Microsoft Word - F1_FRT_Chapter

Inventories and

Government Grants

Chapter

12.1  Inventories

An organisation either buys or manufactures its inventories or stock to then sell to its customers to
generate  revenue.    In  the  income  statement  the  revenues  generated  are  matched  with  the  cost  of
those sales – this is the matching concept.  The gross profit is arrived at as follows:

Revenue

Less cost of goods sold (or cost of sales)

Opening inventories / stock

Plus purchases or manufacturing costs

Less closing inventories / stock

(X)

Cost of goods sold

(X)

Gross profit

§ Goods purchased and held for resale (including land and other property held for re-sale.
§ Raw materials, work in progress and finished goods for manufacturing industries.

IAS 2 does not deal with:

§ Work in progress under construction contracts (this is dealt under IAS 11 construction

contracts).

§ Financial instruments like futures contracts, shares and bonds (dealt under IAS 39).
§ Agricultural industry goods like biological assets (dealt under IAS 41).

Cost measurement

IAS 2 states that inventories must be measured at the lower of cost and net realisable value

Cost of inventories includes the following:

§ Cost of purchase This includes purchase price, import costs, handling costs and other

directly attributable costs.

§ Costs of conversion. These include the costs for bringing the product to its finished state,

including direct labour, direct overheads, variable overheads and fixed overheads
(production overheads).

§ Other costs incurred to bring the inventories to their present location and condition.

The types of costs which are not allowed under IAS 2 are:

§ Abnormal costs. These include buying substandard material which is wasted, additional

labour costs to rectify work and other related production costs which are abnormal in
nature.

§  Administrative expenses (which are not related to production).
§  Selling and distribution costs.
§  Storage costs, unless they are part of the production waiting process.
§  Foreign exchange differences arising on inventory invoiced in foreign currency.

The  types  of  costs  which  are  not  allowed  under  IAS  2  are  charged  as  an  expense  to  the  income
statement in the period incurred.

Methods of valuing inventories

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

Where  the  inventory  consists  of  similar  items  that  have  been  purchased  at  different  times  and  at
different  prices,  it  becomes  more  difficult  to  value  the  inventories  for  cost  of  sale  and  year  end
purposes.  Assumptions  have to be made as to how the inventory  is  flowing through the business
and the fairest methods are used for establishing cost.

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

§ FIFO – first in first out - assumes goods sold in order they were purchased.
§ Weighted average cost - all units are pooled and weighted average cost determined.

The LIFO (last in first out formula) which had been allowed prior to the 2003 revision of IAS 2 is
no longer allowed.

Lecture Example 12.1

Ali Ltd is a manufacturing company, which manufactures Thingmajigs units and the following
details of purchases and sales are relevant.

200 Thingmajigs

purchased

week 1 at £30 per unit

100 Thingmajigs

purchased

week 2 at £35 per unit

200 Thingmajigs

sold

week 3 at £40 per unit

Calculate gross profit earned and the valuation of stock remaining at end of week 3 using following
valuation methods.

1

Weighted average cost

First in first out

Net realisable value (NRV)

The net realisable value is the actual or estimated selling price (net of trade but before settlement
discounts) less further costs to complete and costs of marketing, selling and distribution.

Normally you want the cost to be lower than NRV, situations where this may not be the case:

§  Increase in cost or fall in selling price.
§  Physical deterioration or obsolescence (technology) of stocks.
§  Errors in production or purchasing – costs not accurately budgeted.
§  Company  strategy  -  loss  leaders.    Deliberately  selling  goods  at  a  lower  price  to

encourage sales or beat competition.

At the period end, the NRV of inventories is established normally on an item by item basis.  If this
is not possible, then the related items are grouped together.  Where the NRV is lower than the cost,
the  write  down  is  taken  to  the  income  statement  as  an  expense.    If  the  situation  reverses  in
subsequent  periods,  the  reversal  should  be  taken  to  the  income  statement  as  a  reduction  to  the
expense in the period in which the reversal occurs.

