International Accounting Standards The Key Issues in IAS 2 and 11 Background In this second of my series on international accounting standards, I have chosen to look at the two standards covering the topic of stocks and long term contracts. Both IAS 2 Inventories and IAS 11 Construction and Service Contracts were revised in December 2003. These largely cover the subject matter contained in the Irish standard SSAP 9 Stocks and long term work in progress. The standards are very similar and it will cause very little heartache when the standards are introduced into Irish GAAP. IAS 2 Inventories (Revised December 2003) Objective, Exemptions and Definitions The objective of IAS 2 is very similar to the first half of SSAP 9. It prescribes the accounting treatment for inventories (stocks under SSAP 9) and determines the cost to be recognised as an asset. It also provides guidance on cost formulas to adopt and when to write down inventories to net realisable value. There are a number of exceptions to IAS 2 including work in progress arising in construction and service contracts (covered in IAS 11), financial instruments, biological assets and agricultural and forest products. Inventories include raw materials, short term work in progress and finished goods although they are more formally described as assets: a) Held for sale in the ordinary course of business; b) In the process of production; or c In the form of materials, supplies to be consumed in production or rendering of services. Measurement of Inventories IAS 2 is identical to SSAP 9 in valuing inventories should be measured at the lower of cost and net realisable value. The key aspects in the measurement of cost include: 1. Cost of inventories All costs of purchase, costs of conversion and other costs in bringing the inventories to their present location and condition. 2. Costs of purchase These comprise the purchase price, import duties, transport and handling costs. However trade discounts and rebates must be deducted. 3. Costs of conversion These include direct labour and a systematic allocation of overheads, both fixed and variable, incurred in converting materials into finished goods. Fixed overheads (maintenance, depreciation, factory management costs) should be allocated on the basis of normal capacity i.e. that which could be achieved on average over a number of periods or seasons. Actual capacity may be adopted if it approximates normal activity. Any unallocated overheads must, however, be expended. However in periods of abnormally high production the allocation of overheads should be decreased so that inventories are not measured above cost. Variable production overheads are allocated on the basis of the actual use of the production facilities. Unlike SSAP 9, joint products are covered in IAS 2 and a suitable allocation method should be adopted such as the relative sales value method. By products should be measured at NRV and deducted from the cost of the main product. 4. Other costs These are only permitted if they bring inventories to their present location and condition e.g. the cost of specific designing of products for customers. Examples of specific exclusions include: a) abnormal costs eg wasted materials, labour. b) storage costs c) administration overheads d) selling costs However, borrowing costs are included provided they meet the criteria in IAS 23 Borrowing Costs and are essential in getting the stocks to their present location and condition. In whiskey distilling, for example, it can take several years for a malt whiskey to mature and the distillers require to borrow finance during the maturation period. The interest is therefore an essential cost in improving the condition of that whiskey and thus should be added to stocks rather than being expensed immediately through the profit and loss account. Techniques for the Measurement of Cost Similar to SSAP 9, standard cost and the retail gross margin method may be adopted if their results approximate cost. Both methods must, however, be regularly reviewed and revised, if necessary. If adopting the retail method one must be careful to deduct gross margins but also, in cases of marked down inventories, to ensure that they are not reduced below cost, if they can recover that cost. 37
Cost Formulas Costs should be specifically identified to specific projects, where possible. That, however, is not appropriate where there are large numbers of items of inventories that are ordinarily interchangeable. In those cases the method selected should be FIFO or weighted average. The same formula should be adopted for all inventories having a similar nature and use to the entity. However, a difference in geographical location, by itself, would not be sufficient to justify the use of different cost formulas. FIFO results in inventory valuations being up to date. LIFO would not be an acceptable method as inventories tend to be valued at out of date prices but it has only recently been banned by the revised version of IAS 2. Net Realisable Value Where the cost of inventories may not be recoverable e.g. goods are damaged, obsolete or selling prices declined etc. then inventories should not be carried in excess of the amounts that can be expected to be realised from their sale or use. Inventories are usually written down to NRV on an item by item basis. It is not appropriate to write-down inventories based on a general classification e.g. finished goods, or all inventories in a particular industry. Estimates of NRV are based on the most reliable evidence of amounts expected to realise and should take into account price fluctuations post balance sheet date to the extent that they can confirm conditions at that date. If inventories are for a specific contract reference should be made only to the contract price of that specific contract but, if for sale generally, to general selling prices. Materials are not written down below cost provided the finished products into which they will be incorporated are expected to be sold at or above cost. However, if a decline in material prices indicates that the cost of finished goods exceeds NRV then the materials should be written down to NRV using replacement cost as the best available measure. NRV should be reviewed in every subsequent period and if circumstances reveal that the writedown is no longer appropriate, it should be reversed. Recognition As An Expense Under IAS 2, when inventories are sold, they should be expended in the period when the revenue is recognised with any write-downs or reversals being recorded in the period they occur. However, if some inventories are used in the construction of property, plant etc. they should be capitalised as part of the cost of fixed assets and subsequently expended over their useful lives. Disclosure The financial statements should disclose the following: a) The accounting policies adopting in measuring inventories, including cost formulas. b) The total carrying amount of inventories broken into appropriate classifications c) The carrying amount at fair value less costs to date d) The amount expended in the period e) The amount of any writedowns of inventories f) The amount of any reversal of any writedowns. g) The circumstances or events that led to the writedown(s). h) The carrying amount of inventories pledged as security for liabilities Common classifications include retail merchandise, production supplies, materials, work in progress and finished goods. Effective Date The revised standard is applicable for accounting periods beginning on or after 1st January 2005 IAS 11 Construction Contracts (1993) Background The basic principle of IAS 11 is that when the outcome of a construction contract can be estimated 38
