Case Study Session 1 Revenue recognition, Functional currency and Financial instruments

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1 Revenue recognition Case Study 1 An entity sells goods on extended credit. The goods are sold for C1,200, on 1 January 20X1, receivable on 1 January 20X3. The customer can borrow at 4.5% a year. Question: At what amount should the revenue be recognised? Please pass accounting entries for all the dates (on January 1, 20X1, December 31, 20X1, December 31, 20X2 and January 1, 20X3). Management should determine the fair value of revenue by calculating the present value of the cash flows receivable. On the transaction date, revenue of C1,099 is recorded, being C1,200 discounted for 2 years. The discounted receivable should be updated at each balance sheet date to reflect the passage of time. The resulting increase in the receivable represents interest income and should be recognised as such over the period from the date of sale to the expected date of receipt of cash. Case study 2 A retailer is offering a special 'buy one get one half price' deal whereby customers who purchase one box of chocolates are then entitled to purchase another box at the same time and obtain the second box for half the price. How should the retailer record the transaction? Question: Will the discount given on the second box be accounted as a cost of sale or a marketing expense? The revenue recognised is the cash consideration received for the two boxes of chocolates. The additional cost from offering the second box at a discount to the normal price is recorded as a cost of sales, not as a marketing expense. Case study 3 Entity B (incorporated in Singapore) which is a subsidiary of Entity A (incorporated in India) enter into a tripartite contract with Entity C (incorporated in India). As per the contract, Entity B will supply raw material X, important for the operation of Entity C, to Indian ports as agreed in the agreement. Entity A shall be responsible for transfer of the entire raw material consignment from the port to the factory of Entity C. Entity C shall pay Entity B the cost of goods and Entity A the handling charges based on the quantity of raw material X reaching their factory. Question: - When can Entity B recognise revenue in its standalone books? - When can Entity A recognise revenue in its standalone books? - For the consolidated accounts of Entity A and Entity B will there be a change in the accounting from the standalone? Entity B shall be able to recognise the revenue on the sale of goods in its standalone books at the time of handing over the goods to Entity A if all risks and rewards are transferred to Entity A. Entity A shall be able to recognise its handling income only on delivery to Entity C. Case study 4 Multiple choice questions On a consolidated basis the entire revenue will have to be deferred till the time the actual delivery is made to Entity C. Micrium, a computer chip manufacturing company, sells its products to its distributors for onward sales to the ultimate customers. Due to frequent fluctuations in the market prices for these goods, Micrium has a price protection clause in the distributor agreement that entitles it to raise additional billings in case 1 P a g e

2 of upward price movement. Another clause in the distributor s agreement is that Micrium can at any time reduce its inventory by buying back goods at the cost at which it sold the goods to the distributor. Distributors pay for the goods within 60 days from the sale of goods to them. When should Micrium recognize revenue on sale of goods to the distributors? (a) When the goods are sold to the distributors. (b) When the distributors pay to Micrium the cost of the goods (i.e., after 60 days of the sale of goods to the distributors). (c) When goods are sold to the distributor provided estimated additional revenue is also booked under the protection clause based on past experience. (d) When the distributor sells goods to the ultimate customers and there is no uncertainty with respect to the price protection clause or the buyback of goods. 2. ABC Inc. is a large manufacturer of machines. XYZ Ltd., a major customer of ABC Inc., has placed an order for a special machine for which it has given a deposit of 112,500 to ABC Inc. The parties have agreed on a price for the machine of 150,000. As per the terms of the sales agreement, it is an FOB (free on board) contract and the title passes to the buyer when goods are loaded onto the ship at the port. When should the revenue be recognized by ABC Inc.? (a) When the customer orders the machine. (b) When the deposit is received. (c) When the machine is loaded on the port. (d) When the machine has been received by the customer. 3. Revenue from an artistic performance is recognized once (a) The audience register for the event online. (b) The tickets for the concert are sold. (c) Cash has been received from the ticket sales. (d) The event takes place. 4. X Ltd., a large manufacturer of cosmetics, sells merchandise to Y Ltd., a retailer, which in turn sells the goods to the public at large through its chain of retail outlets. Y Ltd. purchases merchandise from X Ltd. under a consignment contract. When should revenue from the sale of merchandise to Y Ltd. be recognized by X Ltd.? (a) When goods are delivered to Y Ltd. (b) When goods are sold by Y Ltd. (c) It will depend on the terms of delivery of the merchandise by X Ltd. to Y Ltd. (i.e., CIF [cost, insurance, and freight] or FOB). (d) It will depend on the terms of payment between Y Ltd. and X Ltd. (i.e., cash or credit). 5. Company XYZ Inc. manufacturers and sells standard machinery. One of the conditions in the sale contract is that installation of machinery will be undertaken by XYZ Inc. During December 2005, XYZ received a special onetime contract from ABC Ltd. to manufacture, install, and maintain customized machinery. It is the first time XYZ Inc. will be producing this kind of machinery, and it is expecting numerous changes that would need to be made to the machine after the installation is completed, which one period is described in the contract of sale as the maintenance period. The total cost of making the changes during the maintenance period cannot be reasonably estimated at the time of the installation. When should the revenue from sale of this special machine be recognized? 2 P a g e

