no 2 hirsch et al income statements for sales contracts according to ifrs

8/3/2019 No 2 Hirsch Et Al Income Statements for Sales Contracts According to Ifrs

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Income statements for sales contracts according to IFRS

Problems of application and assessment from a cost-theoretical per-

spective

1 IntroductionSales transactions and customers are core elements of a companys business activity. Sales

contracts provide the legal basis for such transactions: they determine the terms of exchange

and thereby form the basis both for receiving revenue from the sale and for the costs incurred

in providing the product or service. As a companys profit and loss can effectively be seen as

the sum of income contributions of all the individual business transactions, income statements

for individual sales agreements can play a vital role in determining profitability. This applies

equally for financial accounting and cost accounting.

Today, many companies base their financial (group) accounting on the International Financial

Reporting Standards (IFRS).1

The IFRS prescribe different accounting rules for different

types of sales agreements, which in turn affects how the income statements used for different

type of sales agreements are calculated. This paper focuses on sales contracts governing con-

struction contracts (IAS 11) and the rendering of services (IAS 18).2

For both types of sales

contracts, the IFRS specify - amongst other aspects - that they should regularly be evaluated

in respect of potential losses (negative income contributions) resulting from the agreements,

which can lead to accounting for provisions for impending losses.

As a general observation, such negative income contributions result when the value of the

goods and services required to be supplied in terms of the agreement (costs) exceeds the value

of what is received in exchange (revenue). This general definition may as observed in prac-

tice by the authors lead to problems in valuing the income derived from individual sales

agreements (and thereby the provision for impending losses). In the main, such problems re-

sult from the fact that the amount of costs to be included in the income statement is not gov-

1In Germany, it was EU regulation No. 1606/2002 in particular that contributed to this development. It

requires capital market oriented parent companies to complete their group accounting according to IFRS

for financial years beginning after 31 December 2004. Cf. Pellens et al., 2006, p. 49.2 This paper does not consider sales contracts for goods (not resulting from custom orders) or sales con-

tracts for leasing companies, where accounting has to follow the regulations of IAS 17.


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erned unambiguously in all cases by the setter of standards. In individual cases, this may even

result in a positive income contribution (profit) or negative income contribution (loss) being

calculated for the very same sales agreement depending on the approach used and the

amount of costs included.

On the one hand, this paper aims to systematically detail the above-mentioned problems of

application. On the other hand, we present a proposal based on IFRS regulations and cost the-

ory that shows which range of costs3

should be used to valuate the sales agreements men-

tioned previously in accordance with the provisions of the IFRS.

The paper is structured as follows. In section 2, we provide an overview of the relevant ac-

counting regulations for construction and service contracts according to IFRS and highlight

gaps in the interpretation of the guidelines. Next, we develop a theory-based proposal in Sec-

tion 3 that proposes a contribution to closing the gaps described in Section 2. In Section 4, we

provide a concrete valuation example in order to explain our approach. Section 5 positions our

approach within the current context of accounting research.

2 Income statements for construction and service contracts according to IFRS2.1 Basic accounting regulationsIn accordance with IAS 11, IFRS understands construction contracts to mean contracts spe-

cifically negotiated for the construction of an asset or a combination of assets that are closely

interrelated or interdependent in terms of their design, technology and function or their ulti-

mate purpose or use. According to this definition, the central characteristic of construction is

that assets are produced specifically to meet customer requirements as defined in a contract.

This criterion differentiates construction from the manufacture of goods for anonymous mar-

kets.4

Construction contracts often govern large-scale building projects of material assets,

such as building bridges, pipelines or tunnels (IAS 11.3 and following).

5

Accounting for such contracts is governed by IAS 11. The core concept of this standard is the

so-called percentage of completion (PoC) method. According to the PoC method, total reve-

nue and costs of a construction contract are captured on every closing key date in proportion

3 The revenue side is not considered in depth; however, calculating this aspect of the income contributions

of individual sales contracts creates significantly fewer problems in practice.4 Regarding this differentiation, cf. IDW RS HFA 2, Tz. 1.

5 Cf. also Adler/Dring/Schmaltz, 2006, section 16, Tz. 6.


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to the degree of completion6.7

In other words, the profit resulting (or expected) from the over-

all project is captured on a pro rata basis even before the project has been completed (IAS

11.22 and following).

In contrast to construction, the rendering of services is not aimed at creating an asset (IAS

18.4). Typical examples of services i]nclude consulting, medical, cleaning, transportation and

other services.8

IAS 18 specifies how sales revenue resulting from such sales agreements

should be accounted for. These regulations are also based on the PoC method.9

In respect of

revenues, costs, and profit, IAS 18 is thereby based on the same fundamental approach for

service transactions as is used for construction contracts according to IAS 11 (IAS 18.20 and

following).

2.2 Regulations concerning income statements2.2.1 ConstructionAs has become clear from the above overview of basic accounting regulations, income state-

ments are of critical importance for construction contracts in the context of the PoC method.

