Chapter 16: Accounting standards

Chapter learning objectives

Upon completion of this chapter you will be able to:

• recognise the difference between tangible non-current assets and intangible non-current assets
• identify types of intangible non-current assets.
• define research and development
• explain the accounting treatment of research and development costs in accordance with IAS 38
• calculate the amounts to be capitalised as development expenditure or expensed from given information.
• explain the purpose of amortisation
• calculate the amortisation charge and account for it correctly
• define an event after the reporting period date.
• account for both adjusting and non-adjusting events correctly in the financial statements
• classify events as adjusting or non-adjusting.
• define provision, contingent liability and contingent asset.
• classify items as provision, contingent asset or contingent liability from information given
• account for provisions, contingent liabilities and contingent assets correctly
• calculate provisions and changes in provisions and account for these changes correctly
• report provisions in the final accounts
• explain what is meant by an accounting policy and the provisions of IAS 8 regarding changes in accounting policy
• identify the appropriate accounting treatment for a change in a material accounting policy according to IAS 8
• describe the provisions of IAS 8 which govern financial statements regarding material errors which result in prior period adjustments
• explain the requirements of IAS 18 governing revenue recognition.

Some other examples of intangible assets which you may come across are brands, quotas and patents.

1 Intangible non-current assets

Non-current assets are assets used within the business on an ongoing basis in order to generate revenue.

They can be split into two distinct types:

Test your understanding 1

Willis Ltd purchased a patent, with a useful economic life of ten years for $20,000 on 1 January 20X9.

Prepare extracts of the financial statements for the year ended 31 December 20X9?

2 Research and development (IAS 38)

Research can be defined as original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.

Development can be defined as the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.

Test your understanding 2

Which of the following should be classified as development?

(1) Braynee Ltd has spent $300,000 investigating whether a particular substance, flubber, found in the Amazon rainforest is resistant to heat.

(2) Cleverclogs Ltd has incurred $120,000 expenses in the course of making a new waterproof and windproof material with the idea that it may be used for ski-wear.

(3) Ayplus Ltd has found that a chemical compound, known as XYX, is not harmful to the human body.

(4) Braynee Ltd has incurred a further $450,000 using flubber in creating prototypes of a new heat-resistant suit for stuntmen.

Accounting treatment of research and development

Where a company undertakes research and development, expenditure is being incurred with the intention of producing future benefits.

The accounting issue is therefore whether these costs should be expensed to the income statement or capitalised as an intangible asset on the statement of financial position to match to future benefits arising.

Research

• All research expenditure should be written off to the income statement as it is incurred. This is in compliance with the prudence concept.
• Research expenditure does not directly lead to future benefits and therefore it is not possible to follow the matching concept.
• Any capital expenditure on research equipment should be capitalised and depreciated as normal.

2.1 Development

• Development expenditure must be capitalised as an intangible asset provided that certain criteria are met:
  • Separate project
  • Expenditure identifiable and reliably measured
  • Commercially viable
  • Technically feasible
  • Overall profitable
  • Resources available to complete

• If the above criteria are not met, development expenditure must be written off to the income statement as it is incurred.
• Once expenditure has been treated as an expense, it cannot be reinstated as an asset.

Subsequent treatment of capitalised development expenditure

• The asset should be amortised over the period that is expected to benefit. This ensures that costs are matched to the revenue in the income statement.
• Amortisation should commence with commercial production. It should be charged over the period of benefit, and also in proportion to the revenue generated.
• Each project should be reviewed at the year end to ensure that the ‘SECTOR’ criteria are still met. If they are no longer met, the previously capitalised expenditure must be written off to the income statement immediately.

If a policy of capitalisation is adopted, it should be applied to all projects that meet the criteria.

IAS 38 Intangible assets

Development

An intangible asset arising from development (or from the development phase of an internal project) should be recognised if, and only if, an enterprise can demonstrate all of the following:

• the technical feasibility of completing the intangible asset so that it will be available for use or sale
• its intention to complete the intangible asset and use or sell it
• its ability to use or sell the intangible asset
• how the intangible asset will generate probable future economic benefits. Among other things, the enterprise should demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.
• the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset
• its ability to measure reliably the expenditure attributable to the intangible asset during its development.

The amount to be included is the cost of the development. Note that expenditure once treated as an expense cannot be reinstated as an asset.

Amortisation

If the useful life of an intangible asset is finite, its capitalised development costs must be amortised once commercial exploitation begins.

The amortisation method used should reflect the pattern in which the asset’s economic benefits are consumed by the enterprise. If that pattern cannot be determined reliably, the straight-line method should be used.

