3、(a) Medsupply operates in the medical supply industry and has a financial year end of 31 May 2018. Medsupply sells technology needed to perform highly complex operations. When a hospital purchases equipment from Medsupply, it provides a very specialised piece of instrumentation, which is an integral part of the surgical process, free of charge.
The legal ownership of the instruments remains with Medsupply. The instruments are returned to Medsupply if they become faulty or at the end of their useful life, which is normally 1·5 years. At this point, Medsupply replaces them with new instruments but retains the right to be reimbursed if the instruments are not returned. The instruments are nearly always returned at the end of their useful life and disposed of as clinical waste.
The directors of Medsupply would like advice on the accounting treatment for the instruments loaned to hospitals. (8 marks)
(b) Medsupply imports medical equipment which is manufactured under a patent. It subsequently adapts the equipment to fit the market in its jurisdiction and sells the equipment under its own brand name. Medsupply originally spent $3 million in developing the know-how required to adapt the equipment and, in addition, it costs around $50,000 to adapt each piece of equipment. Medsupply has capitalised the cost of the know-how and also the cost of the adaptation of each piece of equipment sold, as patent rights.
Medsupply is being sued for patent infringement by Cosine, the owner of the original patent, on the grounds that Medsupply has not materially changed the original product by its subsequent adaptation. If Cosine is able to prove infringement, the court is likely to order Medsupply to pay damages and to stop infringing its patent. Medsupply’s lawyers feel that the court could conclude that Cosine’s patent claim is not valid. Cosine has sued Medsupply for $5 million for the use of a specific patent and an additional $8 million for lost profit due to Medsupply being a competitor in the market for this product. Medsupply has offered $7 million to settle both claims but has not received a response from Cosine. As a result, Medsupply feels that the damages which it faces will be between the amount offered by Medsupply and the amount claimed by Cosine.
The directors of Medsupply would like advice as to whether they have correctly accounted for the costs of the adaptation of the equipment and whether they should make a provision for the potential damages in the above legal case, in the financial statements for the year ended 31 May 2018. (9 marks)
(c) Medsupply conducts clinical trials to gain regulatory approvals for the development of its products. The majority of these clinical trials are carried out by contract research organisations (CRO). The CROs help with medical discovery, clinical development and commercialisation of products. The terms of the contracts require Medsupply to make advanced payments before the CROs will perform the clinical trial management services. These advance payments are normally non-refundable and made up to six months before the activity commences.
Required:
Advise the directors of Medsupply on how each of the above issues should be dealt with in its financial statements with reference to relevant International Financial Reporting Standards (IFRSs).
Note: The mark allocation is shown against each of the three issues above.
Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks)
(a) Evaluating the economic ownership of the instruments loaned to customers is quite judgemental with all factors needing to be evaluated separately. The use of ‘substance over form’ should always be a priority in this situation. The existing asset definition states that it is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Thus an asset is a resource rather than the inflow of economic benefits which the resource may generate. An asset must be capable of producing economic benefits, although these economic benefits need not be certain nor is there any minimum threshold before that resource meets the definition of an asset.
It is therefore important to determine whether the customer or Medsupply has the right to obtain substantially all of the economic benefits arising from use and the right to direct the use of the identified asset throughout the period. A customer has control of an asset if it has the right to operate the asset or has designed the asset in a way that predetermines its use.
The rewards associated with ownership would include the unrestricted ability to use the asset as well as to participate in any potential increases in value. Risks include the possibility of impairment, the risk of loss and usage restrictions. There are several factors which will help to determine who enjoys the economic benefits. On the return of the instruments, they are disposed of as clinical waste and, hence, it would appear that the instruments have no value on return. Additionally, the instruments are nearly always returned at the end of their useful life and hence the economic benefit has remained with the hospital throughout the life of the instrument. It appears from the above discussion that the hospital has the right to obtain substantially all the economic benefits and therefore no assets should appear in the financial statements of Medsupply. This conclusion is despite the fact that Medsupply retains the legal ownership.
Lessors are required to apply IFRS 15 Revenue from Contracts with Customers to allocate the consideration in the contract. Where a contract has multiple performance obligations, an entity will allocate the transaction price to the performance obligations in the contract by reference to their relative standalone selling prices. Thus it could be argued that the contract of sale contains a lease from the viewpoint of the instruments and that the transaction price should be split accordingly between the value of the devices and the instrumentation.
