Hincapie Co. manufactures specialty bike accessories. The company is most well known for its product quality, and it has offered one of the best warranties in the industry on its higher-priced products—a lifetime guarantee. The warranty on these products is included in the sales price. Hincapie has a contract with a service
company, which performs all warranty work on Hincapie products. Under the contract, Hincapie guarantees the service company at least €200,000 of warranty work for each year of the 3-year contract.
The recent economic recession has been hard on Hincapie's business, and sales for its higher-end products have been especially adversely impacted. As a result, Hincapie is planning to restructure its high-quality lines by moving manufacturing for those
products into one of its other factories, shutting down assembly lines, and terminating workers. In order to keep some workers on-board, Hincapie plans to bring all
warranty work in-house. It can terminate the current warranty contract by making a one-time termination payment of €75,000.
The restructuring plans have been discussed by management during November 2014; they plan to get approval from the board of directors at the December board meeting and execute the restructuring in early 2015. Given the company's past success, the accounting for restructuring activities has never come up. Hincapie would like you to do some research on how it should account for this restructuring according to IFRS.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/) (you may register for free eIFRS access at this site). When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)
1. (a) Identify the accounting literature that addresses the accounting for the various restructuring costs that will be incurred in the restructuring.
2. (b) Advise Hincapie on the restructuring costs. When should Hincapie recognize liabilities arising from the restructuring? What costs can be included? What costs are excluded?
3. (c) Does Hincapie have a liability related to the service contract? Explain. If Hincapie has a
liability, at what amount should it be recorded?
Professional Simulation
In this simulation, you are asked to address questions related to the accounting for current liabilities. Prepare responses to all parts.
1This illustration is not just a theoretical exercise. In practice, a number of preference share issues have all the characteristics of a debt instrument, except that they are called and legally classified as preference shares. In some cases, taxing authorities have even permitted companies to treat the dividend payments as interest expense for tax purposes.
2The IASB also indicates two other conditions that do not normally occur. The first is that if the liability is held primarily for trading purposes, it should be reported as a current liability. Trading means that the liability is subject to selling or repurchasing in the short-term. These liabilities are recorded at fair value, and gains or losses are reported in income. In addition, if a liability is not subject to an unconditional right of the company to defer settlement of the liability for at least 12 months after the reporting date, it is classified as current. This condition is discussed more fully on page 602.
3Refinancing a short-term obligation on a long-term basis means either replacing it with a long-term obligation or equity securities, or renewing, extending, or replacing it with short-term obligations for an uninterrupted period extending beyond one year (or the normal operating cycle) from the date of the company's statement of financial position.
4A manufacturing company allocates all of the payroll costs (wages, payroll taxes, and fringe benefits) to appropriate cost accounts such as Direct Labor, Indirect Labor, Sales Salaries, Administrative Salaries, and the like. This abbreviated and somewhat simplified discussion of payroll costs and deductions is not indicative of the volume of records and clerical work that may be involved in maintaining a sound and accurate payroll system.
5Companies provide postemployment benefits to past or inactive employees after employment but prior to retirement. Examples include salary continuation, supplemental unemployment benefits, severance pay, job training, and continuation of health and life insurance coverage.
6Some companies have obligations for benefits paid to employees after they retire. The accounting and reporting standards for postretirement benefit payments are complex. These standards relate to two different types of postretirement benefits: (1) pensions, and (2) postretirement healthcare and life insurance benefits. We discuss these issues extensively in Chapter 20.
7The term provision can be confusing because it can be used to describe a liability, a valuation account, or an expense. Its most common use is to describe a liability and therefore is used as such in this chapter. The IASB is now considering using the term non-financial liability instead to describe provisions for liabilities.
However, until that change occurs, companies will continue to use the term provision to describe various liabilities.
8The distinction is important because provisions are subject to disclosure requirements that do not apply to other types of payables.
9A commentary in the financial magazine Forbes (June 15, 1974), p. 42, stated its position on this matter quite succinctly: “The simple and unquestionable fact of life is this: Business is cyclical and full of unexpected surprises. Is it the role of accounting to disguise this unpleasant fact and create a fairyland of smoothly rising earnings? Or, should accounting reflect reality, warts and all—floods, expropriations and all manner of rude shocks?”
10This type of situation is often referred to as “an incurred but not recorded” (IBNR) provision. A company may not be able to identify the claims giving rise to the obligation, but it knows a past obligating event has occurred.