\ CIPFA EDUCATION AND TRAINING CENTRE Certificate in International Public Sector Accounting Standards Preparation of financial statements part 4 Workbook 5 (Copyright)
First published 2013 For use in assessment January December 2014 Published by CIPFA Education and Training Centre 215-221 Borough High Street London SE1 1JA Email: cetc@cipfa.org Website: http://www.cipfa.org Copyright 2012 Chartered Institute of Public Finance and Accountancy All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6 10 Kirby Street, London EC1N 8TS. Every possible care has been taken in the preparation of this publication but no responsibility can be accepted for loss occasioned to any person acting or refraining from action as a result of any material contained herein. Page 2 Preparation of financial statements part 4
Contents Learning objectives... 5 5.1 IPSAS 19 Provisions, Contingent Liabilities and Contingent Assets... 6 5.1.1 Overview of IPSAS 19... 6 5.1.2 Scope of IPSAS 19... 6 5.1.3 IPSAS 19 Key definitions... 7 5.1.4 Recognition of provisions... 9 5.1.5 Recognition of contingent liabilities... 11 5.1.6 Recognition of contingent assets... 12 5.1.7 Measurement... 13 5.1.8 Application of recognition and measurement rules... 19 5.1.9 Disclosure requirements... 23 5.2 IPSAS 9 Revenue from Exchange Transactions... 25 5.2.1 Overview... 25 5.2.2 IPSAS 9 Revenue from Exchange Transactions... 26 5.2.3 Recognition... 27 5.2.4 Measurement... 27 5.2.5 Sale of goods... 29 5.2.6 Rendering of services... 31 5.2.7 Interest, royalties and dividends... 32 5.2.8 Exchange of assets... 33 5.2.9 Disclosure... 38 5.2.10 Applications of IPSAS 9... 33 5.3 IPSAS 23 Revenue from Non-Exchange Transactions... 39 5.3.1 Overview... 39 5.3.2 IPSAS 23 Revenue from Non-Exchange transactions... 40 5.3.3 Recognition... 41 5.3.4 Measurement... 43 5.3.5 Revenue from taxes... 44 5.3.6 Transfers... 46 5.3.7 Disclosure... 53 5.4 IPSAS 11 Construction Contracts... 54 5.4.1 Introduction... 54 5.4.2 Accounting for construction contracts: The problem... 55 Preparation of financial statements part 4 Page 3
5.4.3 IPSAS 11 - overview... 56 5.4.4 Statement of financial performance... 57 5.4.5 Statement of financial position... 61 5.4.6 IPSAS 11 worked example... 63 5.4.7 IPSAS 11 other issues... 69 5.4.8 IPSAS 11 - disclosures... 73 Summary... 74 Additional exercises... 75 Exam standard questions... 83 Page 4 Preparation of financial statements part 4
Learning objectives In this workbook we will deal with part of syllabus learning aims B and C, i.e.: Aim B: Describe the main requirements of IPSASs. (30% of the syllabus) Aim C: Apply the requirements of IPSASs to determine the appropriate treatment of events and transactions in financial statements. (40% of the syllabus) In the last four workbooks we have looked at several accounting standards relating to the preparation of financial statements, and we will continue by covering the following standards in this workbook: So far we have covered the presentation of financial statements (IPSAS 1) in workbook 2, and the accounting for non-current assets in workbooks 3 and 4. In this workbook, we will look at the other accounting standards that impact the preparation of the financial statements, which are: IPSAS 19 Provisions, Contingent Liabilities and Contingent Assets IPSAS 9 Revenue from Exchange Transactions IPSAS 23 Revenue from Non-Exchange Transactions (Taxes and Transfers) IPSAS 11 Construction Contracts. Preparation of financial statements part 4 Page 5
5.1 IPSAS 19 Provisions, Contingent Liabilities and Contingent Assets 5.1.1 Overview of IPSAS 19 The life of an entity is full of uncertainties regarding future events and management is therefore required to make informed estimates on the outcome of such events. For example: will there be sufficient demand for a service in the future; will all the receivables be collected? The creation of a provision has traditionally provided entities with an opportunity to smooth results. For example, in periods where performance has exceeded expectations an entity might be tempted to make what has been commonly referred to as a rainy day provision. The provision set up in prosperous times would be released in periods when results were below expectations. As a consequence, IPSAS 19 Provisions, Contingent Liabilities and Contingent Assets was introduced to restrict an entity's ability to make large general provisions which can have a significant impact on the reported results of an entity. IPSAS 19 provides guidance on the type of provisions that should be made and on the general principles surrounding recognition. The objective of IPSAS 19 is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount. Scope of IPSAS 19 IPSAS 19 does not apply to provisions and contingent liabilities arising from social benefits provided by an entity for which it does not receive a consideration which is approximately equal to the value of the goods and services provided and paid directly by the recipients of those benefits. Such arrangements would not be regarded as onerous contracts. An onerous contract is a contract for the exchange of assets or services in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits or service potential expected to be received under it. Page 6 Preparation of financial statements part 4
Social benefits refer to goods, services, and other benefits provided in the pursuit of the social policy objectives of a government. These benefits may include: the delivery of health, education, housing, transport, and other social services to the community, as in many cases there is no requirement for the beneficiaries of these services to pay an amount equivalent to the value of these services; and payment of benefits to families, the aged, the disabled, the unemployed, veterans, and others as governments at all levels may provide financial assistance to individuals and groups in the community to access services to meet their particular needs, or to supplement their income. IPSAS 19 does not apply to executory contracts unless they are onerous 1. Also, IPSAS 19 does not apply to specific types of provisions, contingent liabilities and contingent assets which are already dealt with in another standard, for example construction contracts as covered in IPSAS 11 Construction Contracts (see later in this workbook). 5.1.2 IPSAS 19 Key definitions There are some key definitions in IPSAS 19 that we need to learn before we consider the accounting treatment. Provision Key definition: Provision A provision is a liability of uncertain timing or amount. Provisions are distinguished from other liabilities such as payables and accruals because there is uncertainty about the timing or amount of the future expenditure required in settlement. 1 Executory contracts are contracts under which neither party has performed any of its obligations, or both parties have partially performed their obligations to an equal extent. We will deal with the term onerous later in this workbook. Preparation of financial statements part 4 Page 7
