the 2010 draft could help avoid big-bath provision practice
that were prone to happen with the 2005 draft shortcomings.

QUESTION 6
Determine whether the case(s) illustrates a provision or contingent liability. Explain the
treatment.
Case 1: Kleen Limited is a California-based consulting firm, specializing in engineering products
and development. Just before the end of the year the company received a notice of a legal case
from one of its competitors. The case is related to a potential infringement of the competitor's
patent. The in-house legal counsel discussed the case with Kleen Limited's management and
based on information available concluded that the lawsuit was possible, however, there was
not enough information to estimate the potential loss.
Case 2: A local manufacturer of Blue-ray players sells products nationwide. As part of customer
service, the manufacturer provides a warranty to repair or replace its products one year after
the sale. Using accumulated historical information, the manufacturer estimated that each sold
player results, on average, in $30 of warranty expenses. During the current year, the
manufacturer sold 3,000 players.
Case 3: On 12 December 2020 the board of an entity decided to close a division making a
particular product. On 20 December 2020 a detailed plan for closing the division was agreed by
the board, letters were sent to customers warning them to seek an alternative source of supply,
and redundancy notices were sent to the staff of the division.
Case 4: The government introduces changes to the income tax system. As a result of those
changes, an entity in the financial services sector will need to retrain a large proportion of its
administrative and sales workforce in order to ensure continued compliance with tax
regulations. At the end of the reporting period, no retraining of staff has taken place.

ANSWER 6
Case 1
This lawsuit is considered a contingent liability, which should be only described in the notes to
the financial statements as the second criteria (i.e. reasonable estimate of loss amount) was not
met.

Case 2
As it is probable that the manufacturer incurred warranty expenses (i.e. by selling the players
that will need to be fixed later when customers return them) and the amount of warranty
expense can be reasonably estimated (based on historical information), a contingent liability
related to warranty expenses should be recorded in the financial statements. An example of
journal entry to record this warranty expense is as follows:

Account Titles Debit Credit

Warranty Expense 90,000

Warranty Accrual (Reserve) 90,000 *

(*) $90,000 = $30 per unit x 3,000 units sold

Case 3
Present obligation as a result of a past obligating event – the obligating event is the
communication of the decision to the customers and employees, which gives rise to a
constructive obligation from that date, because it creates a valid expectation that the division
will be closed. An outflow of resources embodying economic benefits in settlement is probably.
The conclusion – a provision is recognised at 31 December 20X0 for the best estimate of the
costs of closing the division.

Case 4
Present obligation as a result of a past obligating event – There is no obligation because no
obligating event (retraining) has taken place. Conclusion – No provision is recognized.

QUESTION 7
Amazon Inc. has been sued for the following two alleged infringement of law:
1. unauthorized use of a trademark; the claim is for $100 million
2. non-payment of end-of-service severance pay and gratuity to 5,000 employees who were
terminated without Amazon Inc. giving any reason; the class action lawsuit is claiming $3
million.
Legal counsel has communicated to Amazon Inc. this assessment of the two lawsuits:
Lawsuit 1: the chances of this lawsuit are remote
Lawsuit 2: it is probable that Amazon Inc. would have to pay the displaced employees, but the
best estimate of the amount that would be payable if the plaintiff succeeds against the entity is
$2 million.
What accounting treatment is required for these 2 lawsuits?

ANSWER 7
Lawsuit 1: the chances of this lawsuit are remote
Lawsuit 1 represents a contingent liability. Since the chances of the lawsuit is remote (less than
50% chance of occurring), it does not meet the second condition of a provision (must be
probable). Hence, there is no recognition of provision and no disclosure of the contingent
liability in the financial statements of Amazon Inc.

Lawsuit 2: it is probable that Amazon Inc. would have to pay the displaced employees, but
the best estimate of the amount that would be payable if the plaintiff succeeds against the
entity is $2 million
Lawsuit 2 represents a provision. There is a present obligation for Amazon Inc. to pay the
displaced employees, it is probable that the event would occur and the amount of provision can
be estimated reliably ($2 million).
The provision of $2 million should be treated as a liability in the balance sheet and as an
expense in the income statement. The entity should also disclose the nature of the lawsuit, the
amount recognized as a provision, and the uncertainties involved in the notes of its the
financial statements.

