Income statements for sales contracts according to IFRS Problems of application and assessment from a cost-theoretical perspective

Introduction

Sales transactions and customers are core elements of a companys business activity. Sales contracts provide the legal basis for such transactions: they determine the terms of exchange and thereby form the basis both for receiving revenue from the sale and for the costs incurred in providing the product or service. As a companys profit and loss can effectively be seen as the sum of income contributions of all the individual business transactions, income statements for individual sales agreements can play a vital role in determining profitability. This applies equally for financial accounting and cost accounting. Today, many companies base their financial (group) accounting on the International Financial Reporting Standards (IFRS).1 The IFRS prescribe different accounting rules for different types of sales agreements, which in turn affects how the income statements used for different type of sales agreements are calculated. This paper focuses on sales contracts governing construction contracts (IAS 11) and the rendering of services (IAS 18).2 For both types of sales contracts, the IFRS specify - amongst other aspects - that they should regularly be evaluated in respect of potential losses (negative income contributions) resulting from the agreements, which can lead to accounting for provisions for impending losses. As a general observation, such negative income contributions result when the value of the goods and services required to be supplied in terms of the agreement (costs) exceeds the value of what is received in exchange (revenue). This general definition may as observed in practice by the authors lead to problems in valuing the income derived from individual sales agreements (and thereby the provision for impending losses). In the main, such problems result from the fact that the amount of costs to be included in the income statement is not gov-

In Germany, it was EU regulation No. 1606/2002 in particular that contributed to this development. It requires capital market oriented parent companies to complete their group accounting according to IFRS for financial years beginning after 31 December 2004. Cf. Pellens et al., 2006, p. 49. This paper does not consider sales contracts for goods (not resulting from custom orders) or sales contracts for leasing companies, where accounting has to follow the regulations of IAS 17.

erned unambiguously in all cases by the setter of standards. In individual cases, this may even result in a positive income contribution (profit) or negative income contribution (loss) being calculated for the very same sales agreement depending on the approach used and the amount of costs included. On the one hand, this paper aims to systematically detail the above-mentioned problems of application. On the other hand, we present a proposal based on IFRS regulations and cost theory that shows which range of costs3 should be used to valuate the sales agreements mentioned previously in accordance with the provisions of the IFRS. The paper is structured as follows. In section 2, we provide an overview of the relevant accounting regulations for construction and service contracts according to IFRS and highlight gaps in the interpretation of the guidelines. Next, we develop a theory-based proposal in Section 3 that proposes a contribution to closing the gaps described in Section 2. In Section 4, we provide a concrete valuation example in order to explain our approach. Section 5 positions our approach within the current context of accounting research. 2 2.1 Income statements for construction and service contracts according to IFRS Basic accounting regulations

In accordance with IAS 11, IFRS understands construction contracts to mean contracts specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use. According to this definition, the central characteristic of construction is that assets are produced specifically to meet customer requirements as defined in a contract. This criterion differentiates construction from the manufacture of goods for anonymous markets.4 Construction contracts often govern large-scale building projects of material assets, such as building bridges, pipelines or tunnels (IAS 11.3 and following).5 Accounting for such contracts is governed by IAS 11. The core concept of this standard is the so-called percentage of completion (PoC) method. According to the PoC method, total revenue and costs of a construction contract are captured on every closing key date in proportion

The revenue side is not considered in depth; however, calculating this aspect of the income contributions of individual sales contracts creates significantly fewer problems in practice. Regarding this differentiation, cf. IDW RS HFA 2, Tz. 1. Cf. also Adler/Dring/Schmaltz, 2006, section 16, Tz. 6.

4 5

to the degree of completion6.7 In other words, the profit resulting (or expected) from the overall project is captured on a pro rata basis even before the project has been completed (IAS 11.22 and following). In contrast to construction, the rendering of services is not aimed at creating an asset (IAS 18.4). Typical examples of services i]nclude consulting, medical, cleaning, transportation and other services.8 IAS 18 specifies how sales revenue resulting from such sales agreements should be accounted for. These regulations are also based on the PoC method.9 In respect of revenues, costs, and profit, IAS 18 is thereby based on the same fundamental approach for service transactions as is used for construction contracts according to IAS 11 (IAS 18.20 and following). 2.2 Regulations concerning income statements