Contingent liability Key definition: Contingent liability A contingent liability is: (a) A possible obligation that arises from past events, and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or (b) A present obligation that arises from past events, but is not recognised because: (i) It is not probable that an outflow of resources embodying economic benefits or service potential will be required to settle the obligation; or (ii) The amount of the obligation cannot be measured with sufficient reliability. A contingent liability arises where there is significant uncertainty about a number of aspects regarding the liability. A contingent liability arises where an event that occurred in the past may lead to the entity having a liability in the future, but the financial impact of the event will only be confirmed by the outcome of some future event not wholly within the entity's control. The giving of a guarantee to another entity that is in financial difficulty is likely to be a contingent liability, unless the likelihood of making a payment under the guarantee is remote. A liability that does not meet the provision recognition criteria, for example because the amount of the obligation cannot be measured reliably, is a contingent liability. Contingent asset Key definition: Contingent asset A contingent asset is a potential asset that arises from past events but whose existence can only be confirmed by the outcome of future events not wholly within the entity's control. Page 8 Preparation of financial statements part 4
An example of a contingent asset would be where a hospital is in the process of taking a drugs supplier to court in a claim for damages caused by inadequate labelling on the drugs. 5.1.3 Recognition of provisions IPSAS 19 states that a provision should be recognised when all of the following are true: 1) the entity has a present legal or constructive obligation as a result of a past event 2) it is probable that an outflow of economic benefits or service potential will be required to settle the obligation 3) a reliable estimate can be recognised of the amount of the obligation. Unless all conditions are met, no provision should be recognised. We will consider each criterion in turn. 1) The entity has a present legal or constructive obligation as a result of a past event. Key words in this definition are legal and constructive obligations. Key definitions: Legal obligation A legal obligation is an obligation that derives from a contract, legislation or other operation of law. Constructive obligation A constructive obligation is an obligation that derives from an entity s actions where: (a) By an established pattern of past practice, published policies, or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and (b) As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. The term constructive obligation may be new to you. It means that there is an established past practice that has led to an expectation that Preparation of financial statements part 4 Page 9
an entity will discharge those responsibilities in the future. For example a retail store which has a long-established practice of offering a no quibble returns policy. IPSAS 19 describes a past event that leads to a present obligation as an obligating event. It is the original action causing a liability to arise. As an example, if an entity is required to operate within certain emission levels and these were breached at some point in time, the past event is when the emission levels were breached rather than when the breach was discovered. It is important to realise that an obligating event involves another party, to whom the obligation is owed. In the above example, a penalty may be payable to, say, a regulatory body. 2) It is probable that an outflow of economic benefits or service potential will be required to settle the obligation. An outflow of resources is regarded as probable if the outflow is more likely than not to occur. Where it is not probable that an outflow will occur, a contingent liability arises. Where there are a number of similar obligations (e.g. product warranties) the probability that an outflow is required is determined by looking at the class of obligations as a whole. 3) A reliable estimate can be recognised of the amount of the obligation. Except in extremely rare cases, an enterprise should be able to determine a range of possible outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to use in recognising a provision. Where a reliable estimate cannot be made, a contingent liability arises. Exercise 5.1: Operating losses Requirement An entity anticipates that one of its divisions will make operating losses in future. Can this be recognised as a provision? Why? Page 10 Preparation of financial statements part 4