Long-

Lecture Example 12.2

Butt Ltd has the following information at the company’s year end regarding valuation on different
classes of inventory.

Cost

NRV

Group A

500

400

Group B

120

200

Group C

250

200

Group D

700

600

Total

1,570

1,400

At what value should the inventory be stated in the statement of financial position at year-end?

Disclosures required by IAS 2:

§  Accounting policy for inventories.
§  Cost of inventories recognised as expense (cost of goods sold)
§  Carrying amount inventories in the balance sheet.
§  Carrying amount of any inventories carried at fair value less costs to sell.
§  Any write-down (and reversal of write-downs) of inventories recognised as an expense in

the period.

Where  an  organisation  produces  their  income  statement  by  function,  they  will  show  the  cost  of
goods  line.    Where  the  organisation  produces  their  income  statement  by  nature  then  IAS  2  does
allow the costs of raw materials, consumables,  labour costs, other operating costs and the amount
of the net change in inventories for the period to be shown. This is as per the requirements of IAS 1
presentation  of  financial  statements,  which  allows  the income statement  expenses  to  be presented
by either function or nature.

12.2

IAS 20 Accounting for Government Grants and Disclosure of Government

Assistance

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance outlines how
to account for government grants and other assistance.

Government grants are recognised in profit or loss on a systematic basis over the periods in which
the entity recognises expenses for the related costs for which the grants are intended to compensate,
which in the case of grants related to assets requires setting up the grant as deferred income or
deducting it from the carrying amount of the asset.

This Standard does not deal with:

the special problems arising in accounting for government grants in financial statements
reflecting the effects of changing prices or in supplementary information of a similar
nature;

government assistance that is provided for an entity in the form of benefits that are
available in determining taxable profit or tax loss, or are determined or limited on the basis
of income tax liability. Examples of such benefits are income tax holidays, investment tax
credits, accelerated depreciation allowances and reduced income tax rates;

government participation in the ownership of the entity;

government grants covered by IAS 41 Agriculture.

Accounting for grants

A government grant is recognised only when there is reasonable assurance that:

(a) the entity will comply with any conditions attached to the grant and

(b) the grant will be received.

The grant is recognised as income over the period necessary to match them with the related costs,
for which they are intended to compensate, on a systematic basis.

Non-monetary  grants,  such  as  land  or  other  resources,  are  usually  accounted  for  at  fair  value,
although recording both the asset and the grant at a nominal amount is also permitted.

Even  if  there  are  no  conditions  attached  to  the  assistance  specifically  relating  to  the  operating
activities of the entity (other than the requirement to operate in certain regions or industry sectors),
such grants should not be credited to equity.

A grant receivable as compensation  for costs already  incurred or  for immediate financial support,
with no future related costs, should be recognised as income in the period in which it is receivable.

Presentation of grants related to assets

A grant relating to assets may be presented in one of two ways:

as deferred income that is recognised in the income statement on a systematic basis over
the useful life of the asset.

Journals:

Receipt of grant

Dr Bank

Cr Deferred income (SOFP)

Recognising in the income statement

Cr Income statement Dr Deferred income (SOFP)

by deducting the grant from the asset's carrying amount. The grant is recognised in
profit or loss over the life of a depreciable asset as a reduced depreciation charge.

Journal:

Receipt of grant

Dr Bank

Cr non current asset (SOFP)

Presentation of grants related to income

Grants related to income are presented as part of income statement either:

· Separately or under a general heading such as ‘Other income’.

Journal:

Receipt of grant

Dr Bank

Cr Other income / Grant

Or

· they are deducted in reporting the related expense.

Journal:

Receipt of grant

Dr Bank

Cr Expenses

It could be argued that it is inappropriate to net income and expense items and that separation of
the grant from the expense facilitates comparison with other expenses not affected by a grant.

