L6 - The Role of Professional Judgement PDF

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Lecture Notes on The Role of Professional Judgement...

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The Role of Professional Judgement Identify the role of professional judgement in previous topics Discuss the extent to which accounting for the recognition of revenue & provisions involves the role of professional judgement Apply the requirements of IAS 37 Provisions Critique IAS 18 & outline the requirements of IFRS Revenue from Contracts with Customers Examples of judgment Is it an operating lease or finance lease? How long is an asset’s life & which method of depreciation to apply Which method of inventory valuation should be used? Accountants use judgement all the time which affect the companies financial position e.g. an accountant may use a longer economic life when depreciating if under pressure to improve profits Earnings Management Financialisation: need to generate shareholder value means; Companies generally prefer to report a steady trend of profit growth Higher ‘sustainable’ profits = higher share price Under a lot of pressure from markets Many ways of doing this using judgement Accountants should reflect whats happening in the firm but because of incentive structures & pressure that management are under accountants use earnings management which destroys confidence in markets April 2015 - Toshiba over-stated by at least $1.2 billion. Issues over a seven year period. Income Smoothing Profits may be volatile which markets don’t like and prefer steady income. Managers smooth out fluctuations in earnings. IAS 37 A provisions is a liability of uncertain timing or amount A provision should only be recognised where: The company has a present obligation arising from a past event It is probable that the provision will have to be settled A reliable estimate can made of the amount A provision should be the best estimate of the future liability - faithful representation Creating a provision

Decision Tree: Provision or Contingency? Start - Present obligation as a result of a past event? - Probable outflow/is the likelihood greater than 50% - Can the estimate be reliably estimated - Provide All three conditions must be satisfied If there isn't a present obligation is it possible? No - do nothing. Yes - is there a remote chance of it happening/less than 50%. If yes no nothing. If yes disclose contingent liability Understanding the decision tree What is a present obligation? IAS 37 says obligation can either be a legal obligation or constructive obligation - entity has created an expectation due to its past actions Obligations:Example Legal - warranty provided with the sale of product Constructive - rights of retune above those required by statute, company has a widely publicised environmental policy & a record of honouring it finds contamination on it’s sites. May have a constructive obligation for the cost of the clean up What do we mean by probable outflow? Great than 50% chance of occurring How do we determine the amount to provide? Best estimate of the expenditure required to settle the obligation

IAS 37 - Specific Purposes No obligation for provisions for future losses Before IAS 37 companies did provide provisions for future losses Provision should be recognised if there is an onerous contract - cost of fulfilling the contract exceed the revenues to be received No provisions for restructuring unless there is definite commitment e.g. a detailed formal plan & it has been announced as this would constitute a constructive obligation No provisions for proposed dividends Provisions History Prior to 1998 - Companies use provisions tomato results look better on a staggering scale 1998 - IAS 37 introduced restricts judgement within boundaries 2005 - ED IAS 37 Non-Financial liabilities 2015 - public meetings re revision or replacement Going forwards - If we allow judgement financial statements may be more faithful represented & relevant but scope for manipulation The 1998 standard was introduced to curtail income smoothing using provisioning & big bath accounting ‘Big Bath’ Provisioning Big bath is a business strategy in which a company manipulates its income statement to make poor results look even worse The idea is that a big shock will not be fully reflected in the share price and that the following year will show significant improvement Often on takeovers, companies would declare the new business to be in difficulties & establish large (often hugely inflated) ‘restructuring’ provisions which could be released later - increasing future profits Big bath was sometimes employed by new CEOs to make their first year results more impressive by employing big bath accounting to prior year results Big Baths Gateway Inc, a personal computer seller, took $113.8 million big bath charge in 1997. The stock price dropped 20% when the charge was publicly disclosed & then the price appreciated 83% in a year Cisco Systems Inc, which develops computer network hardware & software, took a big bath of almost $4 billion in 2001, which included an inventory write-down of $2.5 billion IAS 37 Whats wrong with the current standard? Definition of a provision is unclear and would prefer to call it a liability or not IAS 37 not even-handed in treatment of contingent assets & liabilities. More careful abut recognising an asset than it is a liability Division between probable & possible at 50% is too crude - would prefer companies to use probability to estimate the liability Restructuring rules still allow manipulation - rules have been tightened in the exposure draft Is this still a problem? Still a lot of judgement involved in provisioning Is there a constructive obligation? What is the probability of an outflow? - should we apply this probability to a single event or a class of events? What is the estimated cost of the most likely outcome? Some specific issues have been addressed there is still evidence that firms use provisions to smooth income & this may be unavoidable IAS 18 Revenue Recognition In a transaction involving the sale of goods, performance should be regarded as being achieve when the following conditions have been fulfilled: (a) the seller of the goods has transferred to the buyer the significant risk and rewards of ownership, in that all significant acts have been completed & the seller retains no continuing managerial involvement in, or effective control of, the goods transferred to a degree usually associated with ownership; and (b) no significant uncertainty exists regarding the amount to be received for the goods & the costs incurred or to be incurred in producing or purchasing the goods Whats difficult about revenue recognition? Revenue recognition is one of the most common causes of restatements in UK & US - around 10% in US Examples of difficult areas: gift cards & ‘breakage’, returns, warranties, suppliers rebates, variable consideration Gift cards & ‘Breakage’ If a retailer sells a gift card is sold should the revenue be recognised when the gift is card is sold or when the gift card is redeemed A proportion of gift cards wont be redeemed so how do we recognise this element of the revenue?