An intangible asset with an indefinite useful life should not be amortised. An asset has an indefinite useful life if there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the business.

Illustration – Accounting for development costs

Brightspark Ltd is developing a new product, the widget. This is expected to be sold over a three-year period starting in 20X6. The forecast data is as follows:

Show how the development costs should be treated if:

(a) the costs do not qualify for capitalisation

(b) the costs do qualify for capitalisation.

Solution to accounting for development costs

Solution

(a) Profit treating development costs as expenses when incurred

(b) Net profit amortising development costs over life of widgets

Amortisation working:

20X6: (450/1450) x $900,000 = $279,300
20X7: (600/1450) x $900,000 = $372,400
20X8: (400/1450) x $900,000 = $248,300

Test your understanding 3

This year, Deep Blue Sea Ltd has developed a new material from which the next generation of wetsuits will be made. This special material will ensure that swimmers are kept warmer than ever. The costs incurred meet the capitalisation criteria and by the 31 December 20X5 year end $250,000 has been capitalised.

The wetsuits are expected to generate revenue for five years from the date that commercial production commences on 1 January 20X6. What amount is charged to the income statement in the year ended 31 December 20X6?

A nil

B $250,000

C $100,000

D $50,000

IAS 38 Disclosure

Disclosure

The financial statements should disclose the following for capitalised development costs:

• the amortisation method used and the expected period of amortisation
• a reconciliation of the carrying amounts at the beginning and end of the period, showing new expenditure incurred, amortisation and amounts written off because a project no longer qualifies for capitalisation
• amortisation during the period.

In addition, the financial statements should also disclose the total amount of research and development expenditure recognised as an expense during the period

3 Events after the reporting period date (IAS 10)

Events after the reporting period date can be defined as those material events which occur between the statement of financial position date and the date on which the financial statements are approved.

Adjusting and non-adjusting events

Adjusting and non adjusting events

Adjusting events

These events provide additional evidence of conditions existing at the reporting date. For example, irrecoverable debts arising one or two months after the reporting date may help to quantify the allowance for receivables as at the reporting date. Adjusting events may, therefore, affect the amount at which items are stated in the reporting.

Examples of adjusting events

• The settlement after the reporting date of a court case which confirms a year end obligation.
• The receipt of information after the reporting date that indicates that an asset was impaired at the reporting date.
• The bankruptcy of a customer after the reporting date that confirms that a year-end debt is irrecoverable.
• The sale of inventories after the reporting period at a price lower than cost.
• The determination after the reporting date of the cost of assets purchased or proceeds from assets sold before the reporting date.
• The discovery of fraud or errors showing that the financial statements are incorrect.

Non-adjusting events

These are events arising after the reporting date but which do not concern conditions existing at the reporting date. Such events will not, therefore, have any effect on items in the reporting or income statement. However, in order to prevent the financial statements from presenting a misleading position, some form of additional disclosure is required if the events are material, by way of a note to the financial statements giving details of the event.

Examples of non-adjusting events

• Announcing a plan to discontinue an operation.
• Major purchases of assets.
• The destruction of assets after the reporting date by fire or flood.
• Entering into significant commitments or contingent liabilities (see section 4).
• Commencing a court case arising out of events after the reporting date.

Proposed dividends

It is not acceptable to include dividends declared after the reporting date as liabilities at the year end.

If dividends are declared before the year end, they must be shown in the statement of changes in equity and accrued for in the reporting period update.

Test your understanding 4

Which of the following are adjusting events for BigCo Ltd? The year end is 30 June 20X6 and the accounts are approved on 18 August 20X6.

(1) Sales of year-end inventory on 2 July 20X6 at less than cost.

(2) The issue of new ordinary shares on 4 July 20X6.

(3) A fire in the main warehouse occurred on 8 July 20X6. All stock was destroyed.

(4) A major credit customer was declared bankrupt on 10 July 20X6

(5) All of the share capital of a competitor, TeenyCo Ltd was acquired on 21 July 20X6.

(6) On 1 August 20X6, $500,000 was received in respect of an insurance claim dated 13 February 20X6.

A1,4 and 6

B1,2,4 and 6

C1,2,5 and 6

D1,4,5 and 6

Disclosure

Where there are material non-adjusting events, a note to the financial statements should explain:

• the nature of the event
• an estimate of the financial effect.

Disclosure in the accounts

In respect of each event after the reporting that must be disclosed as above, the following information should be stated by way of notes in the financial statements:

(1)the nature of the event

(2)an estimate of the financial effect, or a statement that such an estimate cannot be made.

The date on which the financial statements were authorised for issue, and who gave the authorisation, should be disclosed in the financial statements.

