LA ESCUELA DEL PATERNALISMO LIBERTARIO

Oil contracts 4 Power station 7 Operating leases 5 Proposed dividend 3 Share options 4 Effective communication 2 Available/Maximum 25

REPORT

To: The Directors, Electron Date: July 20X6

From: Accountant

Accounting treatment of transactions

Oil trading contracts

The first point to note is that the contracts always result in the delivery of the commodity. They are therefore correctly treated as normal sale and purchase contracts, not financial instruments.

The adoption of a policy of deferring recognising revenue and costs is appropriate in general terms because of

the duration of the contracts. Over the life of the contracts, costs and revenues are equally matched. However, there is a mismatch between costs and revenues in the early stages of the contracts.

In the first year of the contract, 50% of revenues are recognised immediately. However, costs, in the form of amortisation, are recognised evenly over the duration of the contract. This means that in the first year, a higher proportion of the revenue is matched against a smaller proportion of the costs. It could also be argued that

revenue is inflated in the first year.

While there is no detailed guidance on accounting for this kind of contract, IAS 18 Revenue and the IASB

Conceptual Framework give general guidance. IAS 18 states that revenue and expenses that relate to the same transaction or event should be recognised simultaneously, and the Conceptual Framework says that the 'measurement and display of the financial effect of like transactions must be carried out in a consistent way' It would be advisable, therefore, to match revenue and costs, and to recognise revenue evenly over the duration of

the contract.

Power station

IAS 37 Provisions, contingent liabilities and contingent assets states that a provision should be recognised if:  There is a present obligation as a result of a past transaction or event and

 It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation

 A reliable estimate can be made of the amount of the obligation

In this case, the obligating event is the installation of the power station. The operating licence has created a legal obligation to incur the cost of removal, the expenditure is probable, and a reasonable estimate of the amount can

be made.

Because Electron cannot operate its power station without incurring an obligation to pay for removal, the

expenditure also enables it to acquire economic benefits (income from the energy generated). Therefore Electron

correctly recognises an asset as well as a provision, and depreciates this asset over its useful life of 20 years.

Electron should recognise a provision for the cost of removing the power station, but should not include the cost of rectifying the damage caused by the generation of electricity until the power is generated. In this case the cost of rectifying the damage would be 5% of the total discounted provision.

The accounting treatment is as follows:

STATEMENT OF FINANCIAL POSITION AT 30 JUNE 20X6 (EXTRACTS)

$m Property, plant and equipment

Power station 100.0 Decommissioning costs (W) 13.6 113.6 Depreciation (113.6 ÷ 20) (5.7) 107.9 Provisions

Provision for decommissioning at 1 July 20X5 13.6

Plus unwinding of discount (13.6  5%) 0.7

14.3

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSVIE INCOME FOR THE YEAR ENDED 30 JUNE 20X6 (EXTRACTS)

$m

Depreciation 5.7

Provision for damage 0.1

Unwinding of discount (finance cost) 0.7

Working

$m

Provision for removal costs at 1 July 20X5 (95%  (15 ÷ 1.05)) 13.6

Provision for damage caused by extraction at 30 June 20X6

(5% (15 ÷ 1.05)) 0.7

Operating lease

One issue here is the substance of the lease agreement. IAS 17 Leases classifies leases as either finance leases or

operating leases. A finance lease transfers substantially all the risks and rewards of ownership to the lessee,

while an operating lease does not. The company retains legal ownership of the equipment and also retains the benefits of ownership (the equipment remains available for use in its operating activities). In addition, the present value of the minimum lease payments is only 57.1% of the fair value of the leased assets ($40 million ÷ $70

million). For a lease to be a finance lease, the present value of the minimum lease payments should be substantially all the fair value of the leased assets. Therefore the lease appears to be correctly classified as an operating lease.

A further issue is the treatment of the fee received. The company has recognised the whole of the net present

value of the future income from the lease in profit or loss for the year to 30 June 20X6, despite the fact that only a deposit of $10 million has been received. In addition, the date of inception of the lease is 30 June 20X6, so the term of the lease does not actually fall within the current period. IAS 17 states that income from operating leases should be recognised on a straight line basis over the lease term unless another basis is more appropriate. IAS

18 Revenue applies here. It does not allow revenue to be recognised before an entity has performed under the contract and therefore no revenue should be recognised in relation to the operating leases for the current period. Proposed dividend

The dividend was proposed after the end of the reporting period and therefore IAS 10 Events after the reporting

period applies. This prohibits the recognition of proposed dividends unless these are declared before the end of

the reporting period. The directors did not have an obligation to pay the dividend at 31 October 20X5 and therefore

there cannot be a liability. The directors seem to be arguing that their past record creates a constructive obligation

as defined by IAS 37 Provisions, contingent liabilities and contingent assets. A constructive obligation may exist as a result of the proposal of the dividend, but this had not arisen at the end of the reporting period.

Although the proposed dividend is not recognised it was approved before the financial statements were authorised for issue and should be disclosed in the notes to the financial statements.

Share options

The share options granted on 1 July 20X5 are equity-settled transactions, and are governed by IFRS 2 Share based

payment. The aim of this standard is to recognise the cost of share based payment to employees over the period in which the services are rendered. The options are generally charged to profit or loss on the basis of their fair value at the grant date. If the equity instruments are traded on an active market, market prices must be used. Otherwise

an option pricing model would be used.

The conditions attached to the shares state that the share options will vest in three years' time provided that the employees remain in employment with the company. Often there are other conditions such as growth in share price, but here employment is the only condition.

The treatment is as follows:

 Determine the fair value of the options at grant date.

 Charge this fair value to profit or loss equally over the three year vesting period, making adjustments at each accounting date to reflect the best estimate of the number of options that will eventually vest. This will depend on the estimated percentage of employees leaving during the vesting period.

For the year ended 30 June 20X6, the charge to profit or loss is $3m  94%  1/3 = $940,000. Shareholders' equity will be increased by an amount equal to this profit or loss charge.