QUESTION 8
The existing standard dealing with provisions IAS 37, Provisions, Contingent Liabilities and
Contingent Assets, has been in place for many years and is sufficiently well understood and
consistently applied in most areas. The IASB feels it is time for a fundamental change in the
underlying principles for the recognition and measurement of non-financial liabilities. To this
end, the Board has issued an Exposure Draft, ‘Measurement of Liabilities in IAS 37 – Proposed
amendments to IAS 37’.
Required:
(i) Discuss the existing guidance in IAS 37 as regards the recognition and measurement of
provisions and why the IASB feels the need to replace this guidance,
(ii) Describe the new proposals that the IASB has outlined in the Exposure Draft.
ANSWER 8
(i) The existing guidance requires a provision to be recognised when: (a) it is probable that an
obligation exists; (b) it is probable that an outflow of resources will be required to settle that
obligation; and (c) the obligation can be measured reliably. The amount recognised as a
provision should be the best estimate of the expenditure required to settle the present
obligation at the balance sheet date, that is, the amount that an entity would rationally pay to
settle the obligation at the balance sheet date or to transfer it to a third party.
This guidance, when applied consistently, provides useful, predictive information about non-
financial liabilities and the expected future cash flows, and is consistent with the recognition
criteria in the Framework. The IASB has initiated a project to replace IAS 37 for three main
reasons:
1. To address inconsistencies with other IFRSs. IAS 37 requires an entity to record an obligation
as a liability only if it is probable (i.e. more than 50% likely) that the obligation will result in an
outflow of cash or other resources from the entity. Other standards, such as IFRS 3 Business
Combinations and IFRS 9 Financial Instruments, do not apply this ‘probability of outflows’
criterion to liabilities.
2. To achieve global convergence of accounting standards. The IASB is seeking to eliminate
differences between IFRSs and US generally accepted accounting principles (US GAAP). At
present, IFRSs and US GAAP differ in how they treat the costs of restructuring a business. IAS 37
requires an entity to record a liability for the total costs of restructuring a business when it
announces or starts to implement a restructuring plan. In contrast, US GAAP requires an entity
to record a liability for individual costs of a restructuring only when the entity has incurred that
particular cost.
3. To improve measurement of liabilities in IAS 37. The requirements in IAS 37 for measuring
liabilities are unclear. As a result, entities use different measures, making it difficult for analysts
and investors to compare their financial statements. Two aspects of IAS 37 are particularly
unclear. IAS 37 requires entities to measure liabilities at the ‘best estimate’ of the expenditure
required to settle the obligation.
In practice, there are different interpretations of what ‘best estimate’ means: the most likely
outcome, the weighted average of all possible outcomes or even the minimum or maximum
amount in the range of possible outcomes. IAS 37 does not specify the costs that entities should
include in the measurement of a liability. In practice, entities include different costs. Some
entities include only incremental costs while others include all direct costs, plus indirect costs
and overheads, or use the prices they would pay contractors to fulfil the obligation on their
behalf.
(ii) The IASB has decided that the new IFRS will not include the ‘probability of outflows’
criterion. Instead, an entity should account for uncertainty about the amount and timing of
outflows by using a measurement that reflects their expected value, i.e. the probability-
weighted average of the outflows for the range of possible outcomes.
Removal of this criterion focuses attention on the definition of a liability in the Framework,
which is a present obligation of an entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
Furthermore, the new IFRS will require an entity to record a liability for each individual cost of a
restructuring only when the entity incurs that particular cost.
The exposure draft proposes that the measurement should be the amount that the entity
would rationally pay at the measurement date to be relieved of the liability. Normally, this
amount would be an estimate of the present value of the resources required to fulfil the
liability. It could also be the amount that the entity would pay to cancel or fulfil the obligation,
whichever is the lowest. The estimate would take into account the expected outflows of
resources, the time value of money and the risk that the actual outflows might ultimately differ
from the expected outflows.
If the liability is to pay cash to a counterparty (for example to settle a legal dispute), the
outflows would be the expected cash payments plus any associated costs, such as legal fees. If
the liability is to undertake a service, for example to decommission plant at a future date, the
outflows would be the amounts that the entity estimates it would pay a contractor at the
future date to undertake the service on its behalf. Obligations involving services are to be
measured by reference to the price that a contractor would charge to undertake the service,
irrespective of whether the entity is carrying out the work internally or externally.