If the owners or others have the power to amend the financial statements after issue, that fact should be disclosed.

4 Provisions, contingent liabilities and assets (IAS 37)

A provision can be defined as a Liability of uncertain timing or amount.

Contingent liability

A contingent liability is:

(1) 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 enterprise; or

(2) a present obligation that arises from past events but is not recognised because:

• it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
• the amount of the obligation cannot be measured with sufficient reliability.

A contingent asset is a possible asset 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 enterprise.

Accounting for contingent liabilities and assets

The requirements of IAS 37 as regards contingent liabilities and assets are summarised in the following table:

• Note that the standard gives no guidance as the meaning of the terms in the left-hand column. One possible interpretation is as follows:

Virtually certain > 95%

Probable 51% – 95%

Possible 5% – 50%

Remote <>

Provisions and criteria

A provision is made where all of the following conditions are met:

• A present obligation (legal or constructive) exists as the result of a past event.
• There is a probable transfer of economic benefits.
• A reliable estimate of the amount can be made.

A legal present obligation is an obligation that derives from:

• the terms of a contract
• legislation
• any other operation of law.

A constructive obligation is an obligation that derives from an entity’s actions where:

• The entity has in some way indicated that it will accept certain responsibilities.
• The entity has created an expectation on the part of other parties that it will meet those responsibilities.

Illustration

A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known.

Should a provision be made at the year end?

Solution

The policy is well known and creates a valid expectation.

There is a constructive obligation.

It is probable some refunds will be made.

These can be measured using expected values.

Conclusion: A provision is required.

Test your understanding 5

The draft financial statements of Madras, a limited liability company, for the year ended 31 December 20X6 is currently under review. The following points have been raised:

(i) An ex-employee has started an action against the company for wrongful dismissal. The company’s legal team have stated that the ex-employee is not likely to succeed. The following estimates have been given by the lawyers relating to the case:

Currently no provision has been made by the company in the financial statements.

(ii) The company has a policy of refunding the cost of any goods returned by dissatisfied customers, even though it is under no legal obligation to do so. This policy of making refunds is generally known. At the year end returns totalling $4,800 have been made.

(iii) A claim has been made against a company for injury suffered by a pedestrian in connection with building work by the company. Legal advisers have confirmed that the company will probably have to pay damages of $100,000 but that a counterclaim made against the building subcontractors for $50,000 would probably be successful.

State with reasons what adjustments, if any, should be made by the company in the financial statements.

Accounting entries for provisions

A provision should initially be accounted for at the best estimate of the probable outflow:

Movement in provisions

Provisions should be reviewed at each statement of financial position date and adjusted to reflect the current best estimate.

Disclosure

Reporting provisions in the final accounts

Provisions are reported as a liability.

They may be classed as current or non-current, depending upon the subject matter of the provision.

Disclosure

• Where the requirement is to provide for a contingent liability, the liability is reflected in the financial statements, but called a provision in order to highlight the uncertainty surrounding it
• The movement in this provision is recorded in the financial statements each year.
• When disclosure is made by note, the note should state:
  • the nature of the contingency
  • the uncertain factors that may affect the future outcome
  • an estimate of the financial effect, or a statement that such an estimate cannot be made.

5 Accounting policies, changes in accounting estimates and errors (IAS 8)

The main issues covered by this standard are:

• changes in accounting estimates
• changes in accounting policy
• correction of prior period errors.

Changes in accounting estimates

• These result in the adjustment of the carrying amount of an asset or liability, e.g. revising the useful life of a non-current asset from five years to seven years.
• Any necessary change should be included in the current income statement under the same heading as the previous estimate, with a note giving details of the change if it has a material effect.

Changes in accounting policies

• Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements.
• The consistency theory means that a company’s accounting policies will generally remain the same from year to year. There may, however, be circumstances where the policies do have to change:
  • If required by a standard or interpretation.
  • If the change will result in a more reliable and relevant presentation of events in financial statements.

• The change is applied retrospectively by adjusting the opening balance of accumulated profit; this is reflected in the statement of changes in equity. Comparative information for previous years is also restated.

A change in accounting policy occurs if there has been a change in:

• recognition, e.g. an expense is now recognised rather than an asset
• presentation, e.g. depreciation is now included in cost of sales rather than administrative expenses, or
• measurement basis, e.g. stating assets at replacement cost rather than historical cost.

Fundamental errors

• E.g. discovery of a major fraud which occurred last year
• If a fundamental error from a prior period is reflected in the accounts, this must be corrected.
• The correction involves adjusting the opening balance of accumulated profits; this is reflected in the statement of changes in equity. Comparative information for prior years should also be restated if practical.

