Corporate Reporting Homework – Day 1

Student: Sara Mirchevska; ID: 4229

Chapter 1: PR Kit Q26 Tang (page 37/182)

IFRS 15 Revenue from Contracts with Customers provides detailed and consistent guidance regarding revenue
recognition. IFRS 15 sets out a five-step model, which applies to revenue earned from a contract with a customer
with limited exceptions, regardless of the type of revenue transaction or the industry. Step one in the five-step
model requires the identification of the contract with the customer and is critical for the purpose of applying the
Standard. The remaining four steps in the Standard's revenue recognition model are irrelevant if the contract does
not fall within the scope of IFRS 15.

Required: (a) (i) Discuss the criteria which must be met for a contract with a customer to fall within the scope of
IFRS 15.

(ii) Discuss the four remaining steps which lead to revenue recognition after a contract has been identified as
falling within the scope of IFRS 15.

(b) (i) Tang enters into a contract with a customer to sell an existing printing machine such that control of the
printing machine vests with the customer in two years' time. The contract has two payment options. The customer
can pay $240,000 when the contract is signed or $300,000 in two years' time when the customer gains control of
the printing machine. The interest rate implicit in the contract is 11.8% in order to adjust for the risk involved in
the delay in payment. However, Tang's incremental borrowing rate is 5%. The customer paid $240,000 on 1
December 20X4 when the contract was signed.

(ii) Tang enters into a contract on 1 December 20X4 to construct a printing machine on a customer's premises for a
promised consideration of $1,500,000 with a bonus of $100,000 if the machine is completed within 24 months. At
the inception of the contract, Tang correctly accounts for the promised bundle of goods and services as a single
performance obligation in accordance with IFRS 15. At the inception of the contract, Tang expects the costs to be
$800,000 and concludes that it is highly probable that a significant reversal in the amount of cumulative revenue
recognised will occur. Completion of the printing machine is highly susceptible to factors outside of Tang's
influence, mainly issues with the supply of components.

At 30 November 20X5, Tang has satisfied 65% of its performance obligation on the basis of costs incurred to date
and concludes that the variable consideration is still constrained in accordance with IFRS 15. However, on 4
December 20X5, the contract is modified with the result that the fixed consideration and expected costs increase
by $110,000 and $60,000 respectively. The time allowable for achieving the bonus is extended by six months with
the result that Tang concludes that it is highly probable that the bonus will be achieved and that the contract still
remains a single performance obligation. Tang has an accounting year end of 30 November.

Required: Discuss how the above two contracts should be accounted for under IFRS 15. (In the case of (b)(i), the
discussion should include the accounting treatment up to 30 November 20X6 and in the case of (b)(ii), the
accounting treatment up to 4 December 20X5.)

ANSWER

a) (i) Criteria for a contract under IFRS 15

Contract - exists when an agreement between two or more parties creates enforceable rights and obligations
between those parties. The agreement does not need to be in writing to be a contract but the decision as to
whether a contractual right or obligation is enforceable is considered within the context of the relevant legal
framework of a jurisdiction. Thus, whether a contract is enforceable will vary across jurisdictions. The performance
obligation could include promises which result in a valid expectation that the entity will transfer goods or services
to the customer even though those promises are not legally enforceable.

An entity should only account for a contract with a customer within the scope of IFRS 15 when all of the five
criteria have been met:

Criteria 1: Contract approved and committed to perform obligations  the parties should have approved the
contract and are committed to perform their respective obligations. In the case of oral or implied contracts, this
may be difficult but all relevant facts and circumstances should be considered in assessing the parties'
commitment. The parties need not always be committed to fulfilling all of the obligations under a contract. IFRS 15
gives the example where a customer is required to purchase a minimum quantity of goods but past experience
shows that the customer does not always do this and the other party does not enforce their contract rights. The
IFRS 15 criterion could still be satisfied in this example if there is evidence that the parties are substantially
committed to the contract.

Criteria 2: Entity can identify each party's rights  It is essential that each party's rights can be identified
regarding the goods or services to be transferred. Without this criterion, an entity would not be able to assess the
transfer of goods or services and therefore, the point at which revenue should be recognised.

