COACHING CLASSES FOR ICMAP STUDENTS

COACHING CLASSES FOR ICMAP STUDENTS

Modigliani–Miller theorem

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani–Miller theorem is also often called the capital structure irrelevance principle.

Historical background

Miller and Modigliani derived the theorem and wrote their groundbreaking article when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. The story goes that Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had no prior experience in corporate finance. When they read the material that existed they found it inconsistent so they sat down together to try to figure it out. The result of this was the article in the American Economic Review and what has later been known as the M&M theorem.

Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed byequity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani–Miller theorem states that the value of the two firms is the same.

Without taxes

Proposition I:  where  is the value of an unlevered firm = price of buying a firm composed only of equity, and  is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. Another word for levered is geared, which has the same meaning.

To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.

This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information, in the absence of efficient markets, or if the investor has a different risk profile to the firm.

Proposition II:.

 is the required rate of return on equity, or cost of equity.

•  is the company unlevered cost of capital (ie assume no leverage).
•  is the required rate of return on borrowings, or cost of debt.
•  is the debt-to-equity ratio.

A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC).

These propositions are true assuming the following assumptions:

• no transaction costs exist, and
• individuals and corporations borrow at the same rates.

These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells something very important. That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

With taxes

Proposition I:

where

•  is the value of a levered firm.
•  is the value of an unlevered firm.
•  is the tax rate () x the value of debt (D)
• the term  assumes debt is perpetual

This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible.

Proposition II:

where

•  is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium.
•  is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0).
•  is the required rate of return on borrowings, or cost of debt.
•  is the debt-to-equity ratio.
•  is the tax rate.

The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula however has implications for the difference with the WACC. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100%

The following assumptions are made in the propositions with taxes:

• corporations are taxed at the rate  on earnings after interest,
• no transaction costs exist, and
• individuals and corporations borrow at the same rate

Miller and Modigliani published a number of follow-up papers discussing some of these issues.

The theorem was first proposed by F. Modigliani and M. Miller in 1958.

SWITCH OVER PLAN FOR THE STUDENTS OF CMA 2005 AND CAM 2010 SYLLABUSES UNDER NEW SYLLABUS 2012

SWITCH OVER PLAN FOR THE STUDENTS OF CMA 2005 AND CAM 2010 SYLLABUSES UNDER NEW SYLLABUS 2012

Business SWOT Analysis - Threats is an Opportunity

SWOT Analysis is an abbreviation for Strengths; Weaknesses; Opportunities and Threats. In the application of four factors of SWOT, proper understanding of the differences between them would bring about maximum benefits.

The Four SWOT Factors are also known as the Internal and External Factors. The Internal factors consist of Strengths and Weaknesses, whereas the External Factors consist of Opportunities and Threats.

In normal practice, the four SWOT factors can be clearly categorised based on the findings. Below are some examples:-

Strengths:

Strong financials
vast customer base
positive cash flow

Weaknesses:

long delivery lead time
high inventory
inconsistent quality

Opportunities

export incentives
acceptance of middle east countries
Good relations with trade ministry

Threats

escalating of cost
product substitition
computer virus attack by year 2000

As case study: Every Threats is an Opportunity ?
Every Threats is indeed an opportunity! Take for example: Before Y2K millennium, there was a global threat that the computer system may go burst on the 1st day of year 2000. This Threat was clearly beyond anyones' control, and it was inevitable. During that time, all organizations had 2 choices ie. Do something to overcome the computer threats or do nothing and wait for the worst to happen.

Most big and medium size organizations in Malaysia I contacted chosen to pay a high cost to work on an "enhanced" computer system that supposedly can overcome the computer threats. How did this Y2K threats taken as an opportunity? In fact, those organizations who did something to the computer system took the opportunity to upgrade or enhance their computer system to improve their inventory system while overcome the possible computer threats.

With this example of Threats, you can actually flip the Threats the other way round and turn it into an Opportunity.

What is a going concern qualification?