QUESTION 9
Royan, a public limited company, extracts oil and has a present obligation to dismantle an oil
platform at the end of the platform’s life, which is 10 years. Royan cannot cancel this obligation
or transfer it. Royan intends to carry out the dismantling work itself and estimates the cost of
the work to be $150 million in 10 years’ time. The present value of the work is $105 million.
A market exists for the dismantling of an oil platform and Royan could hire a third party
contractor to carry out the work. The entity feels that if no risk or probability adjustment were
needed then the cost of the external contractor would be $180 million in ten years’ time.
The present value of this cost is $129 million. If risk and probability are taken into account, then
there is a probability of 40% that the present value will be $129 million and 60% probability
that it would be $140 million, and there is a risk that the costs may increase by $5 million.
Required: Describe the accounting treatment of the above events under IAS 37 and the possible
outcomes under the proposed amendments in the Exposure Draft.

ANSWER 9
Under IAS 37, a provision of $105 million would be recognised since this is the estimate of the
present obligation. There will be no profit or loss impact other than the adjustment of the
present value of the obligation to reflect the time value of money by unwinding the discount.
Under the proposed approach there are a number of different outcomes:
– with no risk and probability adjustment, the initial liability would be recognised at $129
million which is the present value of the resources required to fulfil the obligation based upon
third-party prices. This means that in 10 years the provision would have unwound to $180
million, the entity will spend $150 million in decommission costs and a profit of $30 million
would be recognised. If there were no market for the dismantling of the platform, then Royan
would recognise a liability by estimating the price that it would charge another party to carry
out the service.
– With risk and probability being taken into account, then the expected value would be (40% x
$129m + 60% x $140m), i.e. $135·6m plus the risk adjustment of $5 million, which totals $140·6
million.
– $105 million being the present value of the future cashflows discounted. The ED suggests that
the entity should take the lower of:
(a) the present value of the resources required to fulfil the obligation, i.e. $105 million;
(b) the amount that the entity would have to pay to cancel the obligation, for which
information is not available here; and
(c) the amount that the entity would have to pay to transfer the obligation to a third party, i.e.
$140·6 million incorporating the administrative costs.
Therefore $105 million should be provided.
The ED makes specific reference to provisions relating to services such as decommissioning
where it suggests that the amount to transfer to a third party would be the required liability, so
$140·6 million would be provided.

QUESTION 10
In each case below, explain the appropriate accounting treatment under IAS 37. Assume all
amounts are material and that the financial year ends on 31 December 2016.

QUESTION 10.1

Jerry plc. supplies hairdryers to the European market with a 12-month warranty against faults.
Past experience has shown that one hairdryer in every fifty units sold will have major faults
requiring complete replacement, at a cost of €65. Additionally, three in fifty units sold will have
minor faults necessitating repairs costing €18. During 2016, 20,000 hairdryers were sold.
ANSWER 10.1
The existence of a promise to repair defective goods is a present obligation caused by a past
event (the sale of the hairdryers). There is a probable outflow of funds, and the amount can be
reliably estimated by examining past experience.
Therefore, a provision should be made for the expected cost of fulfilling the warranty promise.
Expected cost is (20,000 * 1/50 * €65) + (20,000 * 3/50 * 18) = €26,000 + 21,600 = €47,600.
Dr Profit or loss €47,600
Cr Provision for warranty costs €47,600
If there had been an existing provision carried forward, this amount would be adjusted so the
liability becomes equal to the estimated liability at the reporting date. Assume, in the above
example, there was an existing provision of €40,000 in the books. The adjusting entry would
now become:
Dr Profit or loss (47,600 – 40,000) €7,600
Cr Provision for warranty costs €7,600

QUESTION 10.2

Gamma plc. operates as an oil exploration company in several countries. It often causes
environmental damage, but cleans up only when required to do so by law. In Murphyland,
where the company has been contaminating the environment for several years, a law has been
drafted requiring companies causing contamination to clean up. This law, which will apply
retrospectively to past damage, has passed through all stages of parliament before Gamma’s
year end of 31 December 2016, but has not been signed into law yet as the president is on
holidays. The president normally signs without question laws that are passed by parliament. It
has been estimated that the costs of cleaning up the damage already caused will amount to
€15m, and the damage expected to be caused in 2017 will cost €3.5m to repair if the law is
passed.

