3、Carsoon Co is a company which manufactures and retails motor vehicles. It also constructs premises for third parties. It has a year end of 28 February 2017.
(a) The entity enters into lease agreements with the public for its motor vehicles. The agreements are normally for a three-year period. The customer decides how to use the vehicle within certain contractual limitations. The maximum mileage per annum is specified at 10,000 miles without penalty and the vehicle cannot be used in other jurisdictions. Carsoon is responsible for the maintenance of the vehicle and insists that the vehicle cannot be modified in any way. At the end of the three-year contract, the customer can purchase the vehicle at a price which will be above the market value, or alternatively hand it back to Carsoon. If the vehicle is returned, Carsoon will then sell the vehicle on to the public through one of its retail outlets. These sales of vehicles are treated as investing activities in the statement of cash flows.
The directors of Carsoon wish to know how the leased vehicles should be accounted for, from the commencement of the lease to the final sale of the vehicle, in the financial statements including the statement of cash flows. (8 marks)
(b) On 1 March 2016, Carsoon invested in a debt instrument with a fair value of $6 million and has assessed that the financial asset is aligned with the fair value through other comprehensive income business model. The instrument has an interest rate of 4% over a period of six years. The effective interest rate is also 4%. On 1 March 2016, the debt instrument is not impaired in any way. During the year to 28 February 2017, there was a change in interest rates and the fair value of the instrument seemed to be affected. The instrument was quoted in an active market at $5·3 million but the price based upon an in-house model showed that the fair value of the instrument was $5·5 million. This valuation was based upon the average change in value of a range of instruments across a number of jurisdictions.
The directors of Carsoon felt that the instrument should be valued at $5·5 million and that this should be shown as a Level 1 measurement under IFRS 13 Fair Value Measurement. There has not been a significant increase in credit risk since 1 March 2016, and expected credit losses should be measured at an amount equal to 12-month expected credit losses of $400,000. Carsoon sold the debt instrument on 1 March 2017 for $5·3 million.
The directors of Carsoon wish to know how to account for the debt instrument until its sale on 1 March 2017. (8 marks)
(c) Carsoon constructs retail vehicle outlets and enters into contracts with customers to construct buildings on their land. The contracts have standard terms, which include penalties payable by Carsoon if the contract is delayed, or payable by the customer, if Carsoon cannot gain access to the construction site.
Due to poor weather, one of the projects was delayed. As a result, Carsoon faced additional costs and contractual penalties. As Carsoon could not gain access to the construction site, the directors decided to make a counter-claim against the customer for the penalties and additional costs which Carsoon faced. Carsoon felt that because claims had been made against the customer, the additional costs and penalties should not be included in contract costs but shown as a contingent liability. Carsoon has assessed the legal basis of the claim and feels it has enforceable rights.
In the year ended 28 February 2017, Carsoon incurred general and administrative costs of $10 million, and costs relating to wasted materials of $5 million.
Additionally, during the year, Carsoon agreed to construct a storage facility on the same customer’s land for $7 million at a cost of $5 million. The parties agreed to modify the contract to include the construction of the storage facility, which was completed during the current financial year. All of the additional costs relating to the above were capitalised as assets in the financial statements.
The directors of Carsoon wish to know how to account for the penalties, counter claim and additional costs in accordance with IFRS 15 Revenue from Contracts with Customers. (7 marks)
Required:
Advise Carsoon on how the above transactions should be dealt with in its financial statements with reference to relevant International Financial Reporting Standards.
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) Under IAS 17 Leases, a lease is classified as a finance lease if it transfers substantially all of the risks and rewards incident to ownership. All other leases are classified as operating leases. Classification is made at the inception of the lease. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form.
In this case, the leases are operating leases. The lease is unlikely to transfer ownership of the vehicle to the lessee by the end of the lease term as the option to purchase the vehicle is at a price which is higher than fair value at the end of the lease term. The lease term is not for the major part of the economic life of the asset as vehicles normally have a length of life of more than three years and the maximum unpenalised mileage is 10,000 miles per annum. Additionally, the present value of the minimum lease payments is unlikely to be substantially all of the fair value of the leased asset as the price which the customer can purchase the vehicle is above market value, hence the lessor does not appear to have received an acceptable return by the end of the lease. Carsoon also stipulates the maximum mileage and type of usage, as the vehicles cannot be used in other jurisdictions. This would appear to indicate that the risks and rewards remain with Carsoon. Finally, Carsoon maintains the vehicles which again indicates that the risks and rewards remain with the entity.
Carsoon should account for vehicles held for rental in operating leases as property, plant and equipment (PPE) and depreciate them taking into account the expected residual value. The rental payments should go to profit or loss. Where an item of property, plant and equipment ceases to be rented and becomes held for sale, it should be transferred to inventory at its carrying amount. The proceeds from the sale of such assets should be recognised as revenue in accordance with IFRS 15 Revenue from Contracts with Customers. IFRS 5 Non-current Assets Held for Sale and Discontinued Operations does not apply when assets which are held for sale in the ordinary course of business are transferred to inventories.