5.1.4 Recognition of contingent liabilities An entity should not recognise a contingent liability in the financial statements. Disclosure may be required depending on the likelihood of a settlement being made. If the settlement of the obligation is not probable and not remote then a brief description of the nature of the contingent liability should be disclosed along with an estimate of its financial effect, an indication of the uncertainties that exist and the possibility of any reimbursement. If the settlement of the obligation is remote no disclosure is required. Contingent liabilities may develop in a way not initially expected. Therefore, they are assessed continually to determine whether an outflow of economic benefits or service potential has become probable. If it becomes probable that an outflow of future economic benefits or service potential will be required for an item previously dealt with as a contingent liability, a provision is recognised in the financial statements of the period in which the change in probability occurs (except in the extremely rare circumstances where no reliable estimate can be made). For example, a local government entity may have breached an environmental law, but it remains unclear whether any damage was caused to the environment. Where, subsequently it becomes clear that damage was caused and remediation will be required, the entity would recognise a provision because an outflow of economic benefits is now probable. Exercise 5.2: Loan guarantee During 20X1, a provincial government gives a guarantee of certain borrowings of a private sector operator providing public services for a fee, whose financial condition at that time is sound. During 20X2, the financial condition of the operator deteriorates and, on 30 November 20X2, the operator files for protection from its creditors. Requirement Analyse the above scenario and recommend how it should be treated in the financial statements for the year ending: (a) 31 December 20X1 (b) 31 December 20X2 Preparation of financial statements part 4 Page 11
5.1.5 Recognition of contingent assets Contingent assets should not be included in the financial statements. Where the inflow of economic benefits is probable, disclosure should be made in the financial statements of: a brief description of the nature of the contingent asset where practicable, an estimate of the financial effect. Exercise 5.3: Provisions and contingent liabilities The flow chart below summarises the decisions required when an entity is deciding how to account for provisions and contingent liabilities. Requirement Match boxes 1, 2, and 3 in the flowchart to the following options: a. Do nothing b. Disclose contingent liability c. Recognise provision Page 12 Preparation of financial statements part 4
5.1.6 Measurement The amount to be included should be a best estimate of the expenditure required to settle the present obligation at the end of the reporting period. This is the amount an entity would rationally pay to settle the obligation or to transfer it to a third party. Management will generally be required to make a number of judgements to arrive at a best estimate for a provision. Judgements should be supplemented by experience of similar transactions and where appropriate by advice from independent experts. The outcome of events occurring after the end of the financial year should be taken into account in making estimates. For a single obligation where the best estimate is 10,000 and there is a 55% chance of the expenditure being incurred, then the provision should be 10,000, not 55% of 10,000. Where there are a number of obligations all of the same type, the calculation could necessitate the use of probabilities and discounting. Probabilities The risks and uncertainties that inevitably surround many events and circumstances should be taken into account in reaching the best estimate of a provision. Risk describes the variability of an outcome. Where the provision being measured involves a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities. The name for this statistical method of estimation is known as expected value. Illustration: Expected value A university s fully owned trading subsidiary sells branded goods such as t-shirts and sports kits to students. All goods sold come with a 1 year warranty, and past experience has shown that 10% of items sold have a tendency to fade over time and hence have to be replaced with an identical item under the terms of the warranty. The total revenue earned from sales during the year was 990,000 and the cost of these goods was 790,000. A warranty provision for 10% of the goods sold therefore needs to be recognised. As the cost to the university is the cost of a replacement item, the expected value of the total cost is 10% x 790,000 = 79,000. Preparation of financial statements part 4 Page 13
Exercise 5.4: Expected value A Government Medical Laboratory provides diagnostic ultrasound scanners to both public sector and private hospitals on a full cost recovery basis. The equipment is provided with a warranty under which hospitals are covered for the cost of defects that become apparent during the first year after purchase. If minor defects were to occur in all scanners sold, repair costs of 1 million would be incurred. If major defects were to occur in all scanners sold, repair costs of 4 million would be incurred. Past experience and future expectations indicate that 75% of scanners will have no defect, 20% will have minor defects and 5% will have major defects. Requirement What is the expected value of the cost repairs? Discounting Where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation. The expenditure required to settle an obligation may occur within a short period after the end of the reporting period, in which case the time value of money can be ignored. However, if the outflow of resources or service potential is expected to occur a significant time after the obligation itself arose, the effect of the time value of money should be taken into account in estimating the provision. The discount rate used should be a pre-tax rate that reflects the current market assessments of the time value of money and the risks specific to the liability. You can calculate the discount factor required using the formula: (1/1 + r) y Where r = the discount rate to be applied (a percentage given in the exam question) and y = the number of years until the provision will be settled. This will be shown in the following worked example. The unwinding of the discount each period should be included as a finance cost. Page 14 Preparation of financial statements part 4