The going concern principle is that you assume a business will continue in the future, unless there is evidence to the contrary. When an auditor conducts an examination of the accounting records of a company, he has an obligation to review its ability to continue as a going concern; if his assessment is that there is a substantial doubt regarding the company's ability to continue in the future (defined as the following year), then he must include a going concern qualification in his opinion of the company's financial statements. This statement is typically presented in a separate explanatory paragraph that follows the auditor's opinion paragraph. There are no specific procedures that an auditor must follow to arrive at a going concern opinion. Instead, he derives this information from the sum total of all other audit procedures performed. Indicators of a potential going concern problem are: Negative trends. Can include declining sales, increasing costs, recurring losses, adverse financial ratios, and so forth. Employees. Loss of key managers or skilled employees, as well as labor difficulties of various types. Systems. Inadequate accounting record keeping. Legal. Legal proceedings against the company, which may include pending liabilities and penalties related to environmental or other laws. Intellectual property. The loss of a key license or patent. Business structure. The company has lost a major customer or key supplier. Financing. The company has defaulted on a loan or is unable to locate new financing. The auditor's going concern qualification can be mitigated by management if it has a plan to counteract the problem. If such a plan exists, the auditor must assess its likelihood of implementation and obtain evidential matter about the most significant elements of the plan. For example, if the CEO has declared that he will extend a loan to the company to cover a projected cash shortfall, evidential matter might be considered a promissory note in which the CEO is obligated to provide a stated amount of funds to the company. The going concern qualification is of great concern to lenders, since it is a major indicator of the inability of a company to pay back its debts. Some lenders specify in their loan documents that a going concern qualification will trigger the acceleration of all remaining loan payments. An auditor who is considering issuing a going concern qualification will discuss the issue with management in advance, so that management can create a recovery plan that may be sufficient to keep the auditor from issuing the qualification. Thus, the going concern qualification is a major issue, but you will have a chance to find a way around the problem and potentially keep the auditor from issuing it.