This is the case because project income is reflected in proportion to the degree of completion

in the profit and loss statement even before the corresponding project has been completed.

Correspondingly, the two components of income from a construction contract contract reve-

nue and contract costs are described comprehensively in IAS 11. On the one hand, contract

revenue according to IAS 11.11 encompasses the contractually agreed upon payment for con-

struction. On the other hand, it reflects likely and clearly definable adjustments resulting from

(subsequent) changes to the scope of the contract, for reimbursement of costs incurred by the

contractor and not anticipated in the contract, as well as incentives or bonuses (e.g. for finish-

ing the contract ahead of schedule).10

6 On the calculation of the degree of completion, cf. IAS 11.30 and IDW RS HFA 2, Tz. 15.

7However, this requires certain conditions to be fulfilled regarding the uncertainty connected with a con-

struction contract as well as valuation problems (IAS 11.23). On this topic, cf. also Pellens et al., 2006,

pp. 368.

8 Regarding the differentiation between services to which IAS 18 applies from products or services subject

to IAS 11, cf. Adler/Dring/Schmaltz, 2006, section 4, Tz. 12 and 14.

9Here, too, certain conditions have to be fulfilled, which are similar to those for construction contracts in

IAS 11.

10Cf. IAS 11.12 and the following clauses for more detail. Whereas calculating contract revenue may be

problematic in individual cases (especially regarding components of the clients performance which are

uncertain on the closing date), this paper focusses on the calculation of contract costs.


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According to IAS 11, contract costs include the following (IAS 11.16):

- Costs which can be directly allocated to a construction contract,- costs which can be allocated to activities related to the companys construction con-

tracts in general and which can be divided up between individual contracts,- other costs which can be charged to the customer on the basis of conditions agreed

upon in the contract.

IAS 11 mentions some examples of costs that can be directly allocated to a construction con-

tract, such as project specific labor costs including project supervision costs, costs for materi-

als, and costs incurred through the usage of equipment for a specific contract. Contract acqui-

sition costs can usually also be included in the category of costs that can be directly allocated

to a contract; however, these should only be included in the contract costs if they can be

measured separately and reliably and if it is likely that the contract will be concluded (IAS

11.21).

According to the IASB, costs which can be allocated on a general basis to activities related to

construction contracts and which can be divided up between individual contracts include in-

surance costs and production overheads (such as the costs for working out the payroll of em-

ployees working to produce the goods and services for the contract, IAS 11. 18). Conversely,

general administration and distribution costs as well as research and development costs not

directly related to the contract are mentioned as examples of costs that cannot be allocated to

specific construction contracts.11

Costs which can be allocated on a general basis to contract activities should be allocated to

the individual contracts based on systematic and reasonable methods. The distribution of costs

has to reflect a normal capacity load (IAS 11.18).12

The scope of contract revenue and contract costs13

described above determines income state-

ments for construction costs according to IAS 11 and thus the way they are accounted for in

terms of the PoC method (see section 2.1). Referring to other IFRS regulations in this context

11 For these costs, there may be no reimbursement agreements with the customer because the corresponding

costs would otherwise be part of his contract costs (IAS 11.19).

12 Cf. also IDW RS HFA 2, Tz, 6.

13 Regarding the scope of costs and individual cost components which have to be taken into account, cf. also

Adler/Dring/Schmaltz, 2006, section 16, Tz. 82.


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such as the general regulations on accounting for provisions for impending losses in IAS 37

is therefore neither necessary nor permissible in terms of the regulations (IAS 8.7).14

Should it become likely no matter at which point in time that the total costs resulting from

the contract (the sum of those already incurred plus those expected) exceed the total revenue,then this difference (the expected loss) has to be captured not in proportion to the degree of

completion, but rather in full and without delay (IAS 11.36). The corresponding loss amount

has to be reflected in the active or passive balances from construction contracts on the balance

sheet.15

2.2.2 Service transactionsIn contrast to IAS 11, IAS 18 for service transactions does not provide detailed instructions

concerning the range of revenues and costs to be accounted for in terms of the balance sheet.

In IAS 18, revenue is defined broadly as the gross inflow of economic benefits during the

period arising in the course of the ordinary activities of a company when those inflows result

in increases in equity, other than increases relating to contributions from equity participants

(IAS 18.7). This definition is also relevant for revenue from service transactions (IAS 18.20).

Regarding the costs to be accounted for in terms of the PoC method (see section 2.1), IAS

18.20(d) only states that the costs incurred and the costs to complete the transaction shouldbe considered; however, this does not explain which amount of costs to take into account. IAS

18.21 does note that IAS 18, like IAS 11, is based on the PoC method, and continues: The

requirements of that Standard [referring to IAS 11, the authors] are generally applicable to the

recognition of revenue and the associated expenses for a transaction involving the rendering

of services.16

However, it is not clear whether this reference applies only to the fundamental applicability of

the PoC method (e.g. regarding the basic approach to accounting for revenue and costs and

determining the degree of completion) or also to all other regulations in IAS 11 (such as the

range of associated expenses (IAS 18.21) and accounting for provisions for impending

losses). It is precisely this question that is relevant in practice for deciding whether a service

contract may result in a loss, which would have to be recorded by capitalizing the provision

for impending losses.