Worked example: Discounting of provisions During December 20X1, a hospital became involved in a complex legal case and its legal advisors have advised the hospital that they are likely to have to pay 1m compensation in 3 years time once the case is finalised by the courts. The hospital s policy is to discount provisions using a rate of 2.2%. Show the entries required for the provision in the financial statements as at 31 December 20X1 and 20X2. Solution to worked example The provision will need to be discounted as follows in the financial statements: 20X1 Calculation of discount factor at 2.2% for 3 years = (1/1 + r) y = (1/1 + 0.022) 3 = 94% Therefore, the provision will initially be recognised as 94% x 1m = 940,000. The following journal entry will be required: Dr Cr Operating expenses (statement of financial performance) 940,000 Non-current liabilities: provisions (statement of financial position) 940,000 20X2 In 20X2, we are now one year closer to the settlement of the court case, and hence the discounted provision needs to be recalculated to reflect only 2 years worth of discounting. This is known as unwinding the discount. Using the same formula as before, the discount factor at the end of 20X2 will be: (1/1 + r) y = (1/1 + 0.022) 2 = 96% Therefore, the provision needs to be shown in the statement of financial position as 96% x 1m = 960,000. Preparation of financial statements part 4 Page 15
This represents an increase of 20,000 from the amount shown in last year s statement of financial performance. This increase due to unwinding needs to be included as a finance cost in the statement of financial performance. The accounting entries are therefore: Dr Cr Finance costs (statement of financial performance) 20,000 Non-current liabilities: provisions (statement of financial position) 20,000 Exercise 5.5: Discounting Blatensir Medical Trust is in the middle of a legal case. The Trust s lawyer has advised the trust that it is likely to have to pay compensation of 50,000. The Trust s policy is to discount provisions at a rate of 2.2%. The case is expected to be settled in two years time. Requirement (a) Calculate the provision s value on the statement of financial position for this year and complete the journal entries needed to account for the provision (b) Calculate the value by which the provision will be unwound next year and show the journal entries. Future events It is possible that the amount required to settle an obligation will be dependent on a number of future events. For example, where it is expected that there will be technological advances that will reduce, say, future clean-up costs, the expected effect of these future events should be taken into account in assessing the provision. The effect of possible new legislation that may affect the amount of an existing obligation of a government or an individual public sector entity is taken into consideration in measuring that obligation, when sufficient objective evidence exists that the legislation is virtually certain to be enacted. Page 16 Preparation of financial statements part 4
Expected disposal of assets Gains from the expected disposal of assets should not be taken into account in measuring a provision. IPSAS 19 does not override other standards, so such gains should be dealt with under the relevant standard. Reimbursements In some cases, an entity may be able to look to another party, such as an insurance company or a supplier under a warranty, for reimbursement of all or part of the entity's expenditure to settle a provision. The entity generally retains the contractual obligation to settle the provision, even if the other party fails to make the reimbursement. For example, a government agency may have legal liability to an individual as a result of misleading advice provided by its employees. However, the agency may be able to recover some of the expenditure from professional indemnity insurance. IPSAS 19 requires that the reimbursement should be recognised only when it is virtually certain that the amount will be received. If it is only probable that a reimbursement will be received then the amount is considered to be a contingent asset and will be disclosed. If an asset in respect of the reimbursement can be recognised then it should be reported as a separate asset in the statement of financial position and not netted against any outstanding provision. The recognition of any reimbursement asset is restricted to the amount of the related provision. In the statement of financial performance, the expense relating to a provision may be presented net of the amount recognised for a reimbursement. Worked example: Reimbursements A transport agency has received a claim from a road-user for a damaged vehicle caused by a pothole in the road. The entity's legal advisors believe that it is probable that a settlement will need to be made of 10,000 in favour of the road-user. However, in their opinion it is also probable that a counterclaim by the entity against their contractor for contributory negligence would successfully recover the damages. How would this be accounted for in the entity s financial statements? Preparation of financial statements part 4 Page 17
Solution to worked example A provision should be made for 10,000 as the outflow of economic benefits is probable. The counterclaim asset is not recognised since it is only probable that it will be received. It can only be recognised when it is virtually certain to be received. It should be disclosed as a contingent asset. Changes in provisions Because provisions are inherently uncertain amounts, IPSAS 19 requires them to be reviewed at the end of the reporting period and adjusted to reflect the most up to date information about the estimate. If at the end of the reporting period it is assessed that a transfer of economic benefits or service potential is no longer probable, the provision should be reversed. Where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time. This increase is recognised as an interest expense. Use of provisions A provision should only be utilised against the expenditure which it was originally set up for. Setting expenditures against a provision that was originally recognised for another purpose would conceal the impact of two different events. Page 18 Preparation of financial statements part 4