Criteria 3: Entity can identify each party's payment terms  It is essential that each party's payment terms can
be identified regarding the goods or services to be transferred. This requirement is the key to determining the
transaction price.

Criteria 4: Contract has commercial substance  The contract must have commercial substance before revenue
can be recognised, as without this requirement, entities might artificially inflate their revenue and it would be
questionable whether the transaction has economic consequences. The contract is deemed to have commercial
substance when the risk, timing or amount of the entity's future cash flows is expected to change as a result of the
contract.

Criteria 5: Probable consideration  It should be probable that the entity will collect the consideration due under
the contract. An assessment of a customer's credit risk is an important element in deciding whether a contract has
validity but customer credit risk does not affect the measurement or presentation of revenue.

The consideration may be different to the contract price because of discounts and bonus offerings. The entity
should assess the ability of the customer to pay and the customer's intention to pay the consideration.

Reassessment

If a contract with a customer does not meet these criteria, the entity can continually reassess the contract to
determine whether it subsequently meets the criteria.

Combination of contracts

Two or more contracts which are entered into around the same time with the same customer may be combined
and accounted for as a single contract, if they meet the specified criteria.

Contract modifications

The Standard provides detailed requirements for contract modifications. A modification may be accounted for as a
separate contract or a modification of the original contract, depending upon the circumstances of the case.

(ii) Four remaining IFRS 15 steps As explained in part (a)(i), step one in the five-step model requires the
identification of the contract with the customer. After a contract has been determined to fall under IFRS 15, the
following steps are required before revenue can be recognised.
Step 2: Identify the performance obligations in the contract

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

Step 3: Determine the transaction price

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

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

Step 4: Allocate the transaction price to the performance obligations in the contract

This step requires the allocation of the transaction price to the separate performance obligations. When a contract
contains more than one distinct performance obligation, an entity allocates the transaction price to each distinct
performance obligation on the basis of the relative standalone selling prices of the goods or services promised.
This allocation is made at inception of the contract. It is not adjusted to reflect subsequent changes in the
standalone selling prices of those goods or services. The best evidence of standalone selling price is the observable
price of a good or service when the entity sells that good or service separately. If that is not available, an estimate
is made by using an approach which maximises the use of observable inputs. For example, expected cost plus an
appropriate margin or the assessment of market prices for similar goods or services adjusted for entity-specific
costs and margins or in limited circumstances a residual approach. Where the transaction price includes a variable
amount and discounts, consideration needs to be given as to whether these amounts relate to all or only some of
the performance obligations in the contract. Discounts and variable consideration will typically be allocated
proportionately to all of the performance obligations in the contract. However, if certain conditions are met, they
can be allocated to one or more separate performance obligations.

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

This final step requires revenue to be recognised as each performance obligation is satisfied. An entity satisfies a
performance obligation by transferring control of a promised good or service to the customer, which could occur
over time or at a point in time. The definition of control includes the ability to prevent others from directing the
use of and obtaining the benefits from the asset. Where an entity satisfies its performance obligation over time,
revenue is recognised over time in line with the pattern of transfer.

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

(b)

(i) Existing printing machine

The contract contains a significant financing component because of the length of time between when the
customer pays for the asset and when Tang transfers the asset to the customer, as well as the prevailing interest
rates in the market. This is a slightly unusual situation in which the customer is paying Tang in advance (24 months
before the finished machine is ready for use) but the principles of the treatment of significant financing
components prevail.

A contract with a customer which has a significant financing component should be separated into a revenue
component (for the notional cash sales price) and a loan component. Consequently, the accounting for a sale
arising from a contract which has a significant financing component should be comparable to the accounting for a
loan with the same features.

An entity should use the discount rate which would be reflected in a separate financing transaction between the
entity and its customer at contract inception. The interest rate implicit in the transaction may be different from the
rate to be used to discount the cash flows, which should be the entity's incremental borrowing rate. IFRS 15 would
therefore dictate that the rate which should be used in adjusting the promised consideration is 5%, which is the
entity's incremental borrowing rate, and not 11.8%. As the customer is paying Tang in advance, in substance, Tang
is borrowing $240,000 from the customer which makes Tang's incremental borrowing rate the most appropriate
rate to use.