2.2.1 Construction
As has become clear from the above overview of basic accounting regulations, income statements are of critical importance for construction contracts in the context of the PoC method. This is the case because project income is reflected in proportion to the degree of completion in the profit and loss statement even before the corresponding project has been completed. Correspondingly, the two components of income from a construction contract contract revenue and contract costs are described comprehensively in IAS 11. On the one hand, contract revenue according to IAS 11.11 encompasses the contractually agreed upon payment for construction. On the other hand, it reflects likely and clearly definable adjustments resulting from (subsequent) changes to the scope of the contract, for reimbursement of costs incurred by the contractor and not anticipated in the contract, as well as incentives or bonuses (e.g. for finishing the contract ahead of schedule).10

6 7

On the calculation of the degree of completion, cf. IAS 11.30 and IDW RS HFA 2, Tz. 15. However, this requires certain conditions to be fulfilled regarding the uncertainty connected with a construction contract as well as valuation problems (IAS 11.23). On this topic, cf. also Pellens et al., 2006, pp. 368. Regarding the differentiation between services to which IAS 18 applies from products or services subject to IAS 11, cf. Adler/Dring/Schmaltz, 2006, section 4, Tz. 12 and 14. Here, too, certain conditions have to be fulfilled, which are similar to those for construction contracts in IAS 11. Cf. IAS 11.12 and the following clauses for more detail. Whereas calculating contract revenue may be problematic in individual cases (especially regarding components of the clients performance which are uncertain on the closing date), this paper focusses on the calculation of contract costs.

10

According to IAS 11, contract costs include the following (IAS 11.16): Costs which can be directly allocated to a construction contract, costs which can be allocated to activities related to the companys construction contracts in general and which can be divided up between individual contracts, other costs which can be charged to the customer on the basis of conditions agreed upon in the contract. IAS 11 mentions some examples of costs that can be directly allocated to a construction contract, such as project specific labor costs including project supervision costs, costs for materials, and costs incurred through the usage of equipment for a specific contract. Contract acquisition costs can usually also be included in the category of costs that can be directly allocated to a contract; however, these should only be included in the contract costs if they can be measured separately and reliably and if it is likely that the contract will be concluded (IAS 11.21). According to the IASB, costs which can be allocated on a general basis to activities related to construction contracts and which can be divided up between individual contracts include insurance costs and production overheads (such as the costs for working out the payroll of employees working to produce the goods and services for the contract, IAS 11. 18). Conversely, general administration and distribution costs as well as research and development costs not directly related to the contract are mentioned as examples of costs that cannot be allocated to specific construction contracts.11 Costs which can be allocated on a general basis to contract activities should be allocated to the individual contracts based on systematic and reasonable methods. The distribution of costs has to reflect a normal capacity load (IAS 11.18).12 The scope of contract revenue and contract costs13 described above determines income statements for construction costs according to IAS 11 and thus the way they are accounted for in terms of the PoC method (see section 2.1). Referring to other IFRS regulations in this context

11

For these costs, there may be no reimbursement agreements with the customer because the corresponding costs would otherwise be part of his contract costs (IAS 11.19). Cf. also IDW RS HFA 2, Tz, 6. Regarding the scope of costs and individual cost components which have to be taken into account, cf. also Adler/Dring/Schmaltz, 2006, section 16, Tz. 82.

12 13

 such as the general regulations on accounting for provisions for impending losses in IAS 37 is therefore neither necessary nor permissible in terms of the regulations (IAS 8.7).14 Should it become likely no matter at which point in time that the total costs resulting from the contract (the sum of those already incurred plus those expected) exceed the total revenue, then this difference (the expected loss) has to be captured not in proportion to the degree of completion, but rather in full and without delay (IAS 11.36). The corresponding loss amount has to be reflected in the active or passive balances from construction contracts on the balance sheet.15

2.2.2 Service transactions

In contrast to IAS 11, IAS 18 for service transactions does not provide detailed instructions concerning the range of revenues and costs to be accounted for in terms of the balance sheet. In IAS 18, revenue is defined broadly as the gross inflow of economic benefits during the period arising in the course of the ordinary activities of a company when those inflows result in increases in equity, other than increases relating to contributions from equity participants (IAS 18.7). This definition is also relevant for revenue from service transactions (IAS 18.20). Regarding the costs to be accounted for in terms of the PoC method (see section 2.1), IAS 18.20(d) only states that the costs incurred and the costs to complete the transaction should be considered; however, this does not explain which amount of costs to take into account. IAS 18.21 does note that IAS 18, like IAS 11, is based on the PoC method, and continues: The requirements of that Standard [referring to IAS 11, the authors] are generally applicable to the recognition of revenue and the associated expenses for a transaction involving the rendering of services.16 However, it is not clear whether this reference applies only to the fundamental applicability of the PoC method (e.g. regarding the basic approach to accounting for revenue and costs and determining the degree of completion) or also to all other regulations in IAS 11 (such as the range of associated expenses (IAS 18.21) and accounting for provisions for impending losses). It is precisely this question that is relevant in practice for deciding whether a service contract may result in a loss, which would have to be recorded by capitalizing the provision for impending losses.