14

Cf. ibid., Tz 132 and section 18, Tz. 149.15 Cf. ibid., Tz. 133. Cf. also IDW RS HFA 2, Tz. 17.

16 IAS 18.21.


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The relevant sections of IAS 37 deserve attention as a potential alternative to the (complete)

consideration of IAS 11 in relation to determining the costs of a service transaction (and

thereby the (potentially negative) income resulting from it). Among other elements, this stan-

dard contains regulations on how to account for provisions for impending losses. Its scope in

respect of these regulations is not limited to specific types of business transactions, but it does

point out that corresponding regulations in other standards enjoy precedence if they are appli-

cable (e.g. IAS 11 for construction contracts, IAS 37.5(a)). IAS 37 provides no reasons to

prevent it from being applied to service contracts according to IAS 18; also, the IASB does

not appear to preclude those rendering services from applying the regulations in IAS 37 to

determine whether or not a service contract may result in a loss (IFRS 4.B7(c)).

Pursuant to IAS 37 and corresponding to the regulations on accounting for provisions for im-pending losses, unavoidable expenses for fulfilling contractual obligations have to be taken

into consideration when calculating income from a contract. This figure is in turn defined as

the smaller amount of that which the company would have to pay if it withdraws from the

contract (penalties, damages etc.) and that which it would have to pay if completing the trans-

action (IAS 37.68).17

However, contract fulfillment costs are not specified in any further detail in IAS 37. More

specifically, the regulations in contrast to those relating to construction contracts in IAS 11(see above) do not indicate how one should deal with costs that can be allocated in different

ways in respect of a specific contract.

In order to resolve this problem, the scope of costs relevant according to IAS 37 should be

determined by making use of the concept of unavoidable costs related to contract fulfill-

ment. In this context, the English language IFRS literature proposes to concretize this cost

concept as costs that are directly variable and incremental to the performance of the con-

tract18

, i.e. incremental costs; unavoidable costs should therefore not contain any allocation

of costs incurred independently of the contract and may not contain elements which could be

avoided through future actions of the company.19

17On this topic, cf. also Adler/Dring/Schmaltz, 2006, section 18, Tz. 146. As the problem of how to allo-

cate individual costs (or cost categories) being incurred within the company itself with regard to a con-

crete sales transaction usually does not occur when calculating the costs resulting from withdrawing from

a contract, we will focus exclusively on contract fulfilment costs in the following.18 KPMG, 2007, Tz. 3.12.640.40.

19 Cf. ibid., Tz. 3.12.660.30.


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To summarize, calculating income from service transactions according to IAS 18 is in con-

trast to construction contracts currently not clearly defined in the IFRS, at least as regards

the cost side of calculating income. This has crucial consequences for accounting for provi-

sion for impending losses for such transactions. Until this point has been clarified by the

IASB, companies accounting according to IFRS can make use of the following permissible

approaches:20

a) Complete recourse to IAS 11 including the amount of costs to be used in determiningincome as specified there

b) Applying the regulations in IAS 37 to determine provision for impending losses withreference to the unavoidable costs from a service transaction

For companies deciding to use approach b) to determine the amount of costs, we will show in

the following that the above mentioned relationship or equation of unavoidable costs ac-

cording to IAS 37 with incremental costs from the perspective of cost accounting literature

can be justified (section 3.1). On this basis, the concept of incremental costs, which is little

used in German language cost accounting literature, will be concretized with reference to the

concept of decision oriented costs as developed by R IEBEL (section 3.2). This analysis pro-

vides a basis for developing more concrete specifications for determining provision for im-

pending losses, as will be shown in chapter 4.

3 Concretizing the amount of costs according to IAS 37 on the basis of cost theory3.1 Unavoidable costs as incremental costsEnglish language cost accounting literature defines 'incremental costs as additional costs to

obtain an additional quantity, over and above existing or planned quantities, of a cost ob-

ject21

. This definition implies that additional costs are incurred when an additional unit of a

specific cost object is produced. The relevance of the additionally producedunit is made evenclearer by HEALDS definition of incremental costs: Incremental Cost is defined as the in-

crease in cost associated with producing a second output in addition to a first output.22

20 Cf. ibid., Tz. 3.12.640.40. The company drawing up a balance sheet has to choose one of the two ap-

proaches and apply it to all similar business transactions in accordance with IAS 8.13.21 Horngren et al., 2005, p. 307.