Laws of Indemnity and Guarantee

Laws of Indemnity and Guarantee Definition: A Contract by which one party promises to save the other from loss caused to him - by the conduct of the promisor himself - by the conduct of any other person is called a contract of Indemnity. The loss must be cause by some human agency. • Contingent Contract • Express or Implied Contract • Objective : To same the indemnified from loss • Liability of Indemnifier: Primary, Absolute, Total • Indemnifier cannot sue third person. Parties: 1) Indemnifier: The person who makes the promise of indemnity is called indemnifier. 2) Indemnified (Indemnity Holder): The person with whom the promise of indemnity is made is called Indemnified or Indemnity holder. Rights of Indemnified (When sued): The indemnified in a contract of indemnity is entitled to recover from his indemnifier: 1) Damages: All damages which he may be compelled to pay in any suit in respect of any matter to which indemnity applies. 2) Cost: All cost which he may be compelled to pay in any such suit: - if (in bringing or defending it) he did not contravene the orders of the indemnifier. - if he acted as if would have been prudent for him to act in the absence of any contract of indemnity. 3) Sums: All sums which he may have paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the indemnifier. Contract of Guarantee / Suretyship: A contract: - to perform the promise, or - to discharge the liability of a third person in case of his default is called a contract of guarantee. • Guarantee: An Express contract Parties: 1) Surety (Guarantor): The person who gives the guarantee is called the surety. 2) Creditor: The person to whom the guarantee is given is called creditor. 3) Principal Debtor: The person in respect of who’s default the guarantee is given is called Principal Debtor. Guarantee: A Package of Contracts: An implied contract of Indemnity. Consideration for Guarantee: • Any thing done • Any promise made for the benefit of the Principal Debtor is the sufficient consideration to the surety for giving the guarantee. Nature and Extent of Surety’s Liability: • At the time of making of contract of guarantee, the surety is at liberty to state the limit of his liability • In such a case, the surety is liable only to the extent of his stated limit on the default of the principal debtor. • In the absence of any such contract, the liability of the surety is co-extensive with that of the principal debtor. • Whatever the case may be, the liability of the surety is secondary and conditional that is it arises on the default of the principal debtor. Kinds of Guarantee: 1) Specific Guarantee: A guarantee given for a single particular transaction, undertaking or debt is the specific guarantee. Once if has been upon by the creditor, the surety cannot revoke it. 2) Continuing Guarantee: A Guarantee which extends to a series of transaction is called Continuing guarantee. Revocation of Continuing Guarantee: 1) By Notice: A continuing guarantee may be revoked at any time by the surety by giving notice to the creditor but only for future transaction. 2) By Death (of surety): In the absence of any special contract, a continuing guarantee is revoked by the death of surety but only for future transaction. Invalid Guarantee: 1) Guarantee obtained by Misrepresentation: Any guarantee which has been obtained by means of misrepresentation made by the creditor, or with his knowledge and assent, concerning a material part of the transaction, is invalid. 2) Guarantee obtained by Concealment: Any guarantee which the creditor has obtained by means of keeping silence as to material circumstances is invalid. 3) Failure of Co-surety to join: Where a person gives a guarantee upon a contract that the creditor shall not act upon it until another person has joined in it as co-surety, the guarantee is invalid if that person does not join. Rights of Surety: Against Creditor: 1) Right to securities: A surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time of making a contract of guarantee. This is immaterial whether the surety is or is not aware of the existence of such security. Securities: Jewellry, Expensive Items 2) Right of Set-off: The surety is entitled (in a suit filed by the creditor against the surety) to the benefit of any set-off for counter claim which the principal debtor might possess against the creditor. 3) Right to Quia-Timet (because he fears or apprehends) action: The surety has a right at any time after the guarantee debt has became due and before he called upon to pay to require the creditor to sue the principal debtor for the performance of promise. However the surety must undertake to indemnify the creditor for the risk of delay and expenses which he may incur by so doing. Against Principal Debtor: 1) Right of Subrogation: The terms subrogation may be defined as the substitution of one person with another with same right and liabilities. After discharging his liability on the default of principal debtor, the surety is vested with all the rights which the creditor has against the principal debtor, for e.g. a) Right to securities (if any) held by creditor. b) Right to initiate proceedings against the principal debtor in his own name. 2) Right to Indemnify: The surety is entitled: - to an indemnity from the principal debtor - to recover any sum he has paid rightfully under the Guarantee. Against Co-Sureties: 1) Right of Contribution: - Where a debt is guaranteed by two or more persons * and one of them pays more than his share of that debt, he is entitled to compel contribution from the other(s). - Co-sureties need not to be bound under the same contract, * the right to contribution being independent of any agreement for that purpose. - If the co-sureties are bound indifferent sums, * they are liable to pay equally as far as their agreed obligation permits. Discharge of Surety: When the liability of a surety comes to an end, the surety is said to be discharged. Modes: 1) By Performance: Where the guaranteed obligation is properly discharged by performance of principal debtor, the obligation of surety with respect to that undertaking is thereby discharge. Performance which releases the principal debtor also discharges the surety. 