Tang would account for the significant financing component as follows: Recognise a contract liability for the
$240,000 payment received on 1 December 20X4 at the contract inception. During the two years from contract
inception (1 December 20X4) until the transfer of the printing machine, Tang adjusts the amount of consideration
and accretes the contract liability by recognising interest on $240,000 at 5% for two years. This would result in
interest of $12,000 ($240,000 × 5%) in the year ended 30 November 20X5. Contract liability would stand at
$252,000 ($240,000 + $12,000) at 30 November 20X5. Therefore, interest in the year ended 30 November 20X6
would be $12,600 ($252,000 × 5%). This would bring the contract liability up to $264,600.

Contract revenue would be recognised on the transfer of the printing machine to the customer on 30 November
20X6 by debiting the contract liability and crediting revenue with $264,600.

(ii) Constructed printing machine

Tang accounts for the promised bundle of goods and services as a single performance obligation satisfied over time
in accordance with IFRS 15. At the inception of the contract, Tang expects the following:
Transaction price = $1,500,000

Expected costs = $800,000

Expected profit (46.7%) = $700,000

The $100,000 bonus constitutes variable consideration under IFRS 15. At contract inception, Tang excludes the
$100,000 bonus from the transaction price because it cannot conclude that it is highly probable that a significant
reversal in the amount of cumulative revenue recognised will not occur. Completion of the printing machine is
highly susceptible to factors outside the entity's influence. This is a contract where Tang satisfied its performance
obligation over time. Therefore, revenue should also be recognised over time by measuring the progress towards
complete satisfaction of that performance obligation. By the end of the first year, the entity has satisfied 65% of its
performance obligation on the basis of costs incurred to date. Costs incurred to date are therefore $520,000
($800,000 × 65%) and Tang reassesses the variable consideration of $100,000 and concludes that the amount is
still constrained which means that it may not yet be recognised. Therefore, at 30 November 20X5, only the portion
of the fixed consideration of $1,500,000 related to progress to date may be recognised as revenue. This results in
revenue of $975,000 ($1,500,000 × 65%). The following amounts would therefore be included in the statement of
profit or loss:

Revenue $975,000

Costs $520,000

Gross profit $455,000

However, on 4 December 20X5, the contract is modified. As a result, the fixed consideration and expected costs
increase by $110,000 and $60,000, respectively. This increases the fixed consideration to $1,610,000 ($1,500,000 +
$110,000) and the expected costs to $860,000 ($800,000 + $60,000).

The total potential consideration after the modification is $1,710,000 which is $1,610,000 fixed consideration +
$100,000 completion bonus as Tang has concluded that receipt of the bonus is highly probable and that including
the bonus in the transaction price will not result in a significant reversal in the amount of cumulative revenue
recognised in accordance with IFRS 15. Tang also concludes that the contract remains a single performance
obligation. Thus, Tang accounts for the contract modification as if it were part of the original contract. Therefore,
Tang updates its estimates of costs and revenue as follows:

Tang has satisfied 60.5% of its performance obligation ($520,000 actual costs incurred compared to $860,000 total
expected costs). The entity recognises additional revenue of $59,550 [(60.5% of $1,710,000) – $975,000 revenue
recognised to date] at the date of the modification as a cumulative catch-up adjustment. As the contract
amendment took place after the year end, the additional revenue would not be treated as an adjusting event after
the reporting period. Therefore, it would be accounted for in the year ended 30 November 20X6 rather than as an
adjustment in the year ended 30 November 20X5.

Chapter 6: WB Q8 DT Group (page 787/820)

(a) IAS 12 Income Taxes focuses on the statement of financial position in accounting for deferred taxation, which
is calculated on the basis of temporary differences. The methods used in IAS 12 can lead to accumulation of
large tax assets or liabilities over a prolonged period and this could be remedied by discounting these assets or
liabilities. There is currently international disagreement over the discounting of deferred tax balances.