22 Heald, 1996, p. 58.


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GLEIM/FLESHER choose a similar approach. They define incremental costs as the difference

in total costs between two decisions.23

Semantically speaking, BACKER and JACOBSENS definition of incremental costs approaches

the term unavoidable costs as used in IAS 37.68 even more closely. They define incre-mental costs as costs, which would not be incurred if a particular project is not undertaken.

They are thus avoidable costs. [Emphasis by the authors]24

According to this definition, the

incremental costs of a contract are those which would be avoided if the contract were notcon-

cluded.

On the basis of this definition, equating unavoidable costs according to IAS 37 with incre-

mental costs would be justified if the unavoidable costs mentioned in IAS 37.68 correspond

to avoidable costs according to BACKER und JACOBSENS definition. This correspondence

can be established if one assumes that the unavoidable costs' in IAS 37.68 are costs that be-

come unavoidable as a result of the corresponding transaction/service contract being entered

into, for it is precisely these costs that were avoidable' before the transaction.

As there appear to be no strong reasons contradicting the assumption mentioned above regard-

ing the term 'unavoidable costs' as used in IAS 37, it seems appropriate to interpret the un-

avoidable costs mentioned in IAS 37.68 as avoidable costs according to BACKER und

JACOBSENS definition and therefore as incremental costs.

This conclusion by analogy, whereby unavoidable costs are equated with incremental costs,

can only provide a first approach towards defining the cost concept according to IAS 37 more

precisely on the basis of theory if the definition of incremental costs permits a more accurate

way to be found for determining provision of impending losses for sales contracts. It is there-

fore necessary at this stage to establish a more precise understanding of the incremental prin-

ciple as a basis for determining costs.

23 Gleim/ Flesher, 2006, p. 82. By introducing decisions as the element which causes costs, the level of cost

causation becomes relevant in addition to the above-mentioned definition. The term incremental costs isnot found at first in standard U.S. cost accounting literature. Cf. McRae, 1970, p. 317. McRae lists several

such sources as evidence, e.g. c.f. Fraser, 1937, Edwards/Bell, 1965, Mattesich, 1964, Horngreen, 1965,

Nemmers, 1962. Definitions of incremental costs start appearing and evolving from 1964. Cf. ibid. For

these definitions, cf. Mathews, 1962, p. 422, Moore/Jaedicke, 1963, p. 107, Anthony, 1964, p. 571,

Spencer/Seigelman, 1964, p. 305, Wasson, 1965, p. 9, Carrington/Battersby, 1967, p. 299. After McRae

had discussed a systemic perspective and a link to opportunity costs with his contribution on the defini-tion of incremental costs in 1970, further commentary followed on his writings. This is referenced in the

following, but the discussion will not be analyzed in greater detail at this point. The role of opportunity

costs will also not be subjected to further discussion because, as will be shown, they are no longer men-

tioned in connection with incremental costs in more recent literature. Cf.. Burch/Henry, 1974, pp. 118,McRae, 1974, pp. 124.

24 Backer/Jacobsen, 1964 in connection with Wixon/Kell/Bedford, 1970, p. 76.


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An important concept in decision oriented cost accounting in the USA, the idea of 'incre-

mental costs is built on the incremental principle. Decisions always require comparisons of

alternatives. [] These differences are referred to as differentials or increments; the require-

ment that data for decisions should be estimates of increments is called the incremental prin-

ciple.25

The comparison of alternatives as a precondition for decisions is mentioned as a

starting point for the incremental principle. In this context, incremental costs are often de-

scribed as cost (changes) that result directly from a decision, or change as a result of a deci-

sion.26

This in turn makes it clear that it is the reference object on the one hand and the under-

lying, cost-causing decision on the other hand that are the two significant parameters for de-

termining incremental costs.

This knowledge of the core elements of incremental costs needs to be defined in greater de-tail. In the following, we will review the German language cost accounting literature regard-

ing potential definitions or approaches that could be used to establish a more precise under-

standing of the unavoidable costs mentioned in IAS 37.68 from a cost accounting viewpoint.

3.2 Decision oriented costs as unavoidable costsIn contrast to English language cost accounting literature, which tends to focus on practical

applications, the concept of costs is (traditionally) at the center of theoretical discussions in

German language cost accounting literature, both in relation to cost accounting and financial

accounting27

.28

In order to establish a more precise understanding of incremental costs, the

concepts of avoidable costs or incremental costs first need to be placed into context within

the logic of cost concepts according to German language literature. It is worthwhile to note

that no standard German textbook on cost accounting explicitly addresses the concept of in-

cremental costs.29

25Shillinglaw, 1983, p. 38-2.

26Cf. ibid., p. 38-4.

27 Weber/Weienberger state that terms such as costs could be dispensed with in the area of financial ac-

counting. However, costs are already an integral part of the relevant accounting regulations, such as sec-tion 255 of the German Commercial Code (HGB), which mentions purchase and manufacturing costs. Cf.

