Posted: September 13th, 2017

Revenue recognition and substance over form

Revenue recognition and substance over form

Question 1
Joe is a recently apppointed non-executive director of XY plc, a listed entity. XY’s corporate governance arrangements permit non-executives to seek independent advice on accounting and legal matters affecting the entity, where they have any grounds for concern. Joe has asked you, an independent accountant, for advice because he is worried about certain aspects of the draft financial statements for XY’s year ended 30 September 2012.

The ownership of most of XY’s ordinary share capital is widely dispersed, but the three largest institutional shareholders each own around 10% of the entity’s ordinary shares. In meetings with management, these shareholders have made it clear that they expect improvements in the entity’s performance and position. XY appointed a new Chief Financial Officer at the start of the 2011/12 financial year, and the board has set ambitious financial targets for the next five years.

The 2011/12 targets were expressed in the form of two key accounting ratios, as follows:

• Return on capital employed (profit before interest as a percentage of debt + equity): 7%
• Gearing (long-term and short-term debt as a percentage of the total of debt and equity): below 45%

The draft financial statements include the following figures:
£
Revenue 31,850,000
Profit before interest 2,972,000
Equity 22,450,800
Debt 18,253,500

Joe’s copies of the minutes of board meetings provide the following relevant information:

1. On 1 October 2012 XY sold an item of plant for £1,000,000 to AB, an entity that provides financial services to businesses. The carrying value of the plant at the date of sale was £1,000,000. AB has the option to require XY to repurchase the plant on 1 October 2013 for £1,100,000. If the option is not exercised at that date, XY will be required under the terms of the agreement between the entities to repurchase the plant on 1 October 2014 for £1,210,000. XY has continued to insure the plant and store it on its business premises. The sale to AB was recognised as revenue in the draft financial statements (Debit Cash – Credit Revenue) and the asset was derecognised (Debit Cash – Credit Non-current asset) hence the cash was recorded twice.

2. A few days before the 30 September 2012 year end, XY entered into a debt factoring agreement with FB, a factoring business. The terms of the agreement are that XY is permitted to draw down cash up to a maximum of 75% of the receivables that are covered under the factoring arrangement. However, FB is able to require repayment of any part of the receivables that are uncollectible. In addition, XY is obliged to pay interest at an annual rate of 10% on any amounts it draws down in advance of cash being received from customers by FB. As soon as the agreement was finalised, XY drew down the maximum cash available in respect of the £2,000,000 receivables it had transferred to FB as part of the agreement. This amount was accounted for by debiting cash and crediting receivables.
a) Discuss the accounting treatment of the two transactions, identifying any errors that you think may have been made in applying accounting principles with references, where appropriate, to IFRS. Prepare the adjustments that are required to correct those errors and identify any areas where you would require further information.
b) Explain the effect of your adjustments on XY’s key accounting ratios for the year ended 30 September 2012.

c) Explain, briefly, the results and implications of your analysis to the non-executive director.

Question 2
MD is a motor dealership trading vehicles which are manufactured and supplied by their manufacturer Dover. Trading between the two companies is subject to a contractual agreement, the principal terms of which are as follows:
• MD could hold up to 60 vehicles on its premises although the legal title of the vehicles remained with Dover until they were sold by MD to a third party.
• MD was required to inform Dover within 3 working days of any sale, at which time Dover would raise an invoice at the price agreed at the original date of delivery.
• MD had the right to return any vehicle at any time without incurring a penalty.
• MD was responsible for insuring all the vehicles on its property against loss or damage.
• MD is entitled to use any of the vehicles supplied to it for demonstration purposes and road testing. However, if more than a specified number of kilometres is driven in a vehicle, MD is required to pay Dover a rental charge.
Required:
Discuss the economic substance of MD’s contractual agreement with Dover and explain which company should recognise the vehicles in inventory during the period that they were held at MD’s premises.
Applying the requirements of “IAS 18 Revenue” identify the point at which Dover should recognise the sale of its vehicles.
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