Liability, Revenue and Impact Standards — Practice

Question 1

Classify each of the following for the year ended 31 March: (a) a customer has sued for ₹50 lakh; counsel advises the company will probably lose and the likely amount is ₹30 lakh; (b) a second suit for ₹20 lakh which counsel says the company will probably win, though loss is possible; (c) a third claim counsel describes as frivolous with a remote chance of success; (d) the company is suing a supplier and will probably win ₹15 lakh.

Accepted Answer

AS 29 requires a provision to be recognised when, and only when, there is a present obligation from a past event, an outflow of resources is probable, and a reliable estimate can be made. In (a) all three are met — the past event is the conduct sued on, counsel advises loss is probable, and 30 lakh is a reliable estimate — so a provision of 30 lakh is recognised. In (b) a present obligation may exist but the outflow is possible rather than probable, so it is a contingent liability, disclosed by way of note with a description of the nature of the obligation and an estimate of its financial effect, but not recognised. In (c) the possibility of an outflow is remote, and where that is so AS 29 requires neither recognition nor disclosure; nothing at all is done. In (d) the company's claim is a contingent asset, and contingent assets are neither recognised nor disclosed in the financial statements, however probable. The asymmetry between (b) and (d) is deliberate: a possible loss is disclosed while a possible gain is not mentioned, because recognising or even flagging unrealised gains would let an enterprise report optimism as substance.

Question 2

A retailer has no legal obligation to accept returns of unsatisfactory goods but has done so for many years and advertises the policy prominently. At the year end it estimates ₹8 lakh of returns will arise on the year's sales. Separately, its board has resolved to spend ₹40 lakh on a factory upgrade next year. Advise on both.

Accepted Answer

The refund policy creates a constructive obligation and a provision of 8 lakh is recognised. AS 29 recognises that a present obligation may be legal, arising from a contract or legislation, 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. Here the pattern of past practice and the advertised policy have both created that expectation in customers, so the absence of any legal duty is irrelevant: the enterprise has no realistic alternative to honouring the policy, since refusing would damage the trade it depends on. The past event is the sale, and the outflow is probable and reliably estimable. The board resolution creates no obligation and no provision may be made. A decision by the board or management does not give rise to a present obligation at the balance sheet date unless the decision has been communicated before that date to those affected in a sufficiently specific manner to raise a valid expectation that the enterprise will discharge its responsibilities. Until then the board can simply change its mind, and an obligation the entity can unilaterally avoid is not an obligation.

Question 3

A company sells 10,000 machines with a one-year warranty. Experience suggests 85% will need no repair, 12% will need minor repairs costing ₹2,000 each, and 3% will need major repairs costing ₹9,000 each. Compute the provision, state the measurement basis used, and explain when the alternative basis would apply. The company expects to recover ₹6 lakh from a component supplier, though the claim is disputed.

Accepted Answer

Where a provision involves a large population of items, AS 29 requires the obligation to be estimated by weighting all possible outcomes by their associated probabilities, a basis known as expected value. Applying it: 85 per cent of 10,000 at nil is nil; 12 per cent, that is 1,200 machines, at 2,000 each is 24,00,000; 3 per cent, that is 300 machines, at 9,000 each is 27,00,000. The provision is 51,00,000. The alternative basis applies where a single obligation is being measured, in which case the individual most likely outcome may be the best estimate of the liability — appropriate for a single lawsuit, where an expected value would produce an amount no possible outcome could actually equal. On the supplier claim, no asset may be recognised. AS 29 permits a reimbursement to be recognised only when it is virtually certain that it will be received if the enterprise settles the obligation, and a disputed claim is not virtually certain. Two further points would be needed had it been virtually certain: the reimbursement is recognised as a separate asset and not netted against the provision, and the amount recognised may not exceed the provision.