Weber/Weienberger, 2006, p. 47.

28 Business costs are defined as the purposeful consumption of goods during an accounting period, ex-

pressed in monetary terms. Homburg, 2002, col. 1051, and similarly Weber/Weienberger, 2006, p. 48

and also Hoitsch/Lingnau, 2002, p. 16. Homburg elaborates that factor consumption is defined by the

amount-related component of the definition provided above. As a consequence, valuating it is also of cen-

tral interest. Cf. ibid., cf. similarly Schweitzer/Hettich/Kpper, 1975, p. 34 and cf. Ewert/Wagenhofer,

2005, p. 80.

29However, the term marginal or incremental costs is addressed. With regard to capital costs, the term in-

cremental is translated as Grenz (marginal) in the official translation of IAS 17.4. Cf. IAS 17.4.


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The principle of decision oriented costs30

, which goes back to RIEBEL, is useful in creating a

more precise understanding of the idea of incremental costs.

According to this principle, costs are additional uncompensated payments and expendi-

tures with credit balances that are caused by decisions taken in relation to the object underconsideration.

31According to this definition, the element that causes costs to be incurred is a

so-called initial decision.32

Signing a sales contract is one example of such an initial decision.

In contrast to KOSIOL33

, RIEBEL assumes that no causal or final relationships can exist be-

tween objects to which costs are allocated on the one hand and the goods to which the prod-

ucts or services which have been provided are allocated on the other hand. Instead, he pro-

poses that decisions are the true source of costs in a company. Accordingly, costs can only be

allocated on the basis of the so-called identity principle.34

According to the identity principle,

costs can only be allocated unambiguously and necessarily to an object under consideration

if the existence of this object was caused by the same decision as the costs which are to be

allocated.35

RIEBEL labels costs which can be allocated in this way as true direct costs,

which may be allocated only to the reference object and therefore to the cost unit.36

In relation to the allocation object, direct costs have to be allocated directly to the correspond-

ing object, whereas overheads are allocated indirectly to it. According to RIEBEL, direct costs

are costs which can be unambiguously allocated to a reference object which has to be de-

fined precisely regarding its nature and duration because both the costs (expenses) and the

30The decision oriented cost concept is an evolution of the cash-based cost concept. Koch,1958,p. 361,

understands cash-based costs to mean the uncompensated expenses related to the manufacture and sale

of one production unit or to a period, ibid. In contrast to the value-based cost concept, it is the purchase

price that determines the cost value in the case of the cash-based cost concept. The value-based definition

of costs originating with Schmalenbach is characterized by three criteria: there has to be trade in goods;

the trade in goods has to be related to performance (a concrete objective); and the trade in goods has to be

subject to valuation. On this topic, cf. Schmalenbach, 1963, p. 141.

31

Riebel, 1994, p. 15. This definition is identical to the exact definition of true direct costs. Cf. Riebel, 1992,p. 262.

32Cf. Riebel, 1990, p. 423.

33Cf. Kosiol, 1969, pp. 27.

34 Cf. Riebel, 1972, p. 272.

35 Ibid.

36 Cf. Haberstock, 2004, p. 51. Calculating costs based on the principle of causation or identity becomes

problematic when it is impossible or difficult to capture them on the basis of the criteria of these two prin-

ciples. If one needs to include costs that cannot be captured using one of the two principles described

above, one can use the average or load capacity principle. The literature provides further principles for

distributing costs, such as the proportionality principle and the cost allocation principle. These two princi-ples will not be examined in further detail here; for more information, cf. e.g. Schweitzer/Kpper, 1995,

pp. 90. A further principle, mentioned only for reasons of completeness, is the performance correspon-

dence principle according to Koch. Cf. Koch, 1966.


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reference object result from a common decision.37

To aid understanding, RIEBEL provides a

number of test questions in order to ensure that the concept of direct costs according to his

definition is not diluted by unclear categorization: Which costs would be eliminated if the

reference object were eliminated? Which additional costs would be incurred if an additional

unit of the reference object existed? Can the cost changes and the reference object be linked

back to the same (initial) decisions?38

If one takes into account that the relevant reference object for establishing provisions for im-

pending losses according to IAS 37 in this sense is an individual (sales) contract, these ques-

tions directly help to concretize the concept of unavoidable costs and also help to calculate

them in specific cases. The questions aim at the consequences of an entrepreneurial or man-

agement decision, e.g. accepting a contract, and identify the costs which have become un-avoidable as a result of the decision.

3.3 Interim conclusionStrong arguments can be found with the help of the English language cost accounting litera-

ture for interpreting unavoidable costs according to IAS 37 to mean 'incremental costs'. In

turn, these can be specified more precisely from the perspective of RIEBELS direct cost ac-

counting, which is based on a decision oriented concept of costs; the identity principle which

is an element of this concept matches the idea of incremental costs. In accordance with this

principle, the key characteristic for determining incremental costs is a decision concerning a

specific reference object as the only relevant cost causing element.