Alternatively it can be argued that the expenses might well not have been incurred by the entity if
the grant had not been available and presentation of the expense without offsetting the grant may
therefore be misleading.

Both  methods  are  regarded  as  acceptable  for  the  presentation  of  grants  related  to  income.
Disclosure  of  the  grant  may  be  necessary  for  a  proper  understanding  of  the  financial  statements.
Disclosure  of  the  effect  of  the  grants  on  any  item  of  income  or  expense  which  is  required  to  be
separately disclosed is usually appropriate.

Repayment of government grants

A  government  grant  that  becomes  repayable  shall  be  accounted  for  as  a  change  in  accounting
estimate (IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors).

Repayment  of  a  grant  related  to  income  shall  be  applied  first  against  any  unamortised  deferred
credit  recognised  in  respect  of  the  grant.  To  the  extent  that  the  repayment  exceeds  any  such
deferred credit, or when no deferred credit exists, the repayment shall be recognised immediately in
profit or loss.

Repayment of a grant related to an asset shall  be recognised by  increasing the carrying amount of
the  asset  or  reducing  the  deferred  income  balance  by  the  amount  repayable.  The  cumulative
additional depreciation that would  have been recognised in profit or loss to date in the absence of
the grant shall be recognised immediately in profit or loss.

Circumstances giving rise to repayment of a grant related to an asset may require consideration to
be given to the possible impairment of the new carrying amount of the asset.

Government assistance

Government  grants  do  not  include  government  assistance  whose  value  cannot  be  reasonably
measured, such as technical or marketing advice.

· Excluded from the definition of government grants are certain forms of government

assistance which cannot reasonably have a value placed upon them and transactions with
government which cannot be distinguished from the normal trading transactions of the
entity.

· Examples of assistance that cannot reasonably have a value placed upon them are free

technical  or  marketing  advice  and  the  provision  of  guarantees.  An  example  of  assistance
that  cannot  be  distinguished  from  the  normal  trading  transactions  of  the  entity  is  a
government  procurement  policy  that  is  responsible  for  a portion  of  the entity’s  sales.  The
existence  of  the  benefit  might  be  unquestioned  but  any  attempt  to  segregate  the  trading
activities from government assistance could well be arbitrary.

· The significance of the benefit in the above examples may be such that disclosure of the

nature, extent and duration of the assistance is necessary in order that the financial
statements may not be misleading.

· In IAS 20 government assistance does not include the provision of infrastructure by

improvement to the general transport and communication network and the supply of
improved facilities such as irrigation or water reticulation which is available on an ongoing
indeterminate basis for the benefit of an entire local community.

Disclosure of government grants

The following matters shall be disclosed:

· the accounting policy adopted for government grants, including the methods of

presentation adopted in the financial statements;

· the nature and extent of government grants recognised in the financial statements and an

indication of other forms of government assistance from which the entity has directly
benefited; and

· unfulfilled conditions and other contingencies attaching to government assistance that has

been recognised.

Key summary of chapter “inventories and government grants and disclosures of government

assistance”

The accounting standard which deals with inventories is IAS 2.  It gives guidance on determining
the  cost  of  inventories,  for  subsequently  recognising  an  expense  in  the  income  statement
(including  any  write-down  to  net  realisable  value)  and  it  also  provides  guidance  on  the  cost
formulas that are used to assign costs to inventories.

The basic fundamental rule of IAS 2 is that the closing inventories at the year end must be valued
at the lower of cost and net realisable value.
Cost of inventories includes the following:
§  Cost of purchase
§  Costs of conversion.
§  Other costs

Methods of valuing inventories
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:
§  FIFO – first in first out - assumes goods sold in order they were purchased.
§  Weighted average cost - all units are pooled and weighted average cost determined.

Net realisable value (NRV)
The net realisable value is the actual or estimated selling price (net of trade but before settlement
discounts)  less  further  costs to  complete and  costs  of  marketing,  selling  and  distribution.  Where
the NRV is lower than the cost, the write down is taken to the income statement as an expense.  If
the situation reverses in subsequent periods, the reversal should be taken to the income statement
as a reduction to the expense in the period in which the reversal occurs.