Question 4

On 15 March a board approves a detailed plan to close a division, identifying the location, the 240 employees affected, the ₹90 lakh of redundancy costs, and a June start. The plan is announced to staff on 25 March. Costs include ₹90 lakh redundancy, ₹12 lakh retraining staff who will be redeployed, and ₹8 lakh marketing the reorganised business. Advise for the year ended 31 March.

Accepted Answer

A restructuring provision may be recognised, but only for part of the cost. AS 29 permits recognition where the enterprise has a detailed formal plan identifying at least the business or part concerned, the principal locations affected, the location, function and approximate number of employees who will be compensated for terminating their services, the expenditure that will be undertaken and when the plan will be implemented; and where the enterprise has raised a valid expectation in those affected that it will carry out the restructuring, by starting to implement the plan or announcing its main features to them. Both limbs are satisfied here: the plan meets every element of the detail requirement, and the announcement to staff on 25 March, before the year end, raised the valid expectation. Had the announcement come after 31 March, no provision could have been made. As to amount, a restructuring provision includes only the direct expenditures arising from the restructuring, which are those necessarily entailed by it and not associated with the ongoing activities of the enterprise. Redundancy of 90 lakh qualifies. Retraining of 12 lakh and marketing of 8 lakh both relate to the conduct of the continuing business and are expressly excluded, so they are expensed as incurred in later periods. The provision is 90 lakh.

Question 5

Distinguish a defined contribution plan from a defined benefit plan under AS 15, state who bears the risk in each, and explain why gratuity in India is characteristically the second.

Accepted Answer

A defined contribution plan is a post-employment benefit plan under which the enterprise pays fixed contributions into a separate entity and will have no legal or constructive obligation to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to service in the current and prior periods. A defined benefit plan is any post-employment benefit plan other than a defined contribution plan. The distinction is entirely about where risk lies. Under a defined contribution plan the actuarial risk, that benefits will be less than expected, and the investment risk, that assets will be insufficient to meet expected benefits, both fall on the employee; the employer's obligation ends with the contribution. Under a defined benefit plan both risks fall on the enterprise, because it has promised the benefit and must make it good whatever the fund earns. The accounting follows: for a defined contribution plan the contribution payable for the period is simply recognised as an expense, whereas for a defined benefit plan the obligation must be measured actuarially using the projected unit credit method, plan assets measured at fair value, and the net amount recognised. Gratuity in India is characteristically defined benefit because the employer promises an amount determined by a formula on salary and years of service, regardless of what any fund has earned, so the shortfall risk is the employer's.

Question 6

A contract has a fixed price of ₹600 lakh. Costs incurred to date are ₹210 lakh and estimated costs to complete are ₹490 lakh. Compute the amounts to be recognised, and state the rule that governs. How would your answer change if the outcome of the contract could not be estimated reliably?

Accepted Answer

Total expected costs are 210 plus 490, that is 700 lakh, against contract revenue of 600 lakh, so a loss of 100 lakh is expected. AS 7 provides that when it is probable that total contract costs will exceed total contract revenue, the expected loss should be recognised as an expense immediately. The rule overrides the stage of completion entirely: the whole 100 lakh is recognised now, irrespective of whether work has commenced, irrespective of the stage of completion, and irrespective of the amount of profits expected to arise on other contracts. Revenue is recognised by reference to the stage of completion, which on the cost basis is 210 over 700, that is 30 per cent, giving revenue of 180 lakh; costs of 210 are recognised, and the resulting recognised loss of 30 lakh is supplemented by a further provision of 70 lakh so that the full 100 lakh expected loss is charged in the period. Had the outcome not been reliably estimable, the treatment would be quite different: revenue would be recognised only to the extent of contract costs incurred of which recovery is probable, contract costs would be recognised as an expense in the period incurred, and no profit would be recognised. Note that even in that case the expected loss rule continues to apply, because it does not depend on the outcome being estimable.

