INVENTORY (IAS 2) OBJECTIVE CHAPTER 24 NON FINANCIAL ASSETS The primary issues in accounting for inventories are: - a) the amount to be recognized as an asset and carried forward until the revenues are recognized (matching concept); and b) the determination of cost and its subsequent recognition as an expense and writedown to net realizable value SCOPE The following items are excluded from the scope of the standard: - Financial instruments (IAS 32 & IFRS 9); and Biological assets related to agricultural activity and agricultural produce at the point of harvest (IAS 41) DEFINITIONS 1- Inventories Inventories are assets; - a) Held for sale in the ordinary course of business (merchandise purchased for resale by the retailer, other property held for resale) b) In the process of production for such sale; or (work in progress, finished goods awaiting to be sold) c) In the form of materials or supplies to be consumed in the production process or in the rendering of services (materials/supplies awaiting consumption in the production process) 2- Net Realizable Value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated cost necessary to make a sale. 3- Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The word inventory explained as under: - Inventories encompass goods purchased and held for resale including, for example, merchandise purchased by a retailer and held for resale, or land and other property held for resale. Inventories also encompass finished goods produced, or work in progress being produced, by the entity and include materials and supplies awaiting use in the production process. Costs incurred to fulfill a contract with a customer that do not give rise to inventories (or assets within the scope of another Standard) are accounted for in accordance with IFRS 15 Revenue from Contracts with Customers. MEASUREMENT OF INVENTORIES Measurement Rule The inventories shall be measured at the lower of cost and net realizable value.
Cost of Inventories The cost of inventories will comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. (a) (b) (c) (d) (e) Purchase cost comprise the; i) Purchase price plus; ii) iii) iv) Import duties and other non refundable taxes; Transport, handling and any other cost directly attributable to the acquisition of finished goods, services and materials; less Trade discounts, rebates and other similar amounts Cost of conversion i) Costs directly related to the units of production (direct labor); and ii) Systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. (Factory rent, depreciation of machinery, supervisor salary, power consumption) a) The allocation of fixed overheads to the costs of conversion is based on the normal capacity of the production facilities adjusted by any current year circumstances. b) If the production level is materially higher than normal capacity then Fixed Over Heads (FOH) are allocated using actual production level. c) In the same way if production is materially less than normal capacity, the FOH are allocated on normal capacity level. Joint and by-product a) A production process may result in more than one product being produced simultaneously means when joint products are produced or when there is a major product and by-product. b) In such circumstances the costs may not be separately identifiable then the costs are allocated to the products on some rational and consistent basis. c) The by-products are mostly immaterial and can be measured at NRV and deducted from the cost of main product. Other cost incurred in bringing the inventories to their present location and condition (i.e. non production overheads or costs of designing products for specific customers). The IAS 23 Borrowings costs identifies limited circumstances where borrowing costs are included in the cost of inventories. When the inventory is purchased on deferred installment basis and the arrangement effectively contains a financing element then the difference between the price for normal credit terms and the amount paid should be recognized as interest expense over the period of the financing. The IAS excludes the following from the cost of inventories a) The abnormal amount of wasted material, labor or other production cost; b) Storage costs unless necessary for production before the further production process/stage;
c) Administrative overheads that do not contribute to bringing inventories to their present location and condition; and d) Selling cost Techniques for Measurement of Cost a) Standard cost method (used in production industry). It takes into account normal level of material and supplies, labor, efficiency and capacity utilization. b) Retail Cost method (used in retail industry). It is used in the retail industry for measuring inventories of large numbers of rapidly changing items with similar margins. The cost of inventory is determined by reducing the sale value by appropriate percentage of gross margin. Cost Formulas 1- cost of inventories should be assigned by specific identification of their individual costs for: - a) Items that are not ordinarily interchangeable b) Goods or services produced and segregated for specific projects 2- The cost of inventories other than those dealt above should be assigned by using the First in first out (FIFO) or weighted average cost formula. An entity should use the same formula for all the inventories having similar nature and use to the entity. NET REALIZABLE VALUE As a general rule assets should not be carried at amounts greater than those expected to be realized from their sale or use. (Prudence Concept) The principal situations, in which NRV is likely to be less than cost, i.e. where there has been: Rule: An increase in costs or a fall in selling price A physical deterioration in conditions of inventory Obsolescence of products A decision as part of the company s marketing strategy to manufacture and sell products at a loss Errors in production or purchasing The write down of inventories would normally take place on an item-by-item basis but similar or related items may be grouped together. Fluctuations after Statement of financial statement date should also be taken into account to the extent they confirm the conditions existing at the Statement of financial statement date. The estimate of NRV should also take into account the purpose for which the inventory is held (firm sale / purchase contracts). Materials or supplies held for use in the production process should not be written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost otherwise when the decline in the value of materials indicates that the cost of finished goods exceeds NRV the materials should be written down to NRV (Replacement cost).