Required:

(i) Explain what the terms 'focus on the statement of financial position' and 'temporary differences' mean in
relation to deferred taxation.
(ii) Discuss the arguments for and against discounting long-term deferred tax balances.

(b) DT, a public limited company, has decided to adopt IFRSs for the first time in its financial statements for the
year ending 30 November 20X1. The amounts of deferred tax provided as set out in the notes of the group
financial statements for the year ending 30 November 20X0 were as follows:

The following notes are relevant to the calculation of the deferred tax liability as at 30 November 20X1:

(i) DT acquired a 100% holding in a foreign company on 30 November 20X1. The subsidiary does not
plan to pay any dividends for the financial year to 30 November 20X1 or in the foreseeable future.
The carrying amount in DT's consolidated financial statements of its investment in the subsidiary at
30 November 20X1 is made up as follows:

The tax base of the net assets of the subsidiary at acquisition was $60 million. No deduction is available in the
subsidiary's tax jurisdiction for the cost of the goodwill.

Immediately after acquisition on 30 November 20X1, DT had supplied the subsidiary with inventories amounting to
$30 million at a profit of 20% on selling price. The inventories had not been sold by the year end and the tax rate
applied to the subsidiary's profit is 25%. There was no significant difference between the fair values and carrying
values on the acquisition of the subsidiary.

(ii) The carrying amount of the property, plant and equipment (excluding that of the subsidiary) is $2,600 million
and their tax base is $1,920 million. Tax arising on the revaluation of properties of $140 million, if disposed of at
their revalued amounts, is the same at 30 November 20X1 as at the beginning of the year. The revaluation of the
properties is included in the carrying amount above. Other taxable temporary differences (excluding the
subsidiary) amount to $90 million as at 30 November 20X1.

(iii) The liability for health care benefits in the statement of financial position had risen to $100 million as at 30
November 20X1 and the tax base is zero. Health care benefits are deductible for tax purposes when payments are
made to retirees. No payments were made during the year to 30 November 20X1.

(iv) DT Group incurred $300 million of tax losses in the year ended 30 November 20X0. Under the tax law of the
country, tax losses can be carried forward for three years only. The taxable profit for the year ending 30 November
20X1 was $110 million. In the years ending 30 November, taxable profits were anticipated to be:
The auditors are unsure about the availability of taxable profits in 20X3 as the amount is based upon the projected
acquisition of a profitable company. It is anticipated that there will be no future reversals of existing taxable
temporary differences until after 30 November 20X3.

(v) Income tax of $165 million on a property disposed of in 20X0 becomes payable on 30 November 20X4 under
the deferral relief provisions of the tax laws of the country. There had been no sales or revaluations of property
during the year to 30 November 20X1.

(vi) Income tax is assumed to be 30% for the foreseeable future in DT's jurisdiction and the company wishes to
discount any deferred tax liabilities at a rate of 4% if allowed by IAS 12

(vii) There are no other temporary differences other than those set out above. The directors of DT have calculated
the opening balance of deferred tax using IAS 12 to be $280 million.

Required:

Calculate the liability for deferred tax required by the DT Group at 30 November 20X1 and the deferred tax
expense in profit or loss for the year ending 30 November 20X1 using IAS 12, commenting on the effect that the
application of IAS 12 will have on the financial statements of the DT Group.

ANSWER

a) (i) IAS 12 focuses on the statement of financial position in accounting for deferred taxation. It is based on the
principle that a deferred tax liability or asset should be recognised if the recovery of the carrying amount of the
asset or the settlement of the liability will result in higher or lower tax payments in the future than would be the
case if that recovery or settlement were to have no tax consequences. Future tax consequences of past events
determine the deferred tax liabilities or assets. The calculation of deferred tax balances is determined by looking at
the difference between the tax base of an asset and its statement of financial position carrying value. Differences
between the carrying amount of the asset and liability and its tax base are called 'temporary differences'. The
objective of the temporary difference approach is to recognise the future tax consequences inherent in the
carrying amounts of assets and liabilities in the statement of financial position. The presumption is that there will
be recovery of statement of financial position items out of future revenues and tax needs to be provided in
relation to such a recovery. This involves looking at temporary differences between the carrying values of the
assets and liabilities and the tax base of the elements. The standard recognises two types of temporary
differences: taxable and deductible temporary differences.

