Warmth Home Comfort Limited - Ifrs

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If the effect of the time value of money is material, then the estimate made should be discounted at a pre-tax rate that reflects the time value of money and the risks specific to the provision. IFRS requires that the estimate be remeasured at each reporting period based on the best estimate of the settlement amount.

There are also potential additional liabilities from the health hazards associated with the damaged units. It is virtually impossible to estimate the potential cost of these liabilities since no claims have been made to date and we are not even sure of the number of furnaces affected. As a result, it is not possible to accrue this liability. We should consult independent experts to report on the potential health hazards caused by the damaged furnaces. However, WHCL likely has a contingent liability (IAS 37). A contingent liability is disclosed, and not recognized. Disclosures include the nature of the contingency and, when practicable, the estimated financial effect and indication of uncertainties.

The warranty liability could have a short-term provision (current liability) and long-term provision element, depending on the length of time that the repairs will have to be made. WHCL would prefer to have more of the amount classified as a long-term liability to minimize the impact on the current ratio. The effect on the debt-to-equity ratio is the same regardless of the classification as current or non-current. If the company plans to fix units over the next few months, then the liability should be classified as a short-term provision (current liability).. We should examine the company’s action plan to determine how it is planning to proceed.

If WHCL was aware of this liability at the time it sold the furnaces but failed to accrue it, the accrual could be accounted for retroactively as a correction of an error. If it is proved to be an error, there would be no impact on 2000 income, and therefore no impact on the current ratio. However, the debt-to-equity ratio would be adversely affected since equity would be reduced as a result of the correction.

Research and development

WHCL has been developing a new technology for heating office buildings. Management believes that the technology is ready for market—all that is needed is additional financing of between $150,000 and $200,000. That financing is not yet in hand and negotiations are ongoing. One of the conditions for capitalizing development costs under IAS 38, Paragraph 57 (e) is “the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset” i.e., adequate financial resources must be available to complete the project. WHCL is clearly in need of funds, which suggests that the development costs should not be capitalized. However, there is a potential lender and negotiations with the lender, according to management, have a good chance of being successful, which supports capitalization.

Clearly, WHCL will want these costs to be capitalized. If they are expensed in 2000, the company will be in violation of the debt-to-equity covenant. As a result, management has an incentive to overstate the likelihood of obtaining the needed financing. We will have to examine documents related to the negotiations to determine whether the funding is likely. It is possible that the issue will be resolved before we have to sign off on the statements. A determination of the likelihood of the availability the funds will be required. We will also need to make sure that the other criteria for capitalizing the development costs are met. i.e. IAS 38, paragraph 57 states: “An intangible asset arising from development (or from the development phase of an internal project) shall be recognised if, and only if, an entity can demonstrate all of the following:

(a) the technical feasibility of completing the intangible asset so that it will be available for use or sale.

(b) its intention to complete the intangible asset and use or sell it.

(c) its ability to use or sell the intangible asset.

(d) how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.

(e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.

(f) its ability to measure reliably the expenditure attributable to the intangible asset during its development.”

We will have to check whether a market actually exists for the product—examining any marketing studies will help in this regard. We will need to examine a cost analysis to determine whether the product has the ability to generate probable future economic benefits once the additional costs are considered.

We also need to ensure that the costs included in the development costs are properly classified. Management could try to “hide” unrelated costs among the development costs to reduce expenses. We need to determine how costs were segregated from the ordinary operating costs of the business and whether the basis for charging costs to the project is reasonable. Similarly, how were allocated costs such as amortization charged to the project? Amortizable assets used exclusively on the project are not a problem, but the costs for assets that are used only in part for the project need to be examined carefully. We also need to determine whether the interest charged to the project is for funds specifically borrowed for the project, in which case the charge is appropriate, or whether the interest is an allocation of interest, in which case we need to assess the reasonableness of the basis of allocation which must be calculated using the weighted average cost of borrowings.

In addition, we need to find out what Amortization of product Development is. Amortization has been shown as a separate charge on the face of the balance sheet and income statement. This seems to suggest that the product under development is being amortised. Considering that the product is still under development, amortization would begin only when it is available for use. It may possibly be available for use in fiscal 2000, however would not be for fiscal 1999.

Fixed price contract

In January 2000 WHCL won a fixed price contract to supply heating and air conditioning for a large