ANSWER 10.2
Here, damage of €15m has already been caused to the environment, so a past event has
occurred causing the damage. The question is whether or not an outflow of economic benefit is
probable. The law has passed through parliament and it appears that its signing is merely a
formality. The law is retrospective therefore it is probable that the obligation will involve an
outflow of funds. The amount can be reliably estimated. Therefore a provision should be
recognised for €15m. No provision should be recognised for the damage expected to be caused
in 2017 as no obligating event has yet occurred.
QUESTION 10.3

Hades Ltd operates offshore drilling rigs. As part of the terms of its drilling licence, Hades is
required to dismantle the rigs and clean up any contamination at the end of the rigs’ lives.
During 2016 a new rig was constructed at a cost of €30m. The present value of the expected
cost of dismantling this rig was estimated at €5m, and the present value of the cost of
decontamination due to oil passing through the rig was estimated at €2.4m. At 31 December
2016 the rig was completed, but no oil had yet passed through it.

ANSWER 10.3
At the reporting date the rig has been constructed, therefore a past event has occurred giving
rise to an obligation to deconstruct the rig at a present value cost of €5m. This amount should
be provided for as the obligation arises due to a past event, will lead to an outflow of funds,
and this outflow can be estimated reliably.
No obligating event has yet occurred regarding the expected cost of cleaning up due to oil
passing through the rig. Although Hades has an obligation to clean up such contamination, this
is clearly contingent on oil actually passing through the rig. This hasn’t happened, and therefore
there is no past event giving rise to the obligation. Therefore, no provision should be made for
this part of the clean-up cost.

QUESTION 10.4

Kelly plc. operates several clothing stores throughout Ireland. It has a policy of allowing refunds
on all clothes returned within 4 weeks of purchase when accompanied by a valid receipt. There
is no legal obligation to allow refunds, but it has maintained this policy for several years. Past
experience has suggested that 10% of all clothes sold are returned for refund within the 4
weeks. During the last 4 weeks of the financial year ended 31 December 2016, sales totaling
€780,000 were made at a gross margin of 30%. Returned items can be sold on at a discount of
50% of normal retail price.

ANSWER 10.4
There is no legal obligation to allow refunds on returned items that are not faulty. However,
past practice indicated that there is a constructive obligation to allow such refunds, as the
company has clearly advertised this facility. Hence there is a valid expectation and the company
intends to honor this. As past experience suggests 10% of clothes sold will be returned, there is
a probable outflow of resources, and this can be estimated reliably using past experience as a
guide.
Therefore, provision should be made for the loss expected from the return of 10% of €780,000
worth of goods. The loss involves (1) loss of margin on sale plus (2) discount on subsequent sale
if below cost. Together this is expected to amount to 50% of normal retail price, or €39,000. A
provision should be made for this amount.

QUESTION 10.5
On 12 December 2016 Llama Ltd decided to close down a division. Expected costs of closure
were estimated at €1.2m. No action was taken to communicate this to the affected parties until
23 January 2017.

ANSWER 10.5
Provisions for restructuring may only be recognised when the entity has communicated to those
affected their intention to restructure and formed a detailed plan for the restructuring. Neither
of these seems to have happened at the reporting date, therefore no provision should be made.
The subsequent communication is a non-adjusting event as the conditions were not met at the
reporting date.

QUESTION 10.6

Legislation was passed on 30 September 2016 requiring the fitting of emissions filters to the
factories of Melvil plc. immediately. This law has not been complied with by the year end. The
expected cost of fitting the filters is €375,000.

ANSWER 10.6
No obligating event has yet taken place requiring a provision to be recognised. The law has been
passed, but there is no past event triggering the obligation (such as the actual fitting of filters).
Melvil has alternative options such as selling the factories, ceasing the activities requiring the
filters, or securing alternative accommodation. Until an obligating event occurs no provision
should be made.
QUESTION 10.7

Sam Ltd is being sued for €100,000 by a customer who slipped on a wet floor whilst at Sam’s
premises. Legal advice at the reporting date is that Sam is likely to win the case, as no
negligence seems to be provable.
ANSWER 10.7
A past event has occurred leading to a possible liability. The probability of outflow of economic
benefit seems possible though not probable. Therefore, disclosure of the contingent liability in
the notes should be made.

