Liability, Revenue and Impact Standards
Weightage: Chapters 6 to 9 of ICAI's Paper 1 syllabus, together roughly 14 marks. AS 29, AS 7 and AS 22 are the three that produce full questions; the rest produce four and five-mark applications.
Three questions in one chapter
This chapter collects three of ICAI's groups because they are short individually and because their questions share a shape.
Liabilities — AS 15 and AS 29 — ask: when does an obligation become something you must record, as opposed to something you must merely mention?
Revenue — AS 7 and AS 9 — ask: when has the entity earned this, as distinct from when has it been paid?
Items impacting the financial statements — AS 4, 5, 11, 12, 14 and 22 — ask: something has disturbed the figures you already have; what do you do about it?
AS 29 — Provisions, Contingent Liabilities and Contingent Assets
The most heavily examined standard in this chapter, and the one whose logic is worth learning properly because it recurs everywhere.
The three-way split
Everything turns on a single decision tree, and questions almost always want it applied to a fact pattern rather than described.
A provision is a liability that can be measured only by using a substantial degree of estimation. It is recognised when, and only when, all three of the following hold:
- the enterprise has a present obligation as a result of a past event;
- it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation;
- a reliable estimate can be made of the amount.
If a present obligation exists but the outflow is only possible rather than probable, or the amount cannot be measured reliably, it is a contingent liability — disclosed, not recognised.
If there is no present obligation at all, only a possible obligation whose existence will be confirmed by future events not wholly within the enterprise's control, that too is a contingent liability.
If the possibility of an outflow is remote, nothing is done — no recognition and no disclosure.
A contingent asset is never recognised, and is not even disclosed in the financial statements. Where the inflow of economic benefits is virtually certain, the asset is no longer contingent and is recognised.
The asymmetry between contingent liabilities and contingent assets is deliberate and is examined: a possible loss is disclosed, a possible gain is not mentioned at all.
Present obligation
A present obligation may be legal, arising from a contract, legislation or other operation of law, or constructive, arising from an established pattern of past practice, published policies or a sufficiently specific current statement by which the enterprise has created a valid expectation in others that it will discharge those responsibilities.
The distinction that produces most questions is between an obligation and an intention. A board decision to incur expenditure creates no obligation while the board can still change its mind. A published policy of refunding dissatisfied customers, consistently honoured, creates a constructive obligation even though no contract requires it.
Measurement
The amount recognised is the best estimate of the expenditure required to settle the present obligation at the balance sheet date. Where a single obligation is being measured, the individual most likely outcome may be the best estimate. Where a large population of items is involved, the obligation is estimated by weighting all possible outcomes by their associated probabilities — the expected value.
Discounting is not permitted under AS 29 where the effect of the time value of money is material — this differs from the international position and is examined as a point of difference. Gains from expected disposal of assets are not taken into account in measuring a provision.
Reimbursements from a third party are recognised only when it is virtually certain that reimbursement will be received, and are treated as a separate asset, not netted against the provision. The amount recognised must not exceed the provision.
Specific applications
Restructuring provisions may be recognised only where a detailed formal plan exists identifying the business or part concerned, the principal locations affected, the location, function and approximate number of employees to be compensated, the expenditure to be undertaken, and when the plan will be implemented; and where a valid expectation has been raised in those affected, either by starting to implement the plan or by announcing its main features to them.
A restructuring provision includes only direct expenditures necessarily entailed by the restructuring and not associated with the ongoing activities. It excludes retraining or relocating continuing staff, marketing, and investment in new systems and distribution networks.
Onerous contracts — where the unavoidable costs of meeting the obligations exceed the economic benefits expected to be received — require the present obligation under the contract to be recognised as a provision.
Future operating losses are not provided for, because they do not arise from a past event and there is no present obligation.
AS 15 — Employee Benefits
The four categories
Short-term employee benefits fall due wholly within twelve months after the end of the period in which employees render the service — wages, salaries, paid annual and sick leave, profit-sharing and bonuses payable within twelve months, and non-monetary benefits. They are recognised as an undiscounted amount in the period in which the service is rendered.
Post-employment benefits are payable after employment ends — gratuity, pension, post-employment medical care. Their accounting depends entirely on a classification.
Other long-term employee benefits include long-service leave, sabbaticals, jubilee benefits, and long-term disability benefits.
Termination benefits arise from an enterprise's decision to terminate employment before normal retirement date, or an employee's decision to accept voluntary redundancy. They are recognised as a liability and expense when, and only when, the enterprise is demonstrably committed either to terminate the employment of an employee or group before the normal retirement date, or to provide termination benefits as a result of an offer made to encourage voluntary redundancy.
The classification that decides everything
Defined contribution plans are post-employment benefit plans under which the enterprise pays fixed contributions into a separate entity and has no legal or constructive obligation to pay further contributions if the fund does not hold sufficient assets. The actuarial risk and the investment risk fall on the employee. The accounting is simple: the contribution payable for the period is recognised as an expense.
