ADVANCED Financial Accounting Financial Accounting & & Reporting Part 1 2017 Edition 2017 Edition BASED ON PHILIPPINE FINANCIAL REPORTING STANDARDS (PFRSs)
Nation’s Foremost CPA Review Inc. (NCPAR) 4F Pelizloy Centrum, Lower Session Road, Baguio City 2600, Philippines Mobile Number: (0917) 870 6962 E-mail:
[email protected]
ALL RIGHTS RESERVED 2017
No part of this work covered by the copyright hereon may be reproduced or used in any form or by any means electronic or mechanical, including photocopying – without the written permission of the author or the publisher.
ISBN 978-621-8029-03-3
Any copy of this book not bearing the signature of the author shall be considered as proceeding from an illegal source.
_______________________________________
Published by:
BANDOLIN ENTERPRISE 1F M BLDG., GOLF VIEW VILLAGE, STO. TOMAS, BAGUIO CITY CONTACT NOS. (0917) 870 6962; (0917) 813 6037
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ALL RIGHTS RESERVED 2017
No part of this work covered by the copyright hereon may be reproduced or used in any form or by any means electronic or mechanical, including photocopying – without the written permission of the author or the publisher.
ISBN 978-621-8029-03-3
Any copy of this book not bearing the signature of the author shall be considered as proceeding from an illegal source.
_______________________________________
Published by:
BANDOLIN ENTERPRISE 1F M BLDG., GOLF VIEW VILLAGE, STO. TOMAS, BAGUIO CITY CONTACT NOS. (0917) 870 6962; (0917) 813 6037
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Preface This book is designed to provide an invaluable learning material for accounting students and CPA candidates. Practicing accountants may also find this book a useful reference. This book discusses and illustrates provisions provisions of current financial reporting standards in a clear and easy-to-read manner. Practical insights on how the standards are applied in actual practice are provided as well. This book is a labor of love and it is dedicated to you, my reader. I have written this book with the following goals in mind: completeness, conciseness, simplicity, fun to learn and practical application. Complex accounting concepts are not eliminated simply because they are difficult to comprehend but rather they are simplified to the highest possible extent. This book is based on current Philippine Financial Reporting Standards (PFRSs) adapted by the Financial Reporting Standards Council (FRSC) from the International Financial Reporting Standards (IFRSs) issued by the International Accounting Standards Board (IASB). This textbook is a part of the following series of books:
1. 2. 3. 4.
Title of book Financial Accounting and Reporting Part 1A Financial Accounting and Reporting Part 1B Financial Accounting and Reporting Part 2 Financial Accounting and Reporting Part 3
5. Advanced Financial Financial Accounting Accounting and Reporting Part 1
6. Advanced Financial Financial Accounting Accounting and Reporting Part 2
Topics included Current assets Noncurrent assets Liabilities and Equity Financial statement presentation and PFRS for SMEs Partnership, Insurance Contracts, Build-Operate- Transfer, etc. Business Combination, Derivatives, etc.
The textbooks are patterned after the Commission on Higher Education (CHED) Curriculum.
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Each chapter thoroughly discusses the provisions in a related financial reporting standard. Each financial reporting standard has an equivalent chapter (or group of chapters) in order to facilitate browsing through the contents of this book. This is followed by a chapter summary, review questions and exercises. Suggested answers and solutions to review questions and exercises are available to colleagues in the academe to aid in classroom discussions. Since this book is dedicated to you, your thoughts about this book are important to me. You may send your comments and suggestions to
[email protected]..
[email protected] I would like to extend my sincere gratitude to my family and relatives for their support all throughout the writing of this book; to my wife Eureka and son Devin Joshua for their sacrifices; to my Dad and Mom for the source of inspiration; to my in-laws Engr. John L. Socalo, Sr. and Dominga S. Socalo for the assistance and trust; to my sister Donna Pamela for the extra help; to my college instructors who have taught me most of the techniques I have incorporated in this book; to Mr. Darrell Joe Asuncion, Dean Renante D. Balocating, Mr. Rex B. Banggawan, Mr. Christopher U. Ismael, Mr. John Carlo G. Bandolin, and Mr. Einroul Aljohnza A. Bandolin for the much needed encouragement and support; to my fellow instructors at NCPAR; colleagues in the profession; previous clients; previous students; to the members of the Bandolin Enterprise group; and friends who in one way or another have contributed, directly or indirectly, to the completion of this book.
Zeus Vernon B. Millan
About the author th The author is a 6 Placer in the October 2006 CPA board examinations. He is a co-founder of, and a CPA reviewer at, Nation’s Foremost CPA Review, Inc. (NCPAR), a teacher, and an entrepreneur.
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Tips on using this book To get the most out of this book, I strongly suggest the following, most especially to a CPA candidate: 1. Re-solve the illustrations independently. independently. After reading reading a chapter, re-solve the illustration illustrations s independently independently by covering the suggested solutions with a piece of paper. 2. Read and reread the chapter summaries Be sure to read the summary after reading each chapter. This will reinforce what you have just learned. It is also advisable to reread the chapter summaries from time to time to ensure that you are not forgetting the concepts you have learned as you learn additional concepts. Long-term memory is invaluable in passing the board exams (as well as making professional judgments in the exercise of the profession). However, the human memory is not without limit. The human brain tends to forget information as new information is learned. To avoid this, one will need to recall information previously learned repeatedly as many times as needed. Studies show that when one forgets information learned previously, he will need to spend the same effort in effort in learning that information again! 3. Enjoy learning. learning. Nothing is difficult if you have the passion in doing it.
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Advanced Accounting – Part 1 Contents at a Glance Chapter Chapter Chapter Chapter
1 2 3 4
Chapter 5
Partnership Partnership Partnership Partnership
(Part (Part (Part (Part
1) 2) 3) 4)
Corporate Liquidation and Reorganization
Chapter 6 Joint Arrangements Related standards: PFRS 11 Joint Arrangements PAS 28 Investments in Associates and Joint Ventures
1 24 50 89 135 179
Chapter 7 Construction Contracts 243 Related standard: PFRS 15 Revenue from Contracts with Customers Chapter 8
Accounting for Franchise Operations - Franchisor 358 Related standard: PFRS 15 Revenue from Contracts with Customers Chapter 9 Consignment Sales 420 Related standard: PFRS 15 Revenue from Contracts with Customers Chapter 10
Installment Sales Method
Chapter 11
Home office, Branch and Agency accounting 492
Chapter 12 Insurance Contracts Related standard: PFRS 4 Insurance Contracts
436
570
Chapter 13 Accounting for Build-operate-transfer (BOT) 623 Related standards: IFRIC Interpretation 12 Service Concession Arrangements PFRS 15 Revenues from Contracts with Customers
SIC Interpretation 29 Service Concession Arrangements: Disclosures Appendices – Contents at a glance Financial Accounting and Reporting – Part 1A Financial Accounting and Reporting – Part 1B Financial Accounting and Reporting – Part 2 Financial Accounting and Reporting – Part 3 Advanced Financial Accounting and Reporting – Part 2
659 660 661 662 663
References
664
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TABLE OF CONTENTS CHAPTER 1 PARTNERSHIP – PART 1............................................................................ 1
OVERVIEW ON THE TOPIC.................................................................................. 1 INTRODUCTION ............................................................................................... 1 Characteristics of a partnership ............................................................. 2 Advantages and disadvantages of a partnership ................................... 3 ACCOUNTING FOR PARTNERSHIPS ....................................................................... 3 FORMATION ................................................................................................... 4 Valuation of contributions of partners .................................................. 4 Partners’ ledger accounts ...................................................................... 5 Capital and drawing accounts ............................................................ 6 Receivable from/ Payable to a partner .............................................. 6 Bonus on initial investments.................................................................. 9 Variations to the bonus method ...................................................... 10 CHAPTER 1: SUMMARY .................................................................................. 12 PROBLEMS................................................................................................ 12 CHAPTER 2 PARTNERSHIP – PART 2.......................................................................... 24
DIVISION OF PROFITS AND LOSSES ..................................................................... 24 CHAPTER 2: SUMMARY .................................................................................. 41 PROBLEMS................................................................................................ 41 CHAPTER 3 PARTNERSHIP – PART 3.......................................................................... 50
DISSOLUTION ............................................................................................... 50 Admission of partner............................................................................ 51 Purchase of interest ......................................................................... 51 Revaluation of assets ................................................................... 53 Investment in the partnership ......................................................... 54 Withdrawal, retirement or death of a partner .................................... 61 Incorporation of a partnership............................................................. 70 CHAPTER 3: SUMMARY .................................................................................. 74 PROBLEMS................................................................................................ 75
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CHAPTER 4 PARTNERSHIP – PART 4.......................................................................... 89
LIQUIDATION ................................................................................................ 89 Conversion of non‐cash assets into cash ............................................. 89 Methods of liquidation..................................................................... 89 Settlement of claims ............................................................................ 90 Right of off ‐set ..................................................................................... 90 Lump‐sum liquidation vs. Installment liquidation................................ 90 Marshalling of assets............................................................................ 98 Non‐cash asset used as payment for claim........................................ 112 Safe payments schedule and Cash priority program ......................... 114 Safe payment schedule .................................................................. 114 Cash priority program .................................................................... 119 CHAPTER 4: SUMMARY ................................................................................ 123 PROBLEMS.............................................................................................. 124 CHAPTER 5 CORPORATE LIQUIDATION AND REORGANIZATION .............................. 135
CORPORATE LIQUIDATION ............................................................................. 135 Measurement basis............................................................................ 135 Financial reports................................................................................. 136 Statement of affairs ....................................................................... 136 Statement of realization and liquidation ....................................... 144 REORGANIZATION ....................................................................................... 163 Types of corporate reorganization..................................................... 163 CHAPTER 5: SUMMARY ................................................................................ 164 PROBLEMS:............................................................................................. 167 CHAPTER 6 JOINT ARRANGEMENTS ....................................................................... 179
DEFINITION OF JOINT ARRANGEMENT .............................................................. 179 Contractual arrangement................................................................... 179 Joint control ....................................................................................... 180 TYPES OF JOINT ARRANGEMENT ..................................................................... 183 Consideration for entity’s rights and obligations arising from the arrangement ...................................................................................... 183 Assessment of rights and obligations................................................. 184
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JOINT OPERATIONS ...................................................................................... 187 ACCOUNTING FOR JOINT OPERATION TRANSACTIONS .......................................... 188 No separate records are maintained ................................................. 188 Separate records are maintained....................................................... 195 ADDITIONAL ILLUSTRATIONS: ......................................................................... 200 INTEREST IN JOINT OPERATIONS WHOSE ACTIVITY CONSTITUTES A BUSINESS............ 211 JOINT VENTURES ......................................................................................... 214 Equity method.................................................................................... 214 Presentation in statement of financial position................................. 215 TRANSACTIONS BETWEEN A VENTURER AND A JOINT VENTURE .............................. 215 PARTICIPANT TO A JOINT ARRANGEMENT WITH NO JOINT CONTROL ....................... 221 SEPARATE FINANCIAL STATEMENTS ................................................................. 221 CHAPTER 6: SUMMARY: ............................................................................... 222 RELEVANT PROVISIONS OF THE PFRS FOR SMES ............................................... 224 SECTION 15 INVESTMENTS IN JOINT VENTURES ................................................. 224 Jointly controlled operations ............................................................. 225 Jointly controlled assets..................................................................... 225 Jointly controlled entities................................................................... 226 Measurement – accounting policy election....................................... 226 Transactions between a venturer and a joint venture....................... 226 Investor does not have joint control.................................................. 226 PROBLEMS.............................................................................................. 228 CHAPTER 7 CONSTRUCTION CONTRACTS ............................................................... 243