14 15 16

Cf. ibid., Tz 132 and section 18, Tz. 149. Cf. ibid., Tz. 133. Cf. also IDW RS HFA 2, Tz. 17. IAS 18.21.

The relevant sections of IAS 37 deserve attention as a potential alternative to the (complete) consideration of IAS 11 in relation to determining the costs of a service transaction (and thereby the (potentially negative) income resulting from it). Among other elements, this standard contains regulations on how to account for provisions for impending losses. Its scope in respect of these regulations is not limited to specific types of business transactions, but it does point out that corresponding regulations in other standards enjoy precedence if they are applicable (e.g. IAS 11 for construction contracts, IAS 37.5(a)). IAS 37 provides no reasons to prevent it from being applied to service contracts according to IAS 18; also, the IASB does not appear to preclude those rendering services from applying the regulations in IAS 37 to determine whether or not a service contract may result in a loss (IFRS 4.B7(c)). Pursuant to IAS 37 and corresponding to the regulations on accounting for provisions for impending losses, unavoidable expenses for fulfilling contractual obligations have to be taken into consideration when calculating income from a contract. This figure is in turn defined as the smaller amount of that which the company would have to pay if it withdraws from the contract (penalties, damages etc.) and that which it would have to pay if completing the transaction (IAS 37.68).17 However, contract fulfillment costs are not specified in any further detail in IAS 37. More specifically, the regulations in contrast to those relating to construction contracts in IAS 11 (see above) do not indicate how one should deal with costs that can be allocated in different ways in respect of a specific contract. In order to resolve this problem, the scope of costs relevant according to IAS 37 should be determined by making use of the concept of unavoidable costs related to contract fulfillment. In this context, the English language IFRS literature proposes to concretize this cost concept as costs that are directly variable and incremental to the performance of the contract18, i.e. incremental costs; unavoidable costs should therefore not contain any allocation of costs incurred independently of the contract and may not contain elements which could be avoided through future actions of the company.19

17

On this topic, cf. also Adler/Dring/Schmaltz, 2006, section 18, Tz. 146. As the problem of how to allocate individual costs (or cost categories) being incurred within the company itself with regard to a concrete sales transaction usually does not occur when calculating the costs resulting from withdrawing from a contract, we will focus exclusively on contract fulfilment costs in the following. KPMG, 2007, Tz. 3.12.640.40. Cf. ibid., Tz. 3.12.660.30.

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To summarize, calculating income from service transactions according to IAS 18 is in contrast to construction contracts currently not clearly defined in the IFRS, at least as regards the cost side of calculating income. This has crucial consequences for accounting for provision for impending losses for such transactions. Until this point has been clarified by the IASB, companies accounting according to IFRS can make use of the following permissible approaches:20 a) Complete recourse to IAS 11 including the amount of costs to be used in determining income as specified there b) Applying the regulations in IAS 37 to determine provision for impending losses with reference to the unavoidable costs from a service transaction For companies deciding to use approach b) to determine the amount of costs, we will show in the following that the above mentioned relationship or equation of unavoidable costs according to IAS 37 with incremental costs from the perspective of cost accounting literature can be justified (section 3.1). On this basis, the concept of incremental costs, which is little used in German language cost accounting literature, will be concretized with reference to the concept of decision oriented costs as developed by RIEBEL (section 3.2). This analysis provides a basis for developing more concrete specifications for determining provision for impending losses, as will be shown in chapter 4. 3 3.1 Concretizing the amount of costs according to IAS 37 on the basis of cost theory Unavoidable costs as incremental costs

English language cost accounting literature defines 'incremental costs as additional costs to obtain an additional quantity, over and above existing or planned quantities, of a cost object21. This definition implies that additional costs are incurred when an additional unit of a specific cost object is produced. The relevance of the additionally produced unit is made even clearer by HEALDS definition of incremental costs: Incremental Cost is defined as the increase in cost associated with producing a second output in addition to a first output.22

20

Cf. ibid., Tz. 3.12.640.40. The company drawing up a balance sheet has to choose one of the two approaches and apply it to all similar business transactions in accordance with IAS 8.13. Horngren et al., 2005, p. 307. Heald, 1996, p. 58.

