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Review questions

The major flexibility issues in revenue recognition relate to when revenue shall be recognised (timing of recognition) and to a lesser extent by which amount revenue shall be recognised (measurement). Examples of flexibility includes when the criteria for recognising revenues are fulfilled, how total revenues and cost are estimated when revenues are recognised over time. Other areas include:

  • Modifications of an existing contract or a new contract?
  • Variable elements/considerations
  • Prepayments and non-refundable up-front fees
  • Vouchers
  • Warranties
  • Agents; net or gross

Inventory should be valued as the lower of cost or net realisable value. Cost might be valued using the FIFO or average method (also LIFO under US GAAP). If prices are steadily increasing inventory cost would be higher under LIFO than under average cost and FIFO.

EBITDA would in general be improved, since capitalisation results in a reclassification of the costs from EBITDA to depreciation/amortisation. Net profit/earnings-effect depends on the depreciation/amortisation cost versus the alternative annual expense.

Ratios like ROIC would often be quite stable if assets are capitalised, but be higher the first years and lower the last years than the corresponding ROIC if the same costs are expensed.

Examples: Discount rates, estimated expected cash flows, life of the asset.

Because the new estimate will only affect future profits- but are based on the current book value. Hence an increase of useful life will reduce the annual depreciation going forward.

Under IFRS 16 Leases, all lease contracts (exept contracts under one year and/or of small amounts) will be capitalised. Hence the equity ratio (but normally not the equity since the initial right-of-use asset is (normally) equal to the lease liability) ceteris paribus will decrease for firms who today use operating lease.

A provison should be recognised if it is probable and can be measured reliably. Both factors are subject to management discretion. The value of an uncertain claim (recognised or not) is the expected value of different outcomes or the expected sum that should be paid for others to take over the claim. This will be different from the book value of a contingent claim (not recognised; i.e. with a book value of zero).

In the income statement the annual pension cost is shown net as the sum of:

  • The present value of the pension rights earned for the year; often labelled ‘(current) service cost’.
  • This is the ‘true’ pension cost for the year, and is the best starting point for predicting future pension cost. The other components below are either interests or effects of amendments in plans or assumptions.
  • Plus the interest cost (using the discount rate) of the pension liabilities
  • Minus the expected return on pension assets; using the discount rate as the expected return
  • Plus gains or losses on amendments to pension plan amendments/settlements (‘past service cost’ or, if there are significant amendments to the plan effecting future pension payments ‘curtailments’)
  • Plus salary taxes if applicable

Pension assets (stocks, bonds and other securities that the insurance firm or pension fund has invested on behalf of the firm) are valued at fair values.

Pension obligations are measured as the present value of expected pension payments on earned rights as of reporting.

Key issues are: Different classifcations of FX effects between firms in the income statement, the fact that management may choose whether they account for a de facto hedge as a hedge or not.

The key flexibility is how the assets and liabilities are valued in a purchase price allocation (PPA). This will affect future profits.