NRV should be reassessed at each Statement of financial statement date and necessary adjustments such as further reduction or increase in NRV should be made however, reversal of write down is limited to the original write down of inventories. RECOGNITION AS AN EXPENSE The following treatment is required, when inventories are sold. a) The carrying amount is recognized as an expense in the period in which the related revenue is recognized (matching concept) b) The amount of any write down of inventories to NRV and all losses of inventories are recognized as an expense in the period in which the related write down or loss occurred c) The amount of any reversal of any write down of inventories, arising from the increase in NRV is recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs. d) The inventories allocated to other assets i.e. when the inventory becomes the part of cost of self-constructed assets the inventories are recognized as an expense over the useful life of those assets. Disclosures The financial statements shall disclose: (a) the accounting policies adopted in measuring inventories, including the cost formula used; (b) the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity; (c) the carrying amount of inventories carried at fair value less costs to sell; (d) the amount of inventories recognized as an expense during the period; (e) the amount of any write-down of inventories recognized as an expense in the period; (f) the amount of any reversal of any write-down that is recognized as a reduction in the amount of inventories recognized as expense in the period; (g) the circumstances or events that led to the reversal of a write-down of inventories; and (h) the carrying amount of inventories pledged as security for liabilities. PRACTICE QUESTIONS Q.1 On October 1st 2008, fire destroyed stock of Swat Furniture Ltd. The books of Accounts provided the following data: Rs. (000) Sales for the year ended June 30, 2008 4,880 Stock on (June 30,2008) 1,200 Stock at cost on June 30, 2007 1,400 Purchases for the year ended June 30, 3,300 2008 Purchases from July 1st to September 30, 1,200 2008 Sales from July 1st to September 30, 2008 1,500 The value of stock on June 30, 2008, included an item valuing Rs. 100,000, which has been written down to Rs. 75,000. It was sold in August 2008 for Rs. 56,000. Apart from this, the gross profit ratio has remained uniform. The stock salvaged realized Rs. 140,000 only. The maximum value of stock insured is Rs. 3,000,000.
Required: -You are required to calculate the amount of Insurance claim for stock destroyed by fire? (8) Q.2 M/S Sajid Ltd has un-sold inventory at the yearend of Rs. 100,000 taken at cost to the company. The company has the accounting policy of valuing closing stock at cost or net realizable value (NRV) whichever is lower at the reporting date. The company has also made a contract for sale of 25% inventory to Naji Enterprises (NE) before the year end for Rs. 40,000. After the year end but before the authorization of financial statements, the market value of goods held by the company has significantly reduced due to a superior product launched by a competitor in the market not forecasted at the year end. The NRV is now just Rs. 35,000 and all the goods remained unsold after the year end. The contract with NE is still enforceable and has also assured the company for taking delivery in the next month. Required: - Calculate the amount of inventory to be presented in the statement of financial position? (7) Q.3 NKL Enterprises produces a single product. On July 31, 2010, the finished goods stock consisted of 4,000 units valued at Rs. 220 per unit and the stock of raw materials was worth Rs. 540,000. For the month of August 2010, the books of account show the following: Rs. Raw material 845,000 Direct labor cost 735,000 Selling costs 248,000 Depreciation on plant and 80,000 machinery Distribution costs 89,560 Factory manager s salary 47,600 Indirect labor costs 148,000 Indirect material consumed 45,000 Other production overheads 84,000 Other accounting costs 60,540 Other administrative overheads 188,600 Other information is as under: (i) 8,000 units of finished goods were produced during August 2008. (ii) The value of raw materials on August 31, 2008 amounted to Rs. 600,000. (iii) There was no work-in-progress at the start of the month. However, on August 31, the value of work-in-progress is approximately Rs. 250,000. (iv) 5,000 units of finished goods were available in stock as on August 31, 2008. Required: a) Compute the value of closing stock of finished goods as on August 31, 2008 based on weighted average cost method? (10) b) Define the term Net realizable value (NRV) and comment why the entities follow the rule cost or NRV whichever is lower? (5) ANSWERS A.1 Rs. (000) Insurance claim Stock loss(w-2) 1,325 Salvage value (140) Claim from insurance 1,185 company
W-1 Gross profit for the last year Sales 4,880 Less: cost of sales Opening stock 1,400 Purchases 3,300 Less closing stock 1,250 3,450 Gross profit 1,430 Gross profit % for last year 1430/4880x100 29% W-2 working of stock lying at store Sales (1500-56) 1,444 Less: cost of sales Opening stock 1,150 Purchases 1,200 Less closing stock(balancing 1,325 figure) 1,025 Gross profit (@29% 1444) 419 A.2 The cost of inventory will remain at cost of Rs. 100,000 as 25% of goods are to be sold under a contract and for rest of the goods the conditions were not in existence at the reporting date and cannot be foreseen. A.3 a) Cost of finished goods 5,000 x 212.88 = 1,064,417 Weighted average cost of units available for sales Opening finished goods + cost of goods manufactured Opening number of finished goods units + produced during the year (4,000 x 220) + (1,674,600) 4,000 + 8,000 212.88 Rs. Rs. Cost of raw material consumed Opening stock 540,000 Purchases 845,000 Closing stock (600,000) Raw material consumed 785,000 Direct labor cost 735,000 Prime cost 1,520,000 Production overheads Depreciation 80,000 Factory manager salary 47,600
Indirect labor cost 148,000 Indirect material 45,000 Other production overheads 84,000 404,600 Gross factory cost 1,924,600 Closing work in process (250,000) Cost of goods manufactured 1,674,600 b) The Net Realizable value is estimated selling price less estimated selling expenses less estimated cost to complete. The rule is followed because one of the main qualities of financial statements is reliability for external users of financial statements for making economic decisions. The reliability of financial statements is dependent on prudence concept. That is whenever an accounting estimate is made regarding carrying value of assets and liabilities a degree of consciousness should be observed. The value of assets should not exceed the value of economic benefits expected from the assets. Therefore, while making estimate for value of inventory the rule cost or NRV is observed.