Question 7

A contractor argues that since the customer has paid 60% of the contract price, the contract is 60% complete and revenue should be recognised accordingly. Comment, and list the methods AS 7 does permit.

Accepted Answer

The argument is wrong and AS 7 addresses it expressly. The standard provides that progress payments and advances received from customers often do not reflect the work performed, and they are therefore not a permitted basis for determining the stage of completion. The reason is that payment schedules are negotiated commercial arrangements: a customer may pay a large mobilisation advance before any work is done, or withhold retention money long after work is complete, and in neither case does the cash tell you anything about physical or economic progress. Recognising revenue on payments received would let the parties determine reported profit by drafting the payment clause. AS 7 permits the stage of completion to be determined in a variety of ways, and the enterprise uses the method that measures reliably the work performed. Those methods are the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs; surveys of work performed; and completion of a physical proportion of the contract work. Where the cost basis is used, costs relating to future activity such as materials delivered to site but not yet installed, and payments made to subcontractors in advance of work performed, are excluded.

Question 8

A company sold goods for ₹30 lakh in February. At the year end there is significant uncertainty whether the customer will pay. In a separate case, goods were sold for ₹18 lakh in a prior year, revenue was recognised, and the customer has now become insolvent. State the treatment in each case and the principle distinguishing them.

Accepted Answer

In the first case revenue recognition is postponed. AS 9 provides that where the ability to assess the ultimate collection with reasonable certainty is lacking at the time of raising the claim, revenue recognition is postponed to the extent of the uncertainty involved, and in such cases revenue is recognised only when it is reasonably certain that ultimate collection will be made. The uncertainty existed at the point of recognition, so recognition itself is deferred. In the second case revenue is not reversed. Where the uncertainty arises subsequent to the time of sale or the rendering of the service, a separate provision is made to reflect the uncertainty rather than an adjustment of the amount of revenue originally recorded, so a provision for doubtful debts of 18 lakh is created against the receivable and the revenue of the earlier year stands. The distinguishing principle is the timing of the uncertainty relative to recognition. Revenue recognised when collection was reasonably certain was properly recognised, and the later insolvency is a new event affecting the recoverability of an asset rather than evidence that the sale never earned anything. Reversing it would misstate the year in which the goods were actually sold.

Question 9

For a year ended 31 March, classify each as adjusting or non-adjusting: (a) a customer already in difficulty at the year end is declared insolvent on 20 April; (b) a fire destroys a factory on 5 May; (c) a court delivers judgment on 12 April confirming an obligation that existed at 31 March; (d) the board proposes a dividend on 28 April relating to the year; (e) events in June make the going concern assumption inappropriate.

Accepted Answer

Item (a) is adjusting. The insolvency provides additional evidence of a condition that existed at the balance sheet date, namely that the receivable was already impaired, so the provision is made in the accounts for the year ended 31 March. Item (b) is non-adjusting, since the fire arose from conditions after the balance sheet date; the assets were undamaged at the year end and the figures are not altered, but disclosure is required because non-disclosure of an event of this significance would affect users' ability to make proper evaluations. Item (c) is adjusting on the same footing as (a), the judgment confirming a present obligation at the year end. Item (d) is governed by a specific rule: a proposed dividend declared after the balance sheet date in respect of the period is not recognised as a liability at the balance sheet date, because no obligation existed then, and it is disclosed instead. Item (e) is the standard's override: where an event after the balance sheet date indicates that the fundamental accounting assumption of going concern is no longer appropriate, the financial statements require a fundamental change in the basis of accounting rather than merely an adjustment, and this applies whether or not the event would otherwise be adjusting.

Question 10

A company discovers that depreciation was understated by ₹14 lakh in the previous year because a machine was omitted from the fixed asset register. Separately, it revises the estimated useful life of its vehicles from eight years to five, increasing this year's depreciation by ₹22 lakh. Classify each under AS 5 and state the treatment.

