ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing
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Paper F7 (INT)
Financial reporting
CHAPTER
10
Inventory
Contents
1 Intangible assets: IAS36
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Inventories: IAS2
Definition of inventory
Valuation: lower of cost and net realisable value
Measuring the cost of inventory
Disclosure requirements for inventory
1 Inventories: IAS2
1.1 Definition of inventory
Inventories are:
Assets held for sale. For a retailer, these are items that the business sells – its
stock-in trade. For a manufacturer, assets held for sale are usually referred to as
‘finished goods’
Assets in the process of production for sale (‘work-in-progress’ for a
manufacturer)
Assets in the form of materials or supplies to be used in the production process
(‘raw materials’ in the case of a manufacturer).
There are several rules in IAS2 dealing with the valuation (measurement) of
inventory in the statement of financial position.
1.2 Valuation: lower of cost and net realisable value
IAS2 Inventories states that inventories should be valued at the lower of:
cost and
net realisable value.
Cost consists of all the costs of purchase, plus the costs of conversion and other costs
incurred in bringing the inventories to their present location and condition.
Costs of purchase include the cost of the item itself (less any trade discounts)
plus import duties, transport costs and other handling costs.
Costs of conversion are the ‘internal costs’ incurred in getting the inventory into
its current state, such as the internal costs incurred in producing finished goods.
They include both direct costs (such as labour and expenses) and a share of
production overheads, where production overhead absorption rates are based
on normal levels of activity.
Net realisable value (NRV) is the estimated selling price of the item minus:
all the (estimated) costs to make the item ready for sale, and
all the (estimated) costs necessary to make the sale.
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IAS2 comments that the practice of writing down inventories below cost to their net
realisable value is consistent with the view that assets should not have a carrying
value in the statement of financial position that exceeds the amount expected to be
realised from their sale or use.
1.3 Measuring the cost of inventory
IAS2 allows three methods for measuring the cost of inventories.
Actual cost
First-in, first-out (FIFO)
Weighted average cost (AVCO).
Actual cost is used where items can be individually traced. This is usual for high-
value items. For example, cars for sale in a car dealer’s showroom will normally be
valued at actual cost in the financial statements of the car dealer.
Where it is not possible to identify actual cost, a choice is allowed between FIFO or
AVCO. The chosen method should be applied consistently to all similar types of
inventories.
1.4 Disclosure requirements for inventory
IAS2 requires the following disclosures in notes to the financial statements.
The accounting policy adopted for measuring inventories, including the cost
valuation method used.
The total carrying amount of inventories, classified appropriately. (For a
manufacturer, appropriate classifications will be raw materials, work-in-
progress and finished goods.)
The amount of inventories carried at net realisable value or NRV (‘fair value
minus costs to sell’).
The amount of inventories written down in value, and so recognised as an
expense during the period.
Details of any circumstances that have led to the write-down of inventories to
NRV.
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Construction contracts: IAS11
Definition of a construction contract
The accounting problem with construction contracts
Recognising revenue and costs of a contract in the financial statements
Measuring revenue, costs and profit or loss for a contract
Disclosure in the financial statements and amounts in the statement of
financial position
2 Construction contracts: IAS11
2.1 Definition of a construction contract
A construction contract is a contract specifically negotiated with a client for the
construction of:
a single asset such as a bridge, building, pipeline or road, or
a number of related assets. For example, an oil refinery might be made up of
several assets, such as buildings, pipelines, oil tanks and so on
2.2 The accounting problem with construction contracts
IAS11 Construction contracts sets out how an entity that is constructing an asset
under a construction contract (the contractor) should deal in its financial statements
with the revenues and costs arising from that contract.
The work on a large construction contract is likely to cover at least two accounting
periods (and in the case of large construction contracts is often more than two
accounting periods). The main problem with the accounting for construction
contracts is therefore to decide how to allocate the revenue and costs of the contracts
between the different accounting periods and when to recognise profit.
One possible way of accounting for a construction contract would be to wait until
the contract is complete before taking all the revenue and costs for the contract to
profit or loss. However, this would result in misleading financial statements,
because it would be misleading to report no profits or losses in the years in which a
long-term contract remains unfinished, and then to report all the profit or loss for
several years’ work on the contract in the year of completion. This method of
accounting for construction contracts is therefore not used.
IAS11 requires construction contracts to be accounted for on an accruals basis. It
states that revenue and costs should be matched to accounting periods. This means
that in each accounting period, a proportion of the overall (estimated) profits on the
contract are taken to profit or loss.