BORROWING COST (IAS-23) OBJECTIVE Borrowing costs that are directly attributable to the construction, acquisition or production of a qualifying asset form part of that asset otherwise charged to profit and loss account. SCOPE a) This IAS does not deal with the actual or imputed cost of equity, including preferred capital not classified as a liability. b) The Standard does not deal with the actual or imputed cost of equity, including preferred capital not classified as a liability. c) An entity is not required to apply the Standard to borrowing costs directly attributable to the acquisition, construction or production of: DEFINITIONS i) a qualifying asset measured at fair value, for example a biological asset within the scope of IAS 41 Agriculture; or ii) inventories that are manufactured, or otherwise produced, in large quantities on a repetitive basis. Borrowing cost are interest and other costs incurred by an entity in connection with the borrowing of funds. BORROWING COST INCLUDES Interest expense calculated using the effective interest method as described in IFRS 9; Finance lease charges in respect of finance lease in accordance with the IAS-17; and Exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment of interest cost A Qualifying Asset is an asset that necessarily takes a substantive period of time to get ready for its intended use or sale (e.g. inventories, manufacturing plants, power generation facilities, intangible assets, investment properties etc.). However, financial assets, inventories produced over short period of time and assets ready for intended sale are not qualifying assets. RECOGNITION OF BORROWING COST Borrowing costs that are directly attributable to the construction, acquisition or production of a qualifying asset form part of that asset otherwise charged to profit and loss account. Borrowing costs eligible for capitalization The borrowing cost incurred on the acquisition/construction/production of a qualifying asset will be eligible for capitalization only when they would have been avoided if the qualifying assets have not been manufactured/construction/produced. Borrowing Cost of Specific Funds The borrowing cost of funds, borrowed specifically for the qualifying asset, is the actual cost incurred on the funds during the period less any investment income on the temporary investment of funds.
Borrowing Cost of General funds The borrowing cost of funds, borrowed generally, will be determined by applying a capitalization rate to the expenditures incurred on those assets. The capitalization rate is the weighted average rate of the borrowings cost applicable to the borrowings of the entity outstanding during that period other than specific borrowings. The amount of borrowing cost capitalized during a period should not exceed the borrowing costs incurred during the period. Excess of carrying amount of the qualifying asset over recoverable amount When the carrying amount exceeds the recoverable amount of that asset, the asset should be written down to its recoverable value. Commencement of capitalization The capitalization commences: - Expenditures for the assets are being incurred; Borrowing costs are being incurred; and Activities necessary to prepare the asset for its intended use/sale are in progress Expenditures on a qualifying asset include only those expenditures, which have resulted in transfer of cash/other asset or assumption of interest bearing liabilities and will be reduced by any Government Grant (IAS 20). The activities necessary to complete the qualifying asset include beside physical construction the technical/administrative work such as obtaining permits prior to physical construction. However, such activities exclude the holding of an asset when no production or development that changes the asset s condition is taking place (e.g. borrowing cost incurred while land is under development are capitalized during the period when activities related to the development are in progress). Suspension of capitalization Capitalization should cease when during the extended period the active development is interrupted. Examples are: - Borrowing costs incurred during extended periods when activities to prepare an asset for its intended use/sale are interrupted (costs of holding partially completed assets) On temporary delays the capitalization is not suspended (Geographical region involved - delays due to high water levels and inventories to mature for sale) Cessation of capitalization The capitalization should cease, when all the activities necessary to complete the qualifying asset for its intended use/sale are complete (physical construction is complete, administrative or decorative work may continue). When the construction of a qualifying asset is in parts the capitalization of borrowing cost should cease, when the relevant part is complete for its intended use/sale (building park). Disclosure The financial statements should disclose: - The amount of borrowing cost capitalized during the period; and
