Question

Case 2: PQR SAOC is a manufacturer of edible oil. You are an expert who deals with the transactions related to provisions, contingent assets, contingent liabilities and intangible assets in the company. For each of the scenario mentioned below provide with an appropriate solution with accounting treatment, calculations and necessary comments: (4 x 2.5 marks each = 10 marks) 1. On 5* December 2019, 50 people were hospitalized after consumption of food cooked in oil manufactured by the company. Legal suit was filed in the court of law for a damage of RO 2 million against the company. On the balance sheet date, the lawyer advised that it is likely that the enterprise will be found liable. But the amount of compensation will not exceed RO 1.5 million 2. The company is also sued for RO 30,000 for damages. It disputes the claim. It is unclear whether or not it will be liable. If it is found liable, it is unlikely that it would have to pay the claim in full. 3. The company owns a license to produce a unique type of oil. Such license is freely transferable and was acquired on 1* November 2017 valid for a period of 8 year. The license was acquired at a cost of RO 16,800 and was amortized using straight line method. Overtime the demand for such oil increased and the on 31* December 2019 such license had a trade value of RO 23,000. The company had decided to adopt revaluation model for such license. 4. The company has a franchise with varying value of RO 300,000 on 1* January 2019. It exchanged it for a similar franchise with a market price of RO 550,000. The company also incurred RO 50,000 for publicity and research expenses on one of its new customer products, which was test marketed during the year but proved to be a failure.

Answer 1

Definitions

Provision:

Provisions—which are recognized as liabilities (assuming that a reliable estimate can be made) because they are present obligations and it is probable that an outflow of resources embodying economic benefits or service potential will be required to settle the obligations.

Conditions: A provision should be recognized when:
(a) An entity has a present obligation (legal or constructive) as a result of a past event;
(b) It is probable that an outflow of resources embodying economic benefits or service potential will be required to settle the obligation; and
(c) A reliable estimate can be made of the amount of the obligation.

If these conditions are not met, no provision should be recognized.

Contingent Liability: A contingent liability is:
(a) A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity; or
(b) A present obligation that arises from past events but is not recognized because:
(i) It is not probable that an outflow of resources embodying economic benefits or service potential will be required to settle the obligation; or
(ii) The amount of the obligation cannot be measured with sufficient reliability.

Answers:

1. Present obligation as a result of a past obligating event—On the basis of the evidence available, there is a present obligation.
An outflow of resources embodying economic benefits or service potential in settlement—Probable.
Conclusion—A provision is recognized for the best estimate of the amount to settle the obligation.

Legal Suite Filed for RO 2 million

Provision should be recognised for an amount of RO 1.5million

Expense A/c Dr 1.5million

To Provision A/c 1.5million

Balance RO 0.5 million to be treated as Contingent Liablity.

2. The company also suied for RO 30,000 for damages

Present obligation as a result of a past obligating event—There is no present obligation.

To be disclosed as contingent liability for RO 30,000

3. Intangible assets

Revaluation Model:

Revaluation model After initial recognition, an intangible asset shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated amortisation and any subsequent accumulated impairment losses. For the purpose of revaluations, fair value shall be measured by reference to an active market.

Revaluations shall be made with such regularity that at the end of the reporting period the carrying amount of the asset does not differ materially from its fair value.

When an intangible asset is revalued, the carrying amount of that asset is adjusted to the revalued amount. At the date of the revaluation, the asset is treated in one of the following ways:
(a) the gross carrying amount is adjusted in a manner that is consistent with the revaluation of the carrying amount of the asset.
(b) the accumulated amortisation is eliminated against the gross carrying amount of the asset and the amount of the adjustment of accumulated amortisation forms part of the increase or decrease in the carrying amount.

Revaluation changes shall be accounted for as follows:

If an asset’s carrying amount is increased as a result of a revaluation:
• the increase shall be recognised in other comprehensive income and accumulated in equity under the heading of revaluation surplus; or
• the increase shall be recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognised in profit or loss.

In the given case the intangible assets carrying amount is increased as a result of revaluation.

The increase shall be recognised in other comoprehensive income.

Calculation of carrying amount as on 31st December 2019

Cost = RO 16,800

Period = 8 yeras

Amortisation Value per year = 16,800/8

= RO 2,100

Amortization value for 3 years = RO 2,100*3

= RO 6,300

Carrying Value as on 31st December 2019 = RO 16,800-RO 6,300

= 10,500

Fair Value of the license = RO 23,000

Increasing in carrying amount as a result of revaluation = 23,000 - 10,500

= 12,500

(i) the increase of RO 12,500 shall be recognised in other comprehensive income and accumulated in equity under the heading of revaluation surplus; or
(ii) the increase of RO 12,500 shall be recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognised in profit or loss.

4.  Valuing Franchises

How a franchise is recorded on a balance sheet depends on the conditions of the contract. If a franchisee makes periodic payments to the franchisor over the contract’s term, the franchisee does not record a franchise asset. Instead, the franchisee records a franchise expense when they pays the franchise fee.

If the contract requires that a lump sum be paid up front to secure the franchise rights for several years, the franchisee would record a franchise asset on its balance sheet. Therefore, the value of the franchise asset equals what it cost to acquire.

Therefore, PQR SAOC should record the lumpsum paid as intangible asset i.e, RO 550,000.

The company incurred RO 50,000 for publicity and research expenses during the year but proved to be a failure. Since the amount paid not exists for long term ( because the test resulted in failure) the amount of RO 50,000 to be expensed in the current year.