2) By Variance: If the creditor and principal debtor vary the terms and conditions of their contract without the consent of surety, the surety is discharged in respect of transaction made after the variation. 3) By Revocation: a) By Notice: A continuing guarantee may at any time be revoked by the surety, as to future transactions, by notice to the creditor. b) By Death: The death of the surety operates, in the absence of any contract to the contrary, as a revocation of a continuing guarantee, so far as regards future transactions. 4) By Release of Principal Debtor: The surety is discharged by any contract between the creditor and principal debtor, by which the principal debtor is released. 5) By Act or Omission of Creditor: The surety is discharged by any act or omission of creditor, the legal consequence of which is the discharge of principal debtor. 6) By Composition: A contract by which the creditor makes the composition with principal debtor, discharges the surety unless the surety assents to such contract. 7) By Extension of time: Where a creditor without the consent of surety promises to give time to principal debtor, the surety is discharged. 8) By Promise not to sue: A contract (without the consent of surety) by which the creditor promises not to sue the principal debtor, discharges the surety. 9) By Impairing surety’s remedy: If the creditor - does not act which is in consistent with the rights of the surety, - omits to do any act which his duty to the surety requires him to do and the eventual remedy of the surety himself against the principal debtor is thereby impaired the surety is discharged. 10) By Loss of security: If the creditor: - loses - (without the consent of surety) returns, the security which he has against the principal debtor at the time of making of contract of Guarantee, The surety is discharged to the extent of the value of the security. This is immaterial whether the surety is or is not aware of the existence of such security. Discharges of Surety by acts of Creditor: 1. By Variance 2. Be Release 3. By Act or Omission 4. By Composition 5. By Extension of time 6. By Promise not to sue 7. By Impairing surety’s remedy 8. By Loss of security When surety not discharged due to acts of creditor: 1) Agreement with third person: When a contract to give time to the Principal debtor is made by the creditor with third person and not with the principal debtor, the surety is not discharged. 2) Forbearance to Sue: Mere forbearance on the part of the creditor to sue the principal debtor discharge the surety unless and until the limitation period for recovery of debt expires. 3) Release of Co-Surety: When there are co-sureties a release by the creditor of one of them does not discharge the other, neither does it free the surety so released from his responsibility to the other securities. Difference between Indemnity and Guarantee: Indemnity Guarantee 1) Number of Parties In indemnity there are two parties i.e. indemnifier and indemnified. In guarantee, there are three parties i.e. surety, creditor and principal debtor. 2) Number of Contracts In indemnity there is only one contract between indemnifier and indemnified. In guarantee, there are three contracts i.e. - between surety and creditor - between surety and principal debtor - an implied contract of indemnity between the principal debtor and surety. 3) Formation A contract of indemnity may be expressed or Implied. A contract of guarantee is always be an express contract. 4) Nature of Undertaking A contract of indemnity is of contingent nature A contract of guarantee is a collateral contract 5) Nature of Liability The liability of indemnifier is Primary, Absolute, Total Here the primary liability is that of principal debtor. The liability of surety is secondary and conditional. 6) Commencement of Liability The liability of indemnifier commences when the indemnified suffer loss The liability of surety commences when the principal debtor makes default 7) Objective To save the indemnified from a loss which may occur to him in the future To provide security to the creditor in respect of existing debs and liabilities 8) Right to sue Indemnifier cannot sue the third person in his own name but he may initiate the proceedings on behalf of indemnified On the default of principal debtor, the surety (after discharging his liability) may sue him in his own name. Guarantee is not a contract of uberrimae fidei: A contract of guarantee is not a contract of uberrimae fidei, i.e., one requiring full disclosure of all material facts by the principal debtor or creditor to the surety before the contract is entered into. Fraud on the part of the principal debtor is not enough to set aside the contract, unless the surety can show that the creditor or his agent knew of the fraud and was a party to it. When a guarantee is given to a banker, there is no obligation on the banker to inform the intending surety of matters affecting the credit of the debtor or any circumstance connected with the transaction which render the position of the surety more hazardous. If the guarantee is in the nature of insurance, as in a fidelity guarantee, all material facts must be disclosed, otherwise the surety can avoid the contract.