The capitalization rate used to determine the amount of borrowing cost eligible for capitalization PRACTICE QUESTIIONS Q.1 On 1 January 2005 entity A contracted for the construction of a building for 2,000 on land that it had previously purchased. The building was completed at the end of December 2005, and during the period the following payments were made to the contractor: Payment date Rupees (000) 1 January 2005 200 31 March 2005 600 30 September 2005 1,000 31 December 2005 _200 2,000 Entity A s borrowings as at 31 December 2005 were as follows: a) a 10% 4-year note dated 31 December 2004 with simple interest payable annually, relates specifically to the project; debt outstanding at 31 December 2005 amounts to Rs. 700,000; b) a 12.5% 10-year note dated 1 January 2004 with simple interest payable annually; debt outstanding at 31 December 2005 amounts to Rs. 1,000,000; and c) a 10% 10-year note dated 1 January 2001 with simple interest payable annually; debt outstanding at 31 December 2005 amounts to Rs. 1,500,000. Calculate the total borrowing cost and borrowing cost eligible for capitalization? (10) Q.2 A company has taken the following loans few years back at the interest rates mentioned along with them. Rupees (000) Bank loan 13% 15,000 Bank loan 17% 3,500 Bank loan 19% 4,500 A loan of Rs. 1,000,000 was taken on July 01, 2007 specifically to finance the project at 15%. Expenditure incurred on plant under installation Rs. (000) July 1, 2007 700 September 1, 2007 700 January 1, 2008 1,000 March. 1, 2008 500 Required: a) Capitalization rate of the company (3) b) Total borrowing cost to be capitalized during the year 2008. (5) c) Cost of project at June 30, 2008. (2) Q.3 The extract from statement of financial position of a company at year end June 30, 2008 reflects following status: RS. 000
Plant under installation 5,000 Loans Bank loan 15% 10,000 Bank loan 20% 3,000 Bank loan 13% 4,000 A loan of Rs. 1,000,000 was taken on July 01, 2008 specifically to finance the project at 16.5%. Expenditure incurred on plant under installation RS. (000) July 1, 2008 700 October 1, 2008 700 February 1, 2009 1,000 June 1, 2009 500 An interest income of Rs. 50,000 has also been earned on temporary investment of specific funds borrowed at the start of the year. Required: d) Capitalization rate of the company (3) e) Total borrowing cost to be capitalized during the year 2009. (5) f) Cost of plant at June 30, 2009 and impact if any if the carrying value of asset exceeds its recoverable value. (4) Q.4 Discuss the accounting treatment of the following under IAS 23? (10) a) A telecom company has acquired a telecommunication license. The license could be sold or licensed to a third party. However, management intends to use it to operate a wireless network. Development of the network starts when the license is acquired. Should borrowing costs on the acquisition of the license be capitalized until the network is ready for its intended use? b) A real estate company has incurred expenses for the acquisition of a permit allowing the construction of a building. It has also acquired equipment that will be used for the construction of various buildings. Can borrowing costs on the acquisition of the permit and the equipment be capitalized until the construction of the building is complete? c) Does management take into account payments received in advance from customers when determining the amount of borrowing costs to be included in contract costs? d) A contract accounted for under IAS 11 is financed with general borrowings and is in a net credit position (advances in excess of costs incurred). Is the net interest income treated as a contract cost? e) An entity incurs borrowing costs for the construction of an asset accounted for under IAS 11. Does management treat the borrowing costs as a contract cost under IAS 11? Q.5 On 1 January 2013 an entity contracted for the construction of a building for Rs. 2 million on land that it had previously purchased. The building was completed at the end of December 2013, and during the period the following payments were made to the contractor:
Payment Date Rs. (000) 1 January 2013 200 31 March 2013 600 30 September 2013 1,000 31 December 2013 200 Total 2,000 The company borrowed specifically loan from National Bank Limited @ 15.5% pa. The funds have been evenly invested in the project during the year. The unused funds can be invested @ 7.5% pa. Required: - Calculate the borrowing cost eligible for capitalization? (07) Q.6 A contractor has entered into a contract to construct a building on behalf of a client. The contractor took a loan from the bank for Rs. 10 million at 11.25% interest rate per annum to finance the project and his other working capital needs. The expenditure incurred on the project and progress billings received are as under: - Date Expenditure Progress Incurred billing received Rs. Rs. 01-01-2014 500,000 -- 01-03-2014 200,000 100,000 31-05-2014 350,000 200,000 30-09-2014 -- 150,000 30-11-2014 400,000 50,000 31-12-2014 -- 300,000 Required: - Calculate the amount of borrowing cost to be capitalized? (10) Q.7 The company has started the construction of a qualifying asset, expenses incurred on the qualifying asset during the year ended December 31, 2014 and detail of loans obtained is as under: - i) The detail of loans obtained are as under; - Date of loan taken Loan amount Rate of interest (Rs. 000) % 01-01-2013 100,000 12.50 01-07-2013 50,000 13.50 01-01-2014 450,000 11.75 30-06-2014 50,000 12.50