21 22

GLEIM/FLESHER choose a similar approach. They define incremental costs as the difference in total costs between two decisions.23 Semantically speaking, BACKER and JACOBSENS definition of incremental costs approaches the term unavoidable costs as used in IAS 37.68 even more closely. They define incremental costs as costs, which would not be incurred if a particular project is not undertaken. They are thus avoidable costs. [Emphasis by the authors]24 According to this definition, the incremental costs of a contract are those which would be avoided if the contract were not concluded. On the basis of this definition, equating unavoidable costs according to IAS 37 with incremental costs would be justified if the unavoidable costs mentioned in IAS 37.68 correspond to avoidable costs according to BACKER und JACOBSENS definition. This correspondence can be established if one assumes that the unavoidable costs' in IAS 37.68 are costs that become unavoidable as a result of the corresponding transaction/service contract being entered into, for it is precisely these costs that were avoidable' before the transaction. As there appear to be no strong reasons contradicting the assumption mentioned above regarding the term 'unavoidable costs' as used in IAS 37, it seems appropriate to interpret the unavoidable costs mentioned in IAS 37.68 as avoidable costs according to BACKER und JACOBSENS definition and therefore as incremental costs. This conclusion by analogy, whereby unavoidable costs are equated with incremental costs, can only provide a first approach towards defining the cost concept according to IAS 37 more precisely on the basis of theory if the definition of incremental costs permits a more accurate way to be found for determining provision of impending losses for sales contracts. It is therefore necessary at this stage to establish a more precise understanding of the incremental principle as a basis for determining costs.
23

Gleim/ Flesher, 2006, p. 82. By introducing decisions as the element which causes costs, the level of cost causation becomes relevant in addition to the above-mentioned definition. The term incremental costs is not found at first in standard U.S. cost accounting literature. Cf. McRae, 1970, p. 317. McRae lists several such sources as evidence, e.g. c.f. Fraser, 1937, Edwards/Bell, 1965, Mattesich, 1964, Horngreen, 1965, Nemmers, 1962. Definitions of incremental costs start appearing and evolving from 1964. Cf. ibid. For these definitions, cf. Mathews, 1962, p. 422, Moore/Jaedicke, 1963, p. 107, Anthony, 1964, p. 571, Spencer/Seigelman, 1964, p. 305, Wasson, 1965, p. 9, Carrington/Battersby, 1967, p. 299. After McRae had discussed a systemic perspective and a link to opportunity costs with his contribution on the definition of incremental costs in 1970, further commentary followed on his writings. This is referenced in the following, but the discussion will not be analyzed in greater detail at this point. The role of opportunity costs will also not be subjected to further discussion because, as will be shown, they are no longer mentioned in connection with incremental costs in more recent literature. Cf.. Burch/Henry, 1974, pp. 118, McRae, 1974, pp. 124. Backer/Jacobsen, 1964 in connection with Wixon/Kell/Bedford, 1970, p. 76.

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An important concept in decision oriented cost accounting in the USA, the idea of 'incremental costs is built on the incremental principle. Decisions always require comparisons of alternatives. [] These differences are referred to as differentials or increments; the requirement that data for decisions should be estimates of increments is called the incremental principle.25 The comparison of alternatives as a precondition for decisions is mentioned as a starting point for the incremental principle. In this context, incremental costs are often described as cost (changes) that result directly from a decision, or change as a result of a decision.26 This in turn makes it clear that it is the reference object on the one hand and the underlying, cost-causing decision on the other hand that are the two significant parameters for determining incremental costs. This knowledge of the core elements of incremental costs needs to be defined in greater detail. In the following, we will review the German language cost accounting literature regarding potential definitions or approaches that could be used to establish a more precise understanding of the unavoidable costs mentioned in IAS 37.68 from a cost accounting viewpoint. 3.2 Decision oriented costs as unavoidable costs

In contrast to English language cost accounting literature, which tends to focus on practical applications, the concept of costs is (traditionally) at the center of theoretical discussions in German language cost accounting literature, both in relation to cost accounting and financial accounting27.28 In order to establish a more precise understanding of incremental costs, the concepts of avoidable costs or incremental costs first need to be placed into context within the logic of cost concepts according to German language literature. It is worthwhile to note that no standard German textbook on cost accounting explicitly addresses the concept of incremental costs.29

25 26 27

Shillinglaw, 1983, p. 38-2. Cf. ibid., p. 38-4. Weber/Weienberger state that terms such as costs could be dispensed with in the area of financial accounting. However, costs are already an integral part of the relevant accounting regulations, such as section 255 of the German Commercial Code (HGB), which mentions purchase and manufacturing costs. Cf. Weber/Weienberger, 2006, p. 47. Business costs are defined as the purposeful consumption of goods during an accounting period, expressed in monetary terms. Homburg, 2002, col. 1051, and similarly Weber/Weienberger, 2006, p. 48 and also Hoitsch/Lingnau, 2002, p. 16. Homburg elaborates that factor consumption is defined by the amount-related component of the definition provided above. As a consequence, valuating it is also of central interest. Cf. ibid., cf. similarly Schweitzer/Hettich/Kpper, 1975, p. 34 and cf. Ewert/Wagenhofer, 2005, p. 80. However, the term marginal or incremental costs is addressed. With regard to capital costs, the term incremental is translated as Grenz (marginal) in the official translation of IAS 17.4. Cf. IAS 17.4.