HOW TO DISTRIBUTE QUALITY COST

HOW TO DISTRIBUTE QUALITY COST

LABOUR COST ..Methods of Remuneration

LABOUR COST Methods of Remuneration (systems of wage payment) There are two basic methods of labour remuneration:

a) Time Rate System; and (b) Piece Rate System Time Rate System

Under the time rate system, workers are paid according to the time for which they work. Payment may be on hourly basis, daily basis or monthly basis. In this system, no consideration is given to the quantity or quality of work done. When payment is made on hourly basis, total wages payable are calculated as follows:

Wages = No. of hours worked x Rate per hour Piece Rate System

Wages under this system are paid according to the quantity of work done. A rate is fixed per unit of production and wages are calculated by the following formula:

Wages = Rate per unit x No. of units produced.

 Incentive Plans Both time rate system and piece rate system have their merits and demerits. Incentive plans attempt to combine the good points of both the systems. The primary purpose of an incentive plan is to induce a worker to produce more to earn a higher wage. Naturally, producing more in the same period of time should result in higher pay for the worker. Because of greater number of units produced, it should also result in lower cost per unit for fixed factory cost and also for labor cost.

 Various Incentive Plans Following is the list of many incentive plans being practiced by various organizations. (i) Straight Piece Rate Method (ii) Flat Time Rate Method (iii) Co-partnership (iv) Guaranteed Day Work (v) Taylor Differential Piece Rate Method (vi) Different Time Rates (vii) Rowan Premium Bonus Plan (Variable Sharing Plan) (viii) Halsey Premium Bonus Plan (Halsey Plan and Halsey-Weir Plan) (ix) Group Incentive Schemes (x) Standard Hour Plan (xi) Merrick Multiple Piece Rate (xii) Gantt Task Bonus Wage System (xiii) Bedaux Point System (xiv) Emerson Plan (xv) Barth Premium System (xvi) Accelerating Premium Bonus

We will discuss some of the above mentioned incentive plans in detail.

 1) Straight Piece Rate Method : The method rewards employees based on their output. A fixed rate of wage is paid for each unit produced, or number of operations completed or job completed. The wages payable is calculated by multiplying the number of pieces produced by the wage rate. There is generally a guaranteed hourly rate for workers who are unable to attain the standard in order to pay the minimum ‘day wages’.

 2) Flat Time Rate Method:  This method is used for paying remuneration to employees based on their attendance. A fixed rate of wage is paid hourly, or daily, or weekly on the basis of time spent on the shop floor (i.e. production department) in production. The wages payable is calculated by multiplying the hours/days spent in production by the hourly/daily wage rate.

 3) Halsey Premium Bonus Plan (Halsey Plan and Halsey-Weir Plan):  This plan was introduced by F A Halsey in 1891. It is a simple combination of time and piece rate systems. A worker is paid a guaranteed base rate and is rewarded when his performance exceeds standard. A standard time is established in respect of each job or unit. Bonus is paid on the basis of 50% of time saved.
The total wages payable is calculated as under: = (Hourly rate X Time taken) + (50% X Time saved X Hourly rate)
As a result of increased productivity, conversion cost per unit falls. This is because fixed overhead gets distributed over larger volume of output. Thus, the firm finds it possible to reward workers directly in proportion to production. In the case of Halsey Weir plan, the percentage used is 30 instead of 50.

 4) Rowan Premium Bonus Plan (Variable Sharing plan):  A standard time is established in respect of each job or process. There is a guaranteed base rate. A bonus is paid on the basis of time saved computed as a proportion of the time taken which the time saved bears to the standard time. The total wages payable is calculated as under: =(hourly rate x time taken) + ( time saved x time taken) x hourly rate time allowed

 5) Taylor Differential Piece Rate Method:  This system was introduced by F. W. Taylor, the father of Scientific Management. The main features of this incentive plan are as follows: a. Day wages are not guaranteed, i.e. it does not assure any minimum amount of wages to workers. b. A standard time for each job is set very carefully after time and motion studies. c. Two piece rates are set for each job- the lower rate and the higher rate. The lower piece rate is payable where a worker takes a longer time than the standard time to complete the work. Higher rate is payable when a worker completes the work within the standard time. In other words, lower piece rate is payable to inefficient workers and higher piece rate is payable to efficient workers. It will be seen that there is a great difference between the wages of an efficient and an inefficient worker.

 Problem 1 You are presented with the following information by Olympia Engineering Company related to the first week of December 1999. The firm employs 5 workers at an early rate of 2. During the week, they worked for 4 days for a total period of 40 hours each and completed a job for which the standard time was 48 hours for each worker. Calculate the labour cost under the Halsey method and Rowan method of incentive plan payments.

