Revenue Cut-off and the Delayed Despatch Note
Cedarline Ltd has a 31 December year end. Draft profit before tax is £486,000. On 30 December a customer signed an order for goods with a list price of £120,000 (cost £78,000) and paid a 10% deposit. The goods were still in Cedarline's warehouse on 31 December because the customer's haulier was unavailable; the signed despatch note is dated 4 January. Cedarline's stated policy is that revenue is recognised when goods are despatched, and the draft figures already include the full £120,000 as revenue and the £78,000 as cost of sales. Separately, a £9,000 invoice for January rent was posted to December in error. The finance director is under pressure from the bank covenant (profit before tax must exceed £450,000) and argues the sale is 'substantially complete'.
1. Quantify the effect of the correct treatment on profit before tax and assess whether the covenant is met. Show your workings.
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Revenue reversal: the goods had not been despatched at the year end, so under the despatch policy (and IFRS 15's transfer-of-control principle) revenue of £120,000 must be removed.
Cost reversal: the £78,000 cost of sales is also reversed because the inventory is still on hand at 31 December.
Net effect on profit: −£120,000 + £78,000 = −£42,000.
Rent error: the £9,000 January invoice was posted early, so December profit is overstated by £9,000; reverse it: −£9,000.
Revised PBT: £486,000 − £42,000 − £9,000 = £435,000.
Covenant: £435,000 < £450,000, so the covenant is breached. The FD's 'substantially complete' argument does not override the accounting policy; the deposit is a liability (contract liability), not revenue. The breach should be disclosed/negotiated with the bank rather than avoided by misstatement.
2. The FD proposes instead to change the revenue policy to 'recognition on order confirmation' and apply it only to this transaction. Explain why this is not acceptable and what the correct process would be.
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Why it fails:
- A change of accounting policy must be applied retrospectively to all comparable transactions (IAS 8), not selectively to one sale.
- Selecting a policy to achieve a desired profit outcome is earnings management, not a genuine change in circumstances.
- The new policy would also be inconsistent with the transfer-of-control principle, since the customer cannot direct the use of, or obtain substantially all the benefits from, goods still in the seller's warehouse.
Correct process:
- Determine whether a genuine, supportable change in policy is warranted (e.g. a change in delivery terms across the business).
- If so, restate comparatives and disclose the nature, reason and financial effect.
- If not, retain the existing policy and record the correct cut-off adjustment.
- Document the judgement and escalate to those charged with governance/audit committee.