Defined benefit plans are all other post-employment plans. The enterprise's obligation is to provide the agreed benefits, and the actuarial risk and investment risk fall on the enterprise. The accounting is correspondingly complex: the obligation is measured on an actuarial basis using the projected unit credit method, plan assets are measured at fair value, and the net figure is recognised.
Gratuity in India is characteristically a defined benefit obligation, because the employer promises a formula-determined amount regardless of what any fund has earned.
AS 7 — Construction Contracts
Why it exists
A contract that spans three financial years poses a problem no other revenue standard has to solve. If revenue were recognised only on completion, two years would show nothing and the third would show everything, which describes neither year truthfully.
AS 7 requires the percentage of completion method. Contract revenue and contract costs are recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the balance sheet date, when the outcome of a construction contract can be estimated reliably.
Note what is not there: AS 7 permits no completed contract method. That option existed under the earlier standard and does not survive.
When the outcome can be estimated reliably
For a fixed price contract, all four of the following must hold: total contract revenue can be measured reliably; it is probable that the economic benefits will flow to the enterprise; both the contract costs to complete and the stage of completion at the balance sheet date can be measured reliably; and the contract costs attributable to the contract can be clearly identified and measured reliably so that actual costs can be compared with prior estimates.
For a cost plus contract, two conditions: it is probable that the economic benefits will flow, and the contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably.
When it cannot
Where the outcome cannot be estimated reliably, revenue is recognised only to the extent of contract costs incurred of which recovery is probable, and contract costs are recognised as an expense in the period incurred. No profit is recognised.
The rule that overrides everything
When it is probable that total contract costs will exceed total contract revenue, the expected loss is recognised as an expense immediately, regardless of the stage of completion, regardless of whether work has commenced, and regardless of the outcome of other contracts. This is prudence applied to contracts, and it is the most commonly examined single point in AS 7.
Stage of completion
May be determined by the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs, by surveys of work performed, or by completion of a physical proportion of the contract work. Progress payments and advances received from customers do not necessarily reflect the work performed and are not a basis for measuring the stage of completion.
AS 9 — Revenue Recognition
Scope
AS 9 deals with revenue arising from the sale of goods, the rendering of services, and the use by others of enterprise resources yielding interest, royalties and dividends. It expressly excludes revenue from construction contracts, hire purchase and lease agreements, government grants, and insurance contracts of insurance companies.
Revenue is the gross inflow of cash, receivables or other consideration arising in the course of ordinary activities. It excludes amounts collected on behalf of third parties.
Sale of goods
Revenue is recognised when the seller has transferred to the buyer the property in the goods for a price, or all significant risks and rewards of ownership have been transferred and the seller retains no effective control of the goods to a degree usually associated with ownership; and no significant uncertainty exists regarding the amount of consideration.
Where significant uncertainty exists as to ultimate collection, revenue recognition is postponed. Where the uncertainty arises subsequently, after revenue has already been recognised, the provision is made against the receivable and revenue is not reversed — a distinction that is examined.
Rendering of services
Recognised by the completed service contract method or the proportionate completion method, according to which relates the revenue to the work accomplished.
Interest, royalties and dividends
Interest accrues on a time proportion basis, taking into account the amount outstanding and the rate applicable. Royalties accrue in accordance with the terms of the relevant agreement. Dividends are recognised when the right to receive payment is established.
AS 4 — Contingencies and Events Occurring After the Balance Sheet Date
The heart of this standard is a distinction that is easy to state and constantly misapplied.
Adjusting events provide additional evidence of conditions that existed at the balance sheet date. The figures are adjusted. The insolvency of a customer that was already in difficulty, confirming that a receivable was not recoverable at the year end; the settlement of a court case confirming a present obligation at the year end; the discovery of fraud or errors showing the statements were incorrect.
Non-adjusting events arise from conditions that arose after the balance sheet date. The figures are not adjusted, but disclosure is required where the event is of such significance that non-disclosure would affect the ability of users to make proper evaluations. A fire destroying a factory two weeks after the year end; a major acquisition; a decline in market value of investments after the year end.
Two specific rules must be known. Proposed dividends declared after the balance sheet date but relating to the period are not recognised as a liability at the balance sheet date; they are disclosed. And an event occurring after the balance sheet date that indicates the going concern assumption is no longer appropriate requires a fundamental change in the basis of accounting, regardless of whether it would otherwise be an adjusting event.
AS 5 — Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies
Ordinary activities are activities undertaken as part of the business and related activities that the enterprise undertakes in furtherance of, incidental to, or arising from these activities.
Extraordinary items are income or expenses that arise from events or transactions clearly distinct from the ordinary activities and therefore not expected to recur frequently or regularly. They are disclosed separately as part of net profit or loss for the period, with their nature and amount stated.
Prior period items are income or expenses which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods. The word errors is load-bearing: a revision of an estimate is not a prior period item, however large. Prior period items are separately disclosed so that their impact on the current profit or loss can be perceived.
