IFRS 13: Fair Value Measurement

IFRS13FairValueMeasurement.jpg

I recently told some accounting students that the main points of IFRS 13: Fair Value Measurement can be summarised quite quickly and neatly. To save students some time, I’ve attached the theory excerpt from my own lecture notes:

ifrs-13-fair-value-measurement

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A note on accounting for standard warranty provisions

Introduction

Warranties are a normal part of business for most product selling companies but the accounting for standard warranty costs continues to confuse people.

Before I delve into this any further however, I must define what I mean by a “standard warranty”? A standard warranty is normally built into the sales price of a product and cannot be bought separately by the purchaser e.g. a fridge sold with a standard 12 month warranty. In this scenario, companies will recognise the full amount of revenue for these types of transactions (as it is typically deemed the IAS 18: Revenue criteria have been met) and a separate warranty provision will be recognised as an expense (typically in Cost of Sales) under IAS 37: Provisions.

So let’s consider a very simple example where a company sells a product with a standard warranty but where there exists a number of different warranty terms:

Issue

Alpha Ltd. sells a product for €600 that cost €400 to manufacture. Calculate the warranty provision required and the profit that will be recognised from the transaction on the basis that:

  1. Alpha expects the product will returned and Alpha will provide a full refund. Alpha can resell the returned product.
  2. Alpha expects the product will returned and Alpha will provide a full refund. Alpha must scrap the returned product (assume nil scrapping costs).
  3. Alpha expects the product will returned for repairs and Alpha will have to incur costs of €100 before giving the product back to the customer.
  4. Alpha expects the product will returned and Alpha will provide a replacement product. Alpha must scrap the returned product (assume nil scrapping costs).

Solution

Capture

Explanation

  • Scenario 1: The warranty provision required is the profit on the sale. Alpha must provide a full refund but will get a working product back, no profit or loss is recognised as Alpha, when the item is returned, will be in the exact same position it was before the sale occurred i.e. it has a product costing €400 that it wants to sell.
  • Scenario 2: The warranty provision required is the entire amount of the sale. Alpha must provide a full refund and will have to scrap the product. Therefore it’s net loss will be the cost of the product i.e. €400.
  • Scenario 3: The warranty provision required is the amount of the repair costs. The total product cost, once the repairs are made, will be €500 (400 + 100) and this must be reflected in the accounts when the sale occurs.
  • Scenario 4: The warranty provision required is the cost of the product. In effect, Alpha has made a sale for €600 but will have to provide the customer with two products in order to keep the consideration received.

Final Comments

Another scenario typically encountered is where the customer purchases an extended warranty as part of the overall transaction. In this case the extended warranty is a separate service component of the overall transaction and the revenue relating to the warranty component is recognised over the warranty period (any payments relating to the warranty that are received upfront are deferred).

Finally , when IFRS 15, the new standard on accounting for revenue, is eventually endorsed by the EU and is applied by IFRS account preparers, the accounting for warranty provisions will be slightly different from what I’ve outlined above. I don’t think it’s worth saying anything further about this accounting standard for now, the standard has been issued but is not yet effective and I expect further changes/amendments to the standard before EU endorsement takes place.

Anglo Irish Bank circular transaction and”offsetting” issue explained.

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Former executives from Anglo Irish Bank (“Anglo”) and Irish Life and Permanent (“ILP”) are alleged to have conspired to mislead investors by setting up a €7.2bn circular transaction scheme to bolster Anglo’s balance sheet in 2008.

The simplified debits and credits (from Anglo’s perspective) for the “circular transaction” are as follows:

Part 1) Amount put on deposit with Anglo by ILP: 

Dr Cash €7.2bn

Cr Customer Deposits €7.2bn (shown as a liability)

Part 2) Amount “lent” back to ILP by Anglo:

Dr Loans and Advances to Banks €7.2bn (shown as an entirely separate asset)

Cr Cash €7.2bn

Per the above, the transaction is cash neutral, so what’s the big deal? The issue is that the €7.2bn recorded as a customer deposit with the bank would be (and was) incorrectly interpreted by the bank’s wider stakeholders as a measure of customer confidence in the bank.

So where do the accounting rules stand on this?

First, International Accounting Standard 32 (“IAS 32”) states: A financial asset and a financial liability are offset only when there is a legally enforceable right to offset and an intention to settle net or to settle both amounts simultaneously.

Anglo, in drawing up it’s 2008 accounts, treated the two transactions gross of each other on it’s balance sheet in order to achieve the desired effect of increasing it’s 31 December 2008 customer deposits figure (an approach known as “snapshot accounting”).

However, after year end, the transaction was actually settled net i.e. no transfer of cash, the balances were just written off against each other:

Dr Customer Deposits €7.2bn

Cr Loans and Advances to Banks €7.2bn

Furthermore, ILP are maintaining that it was always the intention of both parties that the transactions would ultimately be netted against each other.

Therefore, based on the above, it would appear that the transactions should have been netted in the 2008 accounts i.e. no gross figures shown on the balance sheet with just some disclosures of the transactions made in the notes to the accounts.

Even if you could excuse the inappropriate treatment under IAS 32 (which I can’t), there is another stumbling block whereby in order for accounts to present a true and fair view of the affairs of a company under International Financial Reporting Standards (IFRS), transactions must be accounted for under their economic substance and not just their legal form. It can be argued that the transaction had no economic substance at all, and therefore the amounts should have been netted on the year end accounts, but at a minimum, it is hard to argue that some disclosure providing  details of the overall arrangement was not required.

New Irish GAAP: A quick overview for students

The attached document provides a “conversational knowledge” overview of new Irish GAAP:

Irish_GAAP_2017

Furthermore, as some people may already know, I am a big fan of BDO’s financial reporting material and have attached, for those looking for more detailed information (but still in summarised form!), a BDO document outlining the key differences between IFRS and FRS 102:

BDO IFRS FRS102 Differences