3 (a) When the machinery is produced. (b) When the machinery is produced and delivered. (c) When the installation is complete. (d) When the maintenance period as per the contract of sale expires. 1 d; 2 c; 3 d; 4 b; 5 d 3 P a g e

4 Functional currency Case study 1 A real estate entity operates in Russia. It owns several office buildings in Moscow and St. Petersburg that are rented to Russian and foreign entities. All lease contracts are denominated in US dollars, but payments can be made in either US dollars or in Russian roubles. However, almost all of the lease payments are settled in roubles. This has also been the historical pattern of payment. 4 P a g e Question: What is the functional currency of the real estate entity? On first analysis, the 'sales and cash inflows' indicators appear to produce a mixed response, because the currency that mainly influences the pricing of the lease contracts is the US dollar, whereas the cash inflows are in roubles. Also, cash outflows such as the principal operating costs, management of properties, insurance, taxes and staff costs are likely to be incurred and settled in roubles, which would indicate that the functional currency is the Russian rouble. The lease payments are denominated in US dollars, but the US dollar is not considered to be significant to the entity's operation because: (a) most of the collection is in roubles, which is subject to short-term changes in US dollar/rouble exchange rate; and (b) it is the local conditions and circumstances in Russia, not the US, that determine the rental yields of properties in Moscow and St Petersburg that mainly influence the pricing of the lease contracts, which are merely denominated in US dollar. It is, therefore, the currency of the Russian economy (roubles), rather than the currency in which the lease contracts are denominated, that most faithfully represents the economic effects of the real estate activity in Russia. Case study 2 Entity A operates an oil refinery in Saudi Arabia. All of the entity's income is denominated and settled in US dollars. The oil price is subject to the worldwide supply and demand, and crude oil is routinely traded in US dollars around the world. Around 45% of entity A's cash costs are imports or expatriate salaries denominated in US dollars. The remaining 55% of cash expenses are incurred in Saudi Arabia and denominated and settled in riyal. The non-cash costs (depreciation) are US dollar denominated, as the initial investment was in US dollars. Question: What is the functional currency of Entity A? The functional currency of entity A is the US dollar. The crude oil sales prices are influenced by global demand and supply. Crude oil is globally traded in US dollars around the world. The revenue analysis points to the US dollar. The cost analysis is mixed. Depreciation (or any other non-cash expenses) is not considered, as the primary economic environment is where the entity generates and expends cash. Operating cash expenses are influenced by the riyal (55%) and the US dollar (45%). Management is able to determine the functional currency as the US dollar, as the revenue is clearly influenced by the US dollar and expenses are mixed. Case study 3 Entity A is a US bank with a US dollar functional currency. Entity A establishes a Special Purpose Entity SPE in a European country in order to invest in a European bond portfolio. Entity A has funded the SPE with equity and inter-company debt denominated in euros. The SPE uses the financing to purchase a portfolio of euro government bonds. There is no intention for the SPE to perform any activities other than holding the bond portfolio. The directors are all employees of the US parent, and the SPE has no