Exercise 5.6: Changes in provisions Refer back to the information on Blatensir Medical Trust from Exercise 5.5. It is year 2. The lawyers for Blatensir Medical Trust have been reviewing the outstanding legal cases. They have decided that their initial estimate for the provision of 50,000 was over prudent given recent court cases. They believe that a more reasonable settlement figure based upon the range of possible outcomes is 40,000. The solicitors still anticipate that the case will be settled within the same timescales. Requirement Show the accounting entries required in year 2 for the provision. 5.1.7 Application of recognition and measurement rules We will now look at how the recognition and measurement rules are applied in specific circumstances. Future operating net deficits Provisions are not recognised for net deficits from future operating activities. This is because net deficits from future operating activities do not meet the definition of liabilities and the general recognition criteria for provisions. An expectation of net deficits from future operating activities may indicate that assets used in these activities may be impaired and should be tested for impairment in accordance with the appropriate IPSAS. Onerous contracts Key definition: Onerous contract An onerous contract is a contract for the exchange of assets or services in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits or service potential expected to be received under it. Preparation of financial statements part 4 Page 19
An example of an onerous contract is an operating lease signed in the past by a government department to rent a building which is now no longer needed. The lease becomes onerous if it cannot be cancelled or sublet, i.e. there are obligations (rent payments) which exceed the service potential of the building. An onerous contract can be recognised as a provision. The signing of the contract is the past event which leads to a present obligation, there is a probable outflow of benefits and a reliable estimate of this amount could be made. When making a best estimate of the provision for an onerous contract the entity should take into account an estimate of any likely income that will be received under the contract. Worked example: onerous contract A local authority entered into a 10 year lease of a building. The annual rent under the lease agreement is 36,000. The local authority has decided to relocate its head office with five years still to run on the original lease. The local authority is permitted to sublet the building and believes that although market rentals have decreased it should be able to sublet the building for the full five years. The expected rental is 24,000 per annum. How would this be accounted for in the entity s financial statements? Solution to worked example A provision should be recognised for the excess costs under the lease contract above the expected benefits to be received. The obligating event was the signing of the lease agreement and 36,000 is required to be paid in each of the remaining five years. A provision for the following amount should be recognised: Annual outflow 36,000 Annual expected inflow 24,000 Excess annual outflow expected 12,000 A provision with a gross value of 60,000 ( 12,000 * 5 years) should be recognised. This would need to be discounted to present value, but you would not be required to do such a complicated discounting calculation in the PSFR exam. Page 20 Preparation of financial statements part 4
Exercise 5.7: Onerous contract A hospital laundry operates from a building that the hospital (the reporting entity) has leased under an operating lease. During December 20X0, the laundry relocates to a new building. The lease on the old building continues for the next four years; it cannot be cancelled. The hospital has no alternative use for the building and the building cannot be re-let to another user. Requirement Analyse the above scenario and recommend how it should be treated in the financial statements for the year ending 31 December 20X0. Restructuring Key definition: Restructuring A restructuring as a program that is planned and controlled by management, and materially changes either: - the scope of an entity s activities; or - the manner in which those activities are carried out. A provision for restructuring costs is recognised only when the general recognition criteria for provisions are met. We will consider how the criteria apply to restructuring. A provision should only be recognised in respect of restructuring costs, for example closing a division or reducing the number of employees, where specific criteria have been met, as detailed below. A constructive obligation to restructure an entity only arises when: a detailed formal plan has been made. This should include identifying the area of the business and location that is going to be restructured, an estimate of the number of employees that will be affected, the likely cost of the restructuring and the estimated time scales involved an announcement about the restructuring plan has been made to those who will be affected. Time scales should be mentioned as part of this announcement, or the entity should have started to carry out the restructuring. Evidence that a restructuring plan has Preparation of financial statements part 4 Page 21
commenced might be the removal or dismantling of assets at the affected location. If an announcement has been made then commencement of the plan should be within a short period of time to reduce the likelihood of significant changes being made. A restructuring provision should only include direct expenditure arising from the restructuring. Costs which relate to the future activities of the entity should not be provided for as part of the restructuring, for example relocating or retraining continuing staff. Exercise 5.8: Provision for restructuring costs Requirement An entity has a formal restructuring plan in place and has raised a valid expectation that this will take place by starting to implement the plan or by announcing its main features to those affected. Can this be recognised as a provision? Why? Sale or transfer of operations No obligation arises as a consequence of the sale or transfer of an operation until the entity is committed to the sale or transfer, that is, there is a binding agreement. Exercise 5.9: Provisions Requirement Can the following be recognised as provisions? 1. An entity offers warranties at the time of sale under which it agrees to make good, repair or replace any items that develop manufacturing defects within three years. 2. Entity X guarantees certain borrowings of Entity Y, whose financial condition is sound. 3. An entity plans to repair certain of its assets next year. Page 22 Preparation of financial statements part 4
