PAS 2 and 39 (Inventories)

26/07/2006
PICPA / ACPACI
Tax Implications of New Accounting
Standards (PAS 2 and 39)*
18 July 2006
*connectedthinking
Agenda
1. Introduction
2. Summary of key changes of PAS 2 and 39 from old GAAP and
related tax effects
3. Application of PAS 2 and 39 common issues and examples
4. Question and answer
26/07/2006
Part
1
Introduction
Introduction
Introduction
PAS 2 Inventories
PAS 39 Financial Instruments: Recognition and Measurement
PAS 2 and PAS 39 are effective for annual periods beginning
on or after January 1, 2005. If an entity applies this Standard

before such period, the said fact should be disclosed.
Tax Implications of New Accounting Standards

Isla Lipana & Co./PricewaterhouseCoopers Philippines
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18 July 2006
26/07/2006
Part
2
Summary of Key Changes PAS 2 and 39
PAS 2 - Inventories
Changes
LIFO no longer allowed
Accounting Implications
Tax Implications
Inventories valued at LIFO need to LIFO also not allowed.
be revalued using acceptable
BIR approval for change of
valuation method under PFRS
inventory valuation must be
secured within 90 days from start
of taxable year
Inventory needs to be carried

at lower of cost or net
realizable value (selling price
less cost to sell/completion).
Reversal of write-down now
allowed by PAS (not allowed
by previous GAAP)
Difference between cost and net

realizable value treated as a
reconciling item for income tax
purposes
Forex loss can no longer be

capitalized as part of
inventory cost under PAS 21

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PAS 39 - Financial Instruments: Recognition and Measurement
Changes
Requires measurement and
recognition of the fair value of
derivatives, including
embedded derivatives
Tax Implications
Mark to market/derivative gains or Temporary differences and fair
losses (unrealized in nature) need value adjustments are not taxable
to be measured at each reporting income/deductible losses.
date
Financial assets/liabilities
need to be measured initially
at FV less cost of
transaction. Subsequently,
assets must be measured at
FV as follows:
Fair value adjustments of financial

assets and liabilities will be
charged/credited to operations
(except available for sale financial
assets which is part of the equity
accounts)
Gain or loss to be recognized upon

realization. Necessary to
determine whether realized gain or
loss is capital or ordinary.
Capital loss deductible only to the

extent of capital gains

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18 July 2006
PAS 39 - Financial Instruments: Recognition and Measurement

Changes
1. Assets/liabilities at FV
through profit and loss - at FV
(market);
2. Held to maturity
investments - at amortized
cost using the effective
interest method
3. Loans and receivables same as 2 above
4. Available for sale financial
assets - at FV (market)

Tax Implications
Application of effective interest
method will create temporary
difference between actual amount
of interest received/paid and
amount reported under effective
interest method.
Fair value adjustments are timing
differences and are taxable
income/ deductible losses once
realized.
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26/07/2006
Part
3
Application of PAS common issues and examples
PAS 2 - Inventories

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26/07/2006
Inventory Valuation
Accounting Treatment
General rule - the cost of inventories shall be determined by
using specific identification, FIFO or weighted average cost
formula.
This cost formula shall be used for all inventories having a
similar nature and use to the entity.

Different cost formulas may be used on inventories with
different nature or use. (PAS 2, Par. 25).

LIFO is no longer allowed.

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18 July 2006
Inventory Valuation
Tax Treatment
LIFO is not acceptable for income tax purposes pursuant to Item
X(B)(2.1) of RAMO 1-00 dated March 17, 2000.

In case an entity will change its inventory valuation method
pursuant to PAS 2, it should secure permission from the BIR on

the change in accounting method (Section 41 of the Tax Code
and Section 168 of RR 2).
If an entity previously uses LIFO for accounting and a different
valuation method for tax, the effect of the change of inventory

valuation shall be a reconciling item in the income tax return i n
the year of change.
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Inventory Valuation
Inventories shall be measured at the lower of cost and net
realizable value (PAS 2, Par. 9).

Net Realizable Value is the estimated selling price in the
ordinary course of business less the estimated costs of
completion and the estimated costs necessary to make the sale
(PAS 2, Par. 6).