This is why all costs, such as those related to a specific contract, are reviewed with regard to

the question of whether they can be linked back to the originating decision (e.g. acceptance of

the contract). The amount of costs relevant for evaluating provision for impending losses can

be determined by means of this process.

In other words, if the costs directly related to the initial decision according to R IEBELS crite-

ria are extracted on the basis of RIEBELS test questions the principle of incremental

37 Riebel, 1994, p. 762.

38 Cf. Riebel, 1994, p. 762. In addition to the original defintion of direct costs, RIEBEL coined the term rela-

tive direct costs. This refers to all those direct costs which cannot be allocated directly to an allocation ob-

ject (product), but can indeed be directly allocated to a cost center. He also refers to these direct costs as

false direct costs or as seemingly direct costs. Cf. ibid., p. 619. In contrast to the direct costs just de-

fined according to RIEBEL, overheads are defined as the costs which affect the accounting object underconsideration and others jointly insofar as they cannot be separately captured even if the best capturing

methods for the object under consideration are employed, and which also cannot be allocated to it on the

basis of the identity principle. Ibid., p. 760.


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costs as used in IAS 37 has been taken into account. Furthermore, the incremental costs

calculated in this way can be transposed to the concept of variable direct costs (in relation to

the corresponding reference object) according to RIEBEL, which is more commonly used in

German language cost accounting literature.

The example provided in the following chapter aims to show which effects applying the in-

cremental principle in practice would have when valuating sales contracts for cost accounting

purposes.

4 Case study to illustrate the concept4.1 Background information on the caseA is a logistics company that owns a railway line between Station 1 and Station 2, on which itrenders passenger transportation services. B is a consulting company whose employees are

characterized by their high degree of site flexibility and mobility. A and B sign a contract

specifying that Bs employees are entitled to cover a total of one million kilometers on As

railway network and on all of As trains (regular service) during the next year. Bs employees

enjoy priority over other customers, meaning that they are guaranteed a seat on any train they

choose. For this service, B pays A a flat fee of 2 million. The contract does not oblige A to

maintain a certain service level (e.g. guaranteeing a minimum number of train connections on

the line) or to employ special trains for B. A expects that B's employees will make use of the

total one million kilometers of transport services. At the same time, based on its internal load

schedule, A does not anticipate that priority for Bs employees will mean that other passen-

gers will not be able to be transported. It is also not considered to be necessary to use addi-

tional trains to be able to fulfill the contract with B.

As a simplifying assumption, it is understood that all connections between Station 1 and Sta-

tion 2 are end to end connections, in other words, there are no stops en route. Calculations byAs controller resulted in the following figures:


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4.2 Calculating unavoidable costs according to IAS 37 for the initial scenarioIn order to calculate unavoidable costs, one first has to determine whether or not the relevant

allocation/reference object from As perspective when applying IAS 37 is the contract with B.

(Other allocation objects could be, for instance, the train connection between the two stations,

company A, a single train trip or a single passenger.)

In accordance with RIEBELS decision oriented perspective, the conclusion of a contract be-

tween A and B is the decision that has to be taken as the causal source of all relevant costs.

Based on this, the amount of the incremental costs can be determined by answering R IEBELS

test questions, as described in section 3. The following two questions are relevant for this ex-

ample:

1. Which costs would be eliminated if the contract with B were eliminated?

2. Can the cost changes and the contract be linked back to the same (initial) decision?39

If one applies the first question to each of the cost categories shown in the table above, one

would reasonably conclude on the basis of the information available on the contract that none

39 Cf. Riebel, 1994, p. 762.

Network data Figures

Distance per train connection between Station 1 and Sta-

tion 2 (one way), in km 320

Number of trips per year on the entire network 219.000

Kilometers travelled per year on the entire network, in km 70.080.000

Revenues derived from providing train connections, perannum 2.847.000.000

Costs per year

Rental for train stations 200.000.000

Depreciation on companys own train stations 320.000.000

Depreciation on rail network 850.000.000

Repairs and maintenance on rail network 450.000.000

Labor costs

- Employees at stations 7.040.000

- Employees on trains 38.400.000

Electricity costs for stations 150.000.000

Electricity costs for trains 200.000.000

Depreciation on trains 300.000.000

Train repairs and maintenance 180.000.000

Costs of centralized administration 20.000.000

Marketing costs 50.000.000

Total costs per year 2.765.440.000

Profit per year 81.560.000


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of the amounts shown would change if the contract with B were eliminated. This is because

neither an additional train nor any other product or service results from the contract beyond

what is being provided anyway. Instead, all of the services specified by the contract between

A and B can be rendered on the basis of As normal operations, which are independent of the

contract. This means that from As perspective, no costs would be eliminated if the contract

with B were eliminated. Therefore, no incremental costs can be calculated for the contract; in

other words, the incremental costs to be allocated to the contract have a zero value. It be-

comes clear that the concept of incremental costs is the diametrical opposite of a full cost

concept40

, according to which some of As costs would be allocated even if they were not

strictly caused by the contract with B, such as proportional depreciation and electricity costs

per kilometer travelled by an employee of B, etc.