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance

IAS  20  Accounting  for  Government  Grants  and  Disclosure  of  Government  Assistance  outlines
how to account for government grants and other assistance.

Government grants are recognised in profit or loss on a systematic basis over the periods in which
the  entity  recognises  expenses  for  the  related  costs  for  which  the  grants  are  intended  to
compensate, which in the case of grants related to assets requires setting up the grant as deferred
income or deducting it from the carrying amount of the asset.

A government grant is recognised only when there is reasonable assurance that:

(a) the entity will comply with any conditions attached to the grant and

(b) the grant will be received.

Presentation of grants related to assets

A grant relating to assets may be presented in one of two ways:

as deferred income that is recognised in the income statement on a systematic basis over
the useful life of the asset.

Journals:

Receipt of grant

Dr Bank

Cr Deferred income (SOFP)

Recognising in the income statement

Cr Income statement Dr Deferred income (SOFP)

by deducting the grant from the asset's carrying amount. The grant is recognised in
profit or loss over the life of a depreciable asset as a reduced depreciation charge.

Journal:

Receipt of grant

Dr Bank

Cr non current asset (SOFP)

Presentation of grants related to income

Grants related to income are presented as part of income statement either:

· Separately or under a general heading such as ‘Other income’.

Journal:

Receipt of grant

Dr Bank

Cr Other income / Grant

Or

· they are deducted in reporting the related expense.

Journal:

Receipt of grant

Dr Bank

Cr Expenses

Repayment of government grants

Repayment  of  a  grant  related  to  income  shall  be  applied  first  against  any  unamortised  deferred
credit  recognised  in  respect  of  the  grant.  To  the  extent  that  the  repayment  exceeds  any  such
deferred credit, or when no deferred credit exists, the repayment shall be recognised immediately
in profit or loss.

Repayment of a grant related to an asset shall be recognised by increasing the carrying amount of
the  asset  or  reducing  the  deferred  income  balance  by  the  amount  repayable.  The  cumulative
additional depreciation that would have been recognised in profit or loss to date in the absence of

the grant shall be recognised immediately in profit or loss.

Government assistance

Government grants do not include government assistance whose value cannot be reasonably
measured, such as technical or marketing advice.

Disclosure of government grants

The following matters shall be disclosed:

· the accounting policy adopted for government grants, including the methods of

presentation adopted in the financial statements;

· the nature and extent of government grants recognised in the financial statements and an

indication of other forms of government assistance from which the entity has directly
benefited; and

· unfulfilled conditions and other contingencies attaching to government assistance that has

been recognised.

Solutions to Lecture Examples

Solution to Lecture Example 12.1

1

Weighted average cost price at end of week 2

(200 x £30) + (100 x £35)

£31.67 per Thingmajig

300

Gross profit

Sales

200 x £40

£8,000

Less cost of goods sold

200 x £31.67

£6,334

Gross profit

£1,666

Calculation of inventory in the statement of financial position

100 Thingmajigs remaining in stock x £31.67

£3,167

FIFO

Gross profit

Sales

200 x £40

£8,000

Less cost of goods sold

200 x £30

£6,000

Gross profit

£2,000

Calculation of inventory in the statement of financial position

100 Thingmajigs remaining in stock x £35

£3,500

One of the features of FIFO based costing is that statement of financial position values are the most
recent and cost of goods sold are historic ones. In period of inflation, FIFO will overstate gross
profit because current revenues are matched with historical costs.

Solution to Lecture Example 12.2

Cost

NRV

Lower of Cost and NRV

Group A

500

400

Group B

120

200

120

Group C

250

200

Group D

700

600

Total

1,570

1,400

1,320

Answer £1,320

Inventories are valued at lower of cost and net realisable value.
The difference of (1570 – 1320) £250 will be expenses in the income statement.