Chapter
Inventories and
Government Grants
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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 X
Less cost of goods sold (or cost of sales)
Opening inventories / stock X
Plus purchases or manufacturing costs X
Less closing inventories / stock (X)
Cost of goods sold (X)
Gross profit X
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.
IAS 2 inventories deals with:
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.
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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 Ł30 per unit
100 Thingmajigs purchased week 2 at Ł35 per unit
200 Thingmajigs sold week 3 at Ł40 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
2 First in first out
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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
Ł Ł
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?
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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.
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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:
1. 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;
2. 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;
3. government participation in the ownership of the entity;
4. 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.
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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)
or
� 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.
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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.
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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.
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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:
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� 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)
or
� 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
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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.
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Solutions to Lecture Examples
Solution to Lecture Example 12.1
1 Weighted average cost price at end of week 2
(200 x Ł30) + (100 x Ł35) = Ł31.67 per Thingmajig
300
Gross profit
Sales 200 x Ł40 = Ł8,000
Less cost of goods sold 200 x Ł31.67 = Ł6,334
Gross profit Ł1,666
Calculation of inventory in the statement of financial position
100 Thingmajigs remaining in stock x Ł31.67 = Ł3,167
2 FIFO
Gross profit
Sales 200 x Ł40 = Ł8,000
Less cost of goods sold 200 x Ł30 = Ł6,000
Gross profit Ł2,000
Calculation of inventory in the statement of financial position
100 Thingmajigs remaining in stock x Ł35 = Ł3,500
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 500 400 400
Group B 120 200 120
Group C 250 200 200
Group D 700 600 600
Total 1,570 1,400 1,320
Answer Ł1,320
Inventories are valued at lower of cost and net realisable value.
The difference of (1570  1320) Ł250 will be expenses in the income statement.
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