ii) The expenses incurred on the asset during the year are as under: - Amount Date Rs. (000) 01-04-2014 14,500 01-05-2014 10,250 01-06-2014 12,500 16-07-2014 25,000 31-08-2014 12,000 31-10-2014 18,000 30-11-2014 5,550 iii) Loan taken during the year is specifically raised to finance the construction of qualifying asset. The excess funds can be invested at the rate of 5.5%. Required: - Calculate the borrowing cost to be capitalized? (10) ANSWERS A.1 Management should capitalize borrowing costs of 92. It should allocate specific borrowings to the project first and then allocate other general borrowings to the extent required to finance the balance of the expenditures incurred on the project. The allocation of funds should be based on the weighted average expenditures incurred. The weighted average interest rate on the general borrowings should be applied to the general borrowings allocated to the project. Weighted average expenditure: Date Expenditure Rs. (000) Capitalization period Average accumulated expenditures Rs. (000) 1 January 2005 200 12 months 200 31 March 2005 600 9 months 450 30 September 2005 1,000 3 months 250 31 December 2005 200 0 months 0 Total 2,000 900 Borrowing cost to be capitalized: Loan Amount Interest Specific 700 700*10%=70 Other 200 200*11%=22
Total 900 92 * Weighted average borrowing cost =12.5%(1,000/2,500)+ 10% (1,500/2,500)= 11% A.2 a) Capitalization of borrowing rate (15,000/23,000) x13% 8.48% (3,500/23,000) x17% 2.59% (4,500/23,000) x19% 3.72% 16.11% b) Weighted average of amount invested July 01 700 x 12/12 = 700 Sep 01 700 x 10/12 = 583 Jan 01 1,000 x 6/12 = 500 Mar01 500 x 4/12 = 167 1,950 Borrowing cost Specific funds (1000 x 15%) 150 General funds ((1,950-1,000) X 16.11%) 153 = 303 c) Cost of the project Funds invested 2,900 Borrowing cost capitalized 303 = 3,203 A.3 a) Capitalization rate 10,000/17,000 x 0.15 = 9% 3,000/17,000 x 0.20 = 4% 4,000/17,000 x 0.13 = 3% 16% b) Average amount invested 5,000x12/12 5,000 700 x 12/12 700 700x9/12 525 1000x5/12 417 500 x 1/12 42 General funds = 6,684 1,000 = 5,684 Specific funds=1,000 6,684 Borrowing cost = [(1,000x0.165) 50 + (5,684 x 0.16)] = 1,024 c) Cos of the asset Opening funds invested = 5,000 Funds invested in currant year = 2,900
Borrowing cost capitalized = 1,024 Total cost of asset = 8,924 A.4 a) When the carrying amount exceeds the recoverable amount of that asset, the asset should be written down to its recoverable value. Borrowing cost are interest and other costs incurred by an entity in connection with the borrowing of funds. BORROWING COST INCLUDES Interest expense calculated using the effective interest method as described in IAS- 39; Finance lease charges in respect of finance lease in accordance with the IAS-17; and Exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment of interest cost A Qualifying Asset is an asset that necessarily takes a substantive period of time to get ready for its intended use or sale (e.g. inventories, manufacturing plants, power generation facilities, intangible assets, investment properties etc.). However, financial assets, inventories produced over short period of time and assets ready for intended sale are not qualifying assets. RECOGNITION OF BORROWING COST Borrowing costs that are directly attributable to the construction, acquisition or production of a qualifying asset form part of that asset otherwise charged to profit and loss account. Borrowing costs eligible for capitalization The borrowing cost incurred on the acquisition/construction/production of a qualifying asset will be eligible for capitalization only when they would have been avoided if the qualifying assets have not been manufactured/construction/produced. Borrowing Cost of Specific Funds The borrowing cost of funds, borrowed specifically for the qualifying asset, is the actual cost incurred on the funds during the period less any investment income on the temporary investment of funds. Borrowing Cost of General funds The borrowing cost of funds, borrowed generally, will be determined by applying a capitalization rate to the expenditures incurred on those assets. The capitalization rate is the weighted average rate of the borrowings cost applicable to the borrowings of the entity outstanding during that period other than specific borrowings. The amount of borrowing cost capitalized during a period should not exceed the borrowing costs incurred during the period. Excess of carrying amount of the qualifying asset over recoverable amount When the carrying amount exceeds the recoverable amount of that asset, the asset should be written down to its recoverable value. Commencement of capitalization The capitalization commences: - Expenditures for the assets are being incurred;
Borrowing costs are being incurred; and Activities necessary to prepare the asset for its intended use/sale are in progress Expenditures on a qualifying asset include only those expenditures, which have resulted in transfer of cash/other asset or assumption of interest bearing liabilities and will be reduced by any Government Grant (IAS 20). The activities necessary to complete the qualifying asset include beside physical construction the technical/administrative work such as obtaining permits prior to physical construction. However, such activities exclude the holding of an asset when no production or development that changes the asset s condition is taking place (e.g. borrowing cost incurred while land is under development are capitalized during the period when activities related to the development are in progress). b) Rs. (m) Rs. (m) Borrowing