28

29

The principle of decision oriented costs30, which goes back to RIEBEL, is useful in creating a more precise understanding of the idea of incremental costs. According to this principle, costs are additional uncompensated payments and expenditures with credit balances that are caused by decisions taken in relation to the object under consideration.31 According to this definition, the element that causes costs to be incurred is a so-called initial decision.32 Signing a sales contract is one example of such an initial decision. In contrast to KOSIOL33, RIEBEL assumes that no causal or final relationships can exist between objects to which costs are allocated on the one hand and the goods to which the products or services which have been provided are allocated on the other hand. Instead, he proposes that decisions are the true source of costs in a company. Accordingly, costs can only be allocated on the basis of the so-called identity principle.34 According to the identity principle, costs can only be allocated unambiguously and necessarily to an object under consideration if the existence of this object was caused by the same decision as the costs which are to be allocated.35 RIEBEL labels costs which can be allocated in this way as true direct costs, which may be allocated only to the reference object and therefore to the cost unit.36 In relation to the allocation object, direct costs have to be allocated directly to the corresponding object, whereas overheads are allocated indirectly to it. According to RIEBEL, direct costs are costs which can be unambiguously allocated to a reference object which has to be defined precisely regarding its nature and duration because both the costs (expenses) and the
30

The decision oriented cost concept is an evolution of the cash-based cost concept. Koch, 1958, p. 361, understands cash-based costs to mean the uncompensated expenses related to the manufacture and sale of one production unit or to a period, ibid. In contrast to the value-based cost concept, it is the purchase price that determines the cost value in the case of the cash-based cost concept. The value-based definition of costs originating with Schmalenbach is characterized by three criteria: there has to be trade in goods; the trade in goods has to be related to performance (a concrete objective); and the trade in goods has to be subject to valuation. On this topic, cf. Schmalenbach, 1963, p. 141. Riebel, 1994, p. 15. This definition is identical to the exact definition of true direct costs. Cf. Riebel, 1992, p. 262. Cf. Riebel, 1990, p. 423. Cf. Kosiol, 1969, pp. 27. Cf. Riebel, 1972, p. 272. Ibid. Cf. Haberstock, 2004, p. 51. Calculating costs based on the principle of causation or identity becomes problematic when it is impossible or difficult to capture them on the basis of the criteria of these two principles. If one needs to include costs that cannot be captured using one of the two principles described above, one can use the average or load capacity principle. The literature provides further principles for distributing costs, such as the proportionality principle and the cost allocation principle. These two principles will not be examined in further detail here; for more information, cf. e.g. Schweitzer/Kpper, 1995, pp. 90. A further principle, mentioned only for reasons of completeness, is the performance correspondence principle according to Koch. Cf. Koch, 1966.

31

32 33 34 35 36

reference object result from a common decision.37 To aid understanding, RIEBEL provides a number of test questions in order to ensure that the concept of direct costs according to his definition is not diluted by unclear categorization: Which costs would be eliminated if the reference object were eliminated? Which additional costs would be incurred if an additional unit of the reference object existed? Can the cost changes and the reference object be linked back to the same (initial) decisions?38 If one takes into account that the relevant reference object for establishing provisions for impending losses according to IAS 37 in this sense is an individual (sales) contract, these questions directly help to concretize the concept of unavoidable costs and also help to calculate them in specific cases. The questions aim at the consequences of an entrepreneurial or management decision, e.g. accepting a contract, and identify the costs which have become unavoidable as a result of the decision. 3.3 Interim conclusion

Strong arguments can be found with the help of the English language cost accounting literature for interpreting unavoidable costs according to IAS 37 to mean 'incremental costs'. In turn, these can be specified more precisely from the perspective of RIEBELS direct cost accounting, which is based on a decision oriented concept of costs; the identity principle which is an element of this concept matches the idea of incremental costs. In accordance with this principle, the key characteristic for determining incremental costs is a decision concerning a specific reference object as the only relevant cost causing element. This is why all costs, such as those related to a specific contract, are reviewed with regard to the question of whether they can be linked back to the originating decision (e.g. acceptance of the contract). The amount of costs relevant for evaluating provision for impending losses can be determined by means of this process. In other words, if the costs directly related to the initial decision according to RIEBELS criteria are extracted on the basis of RIEBELS test questions the principle of incremental