5 active management of its own. Case study 4 Multiple choice questions Question: What is the functional currency of the SPE? The functional currency of the SPE is the US dollar, as the entity has no operations and does not provide any services. The primary indicators therefore do not apply. The financing indicator supports the euro, as all financing is in euros. However, all the financing is inter-company and entity A could denominate the financing in any currency it wanted. Considering the autonomy indicator, it is clear the SPE is not autonomous. It is a shell company, has no independent activities and no active management of its own. 1. Which of these considerations would not be relevant in determining the entity s functional currency? (a) The currency that influences the costs of the entity. (b) The currency in which finance is generated. (c) The currency in which receipts from operating activities are retained. (d) The currency that is the most internationally acceptable for trading. 2. Foreign operations that are an integral part of the operations of the entity would have the same functional currency as the entity. Where a foreign operation functions independently from the parent, the functional currency will be (a) That of the parent. (b) Determined using the guidance for determining an entity s functional currency. (c) That of the country of incorporation. (d) The same as the presentation currency. 3. An entity started trading in country A, whose currency was the dollar. After several years the entity expanded and exported its product to country B, whose currency was the euro. The functional currency of the entity was deemed to be the dollar but by the end of 20X7, 80% of the business was conducted in country B using the euro. At the end of 20X6, 30% of the business was conducted in the euro. The functional currency should (a) Remain the dollar. (b) Change to the euro at the beginning of 20X7. (c) Change to the euro at the end of 20X7. (d) Change to the euro at the end of 20X7 if it is considered that the underlying transactions, events, and conditions of business have changed. 4. An entity started trading in country A, whose currency was the dollar. After several years the entity expanded and exported its product to country B, whose currency was the euro. The business was conducted through a subsidiary in country B. The subsidiary is essentially an extension of the entity s own business, and the directors of the two entities are common. The functional currency of the subsidiary is (a) The dollar. (b) The euro. (c) The dollar or the euro. (d) Difficult to determine. 5. An entity acquired all the share capital of a foreign entity at a consideration of 9 million on June 30, 20X6. The fair value of the net assets of the foreign entity at that date was 6 million. The functional currency of the entity is the dollar. The financial 5 P a g e

6 year-end of the entity is December 31, 20X6. The exchange rates at June 30, 20X6, and December 31, 20X6, were 1.5 = $1 and 2 = $1 respectively. What figure for goodwill should be included in the financial statements for the year ended December 31, 20X6? (a) $2 million. (b) 3 million. (c) $1.5 million. (d) $3 million. 1 d; 2 b; 3 d;4 a; 5 c 6 P a g e

7 Financial instruments Case study 1 An entity purchased quoted equity shares from the market with the intention of profiting from short-term price fluctuations. The entity held the shares for three years due to a large unexpected downturn in the stock market after which it sold the shares in a more buoyant market. 7 P a g e Question: What will be the classification on initial recognition? Will the classification change subsequently? Since management s intention at acquisition was to profit from short-term price fluctuations, the entity would have classified the shares as held-for-trading. The fact that after designation the shares were in fact held for a longer term, because the entity was unable to sell the shares at a loss in a bear market, would not frustrate the held-to-trading classification. Indeed, IAS 39 does not limit the period for which such an instrument can be held as long as the principal purpose at acquisition was to sell them in the near-term. Furthermore, as there is no definition of 'near-term' it is important for the entity to adopt a suitable definition and apply it consistently. Case study 2 Company A is evaluating whether each of these items is a financial instrument and whether it should be accounted for under IAS 32: (a) Cash deposited in banks (b) Gold bullion deposited in banks (c) Trade accounts receivable (d) Investments in debt instruments (e) Investments in equity instruments, where Company A does not have significant influence over the investee (f) Investments in equity instruments, where Company A has significant influence over the investee (g) Prepaid expenses (h) Finance lease receivables or payables (i) Deferred revenue (j) Statutory tax liabilities (k) Provision for estimated litigation losses (l) An electricity purchase contract that can be net settled in cash (m) Issued debt instruments (n) Issued equity instruments Question: Help Company A to determine (1) which of the above items meet the definition of a financial instrument and (2) which of the above items fall within the scope of IAS 32. (a) Yes, cash deposited in a bank is a financial instrument. If an entity deposits cash in a bank, it is a financial asset of the entity and a financial liability of the bank, because the bank has a contractual obligation to repay the cash to the entity. It falls within the scope of IAS 32. (b) No, gold is not a financial instrument. It is a commodity. It is outside the scope of IAS 32. (c) Yes, a trade accounts receivable is a financial instrument. Trade accounts receivable is a financial asset because the holder has a contractual right to receive cash. It falls within the scope of IAS 32. (d) Yes, an investment in a debt instrument is a financial instrument. Investments in debt instruments are financial assets because the investor has a contractual right to