cost eligible 500x15%x5/12 31.25 500x17.5%x3/12 21.88 Total borrowing cost incurred 53.13 Less: interest income (7) 46.13 Funds invested in the asset 350 Total cost of the asset at end of the year 396.13 A.4 The accounting treatment under IAS -23 a) The borrowing cost incurred on the acquisition of intangible asset can also be capitalized if material time is required to operate the intangible asset or to develop the relevant infrastructure. b) Yes for the permit that is specific for one building and it is part of construction cost of the building, can be recognized i which meets the definition of a qualifying asset. No for the equipment, which will be used for other construction projects and is ready for its intended use its acquisition date, it does not meet the definition of a qualifying asset. c) Yes. The determination of the amount of borrowing costs to be capitalized in the financial statements of the constructor are based on the net position of the contract, after taking into account any customer payments in respect of the contract. d) No. If the contract is in a net credit position during the whole construction period, no costs are capitalized. The constructor has not incurred any borrowing costs, as the financing was provided by the client. The net position in a contract may change over the construction period from net debit to net credit (or vice versa). Capitalization is required for those periods when the contract is in a net debit position. e) Borrowing costs that are attributable to contract activity are considered to be part of the contract costs. The cost-to-cost method will generally take into account all
A.5 actual costs incurred and expected costs to complete when measuring the stage of completion. Costs that do not reflect the stage of completion (for example costs that relate to future activity are excluded. This might include borrowing costs incurred on specific borrowings obtained in advance for the whole project. Rs. (000) Borrowing cost eligible 310 Interest income (1,000x7.5%) (75) Net borrowing cost eligible 235 A.6 The amount of borrowing cost to be capitalized is as under: - Weighted average expenditure 500,000 x 2/12 83,333 600,000x3/12 150,000 750,000x4/12 250,000 600,000x2/12 100,000 950,000x1/12 79,167 Total 662,500 Borrowing cost to be capitalized (662,500 x 11.25%) =Rs.74,531 A.7 Weighted average borrowing rate 100,000 x12.5%/600,000 0.0208 50,000 x13.5%/600,000 0.01125 450,000 x 11.75%/600,000 0.0881 12.02% Average expenditure incurred from general loans 14,500 x9/12 10,875 10,250 x8/12 6,833 12,500 x7/12 7,292 5,000 x2/12 833 5,550 x1/12 462.5 26,295.50 Borrowing cost to be capitalized on general loan (26,295.50x12.02%) =3,161 Borrowing cost on specific loan (50,000x12.50%x6/12) = 3,125 Interest income 50,000x5.5% x0.5/12 114.6 25,000x5.5% x1.5/12 171.88 13,000x5.5% x2/12 119 405.48 Net interest cost (3,125-405.48) = 2,719.52 Total cost to be capitalized (2,719.52+3,161) =5,880.52
ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE (IAS 20) SCOPE This IAS shall be applied in accounting for and in the disclosure of government grants and in the disclosure of other forms of government assistance. This IAS does not deal with: - a) The special problems arising in accounting for GG in financial statements reflecting the effect of changing prices b) Government assistance that is provided in the form of benefits that are available in determining taxable income or limited on the basis of tax liability; c) Government participation in the ownership of the entity; d) Government grants covered by IAS 41 DEFINITIONS Government refers to government, government agencies and similar bodies whether local, national or international. Government assistance is action by government designed to provide an economic benefit specific to an entity or range of entities qualifying under certain criteria. Government assistance for the purpose of this Standard does not include benefits provided only indirectly through action affecting general trading conditions, such as the provision of infrastructure in development areas or the imposition of trading constraints on competitors. Government grants are assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. They exclude those 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 (subsidies, subvention, or premiums). Grants related to assets are government grants whose primary condition is that an entity qualifying for them should purchase, construct or otherwise acquire long-term assets. Subsidiary conditions may also be attached restricting the type or location of the assets or the periods during which they are to be acquired to held. Grants related to income are government grants other than those related to assets. Forgivable loans are loans, which the lender undertakes to waive repayment of under certain prescribed conditions. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. RECOGNITION-GOVERNMENT GRANTS Government grants including non-monetary grants at fair value shall not be recognized until there is reasonable assurance that: a) The entity will comply with the conditions attaching to them; and b) The grants will be received Government grants shall be recognized as income over the periods necessary to match them with the related costs, which they are intended to compensate, on a systematic basis.