The practical consequence of calculating incremental costs in order to apply IAS 37 to the

contract between A and B is that even if the price which B pays for the contract were much

lower, but zero no loss is incurred according to the standard and therefore making provi-

sion for impending losses is not necessary for A.

4.3 Variations when using the contract as an allocation object: Scenarios 1 and 2The cost analysis changes if the contract is modified as follows. In contrast to the initial sce-

nario, two supplementary services are added to the contract between A and B:

Scenario 1: A sets up a centralized service hotline

A and B have agreed upon a clause in addition to those contractually defined in the initial

scenario that specifies that A will create a centralized telephone hotline exclusively for the

employees of B. Here, the employees of B will be able to obtain up to date travel information.

It is assumed that the toll-free hotline will be staffed by four additional service employees ofA, who cause labor costs of 50,000 per year and employee. However, no additional offices

are needed for the employees as the existing infrastructure provides sufficient capacity. The

local telecommunications company charges a flat fee of 25,000 per year for activating the

hotline. The incremental costs according to IAS 37 would then have to be calculated as fol-

lows:

40 The valuation of provisions for impending losses in the case of pending sales transactions is also based (at

least in part) on this concept, cf. IDW RS HFA 4, Tz. 35.


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(all amounts in

Euro)

Costs for activating the service hotline, per year 25.000

+ Labor costs for four additional employees, per

year

200.000

= Unavoidable costs according to IAS 37 225.000

Scenario 2: Provision of three special weekend trains for company Bs annual staff out-

ing

We will now assume, in addition to the contractual conditions in the initial scenario, that A

provides B with three special trains for its annual staff outing. Four employees are needed to

control and staff each of the special trains. They work one day during the weekend. The

weekend bonus per employee is 150 per day. The contract specifies a return journey of

320km each way per train. Usually, A does not offer other special trips.

Based on the actual cost causing objects, incremental costs are only incurred as a result of the

three trips by the special trains on the weekend. They can be calculated as follows:

Weekend bonus, per staff member on a train 150

Employees per train 4

Kilometers travelled per year on the entire network in km 70.080.000

Trip per train connection (one way) in km 320

Contractually required special trains, per year 3

Kilometers travelled by special trains, per year 1920

Electricity costs of all trains, per year 200.000.000

Electricity costs per kilometer travelled 2,85 /km

Costs resulting from the contract41

Weekend bonus for all staff members on trains 1.800

+ Total electricity costs of the special trains 5.472 = Unavoidable costs according to IAS 37 7.272

The following table summarizes the above calculations for the initial scenario and scenarios 1

and 2:

41

Proportional costs for maintenance and wear and tear on the rails are not being considered because of thelow number of kilometers travelled by special trains in relation to the total kilometers travelled by all

trains during a year. They are equivalent to 0.00273 percent of the total costs for maintenance and wear

and tear on the tracks. It is also assumed that trains are not depreciated on the basis of distance travelled.


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(all amounts in

Euro)Costs for activat-

ing the service

hotline, per year

Labor costs for

four additional

employees, per

year

Weekend bonus for

all train staff mem-

bers

Total elec-

tricity costs

of the spe-

cial trains

Unavoidable

costs according

to IAS 37

Initial sce-

nario- - - - 0

Scenario 1Hotline

200.000 25.000 - - 225.000

Scenario 2

Special

trains

- - 1.800 5.472 7.272

The overview shows that cost calculations based on the incremental principle according to

IAS 37 tend to lead to very low cost amounts in the case of the above examples when deter-

mining income contributions of individual sales contracts. In general, this result should be

characteristic for sales contracts with a high fixed cost share.

5 Are (supposedly) detrimental sales transactions not shown on IFRS income state-ments?

By applying the incremental principle when calculating unavoidable costs according to IAS

37, only those costs are taken into account when valuating provisions for impending losses

as has been shown which are actually caused by an economic decision in combination with

a concrete allocation object. As the example shows, this may lead especially in the case of

fixed cost-intensive businesses to a result that is intuitively surprising and may be seen as

somewhat unsatisfactory by some parties: individual sales contracts may often not be identi-

fied as loss-causing transactions, for which impending loss provisions have to be captured,

when drawing up an income statement according to IFRS, even though such transactions

(measured against the total (full) costs that can be allocated to them) should be seen as being

detrimental to the company. This result may at first glance create the impression that captur-

ing (supposedly) detrimental sales transactions in IFRS statements may be impossible in

many cases.