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18 July 2006
Inventory Valuation
Tax Treatment
Section 145 of RR 2:
The law provides two tests to which each inventory must conform:
1. It must conform as nearly as possible to the best accounting
practice in the trade or business; and

2. It must clearly reflect the income.
Inventory practice should be consistent from year to year
An inventory that can be used under the best accounting

practice showing the financial position of the taxpayer is, as a
general rule, regarded as clearly reflecting his income

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Inventory Valuation
Tax Treatment
Section 145 of RR 2 (continued):
3. Any goods in an inventory which are unsalable at normal
prices or unusable or unusable in the normal way because of

damage, imperfections, shop wear, changes of style, odd or
broken lots, or other similar causes, including second hand
goods taken in exchange, should be valued at bona fide
selling prices.
Bona fide selling price means actual offerings of goods

during a period ending not later than 30 days after inventory
date.

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18 July 2006
Inventory Valuation
Section 96, RR 2
Losses generally
Must be evidenced by closed and completed transactions.
The amount of loss must be reduced by the amount of any

insurance or other compensation received, and by the
salvage value, if any, of the property.

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Inventory Valuation
Example:
Company A manufactured Product X at cost of P100,000.
Product X is usually sold to customers at P110,000 at a 5%
discount.
Delivery cost is estimated to be P10,000.
Question?
How much should be the carrying value of Product X for
accounting and tax purposes?

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18 July 2006
Inventory Valuation
Example:
Carrying amount of Product X for accounting purposes:
Cost = P100,000
NRV = P94,500 (P110,000 selling price P5,500 discount
P10,000 delivery cost)
Carrying amount is P94,500 lower of cost or NRV
Difference between cost and NRV = P5,500 (charged to cost of
sales)

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Inventory Valuation
Example (continued):
Inventory write-down of P5,500, charged to cost of sales, is not
deductible for income tax purposes. Under the tax rules, cost o f
sales represents the actual cost of producing / purchasing the
inventory.
Write -down of Cost to the Net Realizable Value charged to cost
of sales shall only be deductible once realized.

Any recovery in the value of the inventory will also not be
recognized as a taxable income.

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18 July 2006
Cost of Inventories
Includes
Cost of purchase
Cost of conversion
Other costs to bring inventories to
present location and condition
Excludes
Abnormal waste
Storage costs
Unrelated administrative overhead
Selling costs
Foreign exchange differences
Deferred payment costs

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Cost of Inventories
Tax Treatment
Section 146, RR 2
For merchandise purchased, cost means the invoice price less
trade or other discounts, except strictly cash discounts,

approximating a fair interest rate, which may be deducted or not
at the option of the taxpayer, provided a consistent course is
followed.
To this net invoice price should be added transportation or
other necessary charges incurred in acquiring possession of the

goods.

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18 July 2006
Cost of Inventories
Accounting treatment for inventory purchases with deferred
settlement terms
Recognize interest related to inventories purchased with
deferred settlement terms as expense over financing period.

Difference between purchase price of inventory and present
value of liability is recognized as imputed interest expense.
Tax treatment
Inventory still valued based on actual cost
Interest expense as reconciling item for income tax purposes

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Cost of Inventories
Example Purchase of inventory under deferred settlement:
Purchase price of merchandise = P100,000
Payment terms = 5 years
Discounted at present value = P80,000
Assumed annual amortization of interest = P4,000
Inventory valuation:
Accounting
P80,000
Tax
P100,000
Reconciling item in ITR: P4,000 non-deductible interest expense

Page 23
18 July 2006
Write-down of Inventories
The amount of any write-down of inventories to NRV and all losses
of inventories shall be recognized as an expense in the period when

the write-down or loss occurs. (PAS 2, Par. 34)
Tax Treatment
Write-down of inventories to NRV is not yet deductible for income
tax purposes unless realized

Inventory losses due to normal business operations (i.e.
obsolescence) are deductible for income tax purposes

Write-off of inventories must be accompanied by BIR Certification
of Inventory Destruction
Page 24
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PAS 39 Financial Instruments: Recognition and

Measurement

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18 July 2006
Financial Instrument Defined
A financial instrument is any contract that gives rise to a

financial asset of one entity and a financial liability or
equity instrument of another entity. (PAS 32, Par. 11)

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Categories of Financial Instruments
A. Financial asset or financial liability at fair value through profit

or loss
Classified as held for trading if it is:
Acquired or incurred principally for the purpose of selling or
repurchasing it in the near term;

Part of a portfolio of identified financial instrument; or
A derivative (except for a derivative that is a designated and
effective hedging instrument)