Accepted Answer

The omitted machine gives rise to a prior period item. AS 5 defines prior period items as 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, and an asset left out of the register is exactly such an omission. The 14 lakh is charged in the current period but disclosed separately, with its nature and amount stated, so that its impact on the current profit or loss can be perceived; prior period items are not adjusted against opening reserves under AS 5. The revision of vehicle lives is a change in accounting estimate, not a prior period item, and the size of the effect is irrelevant to that classification. Estimates are revisions of judgements made in the light of new information or subsequent developments, and the earlier estimate was not an error merely because it turned out to be optimistic. The effect is recognised prospectively, in the period of the change and in future periods if it affects both, so the 22 lakh is simply this year's depreciation charge with no restatement of earlier years. Its nature and amount are disclosed because the effect is material. Where it is difficult to distinguish a change in policy from a change in estimate, AS 5 directs that it be treated as a change in estimate with appropriate disclosure.

Question 11

A company with a 31 March year end buys machinery for USD 100,000 on 1 December when the rate is ₹82, and pays on 30 April. It also holds inventory bought for USD 20,000 on the same date, still on hand. The closing rate is ₹85. State the year-end treatment of the machinery, the creditor and the inventory.

Accepted Answer

Every item is initially recorded at the rate on the date of the transaction, so machinery is recorded at 82,00,000, the creditor at 82,00,000 and the inventory at 16,40,000. The year-end treatment then depends on whether each item is monetary. The creditor is a monetary item, being an amount to be paid in a fixed or determinable number of currency units, so it is reported at the closing rate: 100,000 at 85, that is 85,00,000. The resulting exchange difference of 3,00,000 is recognised as an expense in the profit and loss account for the period, AS 11 requiring exchange differences on reporting monetary items at rates different from those at which they were initially recorded to be recognised as income or expense in the period in which they arise. The machinery is a non-monetary item carried at historical cost and is reported using the exchange rate at the date of the transaction, so it stays at 82,00,000 and does not move. The inventory is also non-monetary and stays at 16,40,000, subject to the ordinary AS 2 test of the lower of cost and net realisable value. The organising idea is that a monetary item is a claim to a fixed number of foreign currency units, so its rupee value moves with the rate, whereas a non-monetary item is a thing whose rupee cost was fixed when it was bought.

Question 12

On 1 January a company enters a six-month forward contract to buy USD 50,000 at ₹86 to hedge a payable. The spot rate on 1 January is ₹84. The year end is 31 March. State the treatment of the premium, and contrast it with a contract taken for speculation.

Accepted Answer

The contract is not for trading or speculation, so AS 11's hedging treatment applies. The premium is the difference between the forward rate and the spot rate at the date of inception of the contract, that is 86 less 84, being 2 per dollar on 50,000 dollars, or 1,00,000. That premium is amortised as an expense over the life of the contract, which runs six months from 1 January, so three months fall in the year to 31 March and 50,000 is charged to profit for that year, with the remaining 50,000 carried forward. In addition, any exchange difference on the contract, arising from a change in the exchange rate between the reporting dates or between the last reporting date and the settlement date, is recognised as income or expense for the period. For a contract intended for trading or speculation, the treatment is different in both respects: no premium or discount is separately amortised, and instead a gain or loss is computed by the difference between the forward rate available at the reporting date for the remaining maturity of the contract and the contracted forward rate, and is recognised in the profit and loss account for the period. The distinction reflects purpose: a hedge is priced into the cost of the underlying exposure over time, while a speculative position is simply marked to what it is currently worth.

Question 13

A company receives a ₹60 lakh government grant towards a machine costing ₹240 lakh with a ten-year life and nil residual value. State the two permitted presentations and the effect of each on the first year's profit. Separately, state the treatment of a grant of the nature of promoters' contribution.