 Problem 2 A worker is allowed 10 hours to complete a job on daily wages. He takes 6 hours to complete the job under a scheme of payment by results. His day rate is Rs. 6 per hour and piece rate is Rs. 36. The material cost of the product is Rs.40 and the overheads are charged at 150% of the total direct wages. Calculate the factory cost of the product under i) Piece work plan ii) Rowan Plan iii) Halsey plan Problem 3

From the following particulars calculate wages earned by workers A and B respectively under Taylors System: Standard time allowed 10 units per hour Normal wage rate Rs. 1 per hour Differential rates to be applied: 90% of piece rate when below standard efficiency 125% of piece rate when at or above standard production on a day of 8 hours A – 75 units B -85 units

 Answers: Problem 1 i) Rs. 440 ii) Rs.467 Problem 2 i) Rs.36 ii) Rs.50.40 iii) Rs.48 Problem 3 A- Rs.6.75 and B-Rs.10.63 Solution of Problem # 1 Hasley Method = (Hourly rate x Time taken) + (50% x Time Saved x Hourly rate) = (10 x 40) + (0.5 x 8 x 10) = 440 Rowan Method = (Hourly rate x Time taken) + (Time Saved x Time Taken) x Hourly Rate Time Allowed = (10 x 40) + (8 x 40) x 10 48 = 467

 Solution of Problem # 2 Price Rate System = Rate per Unit x No. of Units produced = 6 x 6 = 36 Rowan Method = (Hourly rate x Time taken) + (Time Saved x Time Taken) x Hourly Rate Time Allowed = (6 x 6) + (4 x 6) x 6 10 = 50.40 Hasley Method = (Hourly rate x Time taken) + (50% x Time Saved x Hourly rate) = (6 x 6) + (0.5 x 4 x 6) = 48 Solution of Problem # 3 Unit rate= 1/10 =0.1 Rs/ unit Below efficiency Rate = 0.10 = 0.10*0.9 = 0.09 Rs/unit. Above efficiency Rate = 0.10 = 0.10*1.25 = 0.125 Rs/unit. Worker A:- Produced unit = 75 Therefore, wage= 75*0.090 = 6.75Rs (ANS) Worker B:- Produced Unit = 85 Therefore, wage= 85*0.125 = 10.625 ~ 10.63Rs (ANS)