5.1.8 Disclosure requirements A number of disclosures are required in relation to provisions, contingent liabilities and contingent assets. For a provision: A full reconciliation should be presented, clearly identifying movements during the period. These might include revisions of the estimate, utilisation of the provision or a release of part of the provision. An explanation should be provided for each class of provision, detailing what the provision is for, the expected timing of outflows, an indication of uncertainties over timing or amount of expected outflows and whether any reimbursement has been recognised. The above disclosures should be provided where an entity elects to recognise provisions for social benefits for which it does not receive consideration that is approximately equal to the value of the goods and services provided directly in return from recipients of those benefits. For a contingent liability, assuming the expected outflow is not remote: A brief description should be provided for each class of contingent liability. This should include an estimate of the financial effect, an indication of any uncertainties and the likelihood of any reimbursements being forthcoming. Where a contingent asset is disclosed because the receipt of economic benefits is probable, the entity should briefly explain the nature of the contingent asset and where practicable the financial effect of such an asset. If information about a contingent liability or asset is not disclosed on practicability grounds then this fact should be disclosed. If the disclosure of information surrounding a provision, contingent liability or contingent asset would be seriously prejudicial to an entity, then the general nature of the item should be disclosed with an explanation of why no additional disclosure has been made. This is expected to be extremely rare in practice, although it may be appropriate in circumstances where there are legal proceedings in progress, the outcome of which could be affected by the disclosure of the estimated settlement. Preparation of financial statements part 4 Page 23
Exercise 5.10: Kole Town Council Kole Town Council is being sued by a former employee for unfair dismissal. The council s legal advisors expect the council that they will lose the case and have advised that in similar recent cases the courts have decided on compensation of around 100,000. Requirement (a) Determine whether this meets the IPSAS 19 criteria for recognising a provision. (b) What accounting entry will be required? (c) What accounting entry will be required in the following financial year when the case goes to court and the judge determines that compensation of 125,000 should be paid? (d) Ignoring the outcome in part c), what would happen instead if in the following year the employee withdraws their claim against the council? Page 24 Preparation of financial statements part 4
5.2 IPSAS 9 Revenue from Exchange Transactions 5.2.1 Overview The recognition and measurement of revenue is important in reporting financial performance. Public sector entities receive revenue in payment for goods or services under normal contractual arrangements similar to those undertaken by private sector businesses. These transactions are called exchange transactions and IPSAS 9 Revenue from Exchange Transactions provides guidance on how to account for these. Key definitions: Exchange transactions Exchange transactions are transactions in which one entity receives assets or services, or has liabilities extinguished, and directly gives approximately equal value (primarily in the form of cash, goods, services, or use of assets) to another entity in exchange. Non-exchange transactions Non-exchange transactions are transactions that are not exchange transactions. In a non-exchange transaction, an entity either receives value from another entity without directly giving approximately equal value in exchange, or gives value to another entity without directly receiving approximately equal value in exchange. Public sector entities also receive taxes and other revenue which is not in direct exchange for an asset or service of approximately equal value. These are called non-exchange transactions and are dealt with under IPSAS 23 Revenue from Non-Exchange Transactions (Taxes and Transfers), which we will look at later in this workbook. This section will concentrate on revenue from exchange transactions first by considering IPSAS 9. Revenue is income that arises in the course of the ordinary activities of the entity, excluding contributions from owners. Income collected on behalf of a third party does not increase equity and is therefore not part of the entity s income. Preparation of financial statements part 4 Page 25
The IPSASB defines revenue as the gross inflow of economic benefits or service potential during the reporting period when those inflows result in an increase in net assets/equity, other than increases relating to contributions from owners. You will notice that the definition includes increases in both economic benefits (most commonly in the form of cash or other realisable assets) and service potential (in the form of assets which might be used to provide services). Revenue is often known by different names, such as sales, fees, interest, dividends and royalties. 5.2.2 IPSAS 9 Revenue from Exchange Transactions IPSAS 9 applies to revenue from the following transactions and events: the sale of goods the rendering of services interest, royalties and dividends. The sale of goods may include: goods produced by the entity for the purpose of sale, such as publications goods purchased for resale, including merchandise or land and other property held for resale. The rendering of services usually involves performing an agreed task over an agreed period of time. This may include the provision of housing, water facilities, and toll roads etc. Note that where this falls under the definition of a construction contract (see later in this workbook), the revenue will be treated in accordance with IPSAS 11 Construction Contracts. Where others use entity assets this gives rise to revenue in the form of: interest, royalties, charges for the use of patents, trademarks, copyrights and computer software, and dividends. IPSAS 9 does not deal with revenue arising from activities which are the subject of other standards, and therefore excludes: lease agreements dividends arising from investments accounted for under the equity method insurance contracts in insurance enterprises Page 26 Preparation of financial statements part 4