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18 July 2006
B. Held-to-maturity investments a non-derivative financial

assets with fixed or determinable payments and fixed maturity
that an entity has the positive intention and ability to hold to
maturity other than:
those that the entity upon initial recognition designates as at fair
value through profit or loss

those that the entity designates as available for sale; and
those that meet the definition of loans and receivables

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C. Loans and Receivables a non-derivative financial assets with

fixed or determinable payments that are not quoted in an active
market, other than:
those that the entity intends to sell immediately or in near term
classified as held for trading, and those that the entity upon initial
recognition designates as at fair value through profit or loss;
those that the entity upon initial recognition designates as
available for sale; or

those for which the holder may not recover substantially all of its
initial investment, other than because of credit deterioration

classified as available for sale.
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18 July 2006
D. Available-for-sale financial assets non-derivative financial

assets that are designated as available for sale or are not
classified as (a) loans and receivables, (b) held-to-maturity
investments or (c) financial assets at fair value through profit or
loss.

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Initial Measurement
Tax Treatment
Financial assets or liabilities are

recognized at fair market values
(FMV). Transaction costs are
included in the case of financial asset
or liability not at fair value through
profit or loss.
Recognized at contract amount or

transaction value.
Financial assets or liabilities with no

provision for payment of interest shall
be recognized at inception date of the
loan at present value (PV) effective
interest rate method.
Difference between actual amount of
loan and PV is recognized as interest
income or expense.
Imputed interest is not a taxable

income or deductible expense.

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18 July 2006
Financial Instrument
Example:
A non-interest bearing notes receivable of P60,000 due in 3 yearly
installments of P20,000. Imputed interest rate of 10%. Present value of the
loan at Year 1 is P49,737.04.
Outstanding
Year
Balance
Payment
Amortization
Interest
Principal
49,737.04
20,000.00
4,973.70
15,026.30
34,710.74
20,000.00
3,471.07
16,528.93
18,181.82
20,000.00
1,818.18
18,181.82
60,000.00
10,262.96
49,737.04

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26/07/2006
1. Entry to record notes receivable
Dr. Notes receivable
49,737.04
Dr. Interest expense
10,262.96
Cr.
Cash
60,000.00
Recon item
in ITR
2. Entry to record installment payment on Year 1

Dr. Cash
Cr.
20,000.00
Notes receivable
20,000.00
Annual accretion of interest income using effective interest method

Cr.
4,973.70
Interest income
4,973.70

Recon item
in ITR
Page 33
18 July 2006
Dr. Cash
Cr.
20,000.00
Notes receivable

Cr.
20,000.00
3,471.07
Interest income
3,471.07
Recon item
in ITR

Dr. Cash
Cr.
20,000.00
Notes receivable

Cr.
Interest income

20,000.00
1,818.18
1,818.18
Recon item
in ITR
Page 34
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26/07/2006
Imputation of Interest Income

Filinvest Development Corporation vs CIR [CA-GR SP No. 72992
dated December 16, 2003
Issue:
Imputation of interest income on Filinvest Development
Corporations (FDC) non-interest bearing cash advances based on
Section 43 (now Section 50) of the Tax Code
Facts:
FDC extended several cash advances to its affiliates with no

stipulation on interest.
The CIR imputed interest income on the said advances.
The CTA upheld the imputation of interest made by the CIR.

Page 35
18 July 2006

Filinvest Development Corporation vs CIR [CA-GR SP No. 72992
dated December 16, 2003
CA held:
Section 43 (now Section 50) of the Tax Code is not applicable in the
case of FDC.
There is no showing that FDCs advances to its affiliates are

designed to evade payment of taxes or that FDC deliberately
devised a scheme to avoid the payment thereof.
No interest shall be due unless it has been stipulated in writing.
There is no implementing revenue regulation authorizing the CIR to

impute a theoretical or imaginary interest income.

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Section 50 of Tax Code
Allocation of Income and Deductions:
In the case of two or more entities, the BIR is authorized to distribute,
apportion, or allocate gross income or deductions between or among
such entities if it determines that such distribution, apportionment or
allocation is necessary in order to prevent evasion of taxes or clearly to
reflect the income of said entities.