QUESTION 10.8

A fire occurred at the premises of Tim Ltd during December 2010. Total damage was assessed
at €350,000. It is a term of Tim’s insurance policy that fire alarms be fitted to all premises. No
fire alarms were fitted to the premises affected by the fire. It is hoped that Tim’s insurers will
cover this loss under the terms of the insurance policy. However, the assessor has not yet
provided his report or recommendations.

ANSWER 10.8
Provision should be made for the costs of the fire by writing down the values of the assets
affected. The potential claim from the insurance company is a contingent asset. The success of
the claim is clearly not virtually certain therefore no recognition should be made of the amount.
If success is considered to be probable, disclosure should be made in the notes. Otherwise, it
should be ignored.
IMPAIRMENT OF ASSETS
QUESTION 1
The objective of IAS 36 Impairment of assets is to prescribe the procedures that an entity
applies to ensure that its assets are not impaired. Explain what is meant by an impairment
review. Your answer should include reference to assets that may form a cash generating unit.
Note: you are NOT required to describe the indicators of impairment or how impairment losses
are allocated against assets.

ANSWER 1
An impairment review is the procedure required by IAS 36 Impairment of assets to determine if
and by how much an asset may have been impaired. An asset is impaired if its carrying amount
is greater than its recoverable amount. In turn the recoverable amount of an asset is defined as
the higher of its fair value less costs to sell or its value in use, calculated as the present values of
the future net cash flows the asset will generate.
The problem in applying this definition is that assets rarely generate cash flows in isolation;
most assets generate cash flows in combination with other assets. IAS 36 introduces the
concept of a cash generating unit (CGU) which is the smallest identifiable group of assets that
generate cash inflows that are (largely) independent of other assets. Where an asset forms part
of a CGU any impairment review must be made on the group of assets as a whole. If
impairment losses are then identified, they must be allocated and/or apportioned to the assets
of the CGU as prescribed by IAS 36.

QUESTION 2
(i)Telepath acquired an item of plant at a cost of $800,000 on 1 April 2010 that is used to
produce and package pharmaceutical pills. The plant had an estimated residual value of
$50,000 and an estimated life of five years, neither of which has changed. Telepath uses
straight-line depreciation. On 31 March 2012, Telepath was informed by a major customer
(who buys products produced by the plant) that it would no longer be placing orders with
Telepath. Even before this information was known, Telepath had been having difficulty finding
work for this plant. It now estimates that net cash inflows earned from the plant for the next
three years will be:

Year ended: $’000

31 March 2013 220
31 March 2014 180
31 March 2015 170

On 31 March 2015, the plant is still expected to be sold for its estimated realisable value.
Telepath has confirmed that there is no market in which to sell the plant at 31 March 2012.
Telepath’s cost of capital is 10% and the following values should be used:

Value of $1 at: $
End of year 1 0·91
End of year 2 0·83
End of year 3 0·75

(ii)Telepath owned a 100% subsidiary, Tilda that is treated as a cash generating unit. On 31
March 2012, there was an industrial accident (a gas explosion) that caused damage to some of
Tilda’s plant. The assets of Tilda immediately before the accident were:
$’000
Goodwill 1,800
Patent 1,200
Factory building 4,000
Plant 3,500
Receivables and cash 1,500
–––––––
12,000
–––––––
As a result of the accident, the recoverable amount of Tilda is $6·7 million.

The explosion destroyed (to the point of no further use) an item of plant that had a carrying
amount of
$500,000.
Tilda has an open offer from a competitor of $1 million for its patent. The receivables and cash
are already
stated at their fair values less costs to sell (net realisable values).

Calculate the carrying amounts of the assets in (i) and (ii) above at 31 March 2012 after
applying any impairment losses. Calculations should be to the nearest $1,000.

ANSWER 2
(i)The carrying amount of the plant at 31 March 2012, before the impairment review, is $500,000
(800,000 – (150,000 x 2)) where $150,000 is the annual depreciation charge (800,000 cost – 50,000
residual value)/5 years). This needs to be compared with the recoverable amount of the plant which
must be its value in use as it has no market value at this date.