DEFINITION OF CONSTRUCTION CONTRACT ....................................................... 245 APPLICATION OF THE BASIC PRINCIPLES OF PFRS 15.......................................... 245 Step 1: Identify the contract with the customer ................................ 245 Combination of contracts............................................................... 246 Step 2: Identify the performance obligations in the contract............ 246 Satisfaction of performance obligations ........................................ 249 Step 3: Determine the transaction price............................................ 254 Step 4: Allocate the transaction price to the performance obligations ........................................................................................................... 257 Step 5: Recognize revenue when (or as) a performance obligation is satisfied .............................................................................................. 257 PERFORMANCE OBLIGATIONS SATISFIED OVER TIME ............................................ 257
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METHODS FOR MEASURING PROGRESS ............................................................ 258 INPUT METHODS ......................................................................................... 258 Cost‐to‐cost ........................................................................................ 258 Efforts‐expended (labor hours‐based) method ................................. 261 CONTRACT COSTS ........................................................................................ 263 ADJUSTMENTS TO THE MEASURE OF PROGRESS UNDER THE INPUT METHOD ............ 268 PRESENTATION ........................................................................................... 271 ACCOUNTING FOR CONSTRUCTION CONTRACTS ................................................ 275 OUTPUT METHODS ...................................................................................... 287 CHANGES IN THE MEASURE OF PROGRESS ......................................................... 290 REASONABLE MEASURES OF PROGRESS ............................................................ 291 ONEROUS CONTRACT ................................................................................... 293 VARIABLE CONSIDERATION ............................................................................ 301 Incentive payments............................................................................ 303 Cost escalations.................................................................................. 307 CONTRACT MODIFICATIONS ........................................................................... 308 Variations on the contract (Change orders)....................................... 310 CHANGES IN THE TRANSACTION PRICE.............................................................. 310 Claims for reimbursements on the contract ...................................... 313 EXISTENCE OF A SIGNIFICANT FINANCING COMPONENT IN THE CONTRACT ............... 318 NON‐CASH CONSIDERATION .......................................................................... 319 UNCERTAINTY IN THE COLLECTABILITY OF CONTRACT REVENUE ............................. 319 ADDITIONAL ILLUSTRATIONS: ................................................................ 322 CHAPTER 7: SUMMARY ................................................................................ 335 PROBLEMS.............................................................................................. 336 CHAPTER 8 ACCOUNTING FOR FRANCHISE OPERATIONS – FRANCHISOR................. 358
LICENSING ................................................................................................. 359 DEFINITION OF FRANCHISE ............................................................................ 360 APPLICATION OF THE PRINCIPLES OF PFRS 15 .................................................. 361 Step 1: Identify the contract with the customer ................................ 361 Step 2: Identify the performance obligations in the contract............ 362 General principles: ......................................................................... 362 Specific principles: (‘Licensing’ section) ......................................... 364 Step 3: Determine the transaction price............................................ 373 Franchise fees ................................................................................ 373
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Step 4: Allocate the transaction price to the performance obligations ........................................................................................................... 375 Step 5: Recognize revenue when (or as) a performance obligation is satisfied .............................................................................................. 378 EXISTENCE OF A SIGNIFICANT FINANCING COMPONENT IN THE CONTRACT ............... 383 JOURNAL ENTRIES .................................................................................. 386 CONTRACT COSTS ........................................................................................ 397 UNCERTAINTY IN THE COLLECTABILITY OF CONTRACT REVENUE ............................. 402 CHAPTER 8: SUMMARY ................................................................................ 408 PROBLEMS.............................................................................................. 409 CHAPTER 9 CONSIGNMENT SALES.......................................................................... 420
CONSIGNMENT ARRANGEMENTS .................................................................... 420 PRINCIPAL VERSUS AGENT CONSIDERATIONS ..................................................... 423 CHAPTER 9: SUMMARY ................................................................................ 426 PROBLEMS:............................................................................................. 427 CHAPTER 10 INSTALLMENT SALES METHOD ............................................................. 436
INSTALLMENT SALES METHOD ........................................................................ 436 Applicability........................................................................................ 436 Brief history........................................................................................ 437 ACCOUNTING PROCEDURES ........................................................................... 437 PRESENT VALUE .......................................................................................... 448 REPOSSESSION............................................................................................ 455 TRADE‐INS ................................................................................................. 462 ALLOCATION OF COST OF GOODS SOLD ............................................................ 468 COST RECOVERY METHOD ............................................................................. 472 CHAPTER 10: SUMMARY .............................................................................. 474 PROBLEMS.............................................................................................. 477 CHAPTER 11 HOME OFFICE, BRANCH AND AGENCY ACCOUNTING............................ 492
BRANCH AND AGENCY DISTINGUISHED ............................................................ 492 ACCOUNTING FOR AN AGENCY ....................................................................... 493 ACCOUNTING FOR BRANCH OPERATIONS .......................................................... 495
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Reciprocal accounts (Interoffice or Intra‐company accounts)........... 495 Individual financial statements .......................................................... 501 Combined financial statements ......................................................... 503 Reconciliation of reciprocal accounts ................................................ 508 Home office with several branches................................................ 514 Special problems in Accounting for branch operations ..................... 523 Shipments to branch billed at a price above cost .......................... 523 ADDITIONAL ILLUSTRATIONS: ........................................................ 530 Inter‐branch transactions................................................................... 554 Inter‐branch transfers of cash........................................................ 554 Inter‐branch transfers of merchandise .......................................... 555 CHAPTER 11: SUMMARY .............................................................................. 557 PROBLEMS.............................................................................................. 558 CHAPTER 12 INSURANCE CONTRACTS ...................................................................... 570
INSURANCE CONTRACT ................................................................................. 571 Essential elements in the definition of an insurance contract ........... 571 Significant insurance risk................................................................ 572 Indemnification against loss........................................................... 573 Legal principles of insurance.............................................................. 574 Types of insurers ................................................................................ 576 Types of insurance contracts ............................................................. 577 Examples of insurance contracts........................................................ 578 RECOGNITION AND MEASUREMENT................................................................. 581 Liability adequacy test........................................................................ 581 Changes in accounting policies .......................................................... 582 Specific issues in changes in accounting policies ........................... 583 INSURANCE CONTRACTS ACQUIRED IN A BUSINESS COMBINATION .......................... 584 CONTRACTS WITH DISCRETIONARY PARTICIPATION FEATURES ............................... 584 Accounting requirements................................................................... 584 UNBUNDLING OF DEPOSIT COMPONENTS ......................................................... 585 EXISTING ACCOUNTING POLICIES FOR INSURANCE CONTRACTS .............................. 585 ACCOUNTING FOR NON‐LIFE INSURANCE CONTRACTS.......................................... 589 Peculiar accounts and line‐items – non‐life insurance....................... 589 Initial recognition ............................................................................... 594 th
Revenue recognition – 24 Method .................................................. 596
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Insurance contracts covering Marine Cargo Risks ............................. 601 Subsequent measurement of Deferred acquisition costs (DAC)........ 606 Gross benefits and claims and Liability adequacy test....................... 607 ACCOUNTING FOR
LIFE INSURANCE CONTRACTS AND
CONTRACTS
WITH
DISCRETIONARY
PARTICIPATION FEATURE (DPF)......................................................................
608
Life insurance contract liabilities........................................................ 609 Gross benefits and claims .................................................................. 609 CHAPTER 12: SUMMARY .............................................................................. 611 PROBLEMS:............................................................................................. 613 CHAPTER 13 ACCOUNTING FOR BUILD‐OPERATE‐TRANSFER (BOT) ........................... 623
FEATURES OF BOT ARRANGEMENTS ............................................................... 624 SCOPE....................................................................................................... 625 ACCOUNTING ISSUES .................................................................................... 626 Treatment of the operator’s rights over the infrastructure............... 626 Recognition and measurement of arrangement consideration......... 626 Construction or upgrade services ...................................................... 627 Consideration given by the grantor to the operator...................... 627 Financial asset ............................................................................ 627 Intangible asset .......................................................................... 627 Partly by a financial asset and an intangible asset..................... 628 Operation services ............................................................................. 628 Contractual obligations to restore the infrastructure to a specified level of serviceability .................................................................................. 628 Borrowing costs incurred by the operator......................................... 628 Items provided to the operator by the grantor ................................. 629 ACCOUNTING FOR SERVICE CONCESSION ARRANGEMENTS .................................. 629 CHAPTER 13: SUMMARY .............................................................................. 647 RELEVANT PROVISIONS OF THE PFRS FOR SMES ............................................... 648 SECTION 34 SPECIALIZED ACTIVITIES ............................................................... 648 Service concession arrangements...................................................... 648 Two principal categories of service concession arrangements.......... 648 Accounting – financial asset model.................................................... 648 Accounting – intangible asset model ................................................. 649 Operating revenue ............................................................................. 649 PROBLEMS.............................................................................................. 649
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APPENDICES APPENDIX A......................................................................................... 659 FINANCIAL ACCOUNTING & REPORTING ‐ PART 1A
CONTENTS AT A GLANCE
APPENDIX B......................................................................................... 660 FINANCIAL ACCOUNTING & REPORTING ‐ PART 1B
CONTENTS AT A GLANCE
APPENDIX C ......................................................................................... 661 FINANCIAL ACCOUNTING & REPORTING ‐ PART 2
CONTENTS AT A GLANCE
APPENDIX D......................................................................................... 662 FINANCIAL ACCOUNTING & REPORTING ‐ PART 3
CONTENTS AT A GLANCE
APPENDIX E ......................................................................................... 663 ADVANCED FINANCIAL ACCOUNTING & REPORTING
‐ PART 2 CONTENTS AT
A GLANCE REFERENCES ........................................................................................ 664
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Chapter 12 Insurance Contracts Related standard: PFRS 4 Insurance Contracts
1. 2. 3. 4.