Returns How should rights of return over & above legal rights of return to be accounted for: Recognise sales & account for returns as the good are returned Identify there is a constructive obligation relating to the expected return rate therefore decrease revenue & create a provision for expected returns IFRS 15: Revenue from contracts with customers Effective from 1st Jan 2018 Replaces IAS 11 & 18 Main requirements of revenue from contracts with customers Revenue is the increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that results in increases in equity, other than those which result from contributions from equity participants Goods and services in one set of rules Five step revenue recognition process; Identify the contract with the customer - Identify separate performance obligations in the contract - Determine transaction price - Allocate the transaction price to the separate performance obligations in the contract - Recognise revenue when the entity settles the performance obligations New standard was needed to remove inconsistencies and weakness in existing standards Risks & rewards models is inconsistent with the definition of an asset which focuses on control Risks & rewards model causes difficulty when an entity supplies goods with services related to the good. The guidance is currently unclear as to how separate performance obligations are identified e.g warranties Provide a more robust framework for addressing revenue recognition issues Reduce the number of standards to which companies must refer - previously needed to refer to IAS 11 & 18, now only need IFRS 15 Improve comparability between countries - developed with counterparts in US Robust framework Lack of guidance around transactions involving the deliver of more than one good or service e.g warranties Lack of guidance & inconsistent practice around recognition of variable consideration The principles of IAS 11 (Construction contracts) & IAS 18 are inconsistent: IAS 11: recognise revenue as the activities required to complete a contract take place (even if the customer doesn't control & have the risk & rewards of ownership of the item being constructed) IAS 18: revenue should be recognised when an entity transfers control & the risks & rewards of ownership of the goods to the customer Warranties Many electrical products are sold with a warranty which provides for replacement of the product if it fails within a period. Should the company treat as though sale & warranty are a single performance obligations; recognise all the income from the sale when the goods are transferred to the customer & make a provision for the estimated cost of the warranty (i.e. estimated number of washing machines which will need to be replaced multiplied by the cost of replacement) Or should the company that the warranty as two separate performance obligations, allocate the revenue to the sale of the goods & to the warranty, make a provision for the estimate cost of the warranty & not recognise the warranty income until the warrant cost is incurred Areas of judgement Identification of separate performance obligations Probabilities around variable consideration Summary Discuss the role of professional judgement in financial reporting Outline why IAS 37 was introduced, the main provisions of the standard, the extent to which it has reduced opportunities for manipulation, what further changes are necessary & the role of judgement with regard to provisioning Outline why the IFRS 15 was produced, the extent to which it will reduce opportunities for manipulation and the role of judgement with regard to revenue recognition...