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.

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.

Is a person having significant influence (to an entities) considered a related parties

We received a very good question from our Accounting & Auditing blog's royal readers with regard to related parties, as follows:

"I would like to inquire that related company or related party does not necessary to own shares in the other company but also have great influence in the decision making. Am I right? What if they do not own shares but has great influence in the decision making, does it still consider as related?"

According to International Accounting Standard 24, the definition of a related party does not only include shareholders, but also many other parties. A person who may exercise significant influence over the entity's decision making is also considered a related party.

Why is it important to identify an individual having significant influence as a related party? This is because we need to consider whether the transaction entred into between the Company and the invidiual ( having significant influence) are conducted on an arms-length basis. There are instances / cases where the said transactions were not entered into on an arms-length basis but not detected by audit committee or auditors.

Hence, the responsiblity of auditors include obtaining the list of related parties from audit client, identify potential related parties not identified by management, pay reasonably sufficient attention to related parties transactions, and ensure that related party transactions are disclosed appropriately in accordance with IAS 24.

Recommendation of new accounting procedures: Investment-equity reconciliation

A good exercise can be undertaken by the holding company is to prepare appropriate documentation to reconcile investor's cost of investment to investee's share capital for any investment-equtiy relationships within the Group.

The procdure appears to be straight forward, simple and non-complex on first thought. However, the reconciliation can turn into a complex procedure, due to:

- impairment been recorded for cost of investment
- difference exchange rate was used to translate the funding (i.e. investor used exchange rate A, while investee used exchange rate B)
- funding remitted / received is not recorded in appropriate account, etc

This recommended procedure is particularly useful for entities with significant number of subsidiaries. Discrepancies (between cost of investment and share capital) are usually expected for large group of entities.

This reconciliation excercise help to ensure that appropriate figures are recorded in respective source ledger, and ensure that appropriate elimination are done at group level.

Accounting treatment for fraud- losses

We received question from our Accounting & Auditing readers on what would be the accounting entries for losses arising from fraud incidence.

In most of the circumstances, the losses arising from fraud wil be recorded in profit & loss statement. For instance, if a Company sufferred misappropriation of cash, the following accounting entries should be recorded:

Dr. Loss (Profit & Loss)
Cr. Cash

If the losses arising from fraud incident is material, this fact (i.e. fraud incident) need to be disclosed in the financial statement of the Company. Management of the Company need to consider the local laws & regulations on the disclosure requirement of fraud.

What is financial auditing?

We received a lot of question asking us what is financial audit? What does a financial audit involved? We will try to explain in a layman term.

Background:

Company ABC is a publicly listed company. They have hired their own accountants to preare the financial statements, including: income statement, balance sheet, cash flow statement on a monthly basis.

Question:

How does the public know if the financial statement prepared by Company ABC is appropriate and in accordance with accounting standard.

Financial audit:

This is when the financial auditor come in and play a major role, where they review the financial statemetn close process of the Company's, review the accouting treatments and policies, and give you their own opinion on the financial statement. The opinion of the auditor is whether " the financial statement is fairly stated". "Fairly stated", in substance, implies that certain tolerable errors are expected.

Life without auditor:

The financial statement prepared by Company ABC may be prepared on a inappropriate manner/ not in accordance with accounting standard. However, since no professional personnel is conducting a review on the financial statement, the inappropriate financial statement will be accepted by the public.

Consequence of life without auditor:

The incorrect financial statement led to wrong decision being made by financial statement user.

Treasury Shares

Definition of a Treasury Shares

What is a Treasury Share?

A company may hold its own equity instruments, often referred to as “treasury shares”. Such treasury shares may be acquired and held by the issuing enterprise itself or by its subsidiaries, depending on the jurisdiction.

Presentation of Treasury Shares on the financial statement

Treasury shares should be presented in the balance sheet as a deduction from equity. The acquisition of treasury shares should be presented in the financial statements as a change in equity.

IAS 32 paragraph 33 states that: If an entity reacquires its own equity instruments, those instruments (‘treasury shares’) shall be deducted from equity. No gain or loss shall be recognised in profit or loss on the purchase, sale, issue or cancellation of an entity’s own equity instruments. Such treasury shares may be acquired and held by the entity or by other members of the consolidated group. Consideration paid or received shall be recognised directly in equity.

As evidenced above, under International Financial Reporting Standard: no gain or loss should be recognised in the income statement on the sale, issuance, or cancellation of treasury shares. Consideration received should be presented in the financial statements as a change in equity.

The amounts of reductions to equity for treasury shares held should be disclosed separately either on the face of the balance sheet or in the notes.

In addition, an enterprise should provide disclosure, in accordance with IAS 24, if the enterprise or any of its subsidiaries re-acquires its own shares from parties able to control or exercise significant influence over the enterprise.