As part of an audit team of Alpha Inc., a U.S. listed company, that is the parent of Stella Co., its 100%-owned Chinese subsidiary, you have been assigned to analyze the following information about sales transactions of Stella Co., and to answer these questions.
Background on Stella Co. and its sales transactions
Stella Co. is a manufacturer of active and passive communications equipment located in Shenzhen, China. It sells its products to all of the major Chinese Communication Carriers (CCC). The CCC is an oligopoly made up of five companies: China Telecom, China Netcom, China Mobile, China Unicom and Orbit Mobile. The CCC are all partially owned and operated by the Chinese government. About half of Stella’s revenues are generated through sales to the CCC.
Due to the significant size and market share of the CCC, the companies within the oligopoly dictate all aspects of their relationship with Stella. These customers do not place formal purchase orders or provide signed contracts prior to initiating an order with Stella. Instead, these customers have in place with Stella approved and enforceable frame agreements that identify the rights and obligations of the parties. Although the frame agreements do not specify fixed prices, they specify general payment terms that include probable discount on quoted price and a payment period of up to six months from product delivery.
Customers within the CCC will place an order for product by calling in a verbal order, sending a text message, or sending an e-mail to Stella sales representative. A price is quoted by Stella when the order is placed. The actual price will be negotiated and specified in the final contract. The actual price has historically been four to six percent less than the price quoted when the order was initially placed. Stella’s record indicates an equal probability of price discount anywhere between four and six percent. It may take up to three months for an agreement with a fixed sales price to be signed (“chopped” is the term used in China) by both parties.
These customers often demand shipment from Stella within three to 10 days after placing an order. Stella often ships products before an agreement is chopped. The products are shipped to the customer’s warehouse. Stella requests a signed delivery confirmation document and also requests that the agreement is chopped when product is received. However, the customers tend to ignore Stella’s requests about signed delivery confirmation, and defer chopping the agreement for up to three months.
The customers in the CCC have a history of paying for their equipment purchases about two months after the agreement is chopped. Thus, payment is received by Stella an average of five months after shipments are received by the customer. The standard customer-payment period for Alpha, Stella’s parent, is only one to two months after shipments. Stella’s other customers also follow this standard payment period. The CCC rarely returns products and the return rate is negligible.Stella prepares its financial statements according to Chinese GAAP as issued by the Chinese Ministry of Finance (MOF). The MOF has been working towards developing accounting standards that are convergent with IFRS since the early 1990s. Chinese GAAP is comprised of the Basic Standard and 38 specific Accounting Standards for Business Entities (ASBEs). The MOF has converged many of the ASBEs with the IFRS standards. For example, the IFRS revenue standard, IAS 18, was fully adopted and incorporated into Chinese GAAP as ASBE 14 in 2001. As a result, the Chinese revenue standard is equivalent to the IFRS revenue standard, IAS 18. While Chinese GAAP is not in complete compliance with IFRS GAAP (i.e. China has not fully adopted IFRS GAAP), its standards are considered to be substantially converged with IFRS GAAP. The EU Commission allows Chinese issuers to use Chinese GAAP when they enter the EU market without adjusting their financial statements in accordance with IFRS endorsed by EU.[1]
Alpha, Stella’s parent, currently issues its consolidated financial statements in accordance with U.S. GAAP. In addition, Alpha is required to report to the Chinese government annual revenue of its subsidiary, Stella, using IFRS. As the FASB and the IASB issued a joint revenue recognition standard in May 2014, Alpha will be required to use the revenue recognition standard when it becomes effective.
Required:
Apply the “currently effective” IFRS (IAS 18) revenue recognition criteria to Stella’s sales transactions to determine when revenue can be recognized. Provide explanation/justification for how you apply each criterion to Stella’s sales transactions.
Discuss transition methods of this new revenue standard, i.e., how an entity should apply this new standard for the first time. Which transition method do users/investors of financial statements likely prefer? Why?