Change in accounting policy is made only if required by statute, for compliance with an accounting standard, or if it is considered that the change would result in a more appropriate presentation. The amount by which any item is affected must be disclosed to the extent ascertainable; where not ascertainable, that fact must be stated.
Change in accounting estimate is applied prospectively, in the period of change if it affects only that period, or in the period of change and future periods if it affects both. The nature and amount of a change having a material effect is disclosed.
Where it is difficult to distinguish a change in policy from a change in estimate, the change is treated as a change in estimate, with appropriate disclosure.
AS 11 — The Effects of Changes in Foreign Exchange Rates
Initial recognition: a foreign currency transaction is recorded by applying the exchange rate at the date of the transaction.
At each balance sheet date:
- Monetary items — money held and items to be received or paid in fixed or determinable amounts of money — are reported using the closing rate.
- Non-monetary items carried at historical cost are reported using the exchange rate at the date of the transaction, so they do not move.
- Non-monetary items carried at fair value are reported using the rates that existed when the values were determined.
Exchange differences arising on the settlement of monetary items or on reporting them at rates different from those at which they were initially recorded are recognised as income or expense in the period in which they arise.
Forward exchange contracts not intended for trading or speculation: the premium or discount, being the difference between the forward rate and the spot rate at inception, is amortised as expense or income over the life of the contract. Exchange differences on such a contract are recognised in profit for the period. For a contract intended for trading or speculation, the gain or loss is computed by the difference between the forward rate available at the reporting date for the remaining maturity and the contracted rate, and is recognised in profit.
Foreign operations are classified as integral — carried on as though an extension of the reporting enterprise's operations — or non-integral. Integral operations are translated as if the transactions were those of the reporting enterprise itself. For non-integral operations, assets and liabilities are translated at the closing rate, income and expense items at the rates at the dates of the transactions, and the resulting exchange difference is accumulated in a foreign currency translation reserve until disposal of the net investment.
AS 12 — Government Grants
Grants related to specific fixed assets may be presented either by deducting the grant from the gross value of the asset, or by treating it as deferred income which is recognised in profit and loss on a systematic and rational basis over the useful life of the asset. Where a grant equals the whole or virtually the whole cost of an asset, the asset is shown at a nominal value.
Grants related to revenue are presented either as a credit in the profit and loss statement or as a deduction from the related expense.
Grants of the nature of promoters' contribution — where no repayment is ordinarily expected and the grant is given as a contribution towards total capital outlay — are credited to capital reserve and treated as part of shareholders' funds.
Non-monetary grants given at a concessional rate are accounted for at their acquisition cost; where given free of cost, at a nominal value.
Refund of a grant is treated as an extraordinary item. A grant related to revenue is applied first against any unamortised deferred credit, and any excess is charged to profit. For a grant related to a fixed asset, the carrying amount is increased or the deferred income balance reduced by the amount refundable, and the resulting additional depreciation is recognised prospectively.
AS 14 — Accounting for Amalgamations
The classification is developed fully in the amalgamation chapter; what belongs here is the definitional core.
Amalgamation in the nature of merger requires all five conditions: all assets and liabilities of the transferor become those of the transferee; shareholders holding not less than ninety per cent of the face value of the equity shares of the transferor become equity shareholders of the transferee; the consideration for those shareholders is discharged wholly by the issue of equity shares, except for cash in respect of fractional shares; the business of the transferor is intended to be carried on by the transferee; and no adjustment is intended to the book values of the assets and liabilities except to ensure uniformity of accounting policies.
Failing any one condition makes it an amalgamation in the nature of purchase. The pooling of interests method applies to a merger; the purchase method applies to a purchase.
AS 22 — Accounting for Taxes on Income
The problem
Taxable income and accounting profit differ, because tax law and accounting standards answer different questions. If tax expense in the accounts were simply the tax payable for the year, the tax charge would not correspond to the profit reported alongside it, and the matching principle would be broken.
AS 22 solves this by recognising deferred tax on timing differences.
Permanent differences originate in one period and do not reverse — a disallowed expense that will never be allowed. They create no deferred tax.
Timing differences originate in one period and are capable of reversal in one or more subsequent periods — depreciation charged at different rates for accounting and tax, expenses allowed on payment rather than accrual. These create deferred tax.
Recognition
Deferred tax liabilities are recognised for all timing differences, subject to the considerations of prudence.
Deferred tax assets are recognised and carried forward only to the extent that there is a reasonable certainty that sufficient future taxable income will be available against which they can be realised.
Where there are unabsorbed depreciation or carry forward of losses under tax laws, the test is stricter: deferred tax assets are recognised only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available.
Deferred tax is measured using the tax rates and tax laws that have been enacted or substantively enacted by the balance sheet date. Deferred tax assets and liabilities are not discounted.
The carrying amount of deferred tax assets is reviewed at each balance sheet date and written down to the extent it is no longer reasonably certain, or virtually certain as the case may be, that sufficient future taxable income will be available.