Grants related to income are recognized over the period and matched with the related expenses and grants related to the assets are recognized over the useful life of the fixed assets in the proportion in which the depreciation on those assets is charged. Grants related to non-depreciable assets are also recognized over the period, in which the related expenses are made. If grants are received as a package of financial or fiscal aids to which a number of conditions are attached then reasons giving rise to costs and expenses should be identified and it may be appropriate to allocate part of grant on one basis and part on another basis. A government grant that becomes receivable as compensation for expenses or losses already incurred or for the purpose of giving immediate financial support to the entity with no future related costs shall be recognized as income of the period in which it becomes receivable. Package grants Grants are sometimes received as part of a package of financial or fiscal aids to which a number of conditions are attached. In such cases, care is needed in identifying the conditions giving rise to costs and expenses which determine the periods over which the grant will be earned. It may be appropriate to allocate part of a grant on one basis and part on another. NON-MONETARY GRANTS In this case the asset and the grant are recognized at the fair value. The other alternative may be to record the grant and the related asset at the nominal amount. Loans at below or nil market interest rates The benefit of a government loan at a below-market rate of interest is treated as a government grant. The loan shall be recognized and measured in accordance with IFRS 9 Financial Instruments. The benefit of the below-market rate of interest shall be measured as the difference between the initial carrying value of the loan determined in accordance with IFRS 9 and the proceeds received. The benefit is accounted for in accordance with this Standard. The entity shall consider the conditions and obligations that have been, or must be, met when identifying the costs for which the benefit of the loan is intended to compensate. Contingent liability or contingent asset Once a government grant is recognized, any related contingent liability or contingent asset is treated in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. PRESENTATION OF GRANTS RELATED TO ASSETS Government grants related to assets, including non-monetary grants at fair value, shall be presented in the statement of financial position either by setting up the grant as deferred income or by deducting the grant in arriving at the carrying amount of the asset. PRESENTATION OF GRANTS RELATED TO INCOME These may be presented as income either separately or under the heading of other income or as deduction from the related expenses. REPAYMENT OF GOVERNMENT GRANTS A government grant that becomes repayable shall be accounted for as a revision to an accounting estimate (IAS 8). Repayment of a grant related to income shall be applied first against any un-amortized deferred credit and if repayment exceeds the deferred credit the rest will be recognized immediately as expense. Repayment of grants related to assets shall be recorded by increasing the carrying amount of the asset or reducing the deferred
income balance by the amount payable. The cumulative additional depreciation that would have been recognized to date as an expense in the absence of the grant shall be recognized immediately as an expense. GOVERNMENT ASSISTANCE The government grants not recognized because no value can be assigned to them or not distinguishable from the other transactions of the entity if material shall be disclosed. DISCLOSURE The following matters shall be disclosed a) the accounting policies adopted for government grants, including the method of presentation followed; b) the nature and extent of government grants recognized in the financial statements and an indication of other forms of government assistance from which the entity has directly benefited; and c) Unfulfilled conditions and other contingencies attaching to government assistance that has been recognized. PRACTICE QUESTIONS Q.1 Being the financial consultant of Insha Chemicals Limited (ICL), a listed company, you have been approached to advice on certain accounting issues. Accordingly, you are required to explain how the following transactions should be disclosed in ICL s financial statements for the year ended June 30, 2009 in accordance with International Financial Reporting Standards: ICL operates a factory in an underdeveloped rural area. Most of the employees in the factory have been hired locally. On observing the positive effects of the project, the government had approved a grant of Rs. 100 million for ICL, on February 1, 2009 for development of a similar factory in another underdeveloped area. However, it had been agreed that disbursement would be made in three phases. The relevant details are as follows: Phases Amount Rs. in million Comments Before commencement of the construction During the construction of factory When the factory becomes operational 10 No condition is attached to this phase of the grant and it was received on March 1, 2009. 40 Total cost of construction is estimated at Rs. 200 million. The construction was 30% complete, as of June 30, 2009. The estimated life of the property, plant and equipment is 15 years and it would be depreciated on the straight line basis. 50 It has been agreed that 400 local persons would be employed. The amount will be given in five equal annual installments. If employment drops below 400 at any time in any of
the five subsequent years, no amount would be paid in that year. ANSWERS A-1 A. 2(b) According to IAS-20, Government Grants are to be recognized as income over the periods necessary to match them with related costs which they are intended to compensate, on a systematic basis. Rs. 10 million related to the first phase was received prior to year end and should be recognized as a liability in the Statement of Financial Position as on June 30, 2009 because the cost of asset which the grant is intended to compensate, have not been completed or brought into use. Similarly, if the amount of Rs. 40 million related to the second phase is received before the completion of the construction of the factory, it would also be recorded as a liability. The grants related to the first two phases i.e. Rs. 10 million and Rs. 40 million can be classified as 'grant related to asset'. Once the construction of the factory is completed, government grant related to both phases should be recognized as income over the period of property, plant and equipment's depreciable life i.e. 15 years. IAS-20 allows two methods to record this income. (i) Method 1: To show the grant as a deferred income. In this case, the grant amount of Rs. 50 million will be shown as deferred income and will be credited to income over (ii) the life of the property, plant and equipment. Method 2: To net off the grant against the cost of asset. In this case, depreciation will be charged on the cost as reduced by the amount of the grant, over life of the asset i.e.15 years. The annual amount of the grant to be received in the third phase would be recorded as income when there is a reasonable assurance that: The company will comply with the condition i.e. employment of 400 locals. The grant will be received.