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Riebel, 1994, p. 762. Cf. Riebel, 1994, p. 762. In addition to the original defintion of direct costs, RIEBEL coined the term relative direct costs. This refers to all those direct costs which cannot be allocated directly to an allocation object (product), but can indeed be directly allocated to a cost center. He also refers to these direct costs as false direct costs or as seemingly direct costs. Cf. ibid., p. 619. In contrast to the direct costs just defined according to RIEBEL, overheads are defined as the costs which affect the accounting object under consideration and others jointly insofar as they cannot be separately captured even if the best capturing methods for the object under consideration are employed, and which also cannot be allocated to it on the basis of the identity principle. Ibid., p. 760.

costs as used in IAS 37 has been taken into account. Furthermore, the incremental costs calculated in this way can be transposed to the concept of variable direct costs (in relation to the corresponding reference object) according to RIEBEL, which is more commonly used in German language cost accounting literature. The example provided in the following chapter aims to show which effects applying the incremental principle in practice would have when valuating sales contracts for cost accounting purposes. 4 4.1 Case study to illustrate the concept Background information on the case

A is a logistics company that owns a railway line between Station 1 and Station 2, on which it renders passenger transportation services. B is a consulting company whose employees are characterized by their high degree of site flexibility and mobility. A and B sign a contract specifying that Bs employees are entitled to cover a total of one million kilometers on As railway network and on all of As trains (regular service) during the next year. Bs employees enjoy priority over other customers, meaning that they are guaranteed a seat on any train they choose. For this service, B pays A a flat fee of 2 million. The contract does not oblige A to maintain a certain service level (e.g. guaranteeing a minimum number of train connections on the line) or to employ special trains for B. A expects that B's employees will make use of the total one million kilometers of transport services. At the same time, based on its internal load schedule, A does not anticipate that priority for Bs employees will mean that other passengers will not be able to be transported. It is also not considered to be necessary to use additional trains to be able to fulfill the contract with B. As a simplifying assumption, it is understood that all connections between Station 1 and Station 2 are end to end connections, in other words, there are no stops en route. Calculations by As controller resulted in the following figures:

Network data Distance per train connection between Station 1 and Station 2 (one way), in km Number of trips per year on the entire network Kilometers travelled per year on the entire network, in km Revenues derived from providing train connections, per annum Costs per year Rental for train stations Depreciation on companys own train stations Depreciation on rail network Repairs and maintenance on rail network Labor costs - Employees at stations - Employees on trains Electricity costs for stations Electricity costs for trains Depreciation on trains Train repairs and maintenance Costs of centralized administration Marketing costs Total costs per year Profit per year

Figures 320 219.000 70.080.000 2.847.000.000 200.000.000 320.000.000 850.000.000 450.000.000 7.040.000 38.400.000 150.000.000 200.000.000 300.000.000 180.000.000 20.000.000 50.000.000 2.765.440.000 81.560.000

4.2

Calculating unavoidable costs according to IAS 37 for the initial scenario

In order to calculate unavoidable costs, one first has to determine whether or not the relevant allocation/reference object from As perspective when applying IAS 37 is the contract with B. (Other allocation objects could be, for instance, the train connection between the two stations, company A, a single train trip or a single passenger.) In accordance with RIEBELS decision oriented perspective, the conclusion of a contract between A and B is the decision that has to be taken as the causal source of all relevant costs. Based on this, the amount of the incremental costs can be determined by answering RIEBELS test questions, as described in section 3. The following two questions are relevant for this example: 1. 2. Which costs would be eliminated if the contract with B were eliminated? Can the cost changes and the contract be linked back to the same (initial) decision?39

If one applies the first question to each of the cost categories shown in the table above, one would reasonably conclude on the basis of the information available on the contract that none

39

Cf. Riebel, 1994, p. 762.

of the amounts shown would change if the contract with B were eliminated. This is because neither an additional train nor any other product or service results from the contract beyond what is being provided anyway. Instead, all of the services specified by the contract between A and B can be rendered on the basis of As normal operations, which are independent of the contract. This means that from As perspective, no costs would be eliminated if the contract with B were eliminated. Therefore, no incremental costs can be calculated for the contract; in other words, the incremental costs to be allocated to the contract have a zero value. It becomes clear that the concept of incremental costs is the diametrical opposite of a full cost concept40, according to which some of As costs would be allocated even if they were not strictly caused by the contract with B, such as proportional depreciation and electricity costs per kilometer travelled by an employee of B, etc. The practical consequence of calculating incremental costs in order to apply IAS 37 to the contract between A and B is that even if the price which B pays for the contract were much lower, but zero no loss is incurred according to the standard and therefore making provision for impending losses is not necessary for A.

