Feel Fresh Limited (the Company) is into manufacturing and retailing of FMCG products listed on stock exchanges in India. One of its products is…

CA Final · Financial Reporting · MTP · November 2024
Feel Fresh Limited (the Company) is into manufacturing and retailing of FMCG products listed on stock exchanges in India. One of its products is bathing soap which the Company sells under the brand name 'Feel Fresh'. The Company does not have its own manufacturing facilities for soap and therefore it enters into arrangements with a third party to procure the soaps. The Company entered into a long-term purchase contract of 10 years with M/s. Radhey. Following are the relevant terms of the contract with M/s. Radhey. (i) M/s. Radhey has to purchase a machine costing - 10,00,000 from the supplier as specified by the Company. The machine will be customized to produce the soaps as designed by the Company. This machine cannot be used by M/s. Radhey to produce the soaps for buyer other than the Company due to the design specifications. The machine has a useful life of 10 years and the straight line method of depreciation is best suited considering the use of the machine. (ii) The Company will pay - 4.75 per soap for the first year of contract. This is calculated based on the budgeted annual purchase of 7,00,000 soaps as follows: Particulars Per soap price Variable cost of manufacturing 4.00 Cost of machine (₹ 1,74,015/7,00,000 soaps) 0.25 M/s. Radhey's margin 0.50 Per soap cost to the Company 4.75 In case the Company purchases more than 7,00,000 (i.e. budgeted number of soaps) soaps in the first year then the cost of the machine (i.e. 0.25 per soap) will not be paid for soaps procured in excess of 7,00,000 units. However, in case Company procures less than budgeted number of soaps, then the Company will pay the differential unabsorbed cost of the machine, at the end of the year. For example, if the Company purchases only 6,00,000 soaps in first year then the differential amount of 24,015 (1,74,015 - (6,00,000 x 0.25)) will be paid by the Company to M/s. Radhey at the end of the year. Variable cost will be actualized at the end of the year. (iii) The cost per soap will be calculated for each year in advance based on the budgeted number of soaps to be produced each year. An amount of 1,74,015 shall be considered each year for the cost of machine for year 1 to year 8 while calculating the cost per soap. Any differential under absorbed amount shall be paid by the Company to M/s. Radhey at the end of that year. A charge of 1,74,015 per annum for the machine is derived using borrowing cost of 8% p.a. For year 9 and year 10, only variable cost and margins will be paid. (iv) M/s. Radhey does not have any right to terminate the contract but the Company has the right to terminate the contract at the end of each year. However, if the Company terminates the contract, it has to compensate M/s. Radhey for any unabsorbed cost of Machine. For example, if the Company terminates the contract at the end of second year then it has to pay - 10,44,090 (i.e. 1,74,015 per year x 6 remaining years) If it terminates the contract after the 8th year then the Company does not have to pay the compensation since the cost of the machine would have been absorbed. (v) In the first year, the Company purchases 5,50,000 soaps at 4.75 per soap. Analyze the contract of the Company with M/s. Radhey and provide necessary accounting entries for first year in accordance with Ind AS with working notes. Assume all cash flows occur at the end of the year.

Suggested Answer and Working Notes:

(a) Identification of the contract (by applying para 9 of Ind AS 116) (a) Identified asset Feel Fresh Ltd. (a customer company) enters into a long term purchase contract with M/s Radhey (a manufacturer) to purchase a particular type and quality of soaps for 10 year period. Since for the purpose of the contract M/s Radhey has to buy a customized machine as per the directions of Feel Fresh Ltd. and also the machine cannot be used for any other type of soap, the machine is an identified asset. (b) Right to obtain substantially all of the economic benefits from use of the asset throughout the period of use Since the machine cannot be used for manufacture of soap for any other buyer, Feel Fresh Ltd. will obtain substantially all the economic benefits from the use of the asset throughout the period of use. (c) Right to direct the use Feel Fresh Ltd. controls the use of machine and directs the terms and conditions of the contract with respect to recovery of fixed expenses related to machine. Hence the contract contains a lease. Lease term The lease term shall be 10 years assuming reasonable certainty. Though the lessee is not contractually bound till 10th year, i.e., the lessee can refuse to make payment anytime without lessor's permission but, it is assumed that the lessee is reasonably certain that it will not exercise this option to terminate. Identification of lease payment Lease payments are defined as payments made by a lessee to a lessor relating to the right to use an underlying asset during the lease term, comprising the following: (a) fixed payments (including in-substance fixed payments), less any lease incentives (b) variable lease payments that depend on an index or a rate (c) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option (d) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease Here in-substance fixed payments in the given lease contract are - 1,74,015 p.a. The present value of lease payment which would be recovered in 8 years @ 8% would be - 10,00,000 (approx.) Variable lease payments that do not depend on an index or rate and are not, in substance, fixed are not included as lease payments. Instead, they are recognised in profit or loss in the period in which the event that triggers the payment occurs (unless they are included in the carrying amount of another asset in accordance with other Ind AS). Hence, lease liability will be recognized by - 10,00,000 in the books of Feel Fresh Ltd. Since there are no payments made to lessor before commencement date less lease incentives received from lessor or initial direct costs incurred by lessee or estimate of costs for restoration / dismantling of underlying asset, the right of use asset is equal to lease liability. Journal Entries On initial recognition ROU Asset Dr. 10,00,000 To Lease Liability 10,00,000 To initially recognise the Lease Liability and the corresponding ROU Asset At the end of the first year Interest Expense Dr. 80,000 To Lease Liability 80,000 To record interest expense and accrete the lease liability using the effective interest method (₹ 10,00,000 x 8%) Depreciation Expense (10,00,000 / 10 years) Dr. 1,00,000 To ROU Asset 1,00,000 To record depreciation on ROU using the straight-line method (₹ 10,00,000 / 10 years) Lease Liability Dr. 1,74,015 To Bank / M/s. Radhey 1,74,015 To record lease payment Cost of soap Dr. 24,75,000 To Bank / M/s. Radhey {5,50,000 x (4 + 0.5)} 24,75,000 To record variable expenses paid as cost of the goods purchased

Topics: Ind AS 116, General

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