reliably, contract revenue and associated costs with the construction contract should be recognised as revenue and expenses respectively. Revenues and costs must be allocated to accounting periods by reference to the stage of completion of the contract activity at the balance sheet date. Any expected loss on a construction contract should be recognised as an expense immediately. These are virtually the same principles as the second half of SSAP 9. Key Definitions Construction contracts A construction contract is a contract specifically negotiated for the construction of an asset or group of inter-related assets. Construction contracts include contracts for architectural, engineering, demolition and other services related to the construction of an asset. There is no definition of a long-term contract. Any contract expressly for building an asset should be included, whether a garden shed at the end of a garden or the Millenium Dome!! Under IAS 11, 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; * The portions of the contract relating to each contract were negotiated separately; and * The costs and revenues of each asset can be measured. Otherwise, the contract should be accounted for in its entirety. Two or more contracts should be accounted for as a single contract if they were negotiated together and the work is inter-related. A group of contracts can only be grouped together as one contract if they are negotiated as a single deal, have effectively one overall profit margin and they occur concurrently or in a continuous sequence. Contract Revenue and Costs Contract Revenue Contract revenue should comprise: (a) the initial amount of revenue agreed in the contract; and (b) variations in contract work, claims and incentive payments: (i) to the extent that is probable that they will result in revenue; and (ii)they are capable of being reliably measured. The latter types of revenue particularly incentive payments and claim are subject to considerable uncertainty with regards to client agreement and whether or not targets are met and therefore should be largely back loaded into profit and loss. Contract Costs Contract costs should comprise: (a) costs that relate directly to the specific contract; (b) costs that are attributable to contract activity in general and can be allocated to the contract; and (c) such other costs as are specifically chargeable to the customer under the terms of the contract. Costs that relate directly to a specific contract include: (a) site labour costs, including supervision; (b) costs of materials used in construction; (c) depreciation of plant used on the contract; (d) costs of moving plant and materials to and from the contract; (e) costs of hiring plant; (f) costs of design and technical assistance directly attributable to the contract; (g) the estimated costs of rectification and guarantee work including expected warranty costs; (h) claims from third parties; Similarly to IAS 2 borrowing costs may also be capitalised under IAS 23. Determining When Contract Revenue and Expenses May Be Recognised Fixed Price Contracts In the case of a fixed price contract, the outcome of a construction can be estimated reliably when all the following conditions are satisfied: (a) the total contract revenue can be measured reliably; (b) it is probable that the economic benefits associated with the contract will flow to the enterprise; (c) both the contract costs to complete and the stage of completion at the balance sheet date can be measured reliably; (d) the contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates. Cost Plus Contracts In the case of a cost plus contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied: (a) it is probable that the economic benefits associated with the contract will flow to the enterprise; (b) the contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably. 39
The stage of completion of a contract may be determined in a variety of ways. The enterprise uses the method that measures reliably the work performed. Depending on the nature of the contract, the methods may include: (a) the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs; (b) surveys of work performed; (c) completion of a physical proportion of the contract work. However, it is made clear that progress payments and advances from customers often do not reflect the work performed. When the stage of completion is determined by reference to the contract costs incurred to date; only those contract costs that reflect work performed are included in costs incurred to date. Examples of contract costs which are excluded are: (a) contract costs that relate to future activity on the contract such as costs of materials that have been delivered to a contract site or set aside for use in a contract but not yet installed, used or applied during contract performance, unless the materials have been made specifically for the contract; and (b) payments made to sub contractors in advance of work performed under the sub contract. When the outcome of a construction contract cannot be estimated reliably: (a) revenue should be recognised only to the extent of contract costs incurred that it is probable will be recoverable; and (b) contract costs should be recognised as an expense in the period in which they are incurred. An expected loss on the construction contract should be recognised as an expense immediately. Expected Losses On Contract When it is probable that total contract costs will exceed total contract revenue, the expected loss should be recognised as an expense immediately. Disclosure Requirements An enterprise should disclose: (a) the amount of contract revenue recognised as revenue in the period; (b) the methods used to determine the contract revenue recognised in the period; (c) the methods used to determine the stage of completion of contracts in progress An enterprise should also disclose each of the following for contracts in progress at the balance sheet date: (a) the aggregate amount of costs incurred and recognised profits less recognised losses to date; (b) the amount of advances received; (c) the amount of retentions. Retentions are defined as amounts of progress billings which are not paid until the satisfaction of conditions specified in the 40
contract for the payment of such amounts or until defects have been rectified. Progress billings are amounts billed for work performed on a contract whether or not they have been paid by the customer. Advances are amounts received by the contractor before the related work is performed. An enterprise should present: (a) the gross amount due from customers for contract work as an asset; (b) the gross amount due to customers for contract work as a liability. Service contracts The principles are similar in accounting for contract accounts and thus both service contract revenue and costs should be included in the profit and loss account as the contracts progress as long as both can be reliably measured. Differences Between IAS 2 and 11 and current Irish Gaap The only major difference between SSAP 9 and IAS 2 is the exclusion of agricultural produce and certain biological assets from the scope of IAS 2. They are instead included in IAS 41 Agriculture, a standard which the ASB have promised will be implemented in the UK/Ireland later this year. IAS 11 is also very similar to SSAP 9 but has less detailed disclosure requirements, particularly in relation to balance sheet presentation. Under the latest Strategy paper, published by the ASB in March 2004, both standards will only be implemented into UK/Irish reporting when the Comprehensive Income Project is finally sorted out at international level. 41