Test your understanding 6

Entity Ltd was incorporated 3 years ago and has depreciated vehicles using the reducing balance method at 35%. It now wishes to change this to allow a fairer presentation to the straight line method over a period of 4 years. In addition certain freehold properties had not been depreciated during the first 2 years. The directors are now of the opinion that all property, plant & equipment should now be depreciated.

Are the above proposals a change in accounting policy or a change in accounting estimate?

6 Revenue (IAS 18)

IAS 18 Revenue defines when revenue from various sources may be recognised. It deals with revenue arising from three types of transaction or event:

• sale of goods
• rendering of services
• interest, royalties and dividends from the assets of the enterprise.

Sale of goods

Revenue from the sale of goods should be recognised when all the following conditions have been satisfied:

(a) All the significant risks and rewards of ownership have been transferred to the buyer.

(b) The seller retains no effective control over the goods sold.

(c) The amount of revenue can be reliably measured.

(d) The benefits to be derived from the transaction are likely to flow to the enterprise.

(e) The costs incurred or to be incurred for the transaction can be reliably measured.

Revenue recognition

Conditions (a) and (b) are usually met at the time when legal ownership passes to the buyer, but there are four examples in IAS 18 where the seller retains significant risks:

• when the seller has an obligation for unsatisfactory performance beyond normal warranty provisions
• when the receipt of the cash for the sale is contingent upon the buyer selling the goods on and receiving cash
• when the goods are to be installed at the buyer’s site and this has not yet been completed
• when the buyer has the right to cancel the contract.

Revenue and associated costs are recognised simultaneously in accordance with the matching concept.

Rendering of services

The provision of a service is likely to be spread over a period of time.

IAS 18 states that revenue from services may be recognised according to the stage of completion of the transaction at the statement of financial position date.

As with the sale of goods, conditions must be satisfied:

(a) The amount of the revenue can be measured reliably.

(b) The benefits from the transaction are likely to flow to the enterprise.

(c) The stage of completion of the work can be measured reliably.

(d) The costs incurred or to be incurred for the transaction can be reliably measured.

When a partly completed service is in its early stages, or the outcome of the transaction cannot be reliably estimated, revenue should be recognised only up to the amount of the costs incurred to date, and then only if it is probable that the enterprise will recover in revenue at least as much as the costs.

If it is probable that the costs of the transaction will not be recovered, no revenue is to be recognised.

Other revenues

Interest, royalties and dividends

Provided the amount of revenue can be reliably measured and the receipt of the income is reasonably assured, these items should be recognised as follows:

• Interest should be recognised on a time-proportion basis taking account of the yield on the asset.
• Royalties should be recognised on an accruals basis in accordance with the relevant agreement.
• Dividends should be recognised when the shareholder’s right to receive payment has been established.

Disclosure

• The accounting policy for revenue recognition, including the methods used to determine the stage of completion of service transactions.
• The amount of revenue recognised for each of the five categories above.
• The amount, if material, in each category arising from exchanges of goods or services.

Chapter summary

Test your understanding answers

Test your understanding 1

Test your understanding 2

The correct answer is C

Both 1 and 3 involve researching materials, without any form of commercial production in mind.

Test your understanding 3

The correct answer is D

Amortisation will be charged for each of the five years that revenue is generated.

As there is no reliable pattern of this revenue, amortisation will be charged on the straight-line basis.

Therefore the amortisation charge for each of the years ended 31 December 20X6 – 20Y0 will be:

$250,000/5 years = $50,000

Test your understanding 4

The correct answer is A

Test your understanding 5

(i) IAS 37 defines a contingency as an obligation or an asset that arises from past events 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 enterprise. A provision should be made if:

The legal costs of $5,000 should therefore be provided for since they will have to be paid whatever the outcome of the case. However, the claim is not likely to succeed and so no provision should be made. A disclosure note should be made for the potential loss of $15,000.

(ii) IAS 37 states that an obligation can be legal or constructive. In this case the policy of refunds has created a constructive obligation. A provision for $4,800 should therefore be made.

(iii) As the success of the claim for damages of $100,000 is probable, it constitutes a present obligation as a result of a past obligating event, and would therefore be accounted for as a provision. The success of the counterclaim for $50,000 is also considered probable and would therefore need to be disclosed as a contingent asset (reimbursement). Only if it were considered virtually certain would the counterclaim be recognised as an asset in the statement of financial position.

Test your understanding 6

The change to the vehicle depreciation is a change in accounting estimate. It does not involve a change to recognition, presentation or measurement basis. The change to the freehold property in that depreciation is now to be charged is a change in accounting policy. The measurement basis of freehold property is now changed.

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