8 Case study 3 Multiple choice questions receive cash. It falls within the scope of IAS 32. (e) Yes, an investment in an equity instrument is a financial instrument. Investments in equity instruments are financial assets because the investor holds an equity instrument issued by another entity. It falls within the scope of IAS 32. (f) While an investment in an equity instrument is a financial instrument (a financial asset), if the investor has significant influence, joint control, or control over the investee, the investment generally is scoped out of IAS 32 and instead accounted for as an investment in an associate, joint venture, or subsidiary. (g) No, prepaid expenses are not financial instruments because they will not result in the delivery or exchange of cash or other financial instruments. They are outside the scope of IAS 32. (h) Yes, finance lease receivables or payables are financial instruments. They are within the scope of IAS 32. (However, they are scoped out of IAS 39 except for recognition and measurement of impairment of finance lease receivables.) (i) No, deferred revenue does not meet the definition of a financial instrument. Deferred revenue is outside the scope of IAS 32. (j) No, deferred taxes do not meet the definition of a financial instrument, because they do not arise from contractual rights or obligations, but from statutory requirements. They are outside the scope of IAS 32. (k) No, provisions do not meet the definition of a financial instrument, because they do not arise as a result of contractual rights or obligations. They are outside the scope of IAS 32. (l) Even though an electricity purchase contract does not meet the definition of a financial instrument, it is included in the scope of IAS 32 (and IAS 39) if it can be settled net in cash unless it will be settled by delivery to meet the entity s normal purchase, sale, or usage requirements. (m) Yes, an issued debt instrument meets the definition of a financial liability. It is within the scope of IAS 32. (n) Yes, an issued equity instrument is a financial instrument that falls within the scope of IAS 32. However, although an issued equity instrument meets the definition of a financial instrument, there is a specific scope exception for issued equity instruments in IAS Are there any circumstances when a contract that is not a financial instrument would be accounted for as a financial instrument under IAS 32 and IAS 39? (a) No. Only financial instruments are accounted for as financial instruments. (b) Yes. Gold, silver, and other precious metals that are readily convertible to cash are accounted for as financial instruments. (c) Yes. A contract for the future purchase or delivery of a commodity or other nonfinancial item (e.g., gold, electricity, or gas) generally is accounted for as a financial instrument if the contract can be settled net. (d) Yes. An entity may designate any nonfinancial asset that can be readily convertible to cash as a financial instrument. 2. Which of the following assets is not a financial asset? (a) Cash. (b) An equity instrument of another entity. (c) A contract that may or will be settled in the entity s own equity instrument and is not classified as an equity instrument of the entity. (d) Prepaid expenses. 3. Which of the following liabilities is a financial liability? 8 P a g e

9 (a) Deferred revenue. (b) A warranty obligation. (c) A constructive obligation. (d) An obligation to deliver own shares worth a fixed amount of cash. 4. Which of the following is not a category of financial assets defined in IAS 39? (a) Financial assets at fair value through profit or loss. (b) Available-for-sale financial assets. (c) Held-for-sale investments. (d) Loans and receivables. 5. Which of the following transfers of financial assets qualifies for derecognition? (a) A sale of a financial asset where the entity retains an option to buy the asset back at its current fair value on the repurchase date. (b) A sale of a financial asset where the entity agrees to repurchase the asset in one year for a fixed price plus interest. (c) A sale of a portfolio of short-term accounts receivables where the entity guarantees to compensate the buyer for any losses in the portfolio. (d) A loan of a security to another entity (i.e., a securities lending transaction). 1 c; 2 d; 3 d; 4 c; 5 a 9 P a g e

Case Study Session 1 Revenue recognition, Functional currency and Financial instruments

Case Study Session 1 Revenue recognition, Functional currency and Financial instruments Revenue recognition Case Study 1 An entity sells goods on extended credit. The goods are sold for C1,200, on 1 January 20X1, receivable on 1 January 20X3. The customer can borrow at 4.5% a year. Question: