Abbas, Johayra M.

December 29, 2019

Alcazaren, Regine Lucy C.
Angas-Lu, Israhayda A.

Summary:
Long-term Construction Contracts

IAS 11 defines construction contract as a contract specifically negotiated for the construction of an
asset or a combination of assets.

Examples of construction contracts include those negotiated for the construction of highways,
buildings, oil rigs, industrial units, pipelines, airlines and other similar assets. IAS 11 deals with
accounting of construction contracts from the perspective of the contractors who undertake such
projects on behalf of its clients. Self-constructed assets for an entity's own use are accounted for in
accordance with IAS 16 and are not within the scope of IAS 11 Construction Contracts.

Accounting Problem

Whereas in most industries, business process cycles are completed within a relatively short period of
time, it is normal practice in the construction industry for the duration of projects to extend beyond
one year. Before the introduction of IAS 11 Construction Contracts, revenue was recognized by
construction firms on Completed Contracts Basis under which, profit on the construction contract was
deferred until the completion of the related project. As a result, there was a considerable time lag
between the performance of contract obligations and the recognition of related profit.

Completed Contract basis of accounting for construction contracts was considered by many as being too
prudent in that no revenue was recognized in respect partially completed construction projects even
when inflow of economic benefits could be reasonably expected. Also, this method of accounting
contradicted with the fundamental accruals concept of accounting whereby income and expenses are
recognized in the accounting period in which they are incurred.

IAS 11 Construction Contracts - Accounting Treatment

IAS 11 Construction Contracts was introduced in order to counter the deficiencies observed in
accounting for construction contracts. It defines how a contractor should recognize costs and revenue
over the life of a construction contract.

IAS 11 proposes accounting for construction contracts on the basis of expected outcome.

a) Outcome of a contract can be reliably measured:

1. Net Profit: If a profit is expected under the contract, revenue and costs (and hence
profit) are to be recognized in the income statement based on the Stage of Completion
of the contract (also known as Percentage of Completion Basis).
2. Net Loss: If a net loss is expected under the contract, the entire loss is recognized
immediately in the income statement. Revenue and contract costs are recognized in
the income statement on the basis of Stage of Completion of the contract.

b) Outcome of contract cannot be measured reliably:

 Uncertain: If the outcome of construction contract is uncertain, no profit is recognized. Costs

are recognized in the period in which they are incurred. Revenue is only recognized to the
extent of costs incurred that are expected to be recovered.
Objective

The proposed treatment of a construction contract by IAS 11 balances the requirement to present
financial statements under Accruals Basis, and the conventional wisdom of the Prudence Concept.
Where a net inflow of economic benefits under a construction contract is probable, costs and revenue
are recognized to the extent of completion of the contract (i.e. Accruals Basis). If however a loss is
expected under the contract, the entire loss is immediately recognized (i.e. Prudence Concept).
Types of Construction Contracts

There are two generic types of construction contracts:

 Fixed Price Contracts: Price of the contract is fixed in advance and is independent of costs
incurred in respect of the construction contract. Outcome of a fixed price contract can be
reliably measured if:
 Contract Revenue can be reliably measured. Revenue can usually be reliably measured
if it is specified in the contract.
 Contract costs incurred and to be incurred can be identified and measured reliably.
 Stage of completion of contract can be reliably measured. It is necessary to know the
stage of completion of construction contract to estimate the extent of future costs to
be incurred to determine the expected outcome (profit and loss).
 The inflow of economic benefits is probable.
 Cost plus Contracts: Price of the contract consists of the reimbursement of allowable
construction expenses incurred along with a predetermined profit margin over and above the
costs. Outcome of a cost plus contract can be reliably measured if:
 Contract costs relating to the contract can be identified and measured reliably.
 The inflow of economic benefits is probable.

Features of Construction Contracts

Construction contracts may also include the following features:

 Cost Escalation Clauses: Contractors may be entitled to claim unanticipated increase in

construction costs above a certain level defined in the cost escalation clause. This is usually
included in fixed price contracts to protect against the risk of abnormal rise in prices which
may render the performance of contract unfeasible for the contractor.
 Incentive Payments: Contractors may be entitled to receive additional payments from clients
upon fulfillment of a predefined criterion such as completion of project within a certain time
frame.
 Penalties & Claims: Contractors may be liable to reimburse clients for not performing
according to the specifications of the contract. Reasonable estimate of losses that may be
suffered due to non-performance of a specific term of the contract may be defined in the
penalty clause (e.g. amount payable for every day exceeding the project deadline).
Conversely, contractor may be entitled to claims against losses suffered due to actions of the
customers such as faulty specifications and delays caused by customer.
 Variations: Contract terms and specifications may be subsequently varied by the mutual
consent of the concerned parties. Variations may be necessary to accommodate unforeseen
factors such as a change in customer requirements.

Accounting for construction contracts mainly includes treatment in respect of contract revenue,
contract costs, trade receivables, gross amount due to / from customers, advances from customers and
retention money.

Contract Revenue

Contract Revenue recognized in the income statements includes:

 Amount of revenue initially agreed in the contract

 Incentive Payments considered likely to accrue to the contractor
 Approved variations in contract revenue
 Amount of claims that are considered likely to be accepted by the customer
Revenue in respect of construction contracts is recognized according to stage of completion in respect
of contracts whose outcome is reliably measured.

Contract Costs

All attributable costs of a contract must be recognized as construction costs. Other costs that cannot
be reasonably attributed to contract activity shall be charged as general and administration expense in
the accounting period they are incurred. Contract costs consist of the following:

 Direct or Specific Costs of the construction contract. Examples of direct costs include:
 Direct material consumed on a specific project
 Direct labor allocated to a particular contract (e.g. project in charge, site engineers,
etc.)
 Insurance cost specifically incurred on a construction contract
 Depreciation of machinery and equipment used on a specific contract
 Indirect Costs that may be allocated to individual contracts on a reasonable basis. Examples
of such costs include:
 Allocation of the cost of central technical assistance department based on for example
number of hours spent by technical staff on various contracts
 Insurance cost allocation in respect of machinery used on multiple sites
 Construction overheads
 Allocation of salary of staff employed on multiple contracts (e.g. project supervisors)
 Indirect costs must be allocated on the basis of normal level of construction activity. Similar to
the requirements of IAS 2 Inventory, any abnormal wastage must not be included in the
contract costs. This is to prevent recognition of any such costs as construction assets which are
not likely to be recoverable in the future.
 Any other costs specifically allowable under the contract.
 Franchises (IAS 18/IFRS 15)

Franchises are rights to sell a specific brand of product or services in a certain geographic area. There
are two parties involve in franchising, namely the franchisor who grants the right to sell his brand of
product or services to another party called the franchisee. Each party contributes resources.

The franchisor contributes his trade name, product, and company’s reputation. He also imparts his
expertise and on continuing basis provides guidance and duties on the manner in which the franchisee
must operate his establishment. The franchisee on the other hand, provides operating capital for the
operation of the franchised business.

Franchise Fees

Franchise agreement usually requires the franchisee to make payments, called the franchise fees to
the franchisor in consideration for the reputation, skill, products and services contributed by the
franchisor. There are two types of franchise fees, the initial franchise fee and the continuing franchise
fee.

Revenue Recognition-Initial Franchise Fee

Before a franchise is granted, an initial franchise fee is paid by the franchisee to the franchisor. Usually
the initial franchise fee is paid by the franchisee via a down payment with the balance evidenced by a
note payable in installment.

The determination of revenue earned on the initial franchise fees lies on the following factors: (1) the
point at which fee is to be considered earned; and (2) the assurance of collectability of the unpaid
portion of the fee, if the initial franchise fee is not paid in full.

Revenue from the initial franchise fee should be recognized on the consummation of the transaction,
which occurs when all material services or conditions of the agreement have been substantially
performed. There is substantial performance by the franchisor when the following conditions are met:

a. The franchisor is not obliged in any way to refund cash already received or forgive unpaid debt.
b. The initial services required of the franchisor have been substantially performed.
c. No other material conditions or obligations exist.

It is assumed that substantial performance occur when the franchisee actually commence operations of
the franchise business.

Cost of Services

Direct franchise costs of initial services rendered by the franchisor shall be deferred until related
revenue is recognized. These costs should not exceed anticipated related revenue. Indirect costs that
occur on a regular basis should be expensed when incurred. Costs yet to be incurred should be accrued
and charged against income not later that the period in which the related revenue is recognized.

The earned and the unearned revenue from the initial franchise fee are computed using the following
approaches:

With Direct Franchise Costs

a. If collection of the note is assured:

Earned franchise fee = Cash collection plus the balance of the note
(accrual method)

Unearned franchise fee = None.

 b. If collection of the note is not assured:
Earned franchise fee = Cash collections applying to principal X
Gross profit rate (installment method)

Unearned franchise fee = Balance of the note

Without Direct Franchise Costs:

a. If collection of the note is assured:

Earned franchise fee = Cash collection plus the balance of the note

Unearned franchise fee = None

b. If collection of the note is not assured:

Earned franchise fee = Cash collections

Unearned franchise fee = Balance of the note

Revenue Recognition-Continuing Franchise Fee

Continuing franchise fee is usually collected from the franchisee at the end of each month in payment
of the continuing services rendered by the franchisor. This is usually based on a certain percentage of
the monthly sales of the franchisee. Continuing franchise fees are recognized as revenue when actually
received.

All direct and indirect costs related to continuing franchise fees are recognized as expense.

Option to Purchase

The franchise agreement may include a provision to the effect that the franchisor has an option to
purchase the franchise business. If the option is granted at the time the franchise agreement is signed,
the initial franchise fee is to be deferred. When the option is exercised and the franchisor acquires the
franchise business, the deferred revenue from the initial franchise fee is treated as a reduction from
the franchisor’s investment.
 Installment Sales

When a sale is made on the installment basis, the buyer usually makes a down payment and promises to
pay the balance in regular installments over a specified period of time. Profit on installment sales is
recognized only when earned. Although there are several theoretical points at which the profit can be
assumed to be earned, for CPA examinations purposes, the choice is generally limited to the
installment method.

Installment Method

Under this method, income is recognized only when collections are made. Problems requiring the use
of the installment method of recognizing income have appeared quite regularly in the CPA exam. The
following are the typical problems often encountered in the CPA exam:

1. Computation of Gross Profit Rate for each year of sales.

2. Computation of Realized Gross Profit for each year of sales.
3. Computation of Deferred Gross Account balance at the end of year.
4. Computation of Gain or Loss on repossessions.

Computation of Gross Profit Rate

To compute the realized gross profit in proportion to the collections made, it is necessary to determine
the gross profit rate for each year’s operations. The following are the formulas in computing gross
profit rate:

Current year sales: Gross Profit Rate = Gross Profit

Installment Sales

Prior year sales:

Gross Profit Rate = Deferred Gross Profit (Beg.) – Prior Year Sales
Installment Accounts Receivable (Beg.) – Prior Year Sales

Computation of Realized Gross Profit

Once the gross profit rates are known, it is possible to compute the realized gross profit based on cash
collections. The formula to be used is:

Realized Gross Profit = Collections (excluding interest) x Gross Profit Rate (based on sale)

Missing Factors. In as much as the realized gross profit under the installment method depends upon
cash collections of receivables, it is important that the amounts collected must be known. However, in
some problems, the collections are not specifically stated. Such collections must be reconstructed from
related information available from the data given. The candidate should remember the following
format in computing the collections:

Current Prior
Year Sales Year Sales
Installment accounts receivable–beginning (xx (xx
Installment accounts receivable–end (xx) (xx)
Total credits (xx (xx
Credit for repossessions (unpaid balance) (xx) (xx)
Credit for installment A/C written off (xx) (xx)
Credit representing collections (xx (xx
Computation of Deferred Gross Profit, End

To compute the balance of Deferred Gross profit at the end of the year, the following formula may be
used:

Installment Account Receivable–End x GPR = Deferred Gross Profit–End

Or

Deferred Gross Profit–before adjustment xx

Less: Realized gross profit xx
Deferred Gross Profit-End xx

Computation of Gain or Loss on Repossession

If a customer does not make an installment payment at the specified time, it is necessary to repossess
the merchandise in order for the seller to minimize his loss.

The gain or loss on repossession is computed as follows:

Fair value of repossessed merchandise (xx

Less: Unrecovered cost
Unpaid balance (xx
Less: deferred gross profit (unpaid balance x GP rate) (xx) (xx)
Gain (loss) on repossession (xx

The fair value of repossessed merchandise at the time of repossession should be before reconditioning
cost and before adding a normal gross profit from sale of repossessed merchandise.

Trade In

This type of installment sales used by car dealers, whereby an old car is received as down payment
from the buyer for sale of the new car. Usually the old car traded-in is overvalued to induce the trade-
in. for problem solving purposes the overvaluation is computed using a formula below:

Trade-in value allowed on the old car (xx

Less: Actual value
Estimated selling price (xx
Less: Normal gross profit from the sale of used car xx
Reconditioning costs xx (xx) (xx)
Over allowance on the old car (xx

The over allowance is treated as a deduction from the selling price of the new car. When there is over
allowance on the old car traded-in, the gross profit rate is computed as follows:

Gross profit ÷ Net Sales (net of over allowance)

The realized gross profit is also computed as follows:

Collections (cash + actual value of old car) x GPR

 CONSIGNMENT

The producers cannot reach everywhere to sell their produce. They reach their consumers l through the
wholesalers or retailers. They also hire other channels for distribution of goods. The goods are also
made available at different places through the agents and agencies. Generally it is seen that a
producer or a wholesaler appoints agents at different markets or in different parts of the country to
sell goods on their behalf against commission. One such arrangement is consignment.

IMPORTANCE OF CONSIGNMENT
1. Consignment helps producers to bring economies of large-scale production with the increased
sale. It facilitates high sale as a result of which large scale of production is required and this
leads to economies of scale as large-scale production results to fall in cost per unit.
2. It is more profitable for those manufacturers who are having their branches at different places
in domestic country or in other countries. As in such situations, the local agents of that place
have much knowledge of that market as compared to the manufacturers. So he facilitates more
profitable sale by approaching local customers.
3. If prospective buyer is not easily approachable by a producer because of long distance between
them the agent plays an important role to contact them on regular basis and to ensure prompt
delivery of goods to them out of his stock of consigned goods by consignor.

NAME OF PARTY
a) Consignor: He is also known as a principal. He is the producer or firm who sends good to an
agent for sale. He enjoys the right of ownership of goods until they are sold by an agent.
b) Consignee: He is also known as an agent. He is the person or firm who sells the goods consigned
to him against commission.

TYPE OF COMMISSION
1. Simple commission: It is that commission which is paid to an total selling the goods of
consignor. It is calculated on total sales (cash + credit).
2. Dell commission: It is that commission which is given to consignee for guarantee credit sale
(full collection from debtors). It is calculated on total sale unless otherwise stated in the
question. This commission given for taking the guarantee of credit sale.
3. Overriding commission: It is that commission which is given for selling the goods at a price
higher than the normal selling price is known as ‘surplus price’. It is calculated on surplus price
at a given rate.

CONSIGNMENT EXPENSES
Those expenses that are to be incurred by consignor and/or consignee for the goods sent on
consignment. They are of two types:
1. Non-recurring or direct expense: Are those expenses which are incurred for a receiving the
goods. They are paid only once when goods are received like caries, freight, unloading and
loading.
2. Recurring or indirect expense: Are those expenses which are paid by consignee for selling the
goods. They are in recurring nature like godown/shop rent advertisement insurance premium
etc.
DISTINCTION BETWEEN CONSIGNMENT AND SALE
Basis Consignment
1. Name of parties Consignor and Consignee
2. Relationship Principle and Agent
3. Return of goods Consignee has the right the goods in
case he is not in possession to sell
them.
4. After delivery In consignment after delivery expenses
expenses are born by consignor those paid by
consignee.
5. Return or In case of consignment the whole profit
reward belong to consignor. Consignee gets
commission only.
6. Transfer of risk In case of consignment risk is not
transferred any loss or damages to the
goods will be borne by consignor.
Sales
Seller and Buyer
Creditor and Debtor
In case of sale goods one for cannot
be return to the seller.
In case of sale after delivery expense
are born by buyer.
In case of sale the whole profit
belongs to seller it is not shared
buyer.
In case of sale risk is transfer from
seller to buyer any loss or damages to
the goods will be borne by buyer.

CONSIGNMENT LOSS
The goods sent by consignor to consignee may suffer two types of losses:
1. Normal Loss: It is that loss which arises due to nature of goods or types of goods. This loss
cannot be fully check or no fully control. For example are loss of coal due to loading and
unloading.
2. Abnormal Loss: It is that loss which arises due to negligence or carelessness. This loss can be
fully check or control. This loss can divided into two parts:
a. Loss in transit: It is that types of abnormal loss which arises when the goods are on the
way from consignor to consignee. For example are goods may be damages in transit due
to accidents.
b. Loss at consignee place: It is that types of abnormal loss which accurse (take place)
after reaching the goods to consignee. For example are goods may be destroyed by
fire.

ACCOUNTING TREATMENT
Books of consignor:
1. Consignment Account
2. Consignee Account
3. Goods sent on consignment

Books of consignee
1. Consignor Account
2. Commission Account

CONSIGNOR'S BOOK
Summary of Procedures
Transactions Debit Credit
1. Goods sent on consignment. Consignment Goods sent on
consignment
2. Expenses incurred by the consignor. Consignment Bank
3. Expenses incurred by the consignee and Consignment Consignee
the commission payable to the
consignee.
4. Sales recorded on the account sales Consignee Consignment
5. Normal Loss No entry
6. Insurance claim received for normal Bank Consignment
stock loss
7. Abnormal Loss Bank/Insurance Consignment (Total loss)
company Profit and loss
8. Payment from the consignee by check or Bank/Bill receivable Consignee
bill
9. Cost of goods sent on consignment Goods sent on Trading account
credited to trading account. consignment
10. Profit on the consignment is transferred Consignment Profit and loss
to the profit and loss account. (Reverse
the entries if it is a loss.)

CONSIGNEE'S BOOK
Summary of Procedures
Transactions Debit Credit
1. Goods received form consignor. No entry
2. Expenses paid by the consignor. No entry
3. Commission received (ordinary and del Consignor Commission received
credere commission).
4. Expenses paid on behalf of the consignor. Consignor Bank
5. Discounts allowed to customers Consignor Debtors
6. Bad debts borne by the consignor. Consignor Debtors
7. Bad debts borne by the consignee Profit or loss/Bad debt Debtors
personally. (When the consignee receives
a del credere commission, he should bear
all losses from bad debts)
8. Cash sales Bank/Cash Consignor
9. Credit sales Debtors Consignor
10. Payment to the consignor by check or bill Consignor Bank/Bill payable

METHOD OF ACCOUNTING
Generally there are two different methods of preparing accounts relating to the consignment of goods.
These two methods are described as under:
1. Cost Price: Under this method, entries relating to consignment in the books of consignor are
passed with the actual cost of goods and amount spent or expenses incurred by him.
2. Invoice price: When consignor sent to the goods to consignee at invoice price (not at cost price)
invoice price is normal selling price which is cost price plus profit.

VALUATION OF STOCK
If there are unsold goods on consignment at the end of the accounting period, the value of the unsold
stock will be carried down to the following period.

Valuation of stock = Consignor’s Cost + Consignee’s Expenses

Where:
Consignor’s cost
= Total consignor’s cost x Units of closing stock / Total units of goods SENT on consignment
= [Cost of goods on consignment + Consignor’s expenses] x Units of closing stock / Total units of goods
sent on consignment

Consignee’s expense
= Total consignee’s expenses (excluding marketing expenses) x Units of closing stock / Total units of
goods received by consignee (after normal loss)
 Service Concession Arrangement – Build, Operate and Transfer (BOT)

In many countries, public-to-private service concession arrangements have evolved as a mechanism for
providing public services.

A service concession arrangements is an agreement between a government unit and an operator in

which:

a. The government unit conveys to the operator the right and obligation to provide public services
through the operation of a facility (capital asset) in exchange for consideration;
b. The operator collects and is compensated by fees from the third parties;
c. The government unit has the ability to modify or approve the services to be provided, to whom
the operator is required to provide the services, and the price of the services; and
d. The government unit is entitled to significant residual interest in the facility at the end of the
arrangement.

Common examples of services concession arrangements include:

1. Arrangement in which an operator agrees to design and build or improve a facility and collect
fees from third parties (e.g., construct a municipal complex or a tollway).
2. Arrangements in which an operator will pay the government unit for the right to operate a
government facility (e.g., a parking structure) and collect fees from the third party for its use.

If the facility associated with the arrangements is an existing facility, the government unit should
continue to report the facility as a capital asset. If the facility is purchased, constructed or improved
by the operator, the government unit should record, (a) the new facility (capital asset) as its fair value
when it is placed in operation, (b) any related contractual obligations as liabilities, and (c) a
corresponding deferred inflow or resources equal to the difference. A contractual obligation is one that
is significant and related to the facility (e.g., an obligation by the government unit to provide
insurance for the facility). These obligations should be measured at their present values.

In the notes to the financial statements, the government should disclose:

1. A general description of the arrangements, including the government’s objectives for entering
into the arrangement.
2. Nature of amounts of assets, liabilities, and deferred outflows and inflows of resources related
to the arrangement.
3. Nature and extent of rights retained by the government.
4. The details of any related guarantees and commitments.

IFRIC 12, Service Concession Arrangements, deals with a private sector entity (an operator) that
provides a public service and operates and maintains that infrastructure (operation services) for
specified period of time.

Philippine interpretation of IFRIC 12 applies to service concession arrangements when the structure for
public use is constructed or acquired by the operator or given for use by the grantor and (1) the grantor
controls what services operator must provide, to whom and at what price, and (2) the grantor controls
any significant residual interest in the existing infrastructure at the end of the term of the service
concession arrangement. Because the grantor continues to control the infrastructure assets, these
assets are not recognized as property, plant and equipment of the operator.

The operator recognizes and measures revenue for the services it performs in accordance with PAS 11,
construction contracts and with PAS 18, Revenue for the services it performs. If more than one service
is performed (e.g., construction or upgrade services and operation services) under a single contract or
arrangement, consideration received or receivable shall be allocated based on relative fair values of
the services delivered. The nature of the consideration the operator receives in exchange for the
construction services determines its subsequent accounting treatment.
If the operator provides construction or upgrade services, the consideration received or receivable by
the operator shall be recognized at its fair value. The consideration may be rights to:

A Financial Asset. An operator shall recognize a financial asset to the extent that it has an
unconditional contractual right to receive cash or another financial asset from or at the
direction of the grantor for the construction services.

The grantor has little, if any, discretion to avoid payment usually because the agreement is
enforceable by law.

The operator has an unconditional right to receive cash if the grantor contractually guarantees
to pay the operator (a) specified or determinable amount and (b) the shortfall, if any, between
amounts received from the users of the public service and specified or determinable amounts,
even if payment is contingent on the operator ensuring that the infrastructure meets specified
quality or efficiency requirements.

A financial asset is recognized during construction, giving rise to revenues from construction
recovered during the period of use of the asset.

 An Intangible Asset. The operator shall recognize an intangible asset when the consideration
the operator receives consists of rights (license) to charge users of the public service, for
example license to charge users tolls for using roads or bridges. A right to charge users of the
public service is not an unconditional right to receive cash because the amounts are contingent
on the extent that the public uses the service.

 Mixed Model. If the operator is paid for the consideration services partly by a financial asset
and partly by an intangible asset it is necessary to account separately for each component of
the operator’s consideration. The consideration received or receivable for both components
shall be recognize initially at the fair value of the consideration received or receivable.

The nature of the considerations given by the grantor to the operator shall be determined by
reference to the contract terms and, when it exists relevant contract laws.

Borrowing Costs

Borrowing costs attributable to the arrangement shall be recognized as an expense in the

period in which they are incurred unless the operator has a contractual right to receive an
intangible asset (a right to charge users of the public service). In case the operator has a
contractual right to receive an intangible asset, borrowing costs may be capitalized during the
construction phase of the arrangement.
 Insurance Contracts

An insurance contract is an arrangement under which one party line (the insurer) accepts significant
insurance risk by agreeing with another party (the policyholder) to compensate the policyholder or
other beneficiary if a specified uncertain future event (the insured event) adversely affects the
policyholder or other beneficiary (other than an event that is only a change in one or more of a
specified interest rate, security price, commodity price, foreign exchange rate, index of prices or
rates, a credit rating or credit index, or similar variable-which would continue to be accounted for
under PAS 39 as derivative contracts). A contract creates sufficient insurance risk to qualify as an
insurance contract only if there is a reasonable possibility that an event affecting the policyholder or
other beneficiary will cause a significant change in the present value of the insurer’s net cash flows
arising from that contract.

Adequacy of Insurance Liabilities

PFRS 4 imposes a liability adequacy test, which requires that at each reporting date the “insurer” must
assess whether its recognized insurance liabilities are adequate, using then-current estimates of future
cash flows under the outstanding insurance contracts. If as a result of that assessment it is determine
that the carrying amounts of insurance liabilities is insufficient given the estimated future cash flows,
the full amount of such deficiency must be reported currently in earnings.

The minimum requirements for the adequacy test are that:

1. The test considers the current estimates of all contractual cash flows, and of such related cash
flows as claims handling costs, as well as cash flows that will result from embedded options and
guarantees.
2. If the test shows that the liability is inadequate the entire deficiency is recognized in profit or
loss.

In situations where the insuring entity’s accounting policies do not require a liability adequacy test, or
provides for a test that does not meet the minimum requirements above, then the entity is required to:

1. Determine the carrying amount of the relevant insurance liabilities, less the carrying amount
of:
a. Any related deferred acquisition cost; and
b. Any related intangible assets, such as those acquired in a business combination or
portfolio transfer.
2. Determine whether the carrying amount of the relevant net insurance liabilities is less than
carrying amount that would be required if the relevant insurance liabilities were within the
scope of PAS 37.

PAS 37 based amount is the required minimum liability to be presented. Therefore, if the current
carrying amount is less, the insuring entity must recognize the entire shortfall in current period
earnings. The corresponding credit to this loss recognition will either decrease the carrying amount of
the related acquisition costs or related intangible assets or increase the carrying amount of the
relevant insurance liabilities, or both, dependent upon the facts and circumstances.

Reinsurance Contract

An insurance contract issued by one insurer (the reinsurer) to compensate another insurer (the cedant)
for losses on one or more contracts issued by the cedant.

Cedant is the policyholder under a reinsurance contract.

Impairment Testing of Reinsurance Assets

When an insuring entity obtains reinsurance (making it the cedant), an asset is created in its financial
statement. As with other assets, the reporting entity must consider whether an impairment has
occurred as of the reporting date. A reinsurance asset is impaired only when there is objective
evidence that the cedant may not receive all amounts due to it under the terms of the contract, as a
consequence of an event that occurred after initial recognition of the reinsurance asset, and
furthermore, the impact of that event is reliably measurably in terms of the amounts that the cedant
will receive from the reinsurer.

When the reinsurance asset is found to be impaired, the carrying amount is adjusted downward and a
loss recognized in current period earnings for the full amount.

Unbundling

Unbundling refers to the accounting for components of a contract as if they were separate contracts.
Some insurance contracts consist of an insurance component and a deposit component PFRS 4 in some
cases requires the reporting entity to unbundle those components, and in other instances provides the
entity with the option of unbundled accounting. Specifically, unbundling is required if both the
following conditions are met:

1. The insuring entity can measure the deposit component (inclusive of any embedded surrender
options) separately; and
2. The insuring entity’s accounting policies do not otherwise require it to recognize all obligations
and rights arising from the deposit component.

On the other hand, unbundling is permitted, but not required, if the insuring entity can measure the
deposit component separately but its accounting policies require it to recognize all obligations and
right arising from the deposit component, regardless of the basis used to measure those rights and
obligations. Unbundling is prohibited if an insuring entity cannot measure the deposit component
separately.

Disclosure

Under the provisions of PFRS 4, ensuring entities must disclose information that identifies and explains
the amounts in its financial statements arising from insurance contracts. This is accomplished by
disclosure of accounting policies for insurance contracts. This is accomplished by disclosure of
accounting policies for insurance contracts and related assets, liabilities, income and expense; of
recognized assets, liabilities, income and expense (and, if it presents its statement of cash flows using
the direct method, cash flows) arising from insurance contract. Additionally, if the insuring entity is a
cedant, it must also disclose gains and losses recognized in profit or loss on buying reinsurance; and if
the cedant defers and amortized gains and losses arising on buying reinsurance, the amortization for
the period and the amounts remaining unamortized at the beginning and end of the period.

Disclosure is also required of the process used to determine the assumptions that have the greatest
effect on the measurement of the recognized amounts described above. When practicable, quantified
disclosure of those assumptions is to be presented as well. The effect of changes in assumptions used
to measure insurance assets and insurance liabilities is required, reporting separately the effect of
each change that has a material effect on the financial statements.

Finally, reconciliation of changes in insurance liabilities, reinsurance assets and, if any related deferred
acquisition costs are mandated by PFRS 4.

Regarding the amount, timing and uncertainty of cash flows, the entity is required to disclose
information that helps users to understand these matters as they result from insurance contracts. This
is accomplished if the insuring entity discloses its objective in managing risks arising from insurance
contracts and its policies for mitigating those risks.