Define an insurance contract. State the applicability and accounting requirements of PFRS 4. State the peculiar accounts of an insurance company. Account for non-life and life insurance contracts.
Introduction The accounting practices for insurance contracts have been diverse and often differed from practices in other sectors. IFRS 4 is introduced primarily: a. To make limited improvements to the accounting for insurance contracts, pending the completion of the second phase of the a IASB’s project on insurance contracts. b. To require any entity issuing insurance contracts (an insurer) to disclose information about those contracts. a
Currently, the IASB and the FASB are undertaking a joint project to develop common, high-quality guidance that will address recognition, measurement, presentation, and disclosure requirements for insurance contracts (including reinsurance). The joint project is intended to improve, simplify, and converge the financial reporting requirements for insurance contracts.
Scope An entity shall apply PFRS 4 to the following: a. Insurance contracts (including reinsurance contracts) that it issues and reinsurance contracts that it holds. b. Financial instruments that it issues with a discretionary participation feature. PFRS 7 requires disclosure about financial instruments, including financial instruments that contain such features. PFRS 4 does not apply to contracts and other transactions specifically dealt with under other relevant standards. Specifically, PFRS 4 does not apply to the following: a. Product warranties (PFRS 15 and PAS 37)
570
b. c.
d.
e. f.
Employers’ assets and liabilities under employee benefit plans (PAS 19 and PFRS 2) Contractual rights or obligations that are contingent on the future use of, or right to use, a non-financial item (PAS 17, PFRS 15 and PAS 38) Financial guarantee contracts unless the issuer has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts, in which case the issuer may elect to apply either PAS 32, PFRS 7 and PFRS 9 or PFRS 4 to such financial guarantee contracts. The issuer may make that election contract by contract, but the election for each contract is irrevocable. Contingent consideration payable or receivable in a business combination (PFRS 3) Direct insurance contracts in which the entity is the policyholder . However, a cedant shall apply PFRS 4 to reinsurance contracts that it holds.
Insurance contract PFRS 4 defines an insurance contract as “a contract under which one party (the insurer ) accepts significant insurance risk from another party (the policyholder ) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event ) adversely affects the policyholder.” PFRS 4 provides the definitions for the following terms: Insurer – the party that has an obligation under an insurance contract to compensate a policyholder if an insured event occurs. Policyholder – a party that has a right to compensation under an insurance contract if an insured event occurs. Insured event – an uncertain future event that is covered by an insurance contract and creates insurance risk.
The definition of an insurance contract determines which contracts are within the scope of PFRS 4 rather than other PFRSs. Thus, an entity shall apply PFRS 4 to all policies it issues or holds that falls within the definition of “insurance contract” as provided under PFRS 4. Essential elements in the definition of an insurance contract 1. Transfer of significant insurance risk – there is transfer of significant insurance risk from the insured (policy holder) to the insurer (insurance provider).
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2.
3.
Payment from the insured (premium) – generally, the insured pays to a common fund from which losses are paid. However, not all insurance contracts have explicit premiums (e.g., insurance cover bundled with some credit card contracts). Indemnification against loss – the insurer agrees to indemnify the insured or other beneficiaries against loss or liability from specified events and circumstances (called as ‘insured event’) that may occur or be discovered during a specified period.
Significant insurance risk Risk (or uncertainty) is a fundamental element of an insurance contract. At least one of the following is uncertain at the inception of an insurance contract: a. the occurrence of an insured event; b. the timing of the event; or c. the level of indemnification that the insurer will need to pay the insured if the event occurs.
Risk – is the possibility of loss or injury when an uncertain future event occurs. Risk can be: a. Speculative risk – a risk that can result in either gain or loss, e.g., fluctuation in the prices of commodities, or b. Pure risk – a risk that can produce a loss only.
Insurance risk – is risk, other than financial risk, transferred from the holder of a contract to the issuer. The risk must be pre-existing at the time the insurance contract was executed. A new risk created by the contract is not insurance risk. Insurance risk is significant if an insured event could cause an insurer to pay significant additional benefits in any scenario, excluding scenarios that lack commercial substance Additional benefits refer to amounts that exceed those that would be payable if no insured event occurred A contract that transfers only an insignificant insurance risk may not be accounted for under PFRS 4. Such contract shall be accounted for under other relevant PFRSs.
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Financial risk is the risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. A contract that exposes the issuer to financial risk without significant insurance risk is not an insurance contract. From the definitions above, insurance risk includes only “pure risk.” If both significant insurance risk and financial risk are present, the contract will be classified as an insurance contract. In addition to financial risk, the following risks are also not insurance risk: a. Lapse or persistency risk – the risk that the counterparty will cancel the contract earlier or later than the issuer had expected in pricing the contract. This is not insurance risk because the payment to the counterparty is not contingent on an uncertain future event that adversely affects the counterparty. b. Expense risk – the risk of unexpected increases in the administrative costs associated with the servicing of a contract, rather than in costs associated with insured events. This is not insurance risk because an unexpected increase in expenses does not adversely affect the counterparty. PFRS 4 states that “a contract that exposes the issuer to lapse risk, persistency risk or expense risk is not an insurance contract unless it also exposes the issuer to insurance risk. However, if the issuer of that contract mitigates that risk by using a second contract to transfer part of that risk to another party, the second contract exposes that other party to insurance risk.” Indemnification against loss Generally, indemnification on insurance contracts is in the form of cash. However, some insurance contracts require or permit payments to be made in kind (i.e., non-cash). For example, the insurer may indemnify the insured a. by replacing the insured property, instead of reimbursing the insured; or b. by providing services, such as i. medical services using the insurer’s own medical facilities and staff ii. repair services and other services for the insured’s property. 573
Legal principles of insurance The principal objective of every insurance contract is to provide financial protection to the insured in case of occurrence of an uncertain future event. Neither the “insured” nor the “insurer” shall misuse an insurance contract to unjustly enrich himself at the expense of the other. 1.
Principle of Insurable Interest – the insured must have an insurable interest in the property or life insured. The insured has an insurable interest in the property if he is benefited by the property’s existence and prejudiced by its destruction. The existence of an insurable interest is a requisite to the legal enforcement of an insurance contract in order to prevent the deliberate destruction of life or property for profit.
2.
Principle of Utmost Good Faith (Uberrimae fidei) – all insurance contracts must be negotiated with utmost honesty and fairness because the contracting parties do not have the same access to relevant information. Material facts must be disclosed.
3.
Principle of Indemnity – the insured is compensated for the loss he incurred and reverted back to his previous financial condition before the occurrence of the loss event. The insured neither profits nor incurs loss due to the occurrence of the loss event. This principle does not apply to life insurance because the value of human life cannot be measured in monetary terms.
4.
Principle of Contribution – this principle is a consequence of the principle of indemnity. The principle of contribution applies when the insured obtains insurance from more than one insurer. In case of a loss event, the insured can only claim compensation for the actual losses he incurred from either insurer or both insurers on a proportionate basis. There is no “double” compensation for actual losses incurred by the insured. If any of the insurers, compensates in full the insured, that insurer can claim from the other insurers their shares on the losses incurred by the insured. Example 1: Mr. John Doe is an employee. As part of his employee benefits, Mr. John has two health insurances acquired by his employer from the Philippine Health Insurance Corporation (PhilHealth) (government requisite) and from the Care Bear Insurance Co. (employer’s discretion). Each of these insurances states clearly the types of sicknesses insured, the accredited hospitals where the insurances are applicable, the amounts of compensation the
574
insurances are bound to indemnify in cases of sickness, and all other relevant information.
Principle of Insurable Interest – the insurable interest is Mr. John’s health. Principle of Utmost Good Faith – the full disclosure of all material facts is an application of the principle of utmost good faith.
A year later, Mr. John had an appendectomy (i.e., the surgical removal of the vermiform appendix). This is covered under both of Mr. John’s health insurances. The accredited hospital billed Mr. John a total of ₱65,000, ₱20,000 of which is covered under Mr. John’s PhilHealth. Mr. John’s hospital bill was settled as follows: Total hospital bill Less: Amount insured under PhilHealth Balance Less: Balance insured under Care Bear Insurance Net amount due
5.
65,000 (20,000) 45,000 (45,000) -
Principle of Indemnity – Mr. John is indemnified only up to extent of the costs he incurred. Mr. John did not gain profit from his appendectomy.
Principle of Contribution – Both insurers shared in indemnifying Mr. John for the actual costs he incurred. Mr. John is prevented from collecting twice from his insurers in respect of the same loss event.
Principle of Subrogation – this principle is an extension and another consequence of the principle of indemnity. Subrogation means substituting one entity (e.g., the insurer) for another entity’s (e.g., the insured) legal right to collect a debt or damages. Example 2: A year after his appendectomy, Mr. John decided to change career. He opened a small bakery. Mr. John’s new business was a success that after operating for only one year, Mr. John was able to save enough money put up a house. Mr. John even changed his name from “John Doe” to “John Dough.” Mr. John insured his house for ₱2M. After a year, Mr. John’s house was totally destroyed by fire due to the negligence his neighbor, Ms. Jane Glow. The insurance company paid Mr. John
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₱2M
and at the same time filed a law suit against Ms. Jane for ₱2.4M, the fair value of the destroyed house.
Principle of Subrogation – Mr. John’s right to claim damages from Ms. Jane is transferred to the insurance company.
If the insurance company wins the case and collects P2.4M from Ms. Jane, the insurance company shall retain 2M (the amount paid to Mr. John) plus other costs incurred on the lawsuit (e.g., attorney’s fees). The balance, if any, is paid to Mr. John. The insurer can benefit out of subrogation rights only up to the amount paid to the insured plus other direct costs incurred. 6.
Principle of Loss Minimization – in cases of sudden loss events (e.g., fire), the insured should try his best to minimize the loss of his insured property by taking all necessary steps to control and reduce the losses and save what is left of the property (e.g., calling the fire department in case of fire). This prevents the insured from neglecting the loss event just because the property is insured.
7.
Principle of Proximate Cause (Causa Proxima) – when a loss is caused by more than one loss events, the closest (proximate) cause, not the furthest cause, is taken into consideration when determining the extent of the insurer’s liability. This principle does not apply to life insurance. Example 3: An earthquake caused an electrical post to collapse which caused a short circuit that caused fire to a building. The building’s fire insurance coverage does not explicitly extend to earthquakes. When determining the extent of the insurer’s liability, the closest cause to the destruction of the building, which is the fire, must be taken into consideration.
Types of insurers 1. Government insurance – operated and regulated by the government. (e.g., Government Service Insurance System (GSIS) which extends life insurance to government employees and Social Security System (SSS) which extends life insurance to employees or employers in the private sector and other voluntary members. 2.
Propriety insurance – owned by stockholders and operated for profit. Policyholders are not among the owners of the business. 576
3.
Mutual insurance – owned by the policyholders themselves, who elect the board of directors, e.g., cooperative insurance.
Types of insurance contracts For purposes of applying PFRS 4, insurance contracts may be classified as: 1. Direct insurance contract – an insurance contract where the insurer directly accepts risk from the insured and assumes the sole obligation to compensate the insured in case of a loss event. PFRS 4 defines a direct insurance contract as “an insurance contract that is not a reinsurance contract.” 2.
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. Relevant terms: 1. Reinsurer – the party that has an obligation under a reinsurance contract to compensate a cedant if an insured event occurs. 2.
Cedant – the policyholder under a reinsurance contract.
Types of reinsurance contracts a. Proportional – the cedant and the reinsurer share on the premiums and claims in proportion to the risk assumed. Proportional reinsurance contracts may be either: i. Treaty (Obligatory) – the reinsurer shares in all risks arising from all of the insurance policies issued by the cedant that are within the scope of the reinsurance contract. ii. Facultative (Specific) – the reinsurer shares only on specific risks on individual insurance policies ceded by the cedant. b.
Non proportional (Excess of loss reinsurance) – in cases of loss events, the reinsurer is obliged to pay only for claims exceeding a predetermined amount (also known as the cedant’s ‘retention limit’ or ‘net retention’).
Examples: Case #1: Direct insurance contract Mr. Juan obtained fire insurance for his house from ABC Insurance Co. In case of fire, ABC Insurance Co. shall be liable in compensating 577
Mr. Juan for the losses incurred. This is an example of a direct insurance contract .
Case #2: Reinsurance contract ABC Insurance Co. is concerned about possible losses on the insurance contract with Mr. Juan. Thus, ABC Insurance Co. obtains insurance from XYZ Insurance Co. for protection against possible losses on the insurance contract with Mr. Juan. In case of fire, ABC Insurance Co. shall compensate Mr. Juan, but this time, ABC Insurance Co. can claim compensation from XYZ Insurance Co. This is an example of a reinsurance contract (simply described as ‘insurance of an insurance’). ABC Insurance Co. is referred to as the cedant (or ceding company or primary insurer ) while XYZ Insurance Co. is referred to as the reinsurer. By entering into the reinsurance contract, ABC Insurance Co. is managing the risk of loss from the direct insurance contract with Mr. Juan. Assuming that only 40% of the risk accepted from Mr. Juan is ceded to XYZ Insurance Co., the other 60% risk retained by ABC Insurance Co. is referred to as the retention limit (or net retention). The 40% risk ceded to XYZ Insurance Co. is referred to as the cession.
Case #3: Retrocession Assume that XYZ Insurance Co. also obtains insurance from another reinsurer, 123 Insurance Co., for protection against possible losses from the reinsurance contract with ABC Insurance Co. This is an example of “retrocession” (simply described as ‘reinsurance of a reinsurance’). 123 Insurance Co. is referred to as the retrocessionaire and the risk transferred is referred to as the retrocession. Examples of insurance contracts PFRS 4 provides the following examples of contracts that are insurance contracts, if the transfer of insurance risk is significant: a. Insurance against theft or damage to property. b.
Insurance against product liability, professional liability, civil liability or legal expenses.
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c.
Life insurance and prepaid funeral plans.
d.
Life-contingent annuities and pensions (i.e., contracts that provide compensation for the uncertain future event, the survival of the annuitant or pensioner, to assist the annuitant or pensioner in maintaining a given standard of living, which would otherwise be adversely affected by his or her survival).
e.
Disability and medical cover.
f.
Surety bonds, fidelity bonds, performance bonds and bid bonds (i.e., contracts that provide compensation if another party fails to perform a contractual obligation, for example an obligation to construct a building).
g.
Credit insurance that provides for specified payments to be made to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due under the original or modified terms of a debt instrument. These contracts meet the definition of a financial guarantee contract which is within the scope of PFRS 9 and PAS 32. Thus, these contracts may only be accounted for under PFRS 4, if the issuer has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts. See also previous discussions. PFRS 4 defines a financial guarantee contract as “a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument.”
h.
Product warranties issued by another party for goods sold by a manufacturer, dealer or retailer. Product warranties issued directly by a manufacturer, dealer or retailer are outside the scope of PFRS 4 because they are within the scope of PFRS 15 and PAS 37.
i.
Title insurance (i.e., insurance against the discovery of defects in title to land that were not apparent when the insurance contract was written). In this case, the insured event is the discovery of a defect in the title, not the defect itself.
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j.
Travel assistance (i.e., compensation in cash or in kind to policyholders for losses suffered while they are travelling).
k.
Catastrophe bonds that provide for reduced payments of principal, interest or both if a specified event adversely affects the issuer of the bond (unless the specified event does not create significant insurance risk, for example if the event is a change in an interest rate or foreign exchange rate).
l.
Insurance swaps and other contracts that require a payment based on changes in climatic, geological or other physical variables that are specific to a party to the contract.
m. Reinsurance contracts.
PFRS 4 provides the following examples of items that are not insurance contracts: a. Investment contracts that have the legal form of an insurance contract but do not expose the insurer to significant insurance risk, for example life insurance contracts in which the insurer bears no significant mortality risk (such contracts are noninsurance financial instruments or service contracts) b. Contracts that have the legal form of insurance, but pass all significant insurance risk back to the policyholder through noncancellable and enforceable mechanisms that adjust future payments by the policyholder as a direct result of insured losses, for example some financial reinsurance contracts or some group contracts (such contracts are normally non-insurance financial instruments or service contracts). c. Self-insurance, in other words retaining a risk that could have been covered by insurance (there is no insurance contract because there is no agreement with another party). d. Contracts (such as gambling contracts) that require a payment if a specified uncertain future event occurs, but do not require, as a contractual precondition for payment, that the event adversely affects the policyholder. However, this does not preclude the specification of a predetermined payout to quantify the loss caused by a specified event such as death or an accident. e. Derivatives that expose one party to financial risk but not insurance risk, because they require that party to make payment based solely on changes in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. 580
f.
A credit-related guarantee (or letter of credit, credit derivative default contract or credit insurance contract) that requires payments even if the holder has not incurred a loss on the failure of the debtor to make payments when due. g. Contracts that require a payment based on a climatic, geological or other physical variable that is not specific to a party to the contract (commonly described as weather derivatives). h. Catastrophe bonds that provide for reduced payments of principal, interest or both, based on a climatic, geological or other physical variable that is not specific to a party to the contract. Recognition and measurement Insurance companies are temporarily permitted under PFRS 4 (pending the finalization of the phase two of IASB’s project) to continue developing their own accounting policies (or continue using their existing accounting policies) for insurance contracts without regard to the requirements of PAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (i.e., hierarchy of reporting standards) and the Conceptual Framework . However, PFRS 4 expressly : a. Prohibits provisions for possible claims under contracts that are not in existence at the reporting date (referred to as catastrophe or equalization provisions) b. Requires a test for the adequacy of recognized insurance liabilities (referred to as the “liability adequacy test” ) c. Requires the retention of insurance liability in the statement of financial position until the obligation is extinguished (i.e., discharged or cancelled or expires) d. Prohibits the off-setting of i. reinsurance assets against the related insurance liabilities; or ii. income or expense from reinsurance contracts against the expense or income from the related insurance contracts. e. Requires an impairment test for reinsurance assets. Impairment loss is recognized when, after the initial recognition of an insurance asset, an event has occurred that leads to amounts due under the contract not being recoverable in full, and a reliable estimate of the loss can be assessed. Liability adequacy test At each reporting period, an insurer shall assess whether its recognized liabilities are adequate using current estimates of future
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cash flows, and related items such as handling costs, arising under the insurance contracts. If the assessment shows that the carrying amount of the insurance liabilities (less related deferred acquisition costs and related intangible assets) is inadequate compared to the current estimate, the deficiency is recognized in profit or loss.
Carrying amount of insurance liability (less related deferred acquisition costs and related intangible assets)
Less than
Current estimate of insurance liability at end of reporting period
=
Deficiency of insurance liability recognized in profit or loss
If the insurer’s accounting policies do not require a liability adequacy test to be carried out, as described above, then an assessment is still required of the potential net liability (i.e. the relevant insurance liabilities less any related deferred acquisition costs). In these circumstances the insurer is required to recognize at least the amount that would be required to be recognized as a provision under PAS 37 Provisions, Contingent Liabilities and Contingent Assets. Any deficiency in insurance liability is also recognized in profit or loss. PFRS 4 provides the following definitions: Insurance liability – an insurer’s net contractual obligations under an insurance contract. Insurance asset – an insurer’s net contractual rights under an insurance contract. Reinsurance assets – a cedant’s net contractual rights under a reinsurance contract.
Changes in accounting policies An insurer is permitted under PFRS 4 to change its accounting policies for insurance contracts if the change results to more relevant and no less reliable, or more reliable and no less relevant , financial information. The general principles in PAS 8 shall be applied in judging relevance and reliability of financial information, but full compliance with the criteria in PAS 8 is not required.
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Specific issues in changes in accounting policies a. Current interest rates – insurers are permitted to designate liabilities to be valued at current market interest rates with changes in values recognized in profit or loss. This election is irrevocable. Once a liability is designated to be valued at current market interest rates, it shall be valued as such until the liability is extinguished. b.
Continuation of existing practices – an entity is permitted to continue using any of the following accounting practices, but is prohibited from introducing any of them if they were not used previously: i. Measuring insurance liabilities on an undiscounted basis ii. Measuring contractual rights to future investment management fees at an amount that exceeds their fair value iii. Using non-uniform accounting policies for the insurance liabilities of a subsidiary
c.
Prudence – an insurer is not required to change its accounting policies on insurance contracts in order to eliminate excessive prudence. However, an insurer that uses sufficient prudence is not required to introduce additional prudence.
d.
Future investment margins – an insurer need not change its accounting policies for insurance contracts to eliminate future investment margins. However, entities cannot change to an accounting policy that adjusts their liabilities to reflect future investment margins unless, for example, this is part of a wider switch to a comprehensive investor-based accounting system.
e.
Shadow accounting – Realized gains or losses on an insurer’s assets may have a direct impact on the measurement of some or all of the insurance liabilities and related deferred acquisition costs and intangible assets. In such cases, an insurer is permitted, but not required, to use “shadow accounting.” Shadow accounting means that unrealized gains or losses on assets, which are recognized in other comprehensive income, are reflected in the measurement of the insurance liabilities (or deferred acquisition costs or intangible assets) in the same way as realized gains or losses. The related adjustment to the insurance liability (or deferred acquisition costs or intangible assets) shall be recognized in other comprehensive income if the unrealized gains or losses are also recognized in other comprehensive income.
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Insurance contracts acquired in a business combination When accounting for business combinations, an insurer may recognize an intangible asset for the difference between the fair value and the carrying amount of insurance liabilities acquired. The intangible asset recognized is excluded from the scope of both PAS 36 Impairment of Assets and PAS 38 Intangible Assets. Contracts with discretionary participation features Some insurance contracts contain a discretionary participation feature as well as a guaranteed element .
PFRS 4 provides the following definitions: Discretionary participation feature (DPF) – a contractual right to receive, as a supplement to guaranteed benefits, additional benefits: a. that are likely to be a significant portion of the total contractual benefits; b. whose amount or timing is contractually at the discretion of the issuer; and c. that are contractually based on: i. the performance of a specified pool of contracts or a specified type of contract; ii. realized and/or unrealized investment returns on a specified pool of assets held by the issuer; or iii. the profit or loss of the company, fund or other entity that issues the contract.
Guaranteed element – an obligation to pay guaranteed benefits, included in a contract that contains a discretionary participation feature. Guaranteed benefits – payments or other benefits to which a particular policyholder or investor has an unconditional right that is not subject to the contractual discretion of the issuer.
Accounting requirements a. Contracts with DPF are continued to be accounted for using existing accounting policies. PFRS 4 does not require a new measurement basis. b. The guaranteed element may or may not be recognized separately from the DPF. If the guaranteed element is recognized separately from the DPF: the guaranteed element shall be classified as a liability ; while
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the DPF shall be classified either as a liability or a separate
component of equity . If the guaranteed element is not recognized separately from the DPF, the whole contract shall be classified as a liability . c.
Any liability recognized is subject to the “liability adequacy test.”
d.
All premiums received may be recognized as revenue without separating any portion that relates to the equity component.
Unbundling of deposit components Some insurance contracts contain both an insurance component and a deposit component. PFRS 4 provides the following definitions: Deposit component – a contractual component that is not accounted for as a derivative under PFRS 9 and would be within the scope of PFRS 9 if it were a separate instrument . Unbundle – account for the components of a contract as if they were separate contracts.
Unbundling is required when both the following conditions are met: a. The deposit component can be measured separately without considering the insurance component, and b. The insurer’s accounting policies does not require it to recognize all obligations and rights arising from the deposit component. Unbundling is permitted, but not required , when the insurer can measure the deposit component separately from the insurance contract but its accounting policies require it to recognize the deposit component. Unbundling is prohibited if an insurer cannot measure the deposit component separately. When a contract is unbundled, the insurer shall apply PFRS 4 to the insurance component and PFRS 9 to the deposit component. Existing accounting policies for insurance contracts The succeeding discussions pertain to existing accounting policies, practices and principles relevant to insurance contracts. Although, these are not specifically required under PFRS 4, they are temporarily permitted pending the finalization of the phase two of IASB’s project. 585
Overview of accounting for insurance contracts: Item Accounting treatment under Phase 1 of PFRS 4 1. Insurance contracts Existing accounting policies 2. Investment or insurance Existing accounting policies contracts with discretionary participation features 3. Investment contracts without PFRS 9 (fair value or discretionary participation amortized cost) features There are various types of insurance contracts, as much as there are various types of risks that can be insured. The examples enumerated previously are just a few (and are only intended to provide general descriptions) of the insurance contracts available in the market today. For purposes of our succeeding discussions, we shall broadly classify insurance contracts into life and non-life. We shall focus our discussions on the following classes of insurance contracts, based on classifications under the Insurance Code of the Philippines:
Non-life: 1. Marine insurance – provides protection against loss or damage of boats, ships, cargo, and terminals during a certain voyage, shipment, stage of preparation or for a fixed period of time. 2.
Fire insurance – provides protection against loss or damage of property caused by fire. Under the Insurance Code, fire insurance may also cover losses resulting from “lightning, windstorm, tornado or earthquake and other allied risks, when such risks are covered by extension to fire insurance policies or under separate policies.” Insurance coverage may include: a. Building, b. Contents of the building, or c. Both the building and its contents.
3.
Casualty insurance – a broad category of insurance covering loss or liability arising from accident and other events not within the scope of marine and fire insurance as defined under the Insurance Code. The following are examples of casualty insurance:
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a.
Motor insurance (vehicle insurance, car insurance, or auto insurance) – is insurance purchased for cars, trucks, public utility vehicles, motorcycles, and other road vehicles. It protects the policyholder against financial loss in case of accident, theft and physical damage. Insurance coverage may include: i. Property coverage – protection against damage to or theft of the vehicle. ii. Liability coverage – protection against legal responsibility to others for bodily injury or property damage. Motor insurance is a legal requisite in the registration of motor vehicles.
4.
b.
Personal accident insurance – provides financial protection against losses from injury and disability caused by accident.
c.
Travel insurance – covers losses incurred while travelling, such as losses arising from lost baggage and other personal belongings, medical expenses, travel delay, and personal liabilities.
d.
Burglary and theft insurance – covers losses of property due to burglary, robbery or larceny.
e.
Health insurance (as written by non-life insurance companies) – provides financial protection against incurrence of medical expenses in case of illness.
Surety – is a contract whereby one party (the surety ) guarantees the performance of another party (the principal or obligor ) in favor of a third party (the obligee). A surety is accounted for under PFRS 4 if it transfers significant insurance risk to the issuer. A common example of a surety contract is fidelity bond . A fidelity bond is a form of insurance that provides financial protection to an employer in cases of losses due to employees’ fraudulent actions (e.g., embezzlement, forgery, or fraudulent trading). Example: ABC Bank employs three cashiers, each of whom, are given access to ABC’s cash. To protect against employee embezzlement, ABC Bank obtains fidelity bonds from XYZ
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Insurance Co. for each of the three employees. In case of embezzlement, ABC Bank may claim compensation from XYZ. In turn, XYZ is subrogated to the rights of ABC in claiming from the dishonest employee. In the example above, XYZ Insurance Co. is surety , the bonded employee is the principal or obligor , and ABC Bank is the obligee.
Life: 5. Life insurance – “Life insurance is insurance on human lives and insurance appertaining thereto or connected therewith.” (Sec. 179, The Insurance Code of the Philippines)
Types of life insurance 1. Term life insurance – is a life insurance which provides coverage at a fixed rate of payments for a limited period of time. After that period expires, coverage at the previous rate of premiums is no longer guaranteed and the client must either forgo coverage or potentially obtain further coverage with different payments and/or conditions. If the insured dies during the term, the death benefit will be paid to the beneficiary. 2.
Permanent life insurance – is a life insurance policy that remains in force for the insured's whole life and requires (in most cases) premiums to be paid every year into the policy. a. Whole life coverage – covers the insured’s entire life and the proceeds (face amount) are paid only upon death of the insured. b. Universal life coverage – provides greater flexibility in premium payment and the potential for greater growth of cash values. c. Limited-pay – premiums are paid only for a specified period, after which no additional premiums are required. d. Endowments – the cash value of the policy equals the death benefit at a certain age (endowment age). Benefits are paid whether the insured lives or dies, after a specific age.
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Accounting for non-life insurance contracts Peculiar accounts and line-items – non-life insurance Assets: 1.
Insurance receivable – this consists of the following: a. Due from policyholders, agents and brokers – this represents the outstanding balance of premiums receivable from direct insurance contracts issued. b. Due from ceding company – this represents the outstanding balance of premiums receivable from reinsurance contracts issued.
Most non-life insurance contracts are of short duration. Many insurance companies recognize insurance receivables on policy inception dates Insurance receivables are recognized on policy inception dates. Most non-life insurance contracts are short-term. Thus, many insurers initially measure insurance receivables at the transaction price (original invoice amount). Subsequently, the insurance receivable is measured at the unpaid balance of the transaction price less allowances for uncollectability and impairment losses. Estimates of uncollectability are recognized in profit or loss in the period where collection becomes improbable. Accounts are written-off when they become worthless.
2.
Deferred acquisition costs (DAC) – this consists of deferred costs representing commissions and other acquisition costs that vary with and are directly related to securing new insurance contracts or renewing existing contracts. These costs are deferred to the extent that they are recoverable out of future premiums. All other acquisition costs are recognized as an expense when incurred. Subsequently, these costs are amortized as expense using the “24th method,” except for contracts covering marine cargo risks where commissions for the last two months of the year are recognized as expense in the following year. DAC is considered when performing the “liability adequacy test” at each reporting date.
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3.
Reinsurance assets – this represents balances due from reinsurance companies. Reinsurance assets are reviewed for impairment at each reporting period.
Liabilities: 4.
Insurance contracts liabilities – this account consists of the following: a. Provision for unearned premiums (Reserve for unearned premiums) – represents premiums already received but not yet expired. Premiums from short-duration insurance contracts are recognized as revenue using the “24th method” over the life of the contract, except for contracts covering marine cargo risks where premiums for the last two months of the year are recognized as revenue in the following year. b.
Provision for Claims reported and Incurred but not reported (IBNR) – this represents unpaid claims and related adjustment expenses arising from the occurrence of insured events, whether or not these claims have been reported to the insurer. These provisions are based on the estimated ultimate cost of settling the claims. These provisions do not include possible claims from insured events that have not yet occurred as of the reporting date (referred to as catastrophe or equalization provisions).
c. Provision for premium deficiency – this represents additional liability for the deficiency in insurance contract liabilities arising from the performance of the “liability adequacy test.”
5.
Insurance payable – this account consists of payables related to insurance or reinsurance contracts, other than provisions included in “insurance contracts liabilities,” and may include the following: a. Due to reinsurers – this represents premiums payable to reinsurers resulting from contracts ceded to them. b. Funds held for reinsurers – this represents the portion of reinsurance premiums withheld by ceding companies in accordance with treaty agreements.
6.
Deferred reinsurance commissions – pertains to the unexpired portion of commissions from reinsurance contracts. These are
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recognized in profit or loss on the same basis as the related acquisition costs are recognized in profit or loss.
Revenue: 7.
Gross premiums – consists of the total premiums receivable over the duration of insurance contracts written during the period. These also include adjustments made during the reporting period relating to contracts written in prior reporting periods. Gross premiums are recognized at the inception date of policies. Premiums from short-duration insurance contracts are recognized as revenue over the period of the contracts using the “24th method,” except for contracts covering marine cargo risks where premiums for the last two months are considered earned in the following reporting period. The unexpired portion of premiums written are accounted for as “Provision for unearned premiums” included in “Insurance contracts liabilities” and presented in the liabilities section of the statement of financial position. The net changes in the “Provision for unearned premiums” are accounted for as adjustments to the “Gross premium.”
8.
Premiums ceded to reinsurers – consists of the total premiums payable over the duration of insurance contracts ceded to reinsurers. These also include adjustments made during the reporting period relating to contracts ceded in prior reporting periods. Premiums ceded to reinsurers are recognized at the inception date of policies.
9.
Net premium – is gross premium minus premiums ceded to reinsurers
Expenses: 10. Gross benefits and claims – consists of all claims occurring during the period, whether reported or not, including direct costs of processing and settling the claims, reduced by salvage value and other recoveries, and adjusted for changes in claims outstanding from previous periods. 11. Claims ceded to reinsurers – the portion of claims occurring during the period which are recoverable from reinsurers. 591
12. Net benefits and claims – is gross benefits and claims minus claims ceded to reinsurers. Some insurers present net benefits and claims in the statement of profit or loss and other comprehensive income by reconciling the cash basis benefits and claims (i.e., ‘Gross benefits and claims paid’) to accrual basis. This is done by adjusting the benefits and claims paid for the changes in insurance contracts liabilities. (See illustrative statement of profit of loss and other comprehensive income below)
Illustrative Statement of financial position of an insurance company
ABC Insurance Co. Statement of financial position As of December 31, 20x1 ASSETS Cash and cash equivalents Held for trading securities Insurance receivables - net Accrued income Deferred acquisition costs Reinsurance assets Property, plant and equipment - net Total assets LIABILITIES Insurance contract liabilities Accrued expenses and other liabilities Income tax payable Insurance payables Deferred reinsurance commissions Total liabilities EQUITY Share capital Retained earnings Other components of equity Total equity Total liabilities and equity
₱
250,000 660,000 1,900,000 1,150,000 95,000 260,000 960,000 ₱ 5,275,000
₱ 1,055,000
96,000 32,000 184,000 60,000 1,427,000
2,000,000 1,748,000 100,000 3,848,000 ₱ 5,275,000
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Illustrative Statement of profit or loss and other comprehensive income of an insurance company ABC Insurance Co. Statement of profit or loss and other comprehensive income As of December 31, 20x1 Notes 6 ₱ 800,000 Gross premiums 6 (200,000) Premiums ceded to reinsurers 600,000 Net premiums Fees and commission income 120,000 Investment income 60,000 180,000 Other revenue Total revenue 780,000 (450,000) Gross benefits and claims paid 100,000 Claims ceded to reinsurers (80,000) Gross change in contract liabilities 20,000 Change in contract liabilities ceded to reinsurers (410,000) Net benefits and claims Finance costs (15,000) Other operating and administrative expenses (270,000) Other expenses (285,000) Total benefits, claims and other expenses (695,000) Profit before tax 85,000 Income tax expense (18,000) Profit for the year 67,000 Other comprehensive income, after tax: Items that will not be reclassified subsequently to profit or loss: Gains on property revaluation 8,000 Other comprehensive income for the year, net of tax 8,000 TOTAL COMPREHENSIVE INCOME FOR THE YEAR ₱ 75,000 Selected notes Note 6: Net premiums Gross premiums written a Direct Assumed Total gross premiums on insurance contracts Change in provision for unearned premiums Gross premium c Premiums ceded to reinsurers Change in provision for unearned premiums Premiums ceded to reinsurers Net premiums
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900,000 300,000 1,200,000 (400,000) 800,000 (300,000) 100,000 (200,000) 600,000
a
Direct premiums – premiums received or receivable directly from brokers, agents, or insured individuals, before deducting premiums paid or payable to reinsurers. b
Assumed premiums – premiums received or receivable from other insurance companies for reinsurance contracts written. c
Premiums ceded to reinsurers – direct and assumed premiums paid or payable to reinsurers for reinsurance contracts obtained. Initial recognition Illustration 1: Journal entries - Direct insurance contract ABC Insurance Co. offers fire insurance. On January 1, 20x1, ABC received notice from its broker of a sale of one-year fire insurance for a premium of ₱1,000. The broker’s commission is 10%. The journal entry is as follows: Jan. 1, Insurance receivable – direct 20x1 Commission expense Gross premiums revenue – Direct
900 100 1,000
Taxes are ignored in order to simplify the illustration. If taxes are considered, additional credits shall be made for taxes payable, such as “Documentary Stamp Tax (DST) payable,” “Output Value-Added Tax (VAT) payable,” Local government tax payable, and other relevant taxes. The account “Due from policyholders, agents and brokers” may be used in lieu of “Insurance receivable – direct.” The “Commission expense” and “Gross premiums revenue” will be adjusted for their unexpired and unearned portions, respectively, at the end of the year. The unexpired portion of the “Commission expense” will be debited to “Deferred acquisition costs” – an asset account. The unearned portion of the “Gross premiums revenue” will be credited to “Provision for unearned premiums” – a liability account. These will be discussed further momentarily.
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Illustration 2: Journal entries - Reinsurance contract written ABC Insurance Co. writes a reinsurance contract for XYZ Insurance Co. for a premium of ₱1,000. Commission expense incurred on the reinsurance contract issued is 10%. The journal entry is as follows: Jan. Insurance receivable – assumed 1, Commission expense 20x1
900 100 1,000
Gross premiums revenue – assumed
The account “Due from ceding company” may be used in lieu of “Insurance receivable – assumed.” Gross premiums are recorded in a premium register also known as “bordereaux” (pronounced as “bor”-“deh”-“row”). This register is the equivalent of a sales register maintained by a trading company.
Illustration 3: Journal entries - Reinsurance contract (Books of cedant and Books of reinsurer) ABC Insurance Co. offers fire insurance. On January 1, 20x1, ABC received notice from its broker of a sale of one-year fire insurance for a premium of ₱1,000. The broker’s commission is 10%. ABC Insurance Co. then ceded 80% of the insurance contract with Mr. Juan to XYZ Insurance Co. Commission earned on the reinsurance is ₱80. Per agreement, ABC Insurance Co. shall withhold half of the premiums due to XYZ Insurance Co. The journal entries for the reinsurance are as follows: Books of ABC (Cedant) Insurance receivable – direct Commission expense Gross premiums revenue – direct
Books of XYZ (Reinsurer)
900 100
No entry 1,000
to record the issuance of direct insurance
Premiums ceded to reinsurers 800 Commission income 80 Funds held for reinsurer 400 Due to reinsurer 320
Insurance receivable – assumed Funds held by cedant Commission expense Gross premiums revenue – assumed
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320 400 80 800
th
Revenue recognition – 24 Method Most insurance contracts issued by nonlife insurance companies are of short duration, normally one year. Premiums from these types of contracts are recognized as revenue over the period of the contracts th using the “24 method,” except for contracts covering marine cargo risks. The unexpired portion of premiums written are accounted for as “Provision for unearned premiums” included in “Insurance contracts liabilities” and presented in the liabilities section of the statement of financial position. The net changes in the “Provision for unearned premiums” are accounted for as adjustments to the “Gross premium” recognized in profit or loss for the period. th
The “24 method” assumes that the average date of issue of all policies written during any month is the middle of that month. Illustration 1: 24th Method – Policy issued at the beginning of period
On January 1, 20x1, ABC Insurance Co. issues a one-year, fire insurance contract for a total premium of ₱12,000. Requirements: a. How much are the earned portions of the premium for the months ended January 31, February 28, and March 31, 20x1, respectively? b. How much are the unearned portions of the premium for the months ended January 31, February 28, and March 31, 20x1, respectively? c. How much is the earned portion of the premium for the year ended December 31, 20x1? d. How much is the unearned portion of the premium for the year ended December 31, 20x1? e. Provide the journal entries on January 1, 20x1 to recognize the gross premium and the adjusting entry on December 31, 20x1 to recognize the adjustment to the gross premium. Solutions: st Requirement (a): Earned portions – 1 quarter Jan. 31 Feb. 28 Gross premium 12,000 12,000 Multiplied by: 1/24 2/24 Earned portions 500 1,000
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Mar. 31 12,000 2/24 1,000
th
Under the 24 method, it is assumed that the average date of issue of all policies written during any month is the middle of that month. Therefore, in January (date of issue) “1” is used in the numerator equal to one-half month. In the succeeding months, the numerator is “2” – equal to whole month. st
Requirement (b): Unearned portions – 1 quarter
Jan. 31 12,000 23/24 11,500
Gross premium Multiplied by: Unearned portions
Feb. 28 12,000 21/24 10,500
Mar. 31 12,000 19/24 9,500
The numerators in the fractions are determined as follows: Jan. 31: (24 – 1 earned in Jan.) = 23 unearned portion Feb. 28: (24 – 1 earned in Jan. – 2 earned in Feb.) = 21 unearned portion Mar. 31: (24 – 1 – 2 – 2) = 19 unearned portion
Requirement (c): Earned portion – Dec. 31, 20x1 Gross premium Multiplied by: Earned portion - Dec. 31, 20x1
12,000 23/24 11,500
Requirement (d): Unearned portion – Dec. 31, 20x1 Gross premium 12,000 Multiplied by: 1/24 Unearned portion - Dec. 31, 20x1 500
Requirement (e): Journal entries The entry on January 1, 20x1 is as follows: Jan. 1, Insurance receivable – direct 20x1 Gross premiums revenue – Direct
12,000
The adjusting entry on December 31, 20x1 is as follows: Dec. Change in provision for unearned 500 31, premiums 20x1 Provision for unearned Premiums
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12,000
500
The “Change in provision for unearned premiums” is recognized in profit or loss as an adjustment to “Gross premiums” to compute for the earned portion. The “Provision for unearned premiums” is presented in the statement of financial position as part of “Insurance contract liabilities.” Gross premium earned will be disclosed in the notes as follows: Gross premiums written Change in provision for unearned premiums Gross premium earned
(increase)
12,000 (500) 11,500
Notice that the method of recording used is the “income method,” as opposed to the “liability method.” Alternatively, the adjusting entry may also be made by directly reducing the gross premiums revenue account, as shown below: Dec. 31, 20x1
Gross premiums revenue – direct Provision for unearned Premiums
500 500
th
Illustration 2: 24 Method – Policy issued during the period In March 20x1, ABC Insurance Co. issues a one-year, fire insurance contract for a total premium of ₱12,000. Requirements: a. How much is the earned portion of the premium for the year ended December 31, 20x1? b. How much is the unearned portion of the premium for the year ended December 31, 20x1? Solutions: Requirement (a): Earned portion – Dec. 31, 20x1 Gross premium Multiplied by: Earned portion - Dec. 31, 20x1
12,000 19/24 9,500
The numerator in the fraction is computed as follows: (1 earned in March) + (2 earned in each of April to December) = 1 + (2 x 9) = 1 + 18 = 19
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Requirement (b): Unearned portion – Dec. 31, 20x1 Gross premium 12,000 Multiplied by: 5/24 Unearned portion - Dec. 31, 20x1 2,500 The numerator in the fraction is computed as follows: (24 – 19) = 5 . th
Illustration 3: 24 Method – Premiums ceded In April 20x1, ABC Insurance Co. writes fire insurance policies for a total premium of ₱36,000. During the same period, total premiums of ₱12,000 were ceded to reinsurers. Requirement: Compute for the following: a. Net premium earned for the year ended December 31, 20x1. b. Balance of provision for unearned premiums as of December 31, 20x1. Solutions: Requirement (a): Net premium earned – Dec. 31, 20x1 Gross premium Multiplied by: Earned portion - Dec. 31, 20x1
36,000 17/24 25,500
Premiums ceded Multiplied by: Earned portion by reinsurers - Dec. 31, 20x1 Net premium earned - Dec. 31, 20x1 (25,500 – 8,500)
(12,000) 17/24 (8,500)
17,000
Requirement (b): Provision for unearned premium – Dec. 31, 20x1
Gross premium Multiplied by: Unearned portion - Dec. 31, 20x1 Premiums ceded Multiplied by: Unearned portion by reinsurers - Dec. 31, 20x1 Provision for unearned premiums, Net - Dec. 31, 20x1
599
36,000 7/24 10,500 (12,000) 7/24 (3,500) 7,000
th
Illustration 4: 24 Method – Adjustments to premiums earned During 20x1, ABC Insurance Co. wrote fire insurance policies for a total premium of ₱5,000,000, ₱3,000,000 of which were ceded to reinsurers. The following are the balances in the provision for unearned premiums:
Balance, Jan. 1 Balance, Dec. 31
Provision for unearned premiums A 2,000,000 2,800,000
Premiums ceded to reinsurers b 1,000,000 1,200,000
Provision for unearned premiums Net c=a-b 1,000,000 1,600,000
Requirement: Compute for the net premiums earned during the period. Solution: Gross premiums Change in provision for unearned premiums – increase in unearned premium (2.8M – 2M) Gross premiums - earned
5,000,000 (800,000) 4,200,000
Premiums ceded to reinsurers Change in provision for unearned premiums – increase in unearned premium (1.2M – 1M) Premiums ceded to reinsurers – earned
3,000,000
Net premiums earned (4.2M - 2.8M)
1,400,000
(200,000) 2,800,000
Checking: We can check the accuracy of our answer above by using T-account analysis, as shown below:
Jan. 1 Premiums written net of premiums ceded (5M - 3M)
Provision for unearned premiums - Net 1M 2M
600
1.4M
Net premiums earned (squeeze)
1.6M
Dec. 31
Insurance contracts covering Marine Cargo Risks For insurance contracts covering marine cargo risks, the premiums for the last two (2) months of the year are deferred and recognized as revenue in the following year.
Illustration 1: Marine cargo risks During the year, ABC Insurance Co. wrote insurance policies covering marine cargo risks. Premiums from these policies are shown below:
January February March April May June July August September October November December Totals
Gross premiums 60,000 100,000 115,000 108,000 77,000 106,000 70,000 57,000 97,000 95,000 146,000 50,000 1,081,000
Premiums Ceded 36,000 82,000 70,000 85,000 54,000 83,000 50,000 33,000 76,000 74,000 119,000 34,000 796,000
Requirements: Compute for the following: a. Provision for unearned premiums as of December 31, 20x1. b. Net premiums earned for the year ended December 31, 20x1 assuming the total gross premiums written and premiums ceded in November and December 20x0 totaled ₱15,000 and ₱10,000, respectively. Solution: Requirement (a): Provision for unearned premium – Dec. 31, 20x1
November December Totals
Gross premiums a 146,000 50,000 196,000
Premiums Ceded b 119,000 34,000 153,000
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Provision for unearned premiums – net c=a–b 27,000 16,000 43,000
For contracts covering marine cargo risks, premiums for the last two (2) months of the year are recognized as revenue in the following year.
Requirement (b): Net premiums earned Gross Premiums premiums Ceded A b From Nov. and Dec. 20x0 15,000 10,000 January 60,000 36,000 February 100,000 82,000 March 115,000 70,000 April 108,000 85,000 May 77,000 54,000 June 106,000 83,000 July 70,000 50,000 August 57,000 33,000 September 97,000 76,000 October 95,000 74,000 Totals 900,000 653,000
Net premium c = a - b 5,000 24,000 18,000 45,000 23,000 23,000 23,000 20,000 24,000 21,000 21,000 247,000
Illustration 1: Comprehensive Premiums on insurance policies written by ABC Insurance Co. during its first year of operations are shown below: Types of non-life insurance Fire Motor Car Bonds Marine Cargo Gross Premiums (Direct and Assumed) January 340,000 120,000 30,000 64,000 February 250,000 60,000 2,000 100,000 March 360,000 72,000 12,000 115,000 April 630,000 75,000 11,000 180,000 May 280,000 48,000 2,400 72,000 June 380,000 74,000 2,000 163,000 July 400,000 69,000 1,000 70,000 August 360,000 68,000 6,000 55,000 September 200,000 80,000 7,000 98,000 October 300,000 64,000 4,000 95,000 November 280,000 63,000 6,000 140,000 December 360,000 45,000 4,000 50,000 Premium Ceded January
204,000
72,000 602
18,000
38,400
February March April May June July August September October November December
150,000 216,000 378,000 168,000 228,000 240,000 216,000 120,000 180,000 168,000 216,000
36,000 43,200 45,000 28,800 44,400 41,400 40,800 48,000 38,400 37,800 27,000
1,200 7,200 6,600 1,440 1,200 600 3,600 4,200 2,400 3,600 2,400
60,000 69,000 108,000 43,200 97,800 42,000 33,000 58,800 57,000 84,000 30,000
Requirements: a. Compute for the balance of the “Provision for unearned premiums” on December 31, 20x1. b. Compute for the net premiums earned for the period. Solutions: The totals of non-life insurance policies written, excluding marine cargo are computed as follows: Fire Motor Car Bonds a B c Gross Premiums (Direct and Assumed) Jan 340,000 120,000 30,000 Feb 250,000 60,000 2,000 Mar 360,000 72,000 12,000 Apr 630,000 75,000 11,000 May 280,000 48,000 2,400 Jun 380,000 74,000 2,000 Jul 400,000 69,000 1,000 Aug 360,000 68,000 6,000 Sep 200,000 80,000 7,000 Oct 300,000 64,000 4,000 Nov 280,000 63,000 6,000 Dec 360,000 45,000 4,000 Premium Ceded Jan 204,000 Feb 150,000 Mar 216,000 Apr 378,000 May 168,000 Jun 228,000
72,000 36,000 43,200 45,000 28,800 44,400 603
18,000 1,200 7,200 6,600 1,440 1,200
Total excluding Marine Cargo
d = a+b+c 490,000 312,000 444,000 716,000 330,400 456,000 470,000 434,000 287,000 368,000 349,000 409,000
294,000 187,200 266,400 429,600 198,240 273,600
Jul Aug Sep Oct Nov Dec
240,000 216,000 120,000 180,000 168,000 216,000
41,400 40,800 48,000 38,400 37,800 27,000
600 3,600 4,200 2,400 3,600 2,400
282,000 260,400 172,200 220,800 209,400 245,400
Requirement (a): Provision for unearned premiums – Dec. 31, 20x1 Total Total Unearned Marine excluding Fraction unearned Marine portion Cargo portion Cargo d = a+b+c E f=dxe g h=f+g
Gross Premiums (Direct and Assumed) Jan 490,000 1/24 20,417 Feb 312,000 3/24 39,000 Mar 444,000 5/24 92,500 Apr 716,000 7/24 208,833 May 330,400 9/24 123,900 Jun 456,000 11/24 209,000 Jul 470,000 13/24 254,583 Aug 434,000 15/24 271,250 Sep 287,000 17/24 203,292 Oct 368,000 19/24 291,333 Nov 349,000 21/24 305,375 Dec 409,000 23/24 391,958 2,411,442 Premium Ceded Jan 294,000 1/24 12,250 Feb 187,200 3/24 23,400 Mar 266,400 5/24 55,500 Apr 429,600 7/24 125,300 May 198,240 9/24 74,340 Jun 273,600 11/24 125,400 Jul 282,000 13/24 152,750 Aug 260,400 15/24 162,750 Sep 172,200 17/24 121,975 Oct 220,800 19/24 174,800 Nov 209,400 21/24 183,225 Dec 245,400 23/24 235,175 1,446,865 Unearned portion - Gross premiums Less: Unearned portion - Premiums ceded Provision for unearned premiums - net
604
20,417 39,000 92,500 208,833 123,900 209,000 254,583 271,250 203,292 291,333 140,000 445,375 50,000 441,958 190,000 2,601,442 12,250 23,400 55,500 125,300 74,340 125,400 152,750 162,750 121,975 174,800 84,000 267,225 30,000 265,175 114,000 1,560,865 2,601,442 (1,560,865) 1,040,577
Requirement (b): Net premiums earned Total excludin g Marine Cargo
Fraction
Earned portion
d= a+b+c e f=dxe Gross Premiums (Direct and Assumed) From last yr.
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Marine Cargo g
Total earned portion h=f+g
490,000
23/24
469,583
64,000
533,583
312,000 444,000
21/24 19/24
273,000 351,500
100,000 115,000
373,000 466,500
716,000
17/24
507,167
180,000
687,167
330,400
15/24
206,500
72,000
278,500
456,000 470,000 434,000
13/24 11/24 9/24
247,000 215,417 162,750
163,000 70,000 55,000
410,000 285,417 217,750
287,000
7/24
83,708
98,000
181,708
368,000 349,000 409,000
5/24 3/24 1/24
76,667 43,625 17,042
95,000 -
171,667 43,625 17,042
2,653,958
1,012,000
3,665,958
Premium Ceded From last yr.
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
294,000 187,200 266,400
23/24 21/24 19/24
281,750 163,800 210,900
38,400 60,000 69,000
320,150 223,800 279,900
429,600 198,240 273,600 282,000
17/24 15/24 13/24 11/24
304,300 123,900 148,200 129,250
108,000 43,200 97,800 42,000
412,300 167,100 246,000 171,250
260,400 172,200
9/24 7/24
97,650 50,225
33,000 58,800
130,650 109,025
220,800 209,400 245,400
5/24 3/24 1/24
46,000 26,175 10,225
57,000 -
103,000 26,175 10,225
1,592,375
607,200
2,199,575
605
Gross premiums earned Less: Premiums ceded Net premium
3,665,958 (2,199,575) 1,466,383
Subsequent measurement of Deferred acquisition costs (DAC) Deferred acquisition costs (DAC) are similar to “prepaid assets” recognized by other types of businesses. For insurance companies, DAC consists of direct acquisitions costs of issuing or renewing insurance contracts. These costs may include commissions and premium taxes. DAC are initially deferred and amortized to profit or loss using the th “24 method,” except for contracts covering marine cargo risks where commissions for the last two months of the year are recognized as expense in the following year.
Illustration: Subsequent recognition of DAC In March 20x1, ABC Insurance Co. issues a one-year, fire insurance contract. The costs of commission incurred on the issuance of the contract amounted to ₱12,000. Requirements: a. How much of the acquisition cost is recognized in profit or loss during the period? b. How much is the balance of the deferred acquisition costs to be presented in the statement of financial position on December 31, 20x1? c. Provide the adjusting journal entry on December 31, 20x1. Solutions: Requirement (a): Acquisition costs recognized in profit or loss Total deferred acquisition costs 12,000 Multiplied by: 19/24 Expired portion 9,500
Requirement (b): Deferred acquisition costs – Dec. 31, 20x1 Total deferred acquisition costs 12,000 Multiplied by: 5/24 Unexpired portion 2,500
606
Requirement (c): Adjusting entry Dec. 31, Deferred acquisition costs 20x1 Commission expense
2,500
2,500
Gross benefits and claims and Liability adequacy test Illustration 1: Journal entries – Benefits and claims ABC Insurance Co. offers fire insurance. On December 1, 20x1, ABC Co. paid a ₱100,000 claim of a policyholder for losses incurred on his insured property. Case #1: Claims paid The journal entry is as follows: Dec. 1, Gross benefits and claims 20x1 Cash in bank
100,000 100,000
The “Gross benefits and claims” is recognized as expense in profit or loss. Case #2: Claims incurred but not yet paid Assume that the claim of the policyholder is not yet paid. The journal entry is as follows: Dec. 1, Gross benefits and claims 20x1 Provision for claims
100,000 100,000
The Provision for claims is included in “Insurance contracts liabilities” presented in the statement of financial position.
Case #3: Claims incurred but not reported (IBNR) Assume that ABC Insurance Co. was made aware of the loss event but the policyholder did not yet file a notice of claim to ABC. The journal entry is as follows: Sept. 1, Gross benefits and claims 20x1 Provision for claims - IBNR
100,000 100,000
Illustration 2: Journal entries – Liability adequacy test ABC Insurance Co. is performing its first year-end “liability adequacy test” for its insurance liabilities. The following amounts were determined:
607
Insurance contracts liabilities Deferred acquisition costs
Carrying amount 1,300,000 200,000
Current estimate 1,250,000
Requirement: Compute for the deficiency in insurance liability, if any. Provide the journal entry. Solution: Insurance contracts liabilities - carrying amount Deferred acquisition costs Net amount Insurance contracts liabilities - current estimate Deficiency in insurance contracts liabilities*
1,300,000 (200,000) 1,100,000 1,250,000 (150,000)
* There is deficiency because the net amount of insurance contracts liabilities is less than the required balance of insurance contracts liabilities of ₱1,250,000 (i.e., current estimate). The journal entry is as follows: Dec. 31, Gross benefits and claims 20x1
Provision for premium deficiency
150,000 150,000
The Provision for premium deficiency is included in “Insurance contracts liabilities” presented in the statement of financial position. Accounting for life insurance contracts and Contracts with Discretionary participation feature (DPF) The accounts and line items used for life insurance contracts are similar to those used for non-life insurance contracts. However, some recognition and measurement principles may differ for life insurance contracts. These differences are discussed below. Premiums from life insurance contracts or insurance contracts with discretionary participation feature are either: a. Single premium – the policyholder is required to make a lump sum payment at the inception of the contract. Revenue is recognized at the inception of the contract . b. Regular premium – the policyholder is required to make payments at regular periods over the term of the contract, e.g., monthly, annually. Revenue is recognized when the premium becomes due from the policyholder .
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Gross reinsurance premiums on life insurance contracts and insurance contracts with DPF are recognized as expense at the earlier of the inception of the contract and the date when premiums become payable.
Illustration 1: Journal entries – Single premium ABC Insurance Co. offers life insurance. On January 1, 20x1, ABC issues life insurance for a single premium of ₱1,000. The journal entry is as follows: Jan. 1, Cash 20x1 Gross premiums revenue – direct
1,000 1,000
Illustration 2: Journal entries – Regular premium ABC Insurance Co. offers life insurance. The life insurance policies written by ABC require recurring regular payments of ₱1,000 due at the beginning of each month. The entry on February 1, 20x1 to record the renewal of an existing contract is as follows: Feb. 1, Insurance receivable 1,000 20x1 Gross premiums revenue – direct 1,000 The entry to record the collection on February 7, 20x1 is as follows: Feb. 7, Cash 1,000 20x1 Insurance receivable 1,000
Life insurance contract liabilities Life insurance contract liabilities are recognized at the inception of the contract. These liabilities are determined actuarially using various assumptions, including assumptions on mortality, morbidity, expenses, investment returns and surrenders. Since life insurance contract liabilities are subject to the “liability adequacy test,” the assumptions may be either based on current assumptions or assumptions established at the inception of the contract. In the latter case, allowances and adjustments for risk and deviation are included. Gross benefits and claims Aside from claims arising during the period and the related costs and adjustments described previously in our discussions on non-life insurance contracts, the gross benefits and claims from life insurance
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contracts also includes changes in the gross valuation of insurance contracts and contracts with discretionary participation feature. The gross benefits and claims for life insurance contracts include the following: a. Death claims b. Surrenders c. Maturities d. Annuity payments An annuity contract is a type of insurance contract that functions like an investment account wherein the annuitant is guaranteed to receive a series of payments (e.g., monthly payments), which may commence immediately or at some future date, until the annuitant dies. Death claims and surrenders are recognized as notifications are received. Maturities and annuity payments are recognized when they become due.
Death claims Illustration: Journal entries ABC Insurance Co. offers life insurance. On January 1, 20x1, ABC receives notification of the death of a policyholder. The sum insured is ₱1,000,000. The journal entry is as follows: Jan. 1, Gross benefits and claims 20x1 Claims payable
1,000,000 1,000,000
The beneficiaries submitted the death certificate and other required documents and the claim is settled on February 8, 20x1. The journal entry is as follows: Feb. 8, Claims payable 20x1 Cash in bank
1,000,000 1,000,000
Surrenders Life insurance contracts accumulate “cash surrender value.” If the policyholder decides not to continue the premium payments, he will be entitled to this amount, which is generally less than the total premiums he had paid on the insurance contract. (See Chapter 11 of Financial Accounting and Reporting Part 1B for discussions on accounting for cash surrender value by policyholders)
610
Illustration: Journal entry ABC Insurance Co. offers life insurance. On January 1, 20x1, a policyholder cancels a life insurance contract and is paid the cash surrender value of ₱200,000. The journal entry is as follows: Jan. 1, Gross benefits and claims 20x1 Cash in bank
200,000 200,000
Chapter 12: Summary PFRS 4 applies to insurance and reinsurance contracts issued by an insurer, reinsurance contracts that it holds, and contracts that it issues with discretionary participation feature (DPF). PFRS 4 does not apply to contracts and other transactions specifically dealt with under other relevant standards. Insurance contract is a contract under which one party (the insurer ) accepts significant insurance risk from another party (the policyholder ) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event ) adversely affects the policyholder.” Insurance risk is risk, other than financial risk, transferred from the holder of a contract to the issuer. Financial risk is the risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. Insurance contracts are either (a) direct insurance contract or (b) reinsurance contract . Reinsurance contract is an insurance contract issued by one insurer (the reinsurer ) to compensate another insurer (the cedant or ceding company ) for losses on one or more contracts issued by the cedant. Direct insurance contract is an insurance contract that is not a reinsurance contract. PFRS 4 temporarily permits insurance companies to continue using or developing their own accounting policies for insurance contracts. However, PFRS 4: (a) prohibits the recognition of catastrophe or equalization provisions; (b) requires the performance of the “liability adequacy test ” at each reporting period; (c) permits derecognition of insurance liabilities only when they are extinguished; (d) prohibits off-setting of reinsurance assets against related insurance liabilities and income and expenses from reinsurance contracts against those from related
611
insurance contracts; and (e) requires an impairment test for reinsurance assets. If the carrying amount of insurance liability, net of DAC is less than its current estimate, the deficiency in insurance liability is recognized in profit or loss. Premiums from short-duration nonlife insurance contracts are th recognized using the “24 method,” except for contracts covering marine cargo risks where premiums for the last two (2) months of the year are recognized as revenue in the following year. th Under the “24 method,” it is assumed that policies written during any month were issued at the middle of that month. Accordingly, the premium revenue for the month is equal to “1/24” of the total premiums written during that month. The remaining “23/24” is recognized as unearned income. Gross single premiums from life insurance contracts are recognized as revenue at the inception of the contract. Gross regular premiums from life insurance contracts are recognized as revenue when they become payable by the policyholder. Gross reinsurance premiums on life insurance contracts and insurance contracts with DPF are recognized as expense at the earlier of the inception of the contract and the date when premiums become payable.
Notable difference between the provisions of the full PFRSs and
the PFRS for SMEs: Full PFRSs PFRS for SMEs Accounting for insurance contracts PFRS 4 Insurance Contracts Since insurers do not normally specifies the financial reporting for qualify as SME, the accounting insurance contracts by an insurer for insurance contracts by an that issues such contracts. insurer is excluded from the PFRS for SMEs. The Section 12 of PFRS for SMEs shall apply only to rights under insurance contracts that could result in a loss to either party as a result of contractual terms that are unrelated to: (i) changes in the insured risk; (ii) changes in foreign exchange rates; or (iii) a default by one of the counterparties. 612