(ii) Deferred tax involves the postponement of the tax liability. Thus, the deferred liability can be viewed as
equivalent to an interest free loan from the tax authorities. Thus it could be argued that it is appropriate to reflect
this benefit of postponement by discounting the liability and recording a lower tax charge. This discount is then
amortised over the period of deferment. The purpose of discounting is to measure future cash flows at their
present value and, therefore, deferred tax balances can only be discounted if they can be viewed as future cash
flows that are not already measured at their present value. Some temporary differences clearly represent future
tax cash flows. For example, where there is an accrual for an expense that is to be paid in the future and tax relief
will only be given when the expense is paid. Some expenses are already measured on a discounted basis, like
retirement benefits, for example, and it is not appropriate to discount the resulting deferred tax. Accelerated tax
depreciation is a liability that will be repaid in the form of higher tax assessments in the future. It can be argued
that there are two cash flows, with the second cash flow occurring on the reversal of the temporary difference, as
the tax payment will be higher. Discounting, however, makes the deferred tax computation more difficult to
calculate and more subjective. Also there will be an additional cost in scheduling and calculating deferred taxation,
as well as the problem of the determination of the discount rate. Thus, IAS 12 specifically prohibits discounting.
(b) Calculation of deferred tax liability

Carrying amount ($m) Tax base ($m) Temporary difference

($m)
Goodwill 14 - -
Subsidiary 76 60 16 =76-60
Inventories 24 30 (6) =24-30
Property,plant&equipment 2,600 1,920 680 =2,600-1,920
Other temporary differences
Liability for health care (100) 0 (100)
benefits
Unrelieved tax losses (W4) (100)
Property sold –Tax due 550
30.11.20x4 (165/30%)
Temporary differences 1,130
Deferred tax liability 1,320 at 396
30%
Deferred tax liability 16 at 4
25%
Deferred tax asset (200) at (60)
30%
Deferred tax asset (6) at 25% (1.5)
338.5

Deferred tax liability 280

Deferred tax attributable to 4
subsidiary to goodwill (76 –
60)  25%
Deferred tax expense for the 54.5
year charged to P/L (balance)
Deferred tax liability 338.5

Notes:

1. As no deduction is available for the cost of goodwill in the subsidiary's tax jurisdiction, then the tax base of
goodwill is zero. IAS 12 states that DT Group should not recognise a deferred tax liability of the temporary
difference associated in B's jurisdiction with the goodwill. Thus, goodwill will be increased by the amount of
the deferred tax liability of the subsidiary, that is $4 million.
2. Unrealised group profit eliminated on consolidation are provided for at the receiving company's rate of tax, so,
at 25%.
3. The tax that would arise if the properties were disposed of at their revalued amounts which was provided at
the beginning of the year will be included in the temporary difference arising on the property, plant and
equipment at 30 November 20X1.
4. DT Group has unrelieved tax losses of $300m. This will be available for offset against current year's profits
($110m) and against profits for the year ending 30 November 20X2 ($100m). Because of the uncertainty about
the availability of taxable profits in 20X3, no deferred tax asset can be recognised for any losses which may be
offset against this amount. Therefore, a deferred tax asset may be recognised for the losses to be offset
against taxable profits in 20X2. That is $100m  30% =$30m.
So, the deferred tax liability of DT Group will rise in total by $335.5 million ($338.5m – $3m), thus reducing net
assets, distributable profits, and post-tax earnings.

The profit for the year will be reduced by $54.5 million which would probably be substantially more under IAS 12
than the old method of accounting for deferred tax. A prior period adjustment will occur of $280m – $3m as IAS
are being applied for the first time (IFRS 1) ie $277m. The borrowing position of the company may be affected and
the directors may decide to cut dividend payments. However, the amount of any unprovided deferred tax may
have been disclosed under the previous GAAP standard used. IAS 12 brings this liability into the statement of
financial position but if the bulk of the liability had already been disclosed the impact on the share price should be
minimal.