changes in the fair value of financial assets and financial liabilities changes in the fair value of other assets biological assets, agricultural produce or the extraction of mineral ores non-exchange revenue transactions, such as taxes and grants. 5.2.3 Recognition Revenue is recognised when it is probable that future economic benefits or service potential will flow to the entity, and these benefits can be measured reliably. All costs associated with the revenue should be accounted for in the same period as the revenue is recognised. This is commonly referred to as the matching of revenue and expenses. Revenue includes only the gross inflows of economic benefits or service potential received and receivable by the entity on its own account. Amounts collected as an agent of the government or another government organisation or on behalf of other third parties; for example, the collection of telephone and electricity payments by the post office on behalf of entities providing such services, are not economic benefits or service potential that flow to the entity, and do not result in increases in assets or decreases in liabilities. Therefore, they are excluded from revenue. Financing inflows, for example borrowings, do not meet the definition of revenue because they have no impact upon net assets/equity. 5.2.4 Measurement Revenue should be measured at the fair value of the consideration received or receivable. Key definition: Fair value Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. Note that consideration is not limited to payments in cash. Preparation of financial statements part 4 Page 27
Discounts - Revenue is recognised after taking into account trade discounts or volume rebates that are given. Consideration is cash - Here the amount of revenue recognised is the amount of cash received or receivable. Payment may be deferred for a longer period, providing the buyer with an interest-free credit period - in such cases the amount of revenue recognised should be determined by discounting all future receipts to present value. When goods or services are exchanged or swapped for goods or services that are of a similar nature and value, the exchange is not regarded as a transaction that generates revenue. Worked example: Deferred payments An entity sells goods to a purchaser for 2,500 on 5 July 2010. Although delivery will take place as soon as possible, the entity has given the purchaser an interest-free credit period of 12 months. How would this be accounted for in the entity s financial statements, assuming an interest rate of 6%? Solution to worked example The present value of the 2,500 receivable in twelve months time needs to be established by reference to the interest given of 6%. You will use the same formula as we saw in section 5.1.6, i.e: (1/1 + r) y (1/1 + 0.06) = 94% Thus the revenue recognised is 2,500 x 94% = 2,350 The balance of 150 represents interest revenue. Therefore the entity should split the 2,500 between revenue and interest. Revenue of 2,350 should be recognised on the 5 July 20X0, with the balance of 150 being recognised as interest revenue over the 12- month credit period. The rationale is that the fair value of the consideration receivable is 2,350. In other words, if the entity sold the goods for cash it would expect to receive 2,350 rather than 2,500. Page 28 Preparation of financial statements part 4
Exercise 5.11: Discount An entity sells goods to a customer for 100,000 less a trade discount of 10,000. Due to the volume of trade with this customer there is a further discount of 5,000. Payment will be made in cash. Credit terms are 30 days. Requirement How much revenue will be recognised? a) 100,000 b) 95,000 c) 90,000 d) 85,000 Exercise 5.12: Discount and deferral An entity sells goods to a customer for 100,000 less a trade discount of 5,000 on one year s interest free credit. Requirement Assuming the applicable discount rate is 10%, how much revenue should be recognised immediately? a) 100,000 b) 95,000 c) 90,909 d) 86,364 5.2.5 Sale of goods Firstly the two general conditions we saw earlier must be met: 1. It is probable that future economic benefits or service potential will flow to the entity. 2. The amount of revenue can be measured reliably. Additional conditions also apply to the sale of goods: 3. The seller must have transferred to the buyer all of the significant risks and rewards of ownership 4. The seller no longer has management involvement or effective control of the goods Preparation of financial statements part 4 Page 29
5. The costs incurred in relation to the transaction can be reliably measured. All five of these conditions must be met before revenue can be recognised. In most cases the transfer of significant risks and rewards of ownership coincides with the transfer of legal title or the passing of possession to the buyer. This is the case for most sales of goods. In other cases the risks and rewards of ownership may pass at a different time to the transfer of legal title or the passing of possession to the buyer. Examples of where the risks and rewards of ownership would not pass to the buyer and where no sale or revenue would be recognised include when: The seller retains an obligation for unsatisfactory performance not covered by a normal warranty arrangement Goods are sold on a sale or return basis The buyer has the right to rescind the purchase and the enterprise is uncertain about the probability of return. In each of these cases no revenue would be recognised. Worked example: Sale of goods A university sells computer software to a private sector company for 20,000 on 1 March 20X0, and includes a two-year warranty. A deferred payment option is being offered by the university to pay in 12 months time. The university has a 31 December year end. How would this be accounted for in the entity s financial statements? Solution to worked example The following steps are needed to account for the sale: 1) Split the 20,000 payment between the cash sale price and the effective interest by discounting the sale price to its present value 2) Recognise the cash sale price as revenue on 1 March 3) Recognise interest income for the 10 months' credit given in the accounting period in which the sale is recognised 4) Recognise the remaining 2 months' interest in the following period 5) Production and installation costs will be recognised in the same period that the revenue relating to the sale of the software is recognised Page 30 Preparation of financial statements part 4