The meaningfulness of this result should, however, not be assessed from a balance sheet per-

spective at the level of an individual sales transaction; instead, it has to be analyzed in respect

of the meaningfulness of the IFRS income statement of the company as a whole (whose object

of reference is the company as a whole). At this level, one needs to take into account that the

company setting up its balance sheet is obliged to carry out a value reduction test on its assets

according to the regulations in IAS 36 (so-called impairment test) under certain conditions,


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which indicate a negative economic development.42

Without going into much detail concern-

ing impairment tests, such tests of value reduction are regularly carried out in accounting

practice at the level of so-called cash-generating units (CGUs); these are sub-units of a com-

pany (asset groups) which are capable of generating essentially independent revenue streams.

Impairment tests are usually carried out according to a specific gross rental method in which

all future payments and receipts of a CGU are discounted to their current value (realizable

value). When calculating the payments and receipts to be allocated to a CGU, there is no re-

quirement to limit the calculation to incremental payment components in contrast to income

calculations for individual sales transactions in the context of calculating impending losses

(see above).43

It also has to be taken into account that for value reduction tests, it is the CGU

which is the relevant allocation object, and not a single transaction. (This alone would lead to

an increase in the size of the incremental costs, which would be the relevant dimension in this

context.)

In the end result, this means that the costs/payments which are potentially not captured when

calculating the income of a possible loss-making transaction because of a lack of sales con-

tract-related incrementality have to be accounted for in the context of an impairment test in

the end. Here, they may lead to a value reduction of a CGU, which would be captured in the

form of an extraordinary depreciation. This means that non-incremental costs/payments of a

sales transaction are fundamentally also reflected in the IFRS statement (before they are in-

curred, i.e. in an anticipative manner); however, this is not done on the basis of an individual

sales transaction as the allocation object for capturing provisions for impending losses, but on

the basis of the allocation object relevant for the value reduction test (as a rule, the respective

CGU).

This does not imply that a loss identified for a single sales transaction on the basis of the total

costs that can be allocated to it necessarily has to lead to an expense of the same amount being

reflected as extraordinary depreciation as a consequence of an impairment test. Instead, there

may be compensatory effects in this regard when carrying out the impairment test because all

payment streams have to be taken into account when calculating the realizable amount for a

CGU. These usually include payments from a large number of sales transactions, which are

concluded under varying conditions and may therefore be partly profitable, partly detrimental.

Extraordinary depreciation on a CGU is only carried out when all discounted payment streams

42 Cf. IAS 36.9 and following.

43 Cf. IAS 36.39.


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that can be allocated to it in the form of realizable amounts are lower than the book value of

the CGU on the balance sheet.44

In summary, (supposedly) detrimental sales transactions are often not followed by the capi-

talization of provisions for impending losses according to IAS 37, but they are included to-gether with all their economic consequences (and especially all their costs) when value reduc-

tion tests according to IAS 36 are carried out; at this level of creating IFRS income state-

ments, there may be an expense (though not necessarily) which reflects the potential detri-

mental effects of a companys sales transactions.

6 Interpretation of resultsThe above analysis can be summarized in the form of the following results, which are based

on theoretical and practical as shown in the example considerations:

1. The concept of incremental costs as defined in English language cost accounting lit-erature can potentially be used as a suitable principle for calculating unavoidable costs

according to IAS 37.

2. The principle of variable direct costs in combination with a decision oriented cost con-cept can be used as a tool for calculating incremental costs, and thereby unavoidable

costs according to IAS 37.

3. In order to calculate unavoidable costs, individual sales contracts serve as cost-causingallocation objects in this approach and pursuant to IAS 37.

4. As shown in the example, unavoidable costs according to IAS 37 are significantlylower (in many cases, close or equal to zero) than the costs which would have to be

taken into consideration when applying full costs, for instance. This applies especially

to businesses with a high share of fixed or overhead costs.

5. In many cases, the capitalization of the provision for impending losses therefore has tobe skipped in accounting practice according to IAS 37. This is because there is no loss

in the case of specific sales transactions if they are analyzed on the basis of unavoid-

able costs calculated in this manner.

44 Cf. IAS 36.104.


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6. On the other hand, the (supposed) detrimental effects of a sales transaction have to betaken into account completely (i.e. by using the full costs for the analysis) when carry-

ing out an impairment test according to IAS 36.

7. However, this usually does not lead to the same results compared with an analysis ofprovision for impending losses done on a full cost basis because the allocation object

being considered (single sales transaction vs. CGU) is fundamentally different.

It is not possible to provide an all-purpose estimate of the quantitative effects of these findings

on IFRS statements created for individual companies; the exact nature of the impact varies

from case to case. It would be a worthwhile research project to analyze critically the meaning-

fulness of IFRS income statements based on the above requirements for external recipients of

income statements. A comparable question relates to the applicability of financial information

calculated as shown above for the purposes of internal reporting in companies (controlling).

These and other aspects related to analyzing income accounting for sales transactions could be

promising subjects for further research.

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