Accepted Answer

AS 12 permits two presentations for a grant related to a specific fixed asset, and both produce the same effect on profit. Under the first, the grant is deducted from the gross value of the asset, so the machine is carried at 240 less 60, that is 180 lakh, and depreciation is 18 lakh a year. Under the second, the grant is treated as deferred income, the machine is carried at 240 with depreciation of 24 lakh a year, and the deferred income of 60 lakh is recognised in profit on a systematic and rational basis over the useful life of the asset, that is 6 lakh a year. The net charge to profit in the first year is 18 lakh under either method, which is the point of permitting both: the choice affects the balance sheet presentation and the gross figures, not the result. Where a grant equals the whole or virtually the whole of the cost of an asset, the asset is recorded at a nominal value. A grant of the nature of promoters' contribution is treated quite differently: where the government gives it as a contribution towards the total capital outlay and no repayment is ordinarily expected, it is credited to capital reserve and treated as part of shareholders' funds, never passing through the profit and loss account at all, because it is capital in substance rather than a subsidy of any particular cost.

Question 14

A company's accounting profit is ₹500 lakh. It includes ₹40 lakh of donations disallowed for tax and ₹30 lakh of expenditure allowable only on payment, unpaid at the year end. Depreciation is ₹120 lakh in the accounts and ₹190 lakh under tax law. The tax rate is 25%. Compute current tax and deferred tax, identifying which differences create deferred tax and why.

Accepted Answer

First separate the differences. Donations of 40 lakh disallowed permanently are a permanent difference: they originate in this period and do not reverse in any subsequent period, so they affect current tax but create no deferred tax. The unpaid expenditure of 30 lakh and the depreciation difference of 70 lakh, being 190 less 120, are both timing differences, originating in one period and capable of reversal in one or more subsequent periods, and both create deferred tax. Taxable income is 500 plus 40 permanent, plus 30 disallowed now and allowed on payment, less 70 excess tax depreciation, that is 500. Current tax is 25 per cent of 500, that is 125 lakh. On deferred tax, the excess tax depreciation of 70 will reverse in later years when accounting depreciation exceeds tax depreciation, giving rise to future taxable amounts, so it creates a deferred tax liability of 25 per cent of 70, that is 17.5 lakh. The unpaid expenditure of 30 will be allowed when paid, giving a future deductible amount, so it creates a deferred tax asset of 25 per cent of 30, that is 7.5 lakh, recognised because there is reasonable certainty of sufficient future taxable income. The net deferred tax liability is 10 lakh, and total tax expense is 125 plus 10, that is 135 lakh, which is 25 per cent of 540, the accounting profit adjusted only for the permanent difference. That reconciliation is the check worth doing.

Question 15

A loss-making company has unabsorbed depreciation and carried forward business losses giving a potential deferred tax asset of ₹80 lakh. Its directors project a return to profit within two years based on a business plan. It also has ₹15 lakh of deferred tax asset arising from a provision for doubtful debts disallowed this year. Advise on recognition of each.

Accepted Answer

AS 22 applies two different tests and the question turns on which applies to which item. The general rule is that deferred tax assets should be recognised and carried forward only to the extent that there is a reasonable certainty that sufficient future taxable income will be available against which such deferred tax assets can be realised. But where an enterprise has unabsorbed depreciation or carry forward of losses under tax laws, deferred tax assets should be recognised only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such deferred tax assets can be realised. The 80 lakh falls in the stricter category, and a directors' business plan projecting a return to profit is not convincing evidence: AS 22 contemplates something like binding export orders or a signed contract that makes the future income essentially certain rather than merely planned, and the existence of unabsorbed losses is itself strong evidence that future taxable income may not be available. The 80 lakh is therefore not recognised, though the position is reviewed at each balance sheet date. The 15 lakh arising from the disallowed provision falls under the ordinary reasonable certainty test and may be recognised if that lower threshold is met on the facts, though a company currently loss-making will often fail even that. The carrying amount of any deferred tax asset recognised must be 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.

Practice — Liability, Revenue and Impact Standards

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