6) A warranty provision will be set up in the period in which the revenue relating to the sale of the software is recognised for expected costs under the warranty provision (in accordance with IPSAS 19 Provisions, contingent liabilities and contingent assets see earlier in this workbook) 7) Costs incurred under the warranty provision will be charged to the warranty provision to the extent that the provision covers the costs. Any excess costs incurred will be recognised in surplus or deficit, and any balance remaining on the provision at the end of the second year will be released to the statement of financial performance. 5.2.6 Rendering of services Again the two general conditions we saw earlier must be met: 1. Iit is probable that future economic benefits or service potential will flow to the entity, and 2. The amount of revenue can be measured reliably. Additional conditions also apply to the rendering of services: 3. The stage of completion can be measured reliably, and 4. The costs incurred and the costs to complete in relation to the transaction can be reliably measured. All four of these conditions must be met before revenue can be recognised. Revenue is recognised by reference to the stage of completion using what is known as the percentage of completion method. The stage of completion can be determined via a number of methods. IPSAS 9 specifically mentions three: surveys of work performed assessing the services performed to date against the total services to be performed under the contract assessing the costs incurred to date against the total costs to be incurred under the contract. When the outcome of a transaction involving the rendering of services cannot be estimated reliably, revenue should only be recognised to the extent that costs incurred to date are recoverable from the customer. Preparation of financial statements part 4 Page 31
Worked example: Rendering of services This is an example of accounting for the rendering of services under the percentage of completion method. An entity enters into a 210,000 fixed price contract for the provision of services. At the end of 20X9, the first accounting period, the contract is assessed as being one-third complete, and costs incurred to date are 45,000. Estimated costs to complete are 90,000. How would this be accounted for in the entity s financial statements? Solution to worked example If costs to complete can be estimated reliably at 90,000, the overall contract is profitable as the total revenue of 210,000 exceeds total costs of 135,000. Revenue to be recognised in the first accounting period will be 70,000, calculated as one-third of the total contract revenue. Costs of one-third of total estimated costs i.e. 45,000 would also be recognised and matched against the related revenue. If the costs to complete cannot be estimated reliably, then the outcome of the total contract cannot be estimated accurately and revenue is recognised to the extent that the costs incurred are believed to be recoverable from the client. 5.2.7 Interest, royalties and dividends Again the two general conditions we saw earlier must be met: It is probable that future economic benefits (or service potential) will flow to the entity, and The amount of revenue can be measured reliably. Revenue should be recognised on the following basis: Interest revenue is recognised on a time apportion basis. Royalties are recognised on an accrual basis. Dividends are recognised when the shareholders' right to receive the dividend is legally established. This is usually when dividends are declared. Page 32 Preparation of financial statements part 4
5.2.8 Exchange of assets Special rules apply where goods or services are exchanged. We will now consider two cases. Similar goods or services Where the entity receives similar goods or services as payment this is essentially a swap transaction. The entity is replacing one asset for another similar asset. In such cases no revenue is generated, with no additional cost reported. Such transactions are quite common in the sale of commodities, for example milk, with suppliers exchanging inventories to fulfil demand in a particular location. Dissimilar goods or services When the payment is receivable in the form of dissimilar goods or services, revenue is generated and costs should be recognised. In such cases the transaction is measured based on the fair value of what will be received. If it is not possible to measure the value of the goods or services received reliably, then the revenue should be based on the fair value of the goods or services supplied. 5.2.9 Applications of IPSAS 9 IPSAS 9 includes an appendix of how to apply the concepts of the standard. (a) Consignment sales Under such arrangements, the buyer takes delivery of the goods and undertakes to sell them on, on behalf of the original seller. In such circumstances although the buyer takes delivery of the goods, he is really acting as an agent on behalf of the original seller. The original seller only recognises his sale when his buyer sells the goods on to a third party, since it is only at this point that the seller passes on the significant risks and rewards of ownership. This treatment is also relevant in sale and return transactions, i.e. revenue should not be recognised until the goods are sold to third parties. An example is when a government publishing operation distributes educational material to schools on a sale or return basis. Preparation of financial statements part 4 Page 33