Sunday, June 10, 2012

Presentation & Disclosure: Gross revenue vs net revenue - Principal vs Agency Relationship

Revenue recognition is a crucial and important topic in the auditing profession. One of the key challenges auditor face is: auditor need to review the substance of the transaction to determine if an entity is a principal or an agent in certain business arrangement. An entity need to present the revenue on a gross basis if the entity is deemed to be a principal, whereas an entity need to present the revenue on a net basis if the entity is deemed to be an agent.

To illustrate, insurance agent is selling insurance contract worth US$300 dollar. Insurance agent is able to earn a commission of US$20 dollar by selling such contract. What should be the revenue for insurance agent upon successful selling of this insurance contract ? US$300 or US$20? IAS18 states that 'in an agency relationship, the gross inflows of economic benefits include amounts collected on behalf of the principal and which do not result in increases in equity for the entity. The amounts collected on behalf of the principal are not revenue. Instead, revenue is the amount of commission.

Determining whether an entity is acting as a principal or as an agent requires judgement and consideration of all relevant facts and circumstances. An entity is acting as a principal when it has exposure to the significant risks and rewards associated with the sale of goods or the rendering of services.

Features that indicate that an entity is acting as a principal include: (a) the entity has the primary responsibility for providing the goods or services to the customer or for fulfilling the order, for example by being responsible for the acceptability of the products or services ordered or purchased by the customer; (b) the entity has inventory risk before or after the customer order, during shipping or on return; (c) the entity has latitude in establishing prices, either directly or indirectly, for example by providing additional goods or services; and (d) the entity bears the customer's credit risk for the amount receivable from the customer.

An entity is acting as an agent when it does not have exposure to the significant risks and rewards associated with the sale of goods or the rendering of services. One feature indicating that an entity is acting as an agent is that the amount the entity earns is predetermined, being either a fixed fee per transaction or a stated percentage of the amount billed to the customer. In the example above, insurance agent should recognise US$20 as its revenue (instead of US$300) as the insurance agent is not entitled to the full economic benefit of entire US$300.

Saturday, June 2, 2012

What is provision for reinstatement costs and how to account for it

It's common for an audit client to enter into rental lease agreement to lease the office building, warehouse, etc with the landlord of certain premises for certain period (e.g. 5 years). For operation purpose, the client may renovate the lease premises, such as installing cubicle in the said lease office.

 A landlord might require the our audit client (i.e. the audit tenant) to reinstate the office building upon moving out from the office while the lease has expired. Audit client may have to incur certain costs to reinstate the lease premises to its original state. Hence, a clause will be stated in the agreement to state cleary that the audit client is required to reinstate the lease premise to its original state. [ note: auditor must read the agreement in a cautiour manner to review of the obligations of our audit client].

In this instance, audit client is required to accrue for reinstatement cost. The question is, how to accrue for it, and who much to accrue for it? Audit client is required to obtain a quote from relevant contractor to estimate the reinstatement cost required to reinstate the premise to its original state (after factoring in the inflation in the future years till the end of the lease period). T

he following accounting entries need to be recorded: Dr. Reinstatement Cost (to be recorded in Fixed Asset) Cr. Provision for reinstatement cost (to be recorded in Accrual) The reinstatement csot capitalised as fixed asset need to be depreciated over the lease period. Consequently, it is evident that the reinstatement cost is expensed off on a straight line basis till the end of the lease period.