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Provided that estimates are made on a reasonable basis, then the amounts taken to
profit or loss in each year, in accordance with IAS11, will reflect the underlying
position – which is that profits are earned over the life of the construction contract,
not on the date that the contract is finally completed.
However, IAS 11 also applies the following requirements.
Revenue and costs can only be recognised when the outcome of a contract can be
estimated reliably.
If a contract is expected to make a loss, the whole of the loss must be recognised
immediately.
These requirements apply the concept of prudence and help to ensure that the
information in the financial statements is reliable.
IAS 11 appears to be at odds with the ‘accounting equation’ approach adopted by
the IASB Framework and other accounting standards, in which equity is the
difference between assets and liabilities, and profit for the year is the increase in
equity (assuming no dividend payments, no share issues and no upward asset
revaluations). IAS 11 takes a different view of the accounting process, in which
transactions are matched to accounting periods and assets and liabilities are the
amounts ‘left over’.
2.3 Recognising revenue and costs of a contract in the financial statements
The following rules apply to the recognition of the revenue and costs for a
construction contract in the financial statements of the contractor.
Contract revenue
Contract revenue is the amount payable by the customer. IAS 11 defines it as:
the initial amount of revenue agreed in the contract; plus
variations in contract work, claims and incentive payments (provided that these
will probably result in revenue and can be reliably measured).
All of the contract price, or a large part of it, may be a fixed amount (= a price
agreed in the terms of the contract). Provided that the outcome of the contract can
be estimated reliably, revenue is taken to profit or loss as the contract progresses.
This is sometimes called the percentage of completion method of accounting for
construction contracts.
Determining the stage of completion of a contract
There are several possible methods of measuring the stage (percentage) of
completion of a contract.
Use the percentage of total contract costs incurred to date (sometimes called the
costs basis). This is the more common method in examination questions.
Use surveys of work performed (sometimes called the sales basis). As a contract
progresses, at periodic intervals, an independent expert such as a surveyor may
inspect the work, and issue a certificate stating the amount or value of the work
done so far. The most recent certificate issued by the independent expert
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provides a basis for judging the proportion of the contract work that has been
completed.
Use the physical proportion of the contract work that has been completed.
The percentage of completion should not normally be based on the percentage of
the total fee received from the customer to date. This is unlikely to reflect the
proportion of the work actually completed.
Contract costs
Contract costs are:
the direct costs of the contract (such as labour costs, costs of materials,
depreciation of plant used in the construction work), and
a reasonable proportion of indirect costs (such as insurance costs, general design
costs that are not attributable to specific contracts, and other general overheads)
any other costs that are specifically chargeable to the customer under the terms
of the contract.
Contract costs are recognised as an expense in the accounting period in which the
work to which they relate is performed.
When can the outcome of a contract be estimated reliably?
Revenue and costs can only be recognised when the outcome of a contract can be
estimated reliably. So when can the outcome be reliably estimated? This depends on
the type of contract. IAS 11 identifies two types of contract:
Fixed price contract: the contractor agrees to a fixed contract price (which is
sometimes subject to cost escalation clauses).
Cost plus contract: the contractor is reimbursed for allowable costs, plus a fee.
The fee can either be a fixed amount or a percentage of the contract costs.
The outcome of a fixed price contract can be estimated reliably when:
total contract revenue can be measured reliably
it is probable that the economic benefits associated with the contract will flow to
the entity
both the costs to complete the contract and the stage of completion at the balance
sheet date can be measured reliably
the costs attributable to the contract can be clearly identified and measured
reliably so that actual contract costs incurred can be compared with prior
estimates.
The outcome of a cost plus contract can be estimated reliably when:
it is probable that the economic benefits associated with the contract will flow to
the entity
the costs attributable to the contract can be clearly identified and measured
reliably.
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When the outcome of a contract cannot be estimated reliably:
revenue should be recognised only to the extent of contract costs incurred that
are expected to be recoverable
contract costs should be recognised as an expense in the period in which they are
incurred.
2.4 Measuring revenue, costs and profit or loss for a contract
To calculate the figures for contract revenue and contract costs that should be
recognised as income or expense in a period, the following steps should be taken.
Step 1: Calculate the total profit expected on the contract.
$
Contract price X
Minus costs to date (X)
Estimated future costs (X)
–
–––––
Total expected profit/(foreseeable loss) X/(X)
–
–––––
If the contract in total shows a loss, the whole loss should be recognised as an
expense immediately.
If the outcome of the contract is uncertain, possibly because it is too early in the life
of the contract to make a reasonable estimate, there should be no profit and no loss
for the contract. In Step 3 below, a nil profit is obtained by making revenue equal to
the costs for the contract so far.
Step 2: Calculate the proportion of the work completed. An examination question
will indicate which basis to use.
Step 3: The figures for revenue, expenses and profit or loss on the contract to date
are normally calculated in the following order:
first, a figure for revenue, and
next, the figure for profit.
Costs are then a balancing figure, equal to the difference between revenue and
profit (or loss).
For a long-term contract, figures are calculated first of all for total revenue, total
profit and total costs to date. The revenue, profit and costs for the current financial
period are then calculated as the difference between:
the total revenue, profit and costs to date, and
the total revenue, profit and costs as at the end of the previous financial period.
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Year 1 Year 2 Year 3
$ $ $
Cumulative to year end X X X
Minus amount recognised as revenue, proft
or costs in previous years
- (X) (X)
–
–––
–
–––
–
–––
This year (balancing figure) X X X
–
–––
–
–––
–
–––
Example
The following are figures in relation to a long-term construction contract
undertaken by Entity D. The figures are for the year ended 31 December Year 4.
$000
Contract price 1,500
Costs to date 1,000
Expected future costs 200
Work certified to date 1,100
Profits taken in earlier years 100
Revenue taken in earlier years 750
Required
Calculate the revenue, profit and costs for the contract for the year ended 31
December Year 4 on
(a) a sales basis
(b) a costs basis.
Answer
Workings
Step 1
Calculate the total profit expected on the contract.
$000
$000
Contract price
1,500
Minus costs to date (1,000)
Estimated future costs (200)
–
–––––
Total expected costs for the contract
(1,200)
–
–––––
Total expected profit
300
–
–––––
Step 2
Calculate the proportion of work completed to date.
(a) Sales basis = Work certified to date/Total sales value = 1,100/1,500 = 73.3%.
(b) Costs basis = Costs to date/Total costs = 1,000/1,200 = 83.3%.
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Step 3
Calculate the figures for revenue first, then profit, then costs as the balancing figure.
Revenue Yearended31DecemberYear4
Sales
basis
Costs
basis
$000$000
Cumulativetoyearend (work
certified)
1,100 (1,500×
83.3%)
1,250
Minusrevenuerecognisedinpreviousyears(750)(750)
–
––
–
–
–––
Revenuethisyear(balancingfigure)350500
–
–––
–
–––
Profit Yearended31DecemberYear4
Sales
basis
Costs
basis
$000$000
Cumulativetoyearend (300×
73.3%)
220 (300×
83.3%)
250
Minusrecognisedasprofitinpreviousyears(100)(100)
–
–––
–
–––
Profitthisyear(balancingfigure)120150
–
–––
–
–––
Costs are then calculated as a balancing figure, the difference between revenue and
profit.
Summary
Yearended31DecemberYear4
SalesbasisCostsbasis
$000$000
Revenue 350500
Costs(balancingfigure) (230)(350)
–
–––
–
–––
Profit 120150
–
–––
–
–––
Example
Entity E has the same figures in relation to its construction contract for the year
ended 31 December Year 4 as Entity D, except that estimated future costs are
$600,000.
Required
Calculate the figures for revenue, profit or loss and costs for the year ended 31
December Year 4 on a costs basis.
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Answer
Workings
Step 1
Calculate the total profit or loss expected on the contract.
$000
Contract price 1,500
Minus costs to date (1,000)
Estimated future costs (600)
–
–––
Foreseeable loss (100)
–
–––
Step 2
Calculate the proportion of work completed to date.
Costs basis = Costs to date/Total costs = 1,000/1,600 = 62.5%
Step 3
Calculate the figures for revenue first, then profit or loss.
Yearended31DecemberYear4
Revenue: $000
Cumulativetoyearend(1,500×62.5%) 938
Minusrevenuerecognisedinincomeinpreviousyears (750)
–
–––
Revenuethisyear(balancingfigure) 188
–
–––
Yearended31DecemberYear4
Profitorloss: $000
Cumulativelosstocurrentyearend (100)
Profittakenrecognisedinpreviousyears 100
–
–––
Losstobereportedthisyear (200)
–
–––
In order to arrive at the correct cumulative position of a loss of $100,000, a loss of
$200,000 is recognised this year, because a profit of $100,000 has been taken in the past.
Summary
Costs are calculated as the difference between revenue and the profit or loss. A loss
should be added to revenue to calculate costs.