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18 July 2006
Requisites for Deductibility of Interest Expense (RR 13-00)

1.
An indebtedness exists.*
2.
The interest has been paid or incurred.*
3.
The indebtedness must be that of that of the taxpayer.*
4.
The indebtedness is connected with the taxpayers trade, business or

exercise of profession.*
5.
The interest was paid or incurred during the taxable year.*
6.
The interest is stipulated in writing and must be legally due. [Filinvest

Development Corporation vs CIR (CA-G.R. SP No. 72992 dated December 16,
2003) and Article 1956 of the Civil Code]
7.
The indebtedness is not between related taxpayers.*
8.
The interest was not incurred to finance petroleum exploration.*
9.
If incurred on an indebtedness to acquire property, the interest was not

treated as a capital expenditure. (Sec 79 of RR 2)
*[Sec 34(B)(1)of the Tax Code]

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Subsequent Measurement
Financial assets at fair value through
profit and loss are charged to P&L
Tax Treatment
Gain or loss arising from changes in
fair values of the financial asset are
non-taxable or not deductible for
income tax purposes. Said gain or
loss is recognized for tax purposes
when actually realized or incurred on a
closed and completed transaction
(e.g. upon sale or exchange).
Financial assets or liabilities on

Amortization of interest income or
amortized cost (loans and receivables interest expense are non-taxable or
and assets held to maturity)
not deductible for income tax
purposes.

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18 July 2006
Impairment loss
Tax Treatment
Impairment loss is recognized for a

If securities become worthless during
financial asset measured other than at the taxable year and are capital
fair value. Such impairment is
assets, the loss resulting therefrom
recognized in the P&L.
shall be considered as a loss from the
sale or exchange of the capital assets
(Section 34(D)(4) of the Tax Code).

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Sale or disposition of financial asset

Tax Treatment
Gain or loss from the sale or

disposition of a financial asset is the
difference between the consideration
received and the carrying value of the
financial asset.
Gain or loss on the sale or disposition

of a financial asset is the difference
between the consideration received
and the unadjusted carrying value of
the financial asset (based on
transaction value).

Page 41
18 July 2006
Derivatives and hedging instruments

Tax Treatment
Derivatives/hedging instruments are

measure at fair values.
Income/losses from derivatives and

hedging instruments shall be
Gains or losses on re-measurement to recognized only when the transaction
fair values are included in P&L unless covered by the instrument has already
been closed and completed.
the derivatives will qualify as cash
flow hedges or hedge of net
investment in a foreign operation
which is recognized as part of equity.

The difference between the

transaction and fair values of the
derivatives and hedging instruments is
not taxable.
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Illustrative Interest rate swap transaction
Fixed interest rate
Counterparty A
Bank
(actual loan)
Transaction with interest
Floating interest
Fixed interest rate
rate
Counterparty B
Page 43
18 July 2006
Derivatives and hedging Instruments

Accounting entries Swap transaction:
Example: A bank enters into an interest rate swap transaction by paying a
fixed interest rate per annum and receives floating interest rate per quarter
1. At transaction date - Memorandum entry only (off-books); reference
asset of the swap transaction (i.e. loan) is only notional.
There is no interest accrual for the trading book. The interest rate element
is addressed via the daily marking-to-market

2. Mark -to-market valuation at cut-off date
In case the bank recognizes a positive mark -to-market fair value on the
swap, it will recognize a gain in the income statement.
Dr.
Cr.
Unrealised MTM Gain on Trading (B/S)

Profit and loss account IRS (P/L)

xxx
xxx
Recon item
in ITR
Page 44
18 July 2006
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26/07/2006

In case the bank recognizes a negative mark-to-market fair value on the
swap, it will recognize a loss in the income statement.
Dr.
Cr.
Profit and loss account IRS (P/L)

Unrealized MTM Loss on Trading (B/S)
xxx
xxx
Recon item
in ITR
Note: The entries to record the swap transaction at fair/market value are
normally reversed in the next business day.
3. At settlement/payment date of the swap, the actual gain or loss on the
swap transaction is recognized.

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18 July 2006

a. If the swap has a positive fair value
Dr.
Cr.
Cash (B/S)
Gain on swap transaction (P/L)
xxx
xxx
Taxable item
in ITR
b. If the swap has a negative fair value

Dr.
Cr.
Loss on swap transaction (P/L)

Cash (B/S)

xxx
xxx
Deductible
item in ITR
Page 46
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26/07/2006

Accounting entries Option transaction:
Example: A bank (buyer of the option) enters into a currency option
transaction.
1. At trade/contract date - Memorandum entry only (off-books)
2. Recording of option premium (Bank has buy option)
Dr.
Cr.
Profit and loss account Option (P/L)

Option Premium Payable (B/S)
xxx
xxx
Recon item
In ITR; not yet
realized

Page 47
18 July 2006

3. Mark -to-market valuation at cut-off date
In case the bank recognizes a positive mark -to-market fair value on the
option, it will recognize a gain in the income statement.
Dr.
Cr.
Option Premium Asset (B/S)

xxx
xxx
Recon item
in ITR
In case the bank recognizes a negative mark-to-market fair value on the

swap, it will recognize a loss in the income statement.
Dr.
Cr.

