Revenue Cut-Off and Sales-and-Leaseback Judgement at a Textile Exporter
Rahman Textiles Ltd ships finished fabric to overseas buyers on CIF terms. In the year just ended, revenue recognised was BDT 480 million and profit before tax BDT 62 million. The auditor finds three issues. First, goods invoiced on 29 June and loaded onto a vessel on 3 July were recorded as sales of BDT 35 million; the shipping documents confirm the vessel sailed after year-end, and control transfers when goods are loaded on board. Second, the company sold a knitting machine to a bank for BDT 40 million cash and leased it back for five years, retaining use of the machine; the carrying amount was BDT 28 million, and the present value of lease payments equals the sale price. Management booked the entire BDT 40 million as other income. Third, a customer owing BDT 18 million has been in financial distress since March; the receivable is still carried at full value and no loss allowance was recorded. The finance director argues that all three treatments are 'commercially reasonable'.
1. Evaluate the cut-off issue and quantify the corrected revenue and profit before tax, stating the principle applied.
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The principle is that revenue is recognised when control of the goods passes to the buyer, not when an invoice is raised. Under CIF terms the seller bears cost, insurance and freight until the goods are on board, so control transfers on loading. The 29 June invoice relates to goods loaded on 3 July, after the reporting date; the BDT 35 million is therefore not revenue of the year.
Correction: reverse the sale (revenue falls by 35 million) and restore inventory net of any unrecoverable costs. Assuming the goods remain the company's inventory at cost and the sale carried a normal margin, the profit effect is the gross margin on that sale, not the full 35 million. If cost of the goods was, say, BDT 28 million, the profit overstatement is BDT 7 million.
Revised figures: revenue 480 - 35 = BDT 445 million; profit before tax 62 - 7 = BDT 55 million (before other adjustments). The point the examiner rewards is the distinction between reversing revenue and reversing profit, and rejecting 'commercially reasonable' as a substitute for the control test.
2. Assess management's accounting for the sale-and-leaseback and state the correct treatment.
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A sale-and-leaseback is genuine only if the transfer qualifies as a sale - that is, the buyer obtains control. Here the company sells the machine and immediately leases it back for five years, retaining use, and the present value of the lease payments equals the sale price. Substantially all the risks and rewards of ownership remain with the company; the transaction is in substance a secured borrowing, not a sale.
The BDT 40 million cash received should be recognised as a financial liability, not as other income. The machine stays on the balance sheet at its carrying amount of BDT 28 million and continues to be depreciated. No gain is recognised at inception; the difference between proceeds and the liability, and the finance charge implicit in the lease payments, is spread over the lease term using the effective interest method.
Management's treatment overstates profit before tax by BDT 40 million and understates liabilities by the same amount. The examiner looks for the control/substance argument, the liability recognition, and the rejection of an immediate gain.
3. Determine the appropriate treatment of the BDT 18 million receivable and explain the effect on the financial statements.
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Receivables are measured at amortised cost less a loss allowance for expected credit losses. The customer has been in financial distress since March, which is objective evidence that the receivable is impaired. The allowance should be based on the present value of expected cash flows, not on waiting for default.
If recovery is estimated at, say, 40 per cent, the expected credit loss is 18 x 60% = BDT 10.8 million. The entry is a debit to impairment expense (profit or loss) and a credit to the loss allowance, reducing the net receivable to BDT 7.2 million.
Combined effect with the earlier adjustments: profit before tax falls by a further BDT 10.8 million, taking the revised figure to roughly BDT 44.2 million, and net receivables fall correspondingly. The examiner rewards identifying that the allowance is required now, the measurement basis, and the presentation as a deduction from gross receivables rather than a direct write-off.