At 31 March 2012, the plant’s value in use of $514,000 is greater than its carrying amount of
$500,000. This means the plant is not impaired and it should continue to be carried at
$500,000.
The plant with a carrying amount of $500,000 that has been damaged to the point of no further
use should be written off (it no longer meets the definition of an asset). The carrying amounts
in the second column above are after writing off this plant. After this, firstly, goodwill is written
off in full.
Secondly, any remaining impairment loss should write off the remaining assets pro rata to their
carrying amounts, except that no asset should be written down to less than its fair value less
costs to sell (net realisable value). After writing off the damaged plant the remaining
impairment loss is $4·8 million (11·5m – 6·7m) of which $1·8 million is applied to the goodwill,
$200,000 to the patent (taking it to its realisable value) and the remaining $2·8 million is
apportioned pro rata at 40% (2·8m/(4m + 3m)) to the factory and the remaining plant. The
carrying amounts of the assets of Tilda, at 31 March 2012 after the accident, are as shown in
the third column above.

QUESTION 3
A company owns a car that was involved in an accident at the year end. It is barely useable, so t
he value in use
is estimated at $1,000. However, the car is a classic and there is a demand for the parts. This res
ults in a
fair value less costs to sell of $3,000. The opening carrying amount was $8,000 and the car was
estimated to have a life of eight years from the start of the year.
Identify the recoverable amount of the car and any impairment required.
ANSWER 3
Recoverable amount is higher of:

• Fair value less costs to sell = $3,000

• Value in use $1,000
Therefore $3,000.

QUESTION 4
An entity owns a property which was originally purchased for $300,000. The property has been
revalued to $500,000 with the revaluation of $200,000 being recognised as other comprehensiv
e income and recorded in
the revaluation reserve. The property has a current carrying amount of $460,000 but the recove
rable amount of the property has just been estimated at only $200,000.
What is the amount of impairment and how should this be treated in the financial statements?

ANSWER 4
Impairment = $460,000 – 200,000 = $260,000
Of this $200,000 is debited to the revaluation reserve to reverse the previous upwards revaluati
on (and recorded as other comprehensive
income) and the remaining $60,000 is charged to the statement of profit or loss.

QUESTION 5
A company runs a unit that suffers a massive drop in income due to the failure of its technology
on 1 January 2018. The following carrying amounts were recorded in the books immediately pri
or to the impairment:

$m
Goodwill 20
Technology 5
Brands 10
Land 50
Buildings 30
Other net assets 40
The recoverable value of the unit is estimated at $85 million.
The technology is worthless, following its complete failure.
The other net assets include inventory, receivables and payables.
It is considered that the carrying amount of other net assets is a reasonable representation of
its net realisable value.
Show the impact of the impairment on 1 January.

ANSWER 5

• Carrying amount is $155 million.

• Recoverable value is $85 million.
• Therefore, an impairment of $70 million is required.
Technology is considered to be completely worthless and therefore must first be written down
to its nil residual value.
Dr Impairment expense $5m
Cr Technology $5m
Following the write down of technology -
the impairment loss to allocate against the remaining CGU assets is $65m.
Dr Impairment expense $65m
Cr CGU (W1) $65m

As the other net assets are held at reasonable representation of the realisable value, no impairment
should be allocated to these. No assets should be written down to below their recoverable amount. On
this basis, the other net assets are left at their current carrying amount.

QUESTION 6
An entity acquires 60 per cent of a subsidiary, which is a CGU. At the year-end, the carrying
amount of the subsidiary's identifiable net assets is GBP 30m; the recoverable amount of the
CGU is GBP 43m. Goodwill is GBP 12m using the partial method or GBP 18m under the full
goodwill method.
Required: Compute the impairment amount under (i) the partial goodwill method, and (ii) the
full goodwill method, and illustrate the treatment of impairment loss for parts (i) and (ii).