IAS 11 – Construction Contracts

Students studying financial reporting papers will often come across the concept of accounting for construction contracts. Depending on the complexity of your financial reporting studies, accounting for construction contracts can become quite complex but with adequate question practise, they can also become very simple. The key to these types of questions is to do them in a methodical format. Accounting for constructions contracts is dealt with in IAS 11 ‘Construction Contracts’. This article will look at the core principles involved in IAS 11 and at the end of the article looks at a typical worked example. The first thing to understand is what a construction contract actually is. IAS 11 defines a construction contract as: “a contract specifically entered into for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, and function or their end use or purpose”. The principal concern of accounting for long-term construction contracts involves the timing of revenue (and thus profit) recognition. Contracts can last for several years and a standard was therefore required to deal with revenue recognition in relation to long-term construction contracts. To avoid distortions in the presentation of periodic financial statements, the percentage of completion method was developed which reports the revenues proportionally to the degree to which the projects are being completed. Percentage of completion method The percentage of completion method is a method of accounting that recognises income on a contract as work progresses by matching contract revenue with contract costs incurred, based on the proportion of work completed. The problem in dealing with the percentage of completion method lies in accurately deciphering the extent to which the projects are being finished and to assess the ability of the entity to actually bill and collect for the work done. The percentage of completion method uses the contract account to accumulate costs and to recognise income. Under the provisions of IAS 11, income is not based on advances (cash collections) or progress billings. Any advances and progress billings are based on contract terms that do not necessarily measure contract performance. Where costs and estimated earnings in excess of billings occurs, then the excess is classified as an asset. If billings exceed costs and estimated earnings, the difference is treated as a liability. There are two ways in which the stage of completion can be calculated as follows: Work certified method: Work certified to date ÷ total contract price; or Cost method: Total costs incurred to date ÷ total contract costs. Contract costs All contract costs are costs that are identifiable with a specific contract plus those that are directly attributable to contracting activity in general and can be allocated to the contract and those that are contractually chargeable to a customer. Examples of such costs could be: Costs of material used in the construction contract Wages and other labour costs directly attributable to the contract Cost of design and technical assistance Costs of hiring plant and machinery to complete the contract Depreciation charges in respect of plant and machinery used in the construction contract Rectification costs Sometimes mistakes happen and the entity will have to incur costs to put mistakes right. These are referred to as ‘rectification costs’ and should be written off to the statement of comprehensive income as soon as they are incurred. Fixed-price and cost-plus contracts IAS 11 recognises two types of construction contract that are distinguished according to their pricing arrangements: Fixed-price contracts; and Cost-plus contracts. Fixed-price contracts are contracts for which the price is not usually adjusted due to costs incurred by the contractor. Where a contractor agrees a fixed-price contract then this essentially means that the contractor agrees to a fixed contract price or a fixed rate per unit of output. These types of contracts are sometimes subject to escalation clauses. Cost-plus contracts are sub-divided into two further classifications: Cost without fee contract; and Cost plus fixed fee contract. Cost without fee contracts are where the contractor is reimbursed for allowable or otherwise defined costs with no provision for a fee. In these contracts, a percentage is usually added that is based on the foregoing costs. Cost plus fixed fee contracts are where the contractor is reimbursed for costs plus a provision for a fee. The contract price is determined by the total amount of reimbursable expenses and a fee. The fee is the profit margin which is calculated as revenue less direct costs to be earned on the contract. Recognition of contract revenue and expenses IAS 11 prohibits the use of the percentage-of-completion method if this method will not result in the financial statements reporting a reasonable level of accuracy. It follows therefore that the percentage-of-completion method can only be used where the outcome of the construction contract can be estimated reliably. Where the contract is either a fixed-price contract or a cost-plus contract, then the following criteria must be met to determine whether the outcome can be estimated reliably: If it is a fixed-price contract: It meets the recognition criteria laid down in the Framework Document which is that total contract revenue can be measured reliably and it is probable that economic benefits will flow to the entity. Both the contract costs to complete and the stage of completion can be measured reliably. Contract costs attributable to the contract can be identified properly and measured reliably so that comparison of actual contract costs with estimates can be done. If it is a cost-plus contract: It is probable that economic benefits will flow to the entity. The contract costs attributable to the contract, whether or not reimbursable, can be identified and measured reliably. Note – all conditions above must be satisfied. The outcome of the contract cannot be estimated reliably Where the outcome of a contract cannot be estimated reliably, contract revenue and costs should be recognised by reference to the stage of completion. Revenue should be recognised only to the extent of the contract costs incurred that are probable of being recovered, so therefore revenue will equal costs and no profit recognised as shown in the following illustration: The Facts A company enters into a two-year contract. The project manager is unsure whether the contract will be profitable or loss-making. Costs incurred to date amount to $10,000. Solution As the outcome of the contract cannot be estimated then the amount of revenue to be recognised in the company’s financial statements is the same as the costs incurred resulting in no profit being taken, so: Dr receivables $10,000 Cr revenue $10,000 The outcome of the contract is profitable Where the contract is profitable, revenue should be recognised by reference to the stage of completion. Costs incurred in reaching the stage of completion are taken to the statement of comprehensive income as cost of sales. This is achieved by the percentage of completion to the total costs that are expected to occur over the life of the contract. An illustration of how this works is shown at the end of this article. The outcome of the contract is loss-making Where contracts are loss-making, revenue is recognised by reference to the stage of completion and cost of sales is the balancing figure which generates the required loss. See the following illustration: The Facts Lucas Inc has a contract that is expected to make a loss of $1,000. The finance director at Lucas Inc has calculated that the amount of contract revenue to be recognised is $800. Solution The statement of comprehensive income will include $800 worth of contract revenue. The loss is estimated to be $1,000 so cost of sales will be $1,800 to generate the required loss (i.e. a ‘balancing figure’). This method is used because IAS 11 says that losses must be recognised in the statement of comprehensive income as soon as they are foreseen. Worked Example We shall look at a worked example of how IAS 11 works as follows: Leah Inc reports under IFRS and is preparing their financial statements for the year ended 31 March 2009. On 1 October 2008 Leah Inc commenced work on a contract. The price agreed for the contract was a fixed price of $50 million. Leah purchased plant at a cost of $15 million exclusively for use on the contract. The directors of Leah Inc have estimated that the plant will have no residual value at the end of the contract which is due to finish on 30 September 2009. Costs incurred on the contract plus estimated costs to complete are as follows:

