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Inventories, Construction Contracts & Leases

IAS 2, 11 & 17

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Scope of IAS 2 – Inventories Deals with Amount of cost to be recognised

as an asset and carried forward until related revenues are recognised

Recognition of inventories as an expense

Writing down inventories to Net Realisable Value (NRV)

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What constitutes “inventories”? Inventories include assets held

for sale in the ordinary course of business (finished goods)

assets in the production process for sale in the ordinary course of business (work in process)

materials and supplies that are consumed in production (raw materials)

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Exclusions from IAS 2 IAS 2 excludes certain

inventories from its scope work in process arising under

construction contracts - IAS 11 financial instruments - IAS 39 biological assets related to

agricultural activity and agricultural produce at the point of harvest - IAS 41

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Fundamental Principle of IAS 2

Inventories are required to be stated at

the lower of cost and net realisable value (NRV)

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Measurement of Inventories Cost should include all costs of purchase (including taxes,

transport, and handling) net of trade discounts received

costs of conversion (including fixed and variable manufacturing overheads) and

other costs incurred in bringing the inventories to their present location and condition

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But not…. Inventory cost should not include: abnormal waste storage costs administrative overheads unrelated to

production selling costs foreign exchange differences arising

directly on the recent acquisition of inventories invoiced in a foreign currency

interest cost when inventories are purchased with deferred settlement terms

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Inventory costing methods The standard cost and retail methods may be

used for the measurement of cost, provided that the results approximate actual cost

For inventory items that are not interchangeable, specific costs are attributed to the specific individual items of inventory

For items that are interchangeable, IAS 2 allows the FIFO or weighted average cost formulas

The LIFO formula, ( allowed prior to the 2003 revision of IAS 2) is no longer allowed

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Retail method Discounted selling price

In some cases, where such large numbers of rapidly changing individual items are held, the only practical method of arriving at a figure to represent cost is to value the items at current selling price less the normal gross profit margin.

For example, in the case of a department store, a valuation by reference to the ticketed selling price of the stock reduced by the appropriate departmental mark-up.

This method of valuation is acceptable if it can be demonstrated that it gives a reasonable approximation of the actual cost.

Whilst this method may lead to some undervaluation where the original ticketed selling price has already been reduced, other stock may never reach its ticketed selling price and to that extent would be overvalued.

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Consistency of measurement The same cost formula should

be used for all inventories with similar characteristics as to their nature and use to the enterprise

For groups of inventories that have different characteristics, different cost formulas may be justified

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Write-Down to Net Realisable Value NRV is the estimated selling price in the ordinary

course of business, less the estimated cost of completion and the estimated costs necessary to make the sale

Any write-down to NRV should be recognised as an expense in the period in which the write-down occurs

Any reversal should be recognised in the income statement in the period in which the reversal occurs

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Disclosure Notes to the accounts should disclose: Accounting policies used and cost formula

employed Total carrying amount of inventories in the

BS classified into categories Carrying amount of inventories less costs

to sell Amount of inventories recognised as

expense in the period Amount of any write-down recognised as

an expense in the period Amount of any reversal of write down in

the period

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Construction Contracts – IAS 11 Deals with the treatment of recognition of

revenue and costs in construction contracts

What is a Construction Contract? A construction contract is a contract

specifically negotiated for the construction of an asset or a group of interrelated assets

It does not have to last for MORE than a year.

What is important is that it begins in one accounting period and ends in a different accounting period

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Types of Contract There are 2 types of contract Fixed Price Contract A contract in which the contractor agrees

to a fixed contract price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.

Cost Plus Contract A contract in which the contractor is

reimbursed for allowable or otherwise defined costs, plus a percentage of those costs or a fixed fee.

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Construction of more than one asset If a contract covers two or more assets,

the construction of each asset should be accounted for separately if -

separate proposals were submitted for each asset

portions of the contract relating to each asset were negotiated separately and

costs and revenues of each asset can be measured.

If not, then the contract should be accounted for in its entirety

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Contract Revenue Contract Revenue The amount specified in the contract Subject to variations in contract work, incentive

payments and claims IF They are expected to give rise to revenue and IF They can be reliably measured Types of uncertainty which can affect measurement of

contract revenue Agreed variation (increase/decrease) Cost escalation clauses in fixed price contract

(increase) Penalties for delays (decrease) Variation in number of units in fixed price per unit

contract (increase/decrease)

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Contract Costs Contract Costs Contract costs should include costs that relate directly to the

specific contract plus costs that are attributable to the

contractor's general contracting activity to the extent that they can be reasonably allocated to the contract

plus such other costs that can be specifically charged to the customer under the terms of the contract

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Costs that relate directly to the specific contract Costs that relate directly include - Site labour costs Costs of materials used in construction Depreciation of plant & equipment Costs of moving plant, materials, etc Costs of hiring plant & equipment Costs of design & technical assistance

related directly to the contract Estimated costs of rectification work Claims from third parties

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General contracting activity & Specifically chargeable costs Costs that relate to general contracting activities Should be allocated Systematically Rationally and Consistently Based on normal levels of construction activities Specifically chargeable costs ONLY if in contract General admin costs – if in contract R&D – if in contract Never Selling Costs Depreciation of idle plant & equipment not used on

any particular contract

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Recognition of revenue and costs Percentage Completion Method Recognised according to the stage

of completion of the contract at the BS date

Only when the outcome of the activity can be estimated with certainty

If a loss is predicted it should be recognised IMMEDIATELY

Reliable estimates can only be made under certain conditions

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Conditions for reliable estimates Fixed Price Contracts Probable economic benefit will flow to the entity Total contract revenue can be reliably measured Stage of completion at BS date and costs to complete

can be measured reliably Costs attributable to contract can be identified and

measured Cost Plus Contracts Probable economic benefit will flow to the entity Costs attributable to contract can be identified and

measured The percentage of completion method is application

of accruals method Revenue is matched to costs and Attributed to proportion of work completed.

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Reliable estimates When can reliable estimates be

made? Only when a contract has been

agreed which establishes the following:

The enforceable rights of each party The consideration that is to be

exchanged Terms and manner of settlement

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Stage of completion Determining the stage of

completion The stage of completion of a

contract can be determined in a variety of ways proportion that contract costs incurred

for work performed to date bear to the estimated total contract costs

surveys of work performed completion of a physical proportion of

the contract work

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Example

EXAMPLE

Stage of completion

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If outcomes cannot reliably be predicted

In such cases then Only recognise revenue to the

extent that contract costs are expected to be recovered

Recognise costs as expenses in period in which they are incurred

This is likely to be the case near start of contract

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Non-recoverable contract costs If contract costs cannot be recovered

recognise as expense immediately Circumstances would be:

Contract not fully enforceable Completion is subject to litigation Contract relates to properties which will

probably be expropriated or condemned Customer cannot meet obligations

under contract Contractor cannot complete contract Losses on contracts should be

recognised as soon as they are foreseen

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Disclosures Disclosures amount of contract revenue recognised method used to determine revenue method used to determine stage of

completion for contracts in progress at balance

sheet date: aggregate costs incurred and recognised

profit amount of advances received amount of retentions

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Presentation

Presentation The gross amount due from

customers for contract work should be shown as an asset

The gross amount due to customers for contract work should be shown as a liability

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Classification of Leases A lease is a FINANCE lease if It transfers substantially all the risks

and rewards incident to ownership All other leases are OPERATING leases Classification is made at the inception

of the lease Classification depends on the

substance of the transaction rather than the form

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Classification of Leases - 1 Situations that would normally lead to a lease

being classified as a finance lease include the following

the lease transfers ownership of the asset to the lessee by the end of the lease term

the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable

the lease term is for the major part of the economic life of the asset, even if title is not transferred

at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset

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Classification of Leases - 2 the lease assets are of a specialised

nature such that only the lessee can use them without major modifications being made.

if the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee

gains or losses from fluctuations in the fair value of the residual fall to the lessee

the lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent

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Land and Buildings Land and buildings elements would

normally be considered separately The minimum lease payments are

allocated between the land and buildings elements in proportion to their relative fair values

The land element is normally classified as an operating lease unless title passes to the lessee at the end of the lease term

The buildings element is classified as an operating or finance lease by applying the classification criteria

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Accounting by Lessees - 1 The following principles should be applied

in the financial statements of lessees: At commencement of the lease term FINANCE leases should be recorded as an

asset and a liability at the lower of the fair value of the asset and the present value of the minimum lease payments

i.e. discounted at the interest rate implicit in the lease or at the enterprise's incremental borrowing rate

Therefore: Dr Asset Account Cr Lessor (liability) account

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Accounting by Lessees - 1 FINANCE lease payments should be

apportioned between the finance charge and the reduction of the outstanding liability

The rule being that the finance charge be allocated so as to produce a constant periodic rate of interest on the remaining balance of the liability

The depreciation policy for assets held under FINANCE leases should be consistent with that for owned assets

If there is no reasonable certainty that the lessee will obtain ownership at the end of the lease - the asset should be depreciated over the shorter of the lease term or the life of the asset

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For OPERATING leases The lease payments should be recognised

as an expense in the income statement over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern of the user's benefit

Incentives (e.g. rent free periods) for the agreement of a new or renewed operating lease should be recognised by the lessee as a reduction of the rental expense over the lease term, irrespective of the incentive's nature or form, or the timing of payments

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Apportionment of Rental Payments

When a lessee makes a rental payment it consists of 2 parts

Interest charge on the finance provided

Repayment of Capital Cost The principal part will be

debited to the Liability account to reduce outstanding liability

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How to decide capital/interest split? Sum-of-digits method Assigns a digit to each instalment. Last instalment = 1, penultimate = 2, etc Add up digits n(n + 1) / 2 Therefore for 12 (12 X 13) / 2 = 156 / 2 = 78 Interest charge for each instalment = Digit applicable to the instalment Sum of the Digits

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How to decide capital/interest split? Actuarial method At beginning of lease capital

invested = fair value of asset, less any deposit paid

This amount reduces by each instalment, therefore interest is greater in earlier part of lease as more capital is outstanding

Straight line method Total finance cost Number of instalments

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Example On 1st January 20X0 Bacchus Co. buys bottling

machine under a finance lease Cash price is $7,710 and amount to be paid is

$10,000 Agreement required immediate payment of $2,000 Balance to be settled in 4 equal annual

instalments Commencing 31 December 20X0 Charge of $2,290 = interest of 15% calculated on

remaining balance of the liability during each accounting period

Depreciation is on 20% straight-line per annum Assumes Zero residual value So Equal instalments must be ($10,000 - $2,000) / 4 = $2,000