4.3

Variations when using the contract as an allocation object: Scenarios 1 and 2

The cost analysis changes if the contract is modified as follows. In contrast to the initial scenario, two supplementary services are added to the contract between A and B: Scenario 1: A sets up a centralized service hotline A and B have agreed upon a clause in addition to those contractually defined in the initial scenario that specifies that A will create a centralized telephone hotline exclusively for the employees of B. Here, the employees of B will be able to obtain up to date travel information. It is assumed that the toll-free hotline will be staffed by four additional service employees of A, who cause labor costs of 50,000 per year and employee. However, no additional offices are needed for the employees as the existing infrastructure provides sufficient capacity. The local telecommunications company charges a flat fee of 25,000 per year for activating the hotline. The incremental costs according to IAS 37 would then have to be calculated as follows:

40

The valuation of provisions for impending losses in the case of pending sales transactions is also based (at least in part) on this concept, cf. IDW RS HFA 4, Tz. 35.

Costs for activating the service hotline, per year + Labor costs for four additional employees, per year = Unavoidable costs according to IAS 37

(all amounts in Euro) 25.000 200.000 225.000

Scenario 2: Provision of three special weekend trains for company Bs annual staff outing We will now assume, in addition to the contractual conditions in the initial scenario, that A provides B with three special trains for its annual staff outing. Four employees are needed to control and staff each of the special trains. They work one day during the weekend. The weekend bonus per employee is 150 per day. The contract specifies a return journey of 320km each way per train. Usually, A does not offer other special trips. Based on the actual cost causing objects, incremental costs are only incurred as a result of the three trips by the special trains on the weekend. They can be calculated as follows:

Weekend bonus, per staff member on a train Employees per train Kilometers travelled per year on the entire network in km Trip per train connection (one way) in km Contractually required special trains, per year Kilometers travelled by special trains, per year Electricity costs of all trains, per year Electricity costs per kilometer travelled Costs resulting from the contract41 Weekend bonus for all staff members on trains + Total electricity costs of the special trains = Unavoidable costs according to IAS 37

150 4 70.080.000 320 3 1920 200.000.000 2,85 /km

1.800 5.472 7.272

The following table summarizes the above calculations for the initial scenario and scenarios 1 and 2:

41

Proportional costs for maintenance and wear and tear on the rails are not being considered because of the low number of kilometers travelled by special trains in relation to the total kilometers travelled by all trains during a year. They are equivalent to 0.00273 percent of the total costs for maintenance and wear and tear on the tracks. It is also assumed that trains are not depreciated on the basis of distance travelled.

(all amounts in Euro)

Labor costs for Costs for activatWeekend bonus for four additional ing the service all train staff mememployees, per hotline, per year bers year 200.000 25.000 1.800

Total electricity costs of the special trains 5.472

Unavoidable costs according to IAS 37 0 225.000 7.272

Initial scenario Scenario 1 Hotline Scenario 2 Special trains

The overview shows that cost calculations based on the incremental principle according to IAS 37 tend to lead to very low cost amounts in the case of the above examples when determining income contributions of individual sales contracts. In general, this result should be characteristic for sales contracts with a high fixed cost share.

Are (supposedly) detrimental sales transactions not shown on IFRS income statements?

By applying the incremental principle when calculating unavoidable costs according to IAS 37, only those costs are taken into account when valuating provisions for impending losses as has been shown which are actually caused by an economic decision in combination with a concrete allocation object. As the example shows, this may lead especially in the case of fixed cost-intensive businesses to a result that is intuitively surprising and may be seen as somewhat unsatisfactory by some parties: individual sales contracts may often not be identified as loss-causing transactions, for which impending loss provisions have to be captured, when drawing up an income statement according to IFRS, even though such transactions (measured against the total (full) costs that can be allocated to them) should be seen as being detrimental to the company. This result may at first glance create the impression that capturing (supposedly) detrimental sales transactions in IFRS statements may be impossible in many cases. The meaningfulness of this result should, however, not be assessed from a balance sheet perspective at the level of an individual sales transaction; instead, it has to be analyzed in respect of the meaningfulness of the IFRS income statement of the company as a whole (whose object of reference is the company as a whole). At this level, one needs to take into account that the company setting up its balance sheet is obliged to carry out a value reduction test on its assets according to the regulations in IAS 36 (so-called impairment test) under certain conditions,

