Lecture 3 Q&A - Innovate

Lecture 3
1. Innovate is an IT software company that is owned by its founding members who are all directors
of the company. The directors are about to retire and are seeking a buyer for the company. Your
company, HydePark, has expressed interest in acquiring Innovate and your finance director has
tasked you to examine in greater detail the latest financial statements of Innovate for the year to
31 January 2022 which reported profit before tax of £5 million.
You have identified the following transactions that have attracted your interest:
(i) The sales revenue for the year to 31 January 2022 includes £95,000 received from a
new overseas customer. The £95,000 was a 10% deposit for an order of £950,000 worth
of goods. Innovate is still waiting for the results of the new customer’s credit reference
and at 31 January 2022, has not despatched any goods.
(ii) On 1 November 2021 one of Innovate’s customers started litigation against the
company, claiming damages for loss of business caused by an alleged defect in software
purchased from the company. The case was still pending in court by 31 January 2022 but
Innovate has been advised by lawyers that it would probably lose the case and that the
claim for £40,000 would probably succeed. Innovate had not made any accounting entry
or disclosure regarding this litigation in its financial statements to 31 January 2022.
(iii) On 1 February 2021, Innovate sold a freehold interest in land to a financing institution
for £7.2 million. The contractual terms require that Innovate repurchase the freehold on
31 January 2024 for £8.82 million. Innovate has the option to repurchase on 31 January
2022 for £7.7 million or on 31 January 2023 for £8.24 million. Prior to the disposal, the
land was recorded at its carrying value of £6 million in Innovate’s accounting records.
The receipt of £7.2 million has been recorded with a corresponding credit to suspense
account. The suspense account was eventually set off against operating expenses. No
other accounting entries have been made in respect of this transaction. At 31 January
2022, Innovate’s directors had not made any decision on the option to repurchase.
(iv) On 01 February 2021 the directors of Innovate sold a property to another company for
£8 million. Innovate has signed an unconditional agreement to repurchase the property
back after 3 years for a fixed amount of £12.5 million. The property had been taken off
the statement of financial position, and a profit on the sale of £600,000 has been
included in the statement of profit or loss for the year to 31 January 2022. Innovate had
originally charged depreciation on the property at 5% per annum on its carrying value. If
Innovate had borrowed money from the bank it would have paid interest of 12.5%
Required:
Briefly discuss the economic substance of each transaction and explain its impact on the
financial statement. You should show the impact of any adjustments on Innovate’s reported
profit of £5 million.
Support your explanations with relevant numerical calculations
2. PowerJump is a power generator dealership which prepares its financial statements to 31
January. In the year to 31 January 2022, its transactions included the following:
PowerJump had power generators on its premises that were supplied by a manufacturer,
Dagenham. Trading between PowerJump and Dagenham was subject to a contractual
agreement. This agreement stated that PowerJump could hold up to 50 power generators on
its premises although the legal title of the power generators remained with Dagenham until
they were sold by PowerJump to a third party. PowerJump was required to inform
Dagenham within 5 working days of any sale, at which time Dagenham would raise an
invoice at the price agreed at the original date of delivery. PowerJump had the right to return
any power generator at any time without incurring a penalty. PowerJump was responsible
for insuring all the power generators on its property.
Required:
Briefly discuss the economic substance of PowerJump’s contractual agreement with

Dagenham and explain which entity should recognise the power generators in inventory
during the period that they were held at Powerjump’s premises.
Answer to Question One
Item (i)
The principles in IFRS 15 Revenue from Contracts with Customers, are applied using the following
five steps:
1. Identify the contract(s) with a customer

2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract
5. Recognise revenue when (or as) the entity satisfies a performance obligation.
Entities need to exercise judgement when considering the terms of the contract(s) and all of the
facts and circumstances, including implied contract terms.
Significant risks and rewards of ownership of the goods have not been transferred to the buyer
The selling entity still retains influence or control over the goods as no goods have been despatched.
All the IFRS 15 conditions for revenue recognition have not been met and therefore Innovate
should not recognise any revenue in its financial statements for the year ended 31 January 2013. It
should record the deposit received as a current liability.
Item (ii)
Innovate has a present obligation as a result of a past event; it is probable that a transfer of
economic benefits will be required to settle the obligation, and a reliable estimate can be made of
the obligation.
Recognise a provision for 40,000:
Dr Administrative expenses £40,000

Cr Provision for damages £40,000 (include in current liabilities)
Item (iii)
The substance of the transaction is that Innovate borrowed £7.2m against the security of the
freehold land.
The initial liability of £7.2m should be recognised. The related interest expense should be
recognised over the relevant period. In this case the increase each year in the repayable amount
reflects an interest charge.
Dr Suspense A/c /(Operating expenses) £7.2m

Cr Non-current liability £7.2m
Dr Interest expense (7.7-7.2) m £0.5m

Cr Non-current liability £0.5m
Recognition of accrued interest
Item (iv)
The substance of the transaction is a loan of £8m secured against the property.
The initial liability of £8m should be recognised. The related interest expense should be recognised
over the relevant period, in this case at 12.5% on the amount outstanding at the end of each year.
Dr Property (PPE) (8m-600K) £7.4m

Dr Profit on disposal £ 0.6m
Cr Non-current liability £8m
Dr Interest expense 12.5% x 8m £1m

Cr Non-current liability £1m
Recognition of accrued interest
Dr Operating expenses £0.37

Cr Accumulated depreciation £0.37
Depreciation charge for year: 12.5% x7.4m
Answer to Question Two
The economic substance of the transaction is determined by analysing the risks and benefits of the
transaction.
PowerJump had access to the following benefits of ownership:

- protected from price increases as prices are agreed at the point of delivery;
But incurred the following costs and was subject to the following risks:
- incurred the cost of insurance while power generators were on display on its premises;
- retained risk that price reductions were not passed on since price was agreed at point of
delivery;
Dagenham retained legal title to power generators so in the event of any dispute Dagenham would
probably be entitled to recover its legal property.
However, Dagenham bears the risk of obsolescence since PowerJump can return the power
generators at any time without penalty.
For inventory of a specialised good such as power generators the risk of obsolescence is significant
and so Dagenham should continue to recognise the goods within its inventory.

Lecture 3 Q&A - Innovate

Uploaded by

Copyright:

Available Formats

Lecture 3 Q&A - Innovate

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture 3 Q&A - Innovate

Uploaded by

Copyright:

Available Formats

Lecture 3

Briefly discuss the economic substance of PowerJump’s contractual agreement with

Answer to Question One

1. Identify the contract(s) with a customer

Dr Administrative expenses £40,000

Dr Suspense A/c /(Operating expenses) £7.2m

Dr Interest expense (7.7-7.2) m £0.5m

Dr Property (PPE) (8m-600K) £7.4m

Dr Interest expense 12.5% x 8m £1m

Dr Operating expenses £0.37

Answer to Question Two

PowerJump had access to the following benefits of ownership:

You might also like