IAS 7 Statements of Cash Flows states that payments from operating activities are primarily derived from the principal revenue-producing activities of the entity. Therefore, they generally result from the transactions and other events which enter into the determination of profit or loss. Therefore cash payments made to acquire assets formerly held for rental and subsequently held for sale should be treated as cash flows from operating activities and not investing activities.
(b) For financial assets which are debt instruments measured at fair value through other comprehensive income (FVOCI), both amortised cost and fair value information are relevant because debt instruments in this measurement category are held for both the collection of contractual cash flows and the realisation of fair values. Therefore, debt instruments measured at FVOCI are measured at fair value in the statement of financial position. In profit or loss, interest revenue is calculated using the effective interest rate method and impairment gains and losses are derived using the same method as for financial assets measured at amortised cost. The fair value gains and losses on these financial assets are recognised in other comprehensive income (OCI). As a result, the difference between the total change in fair value and the amounts recognised in profit or loss are shown in OCI. When these financial assets are derecognised, the cumulative gains and losses previously recognised in OCI are reclassified from equity to profit or loss. Expected credit losses (ECLs) do not reduce the carrying amount of the financial assets, which remains at fair value. Instead, an amount equal to the ECL allowance which would arise if the asset were measured at amortised cost is recognised in OCI.
The fair value of the debt instrument therefore needs to be ascertained at 28 February 2017. IFRS 13 Fair Value Measurement states that Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities which the entity can access at the measurement date. The standard sets out that adjustment to Level 1 prices should not be made except in certain circumstances. An entity may, as a practical expedient, measure fair value using an alternative pricing method which does not rely exclusively on quoted prices and this price would be within a lower level of the fair value hierarchy. In-house models are alternative pricing methods which do not rely exclusively on quoted prices. It would seem that a Level 1 input is available, based upon activity in the market and further that, because of the active market, there is no reason to use a ‘practical expedient’ to value the debt.
Therefore the accounting for the instrument should be as follows: The bonds will be initially recorded at $6 million and interest of $0·24 million will be received and credited to profit or loss. At 28 February 2017, the bonds will be valued at $5·3 million, which recognises 12-month credit losses and other reductions in fair value. The loss of $0·7 million will be charged as an impairment loss of $0·4 million to profit or loss and $0·3 million to OCI. When the bond is sold for $5·3 million on 1 March 2017, the financial asset is derecognised and the loss in OCI ($0·3 million) is reclassified to profit or loss. Also the fact that the bond is sold for $5·3 million on 1 March 2017 illustrates that this should have been the fair value on 28 February 2017.
(c) IFRS 15 Revenue from Contracts with Customers specifies how to account for costs incurred in fulfilling a contract which are not in the scope of another standard. Costs to fulfil a contract which is accounted for under IFRS 15 are divided into those which give rise to an asset and those which are expensed as incurred. Entities will recognise an asset when costs incurred to fulfil a contract meet certain criteria, one of which is that the costs are expected to be recovered.
For costs to meet the ‘expected to be recovered’ criterion, they need to be either explicitly reimbursable under the contract or reflected through the pricing of the contract and recoverable through the margin.
The penalty and additional costs attributable to the contract should be considered when they occur and Carsoon should have included them in the total costs of the contract in the period in which they had been notified.
As regards the counter claim for compensation, Carsoon accounts for the claim as a contract modification in accordance with IFRS 15. The modification does not result in any additional goods and services being provided to the customer. In addition, all of the remaining goods and services after the modification are not distinct and form part of a single performance obligation. Consequently, Carsoon should account for the modification by updating the transaction price and the measure of progress towards complete satisfaction of the performance obligation.
A contract modification may exist even though the parties to the contract have a dispute about the scope or price (or both) of the modification or the parties have approved a change in the scope of the contract but have not yet determined the corresponding change in price. In determining whether the rights and obligations which are created or changed by a modification are enforceable, an entity should consider all relevant facts and circumstances including the terms of the contract and other evidence. On the basis of information available, it is possible to feel that the counter claim had not reached an advanced stage, so that claims submitted to the client could not be included in total revenues.
When the contract is modified for the construction of the storage facility, an additional $7 million is added to the consideration which Carsoon will receive. The additional $7 million reflects the stand-alone selling price of the contract modification. The construction of the separate storage facility is a distinct performance obligation; the contract modification for the additional storage facility would be, in effect, a new contract which does not affect the accounting for the existing contract. Therefore the contract is a performance obligation which has been satisfied as assets are only recognised in relation to satisfying future performance obligations. General and administrative costs cannot be capitalised unless these costs are specifically chargeable to the customer under the contract. Similarly, wasted material costs are expensed where they are not chargeable to the customer. Therefore a total expense of $15 million will be charged to profit or loss and not shown as assets.