Option Premium Liability (B/S)
xxx
xxx
Recon item
in ITR
Note: The entries to record the option transaction at fair/market value are
normally reversed in the next business day.
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18 July 2006
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26/07/2006

4. On exercise date of the options, the memorandum entry at the date of
transaction will be reversed.
The actual gain or loss on the transaction is a taxable/deductible item on
exercise date.

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18 July 2006

Taxation of derivatives and hedging instruments
BIR Rulings on swap transactions (BIR Ruling Nos. 137-97;146-95; DA
9-01; DA 381-98)
gains or losses on swap transactions are recognized on a realized
basis for tax purposes

only net swap receipts/payments are subject to income tax/GRT
not subject to DST as the reference asset/principal is not an actual
loan agreement but merely notional; also derivatives are not subject to
DST pursuant to Section 199(h) of the Tax Code (as amended by RA
9243 or the amended DST law)

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Taxation on sale of stock options
Sale of stock options is subject to capital gains tax
Section 22 (Definitions on Tax on Income) of the Tax Code defines
shares of stock to include warrants and/or options to purchase shares

of stock
Sale of stock options is not subject to documentary stamp tax

Page 51
18 July 2006

Taxation on exercise of stock options (employer-employee transaction)
Exercise of stock option at an exercise price lower than market value
of the stock gives rise to a taxable event for the person (e.g. employee)
exercising the option
Employer is required to withhold tax (WT on compensation) on the
benefit derived by its employee upon exercise of the stock option.

DST on original issuance of shares of stock (P1.00 for every P200 of
the par value of shares)

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Reclassification
Reclassification of financial assets
and liabilities.

Tax Treatment
Gains or losses arising from
reclassification of financial assets and
liabilities shall have no tax effect.
Page 53
18 July 2006
Part
4
Question and Answer
27
26/07/2006
Thank you.
2004 PricewaterhouseCoopers. All rights reserved. PricewaterhouseCoopers refers to the network

of member firms of PricewaterhouseCoopers International Limited,each of which is a separate and
independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers.
PwC
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PAS 2 and 39 (Inventories)

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PAS 2 and 39 (Inventories)

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26/07/2006

on or after January 1, 2005. If an entity applies this Standard

Tax Implications of New Accounting Standards

Summary of Key Changes PAS 2 and 39

Summary of Key Changes PAS 2 and 39

Inventory needs to be carried

Difference between cost and net

Forex loss can no longer be

Tax Implications of New Accounting Standards

Summary of Key Changes PAS 2 and 39

Fair value adjustments of financial

Gain or loss to be recognized upon

Capital loss deductible only to the

Tax Implications of New Accounting Standards

Summary of Key Changes PAS 2 and 39

PAS 39 - Financial Instruments: Recognition and Measurement

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

Application of PAS common issues and examples

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

similar nature and use to the entity.

different nature or use. (PAS 2, Par. 25).

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

X(B)(2.1) of RAMO 1-00 dated March 17, 2000.

pursuant to PAS 2, it should secure permission from the BIR on

valuation method for tax, the effect of the change of inventory

Application of PAS common issues and examples

realizable value (PAS 2, Par. 9).

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

practice in the trade or business; and

Inventory practice should be consistent from year to year

An inventory that can be used under the best accounting

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

prices or unusable or unusable in the normal way because of

Bona fide selling price means actual offerings of goods

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

Must be evidenced by closed and completed transactions.

The amount of loss must be reduced by the amount of any

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

of sales shall only be deductible once realized.

recognized as a taxable income.

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

trade or other discounts, except strictly cash discounts,

other necessary charges incurred in acquiring possession of the

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

deferred settlement terms as expense over financing period.

Tax Implications of New Accounting Standards

Application of PAS common issues and examples

Reconciling item in ITR: P4,000 non-deductible interest expense

Application of PAS common issues and examples