All the costs which have been incurred to date have all been debited to the Contract Account in the general ledger. Leah Inc have appointed an agent who has confirmed that at the reporting date (31 March 2009), the contract was 40% complete at which point the customer made a progress payment amounting to $15 million. The finance department have credited this progress payment to the contract account. There have been no other entries made in respect of this contract. Required Show how the contract should be accounted for under the provisions of IAS 11 ‘Construction Contracts’ in the financial statements of Leah Inc for the year ended 31 March 2009. Solution Step 1 The overall revenue for the contract amounts to $50 million (the fixed price agreed). Step 2 We know that Leah has incurred the following costs and has made estimates of costs to complete as follows: purchase of machine 15000 purchase of material 9000 labour & other overheads 7000 estimated cost to complete 13000 _______ 44000 As costs are less than total revenue we know the contract is going to make a profit of ($50 million less $44 million) = $6 million. Step 3 The agent has confirmed the contract is 40% complete so we take 40% of the total costs to ‘cost of sales’ in the income statement. We then add 40% of the expected revenue to revenue in the statement of comprehensive income. Financial Statements (extracts) Revenue (40% x $50 million) $20,000 Cost of Sales Construction contract (40% x $44 million) ($17,600) Step 4 We then need to work out how much should be shown in the statement of financial position as ‘Gross Amounts due from Customer’. We need a working for this: Working – Gross Amounts Due from Customer cost to date purchase of material 9000 labour and overhead 7000 plant depreciation 7500 total cost to date 23500 contract profit(50000-44000) 6000 ______ 29500 less:progress billings (15000) ---------- gross amount due from customer 14500 The gross amount due from customer can be shown as an ‘other current asset’ in the statement of financial position. Conclusion It is important that when you are dealing with construction contracts questions that you adopt a logical method of dealing with the numbers and are familiar with how to recognise revenue and profits depending on whether a contract is profitable, loss-making or uncertain. Once you have mastered the approach and understand how IAS 11 works, questions on construction contracts become a favourite topic!

My Pakistan: Decentralization, Segment Reporting and Transfer Pricing:PART 1

My Pakistan: Decentralization, Segment Reporting and Transfer Pricing:PART 1

DEFERRED COST

A deferred cost is a cost that occurred in a transaction, but will not be expensed until a future accounting period. An example of a deferred cost is the fees necessary to register a new bond issue. A company will likely have to pay attorneys and accountants to prepare and audit the many statements required by government agencies. When these fees are significant, they are recorded as deferred costs in the long-term asset account, Bond Issue Costs or Unamortized Bond Issue Costs. The amount of the deferred costs will then be amortized (systematically charged) to Bond Issue Cost Expense over the life of the bonds. A second example is the amount paid in advance for the next six months of insurance. This prepayment is a deferred cost that is recorded in the current asset Prepaid Insurance. In each of the future months, one-sixth of the deferred amount of the insurance premium should be charged to Insurance Expense. The capitalization of interest involved when a company constructs its own building is also a deferred cost. The reason is that the interest will be added to the cost of the building and depreciated over the life of the building—instead of being expensed immediately as interest expense.

FRESH COACHING CLASSES FOR ICMAP STAGE 1,2 & 3

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