PROPERTY, PLANT AND EQUIPMENT (IAS 16) OBJECTIVE The objective of this standard is to prescribe the accounting treatment for property, plant and equipment. The principal issues in accounting for property plant and equipment are: - (i) (ii) (iii) SCOPE The time of recognition of the assets; The determination of their carrying amounts; and The depreciation charges and impairment losses to be recognized in relation to them a) This standard should be applied in accounting for property, plant and equipment except when another IAS requires or permits otherwise. b) This standard does not apply to: - (i) Property, plant and equipment classified as held for sale in accordance with the IFRS 5; (ii) The recognition and measurement of exploration and evaluation assets (IFRS (iii) 6); and Biological assets related to agricultural activity other than bearer plants however, this standard does not apply to produce on bearer plants (IAS 41). DEFINITIONS 1- Carrying amount Carrying amount is the amount at which an asset is recognized after deducting any accumulated depreciation and accumulated impairment losses. 2- Cost Cost is the amount of cash or cash equivalents paid or the fair values of the other consideration given to acquire an asset at the time of its acquisition or construction. 3- Depreciable amount Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value. 4- Depreciation Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. 5- Entity specific value Entity specific value is the present value of the cash flows an entity expects to arise from the continuing use of an asset and from its disposal at the end of its useful life or expects to incur when settling a liability. 6- Impairment loss Impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable amount. 7- Property, plant and equipment are tangible items that: (a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period 8- Recoverable amount Recoverable amount is the higher of an asset s net selling price and its value in use 9- Residual value Residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life. 10- Useful life is: (a) the period over which an asset is expected to be available for use by an entity; or
(b) the number of production or similar units expected to be obtained from the assets by an entity 11- a bearer plant is a living plant that: a) is used in the production or supply of agricultural produce; b) is expected to bear produce for more than one period; and c) has a remote likelihood of being sold as agricultural produce, except for incidental scrape sales RECOGNITION The recognition of the property, plant and equipment depends on two criteria. a) The item meet the definition of property, plant and equipment; b) It is probable that future economic benefits associated with the asset will flow to the enterprise; and c) The cost of the item can be measured reliably Application of Recognition Spare parts and servicing equipments: - are usually carried as inventory and recognized in the profit and loss when consumed. However, major spare parts and standby equipments qualify as property, plant and equipment, when: - a) the entity expects to use them for more than one year; b) they can be used only with an item of property, plant and equipment; and c) they are material in terms of cost Safety equipments: - Property, plant and equipment acquired for safety or environmental reasons qualify for recognition, as assets when they enable the enterprise to obtain future economic benefits from the related assets in excess of those it would obtain otherwise. Aggregation and segmenting This IAS does not provide what constitute an item of property, plant and equipment and judgment is required in applying the recognition criteria to specific circumstances or types of enterprise. That is: - (i) It may be appropriate to aggregate individually insignificant items, such as moulds, tools dies, etc. (ii) It may be appropriate to allocate total expenditure on an asset to its component parts and account for each component separately e.g. an aircraft and its engines. Initial measurement If any item meets the recognition criteria that will be initially recognized at cost. Subsequent cost Day to day servicing / repair and maintenance expenses should be charged to profit and loss account. When some parts / interiors are replaced regularly or replaced several times during the useful life of the property, plant and equipment then these can be recognized as part of carrying cost when they meet recognition criteria and should be derecognized according to the provisions of this standard when replaced (aircrafts, furnaces). When the condition of property, plant and equipment is regularly inspected for faults regardless of the parts replacement, the cost of inspection can be recognized as cost if the recognition criteria are satisfied. The carrying amount of inspection cost should be de-recognized when the new inspection takes place. Elements of cost Following are the elements of cost of property, plant and equipment Purchase price, less any trade discount or rebate Import duties and non-refundable purchase taxes
The estimated cost of dismantling and removing the assets and restoring the site on which it is located, to the extent that it is recognized as a provision under IAS-37 Directly attributable cost of bringing the assets to the location and condition necessary for the intended performance, e.g. Costs of employees benefits arising directly from the construction or acquisition of property, plant and equipment The cost of site preparation Initial delivery and handling costs Installation costs Cost of testing whether the asset is functioning properly after the net proceeds from the sale of any trial production (samples produced while testing equipment) Professional fees (architects, engineers) Examples of costs that are not part of cost of an item of property, plant and equipment Cost of opening a new facility Cost of introducing a new product or service (advertising, promotional) Cost of conducting business in new location or with a new class of business (staff training cost) Administration and other general expenses Recognition of costs in the carrying amount ceases when the asset is in location and condition for its intended use by the management. The following are the examples: - Costs incurred while an item is ready for its intended use but yet to be brought in use or being operated at less than full capacity. Initial operating losses Costs of relocating or reorganizing part or all of an entity s operations Incidental incomes/expense All of these will be recognized as an expense rather than an asset Self constructed assets In case of self-constructed assets, the same principles are applied as for as acquired assets. It the enterprise makes similar assets during the normal course for sale externally then the cost of the asset will be the cost of its production under IAS-2 (Inventories). The borrowing cost under IAS-23 and Government Grant under IAS -20 can further adjust the carrying value of assets. Bearer plants Bearer plants are accounted for in the same way as self-constructed items of property, plant and equipment before they are in the location and condition necessary to be capable of operating in the manner intended by management. Consequently, references to construction in this Standard should be read as covering activities that are necessary to cultivate the bearer plants before they are in the location and condition necessary to be capable of operating in the manner intended by management. Deferred Payments When the payment of an asset is deferred beyond normal credit terms, its cost is the cash price equivalent; the difference is recognized as interest expense unless it is capitalized in accordance with IAS-23. Exchanges of assets An asset may be acquired in exchange or part exchange for a non-monetary asset or assets or a combination of monetary and non-monetary assets.