The costs incurred to fulfil a contract are recognised as an asset if and only if all of the following criteria are met:
– the costs relate directly to a contract (or a specific anticipated contract);
– the costs generate or enhance resources of the entity which will be used in satisfying performance obligations in the future; and
– the costs are expected to be recovered.
Thus utilising the above criteria from IFRS 15, it would indicate that the cost of the instrumentation should not be shown as an asset of Medsupply as it will not be recovered. The instruments form an integral part of an overall surgical process and are part of a multiple-component arrangement between Medsupply and the hospital. However, in this case, the instruments are simply a cost of sale. The instruments should be initially recorded at their acquisition and/or production cost in accordance with IAS 2 Inventory. Subsequent to initial recognition, the instruments should be measured at the lower of cost and net realisable value and when the instrument is loaned to the hospital, the manufacturer should reduce its inventory and recognise costs of sales accordingly, as Medsupply is not receiving proceeds for the usage of the instrument.
(b) IAS 38 Intangible Assets states that the three attributes to intangible assets are identifiability, control and future economic benefits. In addition, the cost of the intangible asset should be capable of reliable measurement. Development costs are capitalised only after the technical and commercial feasibility of the asset have been established. The entity must intend and be able to complete the intangible asset and either use it or sell it and be able to demonstrate how the asset will generate future economic benefits. In principle, the above criteria may appear to be satisfied in the case of the costs of adapting the medical equipment imported by Medsupply. However, only the costs incurred in developing the initial know-how of $3 million may be capitalised as these are the costs of establishing the technical and commercial feasibility of the equipment. The costs of adapting each piece of equipment of $50,000 are simply production costs to be included in costs of sales and, if the equipment is not sold, they should be included in the inventory valuation of the equipment.
IAS 37 Provisions, Contingent liabilities and Contingent Assets requires that a provision be recognised if the following conditions are met:
(i) present obligation (legal or constructive) as a result of a past event;
(ii) probable outflow of economic resources to settle the obligation; and
(iii) the amount of the obligation can be estimated reliably.
An outflow of economic resources is deemed probable when the outflow of resources is more likely than not to occur. In order for an estimate of the amount of the obligation to be reliable, it is sufficient if a range of probable outcomes can be determined. The amount recognised as provision should be the best estimate of the expenditure which an entity would rationally pay to settle. Medsupply’s lawyers feel that the court could conclude that the patent claim is not valid. However, Medsupply has offered $7 million to settle both claims without going to court and therefore this implies that Medsupply believes that it is more likely than not that a present obligation exists and this is the result of a past event. The amount of the provision may not correspond to the amount which has been offered to Cosine as there is no certainty that Cosine will accept the offer. Therefore, as it is difficult to determine the amount of the provision within a range of probable outcomes, IAS 37 states that where a continuous range of possible outcomes exists, and each point in that ranges is as likely as any other, the mid-point of the range should be used. Thus, Medsupply should recognise a provision of $10 million in its financial statements at 31 May 2018 and disclose the uncertainties relating to the amount or timing of these cash outflows.
(c) The International Accounting Standards Board’s (IASB’s) Conceptual Framework states that expenses are recognised when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen which can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets. Essentially, this recognition should occur when the related goods or services are consumed, irrespective of the timing of funds being paid.
IAS 38 Intangible Assets provides guidance on internally generated intangible assets which are recognised only if, amongst other criteria, the technical feasibility of a development project can be demonstrated.
Initially, Medsupply should record the pre-payment to CUT as an asset. Then, as the research services are performed by CUT, Medsupply must continue to determine if the criteria for the capitalisation of an intangible asset have been met. The services being performed by CUT appear to be of a research nature and not development work as CUT has been contracted to aid and support the development of knowledge in the field of tropical disease. Additionally, CUT provides advice on the early development of research proposals and design. Thus almost certainly the costs incurred will be classed as research expenditure. Therefore, Medsupply should expense the related costs as services rendered.
The Framework states that income is recognised when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen which can be measured reliably. IFRS 15 Revenue from Contracts with Customers states that entities must evaluate whether non-refundable upfront fees relate to the transfer of a good or service. In many situations, an upfront fee represents an advance payment for future goods or services. Medsupply will need to assess if the non-refundable fee relates to a separate performance obligation. The upfront fee appears to represent an advance payment for future goods or services and it appears that these services will not commence for at least four months as that is the date when the contract with CUT commences. Such fees would be recognised as revenue only when those future goods or services are provided, that is in four months’ time.