ANSWER 6
6(i)
[CA]
Net assets = GBP 30m
Goodwill:
@ 60% = GBP 12m
@ 100% = (GBP 12m x 100%/60% = GBP 20m)*
*cross-multiply

Total CA = GBP 30m + GBP 20m = GBP 50m

[RA = GBP 43m]

CA>RA, existence of impairment loss

Impairment Loss = CA - RA = GBP 50m - GBP 43m = GBP 7m

6(ii)
[CA]
Net Asset = GBP 30m
Goodwill = GBP 18m**

**Full method so use as stated

Total CA = GBP 30m + GBP 18m = GBP 48m

[RA = GBP 43m]

CA>RA, existence of impairment loss

Impairment Loss = CA - RA = GBP 48m - GBP 43m = GBP 5m

Impairment loss using full goodwill method will recognise the impairment in full
100% = GBP 5m
Allocation to:
Parent = 60% x GBP 5m = GBP 3m
NCI = 40% x GBP 5m = GBP 2m

QUESTION 7
Aphrodite Co has a year end of 31 December and operates a factory which makes computer
chips for mobile phones. It purchased a machine on 1 July 2015 for $80,000 which had a useful
life of 10 years and is depreciated on the straight-line basis, time apportioned in the years of
acquisition and disposal. The machine was revalued to $81,000 on 1 July 2014. There was no
change to its useful life at that date.

A fire at the factory on 1 October 2016 damaged the machine leaving it with a lower operating
capacity. The accountant considers that Aphrodite Co will need to recognise an impairment loss
in relation to this damage. The accountant has ascertained the following information at 1
October 2016:

• The carrying amount of the machine is $60,750

• An equivalent new machine would cost $90,000
• The machine could be sold in its current condition for a gross amount of $45,000.
Dismantling costs would amount to $2,000
 • In its current condition, the machine could operate for three more years which gives
it a value in use figure of $38,685

Calculate the total impairment loss associated with Aphrodite Co’s machine at 1 October 2016.

ANSWER 7
1 Oct 2016

• Carrying amount = $60,750

• Recoverable amount = the higher of FVLCS and VIU = $43,000
o FVLCS = $45,000 - $2,000 = $43,000
o VIU = $38,685
• Impairment loss = CA - RA = $60,750 - $43,000 = $17,750

QUESTION 8
Riley acquired a non-current asset on 1 October 2009 at a cost of $100,000 which had a useful
economic life of 10 years and a nil residual value. The asset had been correctly depreciated up
to 30 September 2014. At that date, the asset was damaged and an impairment review was
performed. On 30 September 2014, the fair value of the asset less costs to sell was $30,000 and
the expected future cash flows were $8,500 per annum for the next five years. The current cost
of capital is 10% and a five-year annuity of $1 per annum at 10% would have a present value of
$3.79.
Required: What amount would be charged to profit or loss for the impairment of this asset for
the year ended 30 September 2014?

ANSWER 8
QUESTION 9
Ben Co has a year end of 30 September and owns an item of plant which it uses to produce and
package pharmaceuticals. The plant cost $750,000 on 1 October 2010 and, at that date, had an
estimated useful life of five years. A review of the plant on 1 April 2013 concluded that the
plant would last for a further three and a half years and that its fair value was $560,000.

Ben Co adopts the policy of revaluing its non-current assets to their fair value but does not
make an annual transfer from the revaluation surplus to retained earnings to represent the
additional depreciation charged due to the revaluation.

On 30 September 2013, Ben Co was informed by a major customer that it would no longer be
placing orders with Ben Co. As a result, Ben Co revised its estimates that net cash inflows
earned from the plant for the next three years would be:
Year ended 30 September: $
2014 220,000
2015 180,000
2016 200,000

Ben Co’s cost of capital is 10% which results in the following discount factors:
Value of $1 at 30 September:
2014 0.91
2015 0.83
2016 0.75

Ben Co also owns Rilda Co. a 100% subsidiary, which is treated as a cash generating unit. On 30
September 2013, there was an impairment to Rilda’s assets of $3,500,000. The carrying amount
of the assets of Rilda Co immediately before the impairment were:
Goodwill 2,000,000
Factory Building 4,000,000
Plant 3,500,000
Receivables and cash (at recoverable amount) 2,500,000
 12,000,000

Required: Calculate the value in use of Ben Co’s plant as at 30 September 2013

ANSWER 9

VIU = $200,200 + $149,400 + $150,000 = $499,600

QUESTION 10
Refer to Question 9
Required: Calculate the carrying amount of Rilda Co’s plant at 30 September 2013 after the
impairment loss has been correctly allocated to its assets.

ANSWER 10