which indicate a negative economic development.42 Without going into much detail concerning impairment tests, such tests of value reduction are regularly carried out in accounting practice at the level of so-called cash-generating units (CGUs); these are sub-units of a company (asset groups) which are capable of generating essentially independent revenue streams. Impairment tests are usually carried out according to a specific gross rental method in which all future payments and receipts of a CGU are discounted to their current value (realizable value). When calculating the payments and receipts to be allocated to a CGU, there is no requirement to limit the calculation to incremental payment components in contrast to income calculations for individual sales transactions in the context of calculating impending losses (see above).43 It also has to be taken into account that for value reduction tests, it is the CGU which is the relevant allocation object, and not a single transaction. (This alone would lead to an increase in the size of the incremental costs, which would be the relevant dimension in this context.) In the end result, this means that the costs/payments which are potentially not captured when calculating the income of a possible loss-making transaction because of a lack of sales contract-related incrementality have to be accounted for in the context of an impairment test in the end. Here, they may lead to a value reduction of a CGU, which would be captured in the form of an extraordinary depreciation. This means that non-incremental costs/payments of a sales transaction are fundamentally also reflected in the IFRS statement (before they are incurred, i.e. in an anticipative manner); however, this is not done on the basis of an individual sales transaction as the allocation object for capturing provisions for impending losses, but on the basis of the allocation object relevant for the value reduction test (as a rule, the respective CGU). This does not imply that a loss identified for a single sales transaction on the basis of the total costs that can be allocated to it necessarily has to lead to an expense of the same amount being reflected as extraordinary depreciation as a consequence of an impairment test. Instead, there may be compensatory effects in this regard when carrying out the impairment test because all payment streams have to be taken into account when calculating the realizable amount for a CGU. These usually include payments from a large number of sales transactions, which are concluded under varying conditions and may therefore be partly profitable, partly detrimental. Extraordinary depreciation on a CGU is only carried out when all discounted payment streams

42 43

Cf. IAS 36.9 and following. Cf. IAS 36.39.

that can be allocated to it in the form of realizable amounts are lower than the book value of the CGU on the balance sheet.44 In summary, (supposedly) detrimental sales transactions are often not followed by the capitalization of provisions for impending losses according to IAS 37, but they are included together with all their economic consequences (and especially all their costs) when value reduction tests according to IAS 36 are carried out; at this level of creating IFRS income statements, there may be an expense (though not necessarily) which reflects the potential detrimental effects of a companys sales transactions. 6 Interpretation of results

The above analysis can be summarized in the form of the following results, which are based on theoretical and practical as shown in the example considerations: 1. The concept of incremental costs as defined in English language cost accounting literature can potentially be used as a suitable principle for calculating unavoidable costs according to IAS 37. 2. The principle of variable direct costs in combination with a decision oriented cost concept can be used as a tool for calculating incremental costs, and thereby unavoidable costs according to IAS 37. 3. In order to calculate unavoidable costs, individual sales contracts serve as cost-causing allocation objects in this approach and pursuant to IAS 37. 4. As shown in the example, unavoidable costs according to IAS 37 are significantly lower (in many cases, close or equal to zero) than the costs which would have to be taken into consideration when applying full costs, for instance. This applies especially to businesses with a high share of fixed or overhead costs. 5. In many cases, the capitalization of the provision for impending losses therefore has to be skipped in accounting practice according to IAS 37. This is because there is no loss in the case of specific sales transactions if they are analyzed on the basis of unavoidable costs calculated in this manner.

44

Cf. IAS 36.104.

6. On the other hand, the (supposed) detrimental effects of a sales transaction have to be taken into account completely (i.e. by using the full costs for the analysis) when carrying out an impairment test according to IAS 36. 7. However, this usually does not lead to the same results compared with an analysis of provision for impending losses done on a full cost basis because the allocation object being considered (single sales transaction vs. CGU) is fundamentally different. It is not possible to provide an all-purpose estimate of the quantitative effects of these findings on IFRS statements created for individual companies; the exact nature of the impact varies from case to case. It would be a worthwhile research project to analyze critically the meaningfulness of IFRS income statements based on the above requirements for external recipients of income statements. A comparable question relates to the applicability of financial information calculated as shown above for the purposes of internal reporting in companies (controlling). These and other aspects related to analyzing income accounting for sales transactions could be promising subjects for further research.

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