Professional Documents
Culture Documents
1 INTRODUCTION
Inventories constitute a substantial item for both income statement and balance sheet. Inventories
are vital for the business derives its existence from selling or converting stocks into either sales of
goods or services. Inventories are also subject to variations over time and it is difficult to determine
their value.
The value of inventories may differ from the actual carrying cost on account of changing fair values
or exchange rates fluctuations. Computation of the cost of inventories requires computation of
relevant costs and an agreed stock valuation method to be applied. The values of inventories
represent deferred cost to or from accounting period prior or after the current accounting period.
This lesson deals with the topics of accounting for stock and accounting for contracts as per IAS 2
“Inventories” and IAS 11 that lays down the principles and procedures for accounting for inventory
and construction contracts respectively. The terms ‘stock’ and ‘inventory’ are interchangeable.
2 LEARNING OBJECTIVES
After completing this lesson you will be able to:
1. determine relevant cost of stock for financial reporting purposes;
2. value and account for stock in accordance with accounting standards;
3. disclose all elements of stock in accordance with accounting standards;
4. compute annual turnover, cost of sales and profit or loss on a contract;
5. record all amounts relating to contracts via journal entries and accounts;
6. calculate and record any balance sheet totals arising on contracts;
7. disclose contract balances in accordance with accounting standards
3 INVETORIES
The value of inventories and its accounting principles has impacts on both the performance and
financial position. The income for the year depends very much on amount of stocks at start and end
of each period. The cost of inventory not sold at the end each year is deferred to the following year
and therefore reducing the cost of sales and at the same time increasing the assets the company
may recover from the following year’s sales.
Journal entries
Closing Stock
Opening Stock
Dr Cost of Sales (P&L) xxxx
Cr Inventories (B/S) xxxx
To record transfer of inventories from inventories asset to cost of sales expense
3.1 Definitions
Inventories are assets:
a) held for sale in the ordinary course of business;
b) in the process of production for such sale; or
c) In the form of materials or supplies to be consumed in the production process or in the
rendering of services.
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Net realisable 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.
Fair value is the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm's length transaction.
Net realisable value refers to the net amount that an entity expects to realise from the sale of
inventory in the ordinary course of business. Fair value reflects the amount for which the same
inventory could be exchanged between knowledgeable and willing buyers and sellers in the
marketplace. The former is an entity-specific value; the latter is not. Net realisable value for
inventories may not equal fair value less costs to sell.
Para 9 of IAS 2:- “Inventories should be measured at the lower of cost and net realisable
value”.
Net realisable value is the net amount that an entity expects to realize from the sale of inventory in
the ordinary course of business.
Fair value reflects the amount for which the same inventory could be exchanged between
knowledgeable and willing buyers and sellers in the marketplace. The former is an entity-specific
value; the latter is not. Net realisable value for inventories may not equal fair value less costs to
sell.
Inventories includes
a) Goods purchased and held for resale;
b) finished goods produced, or work in progress being produced or raw materials;
c) In the case of a service provider, the costs of the service for which the entity has
not yet recognised the related revenue (para 19)
The value of inventories is determined on line to line basis.
Eexercise 1: Lucky Store stocks values as June 31, 2007 was as under:
Required
Compute the value of closing stock
The value of inventory may have increased between acquisition of stocks and its valuation. The
company may not recognize such an increase for it is not prudent to realize the increase in value as
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it may not necessarily accrue to the company and that the company still control the stocks.
Where future revenues will not cover the level of costs already incurred, any excess should be
immediately written off to the profit and loss account in the current year. This might occur where
stock is obsolete, where there is a change in economic circumstances, or where the stock has
physically deteriorated.
3.3 COST OF INVENTORIES AND COSTS OF PURCHASE (Paras 10 & 11)
The costs of purchase of inventories comprise the purchase price, import duties and other taxes
(other than those subsequently recoverable by the entity from the taxing authorities), and
transport, handling and other costs directly attributable to the acquisition of finished goods,
materials and services. Trade discounts, rebates and other similar items are deducted in
determining the costs of purchase.
In Tanzania taxes that may apply on purchase of stocks, local or imported, are import duty, excise
duty and value added tax. In some cases VAT may be chargeable or not and may as be recoverable
or not depending on the use in which the stock is put and the tax status of company owning such
stocks. Other costs include inspection and port charges.
Exercise 2: Micro Trader imported 10,000 tones of raw incurred the following costs
VAT is recoverable from the output tax charged on sales to customers. Port and clearing charges is
gross of VAT which is also recoverable. Micro Trader benefits from a 5% trade discount on cost and
that is has not deducted from the invoice price. Micro Trader exports of its products and eligible to
50% of both duty draw back of import duty and excise duty on raw materials utilized in production
of exported goods exported. Micro Trader also enjoys a 2% cash discount by settling the invoices
within prescribed periods. By the year end only 70% of purchased raw materials were consumed
The costs of conversion of inventories include directly costs and indirect costs in form of overheads.
Overheads refer to systematic allocation of fixed and variable production overheads that are
incurred in converting materials into finished goods. Fixed production overheads are those indirect
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costs of production that remain relatively constant regardless of the volume of production, such as
depreciation and maintenance of factory buildings and equipment, and the cost of factory
management and administration. Variable production overheads are those indirect costs of
production that vary directly, or nearly directly, with the volume of production, such as indirect
materials and indirect labour.
Fixed production overheads are based only on the normal capacity of the production facilities.
Normal capacity is the production expected to be achieved on average over a number of periods. If
production is below normal, fixed production overhead per unit should not be increased as a result
of the low production or idle plant. The same principle does not apply to abnormally high levels of
production. Stock is never valued above the actual cost incurred.
Exercise 3
A company has variable production costs of 5,000 per unit and total fixed production costs of
20,000,000. The normal capacity of the business is 250,000 units.
During the year to 31 December 2005 actual production was 200,000 units of which 13,750 were in
closing stock.
Required:
1) Calculate the cost of closing stock
a) Assuming production was 280,000 units;
b) Assuming production was 200,000 units
2) In any case determine how much of stock cost should be charged to income statement.
When the costs of conversion of each product are not separately identifiable, they are allocated
between the products on a rational and consistent basis. The allocation may be based the relative
sales value of each product either
a) At the stage in the production process when the products become separately identifiable;
or
b) At the completion of production.
The net realizable value of by-product is deducted from the cost of the main product.
A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its
intended use or sale (IAS 23 para 4). Most stocks do not take a substantial period. An exception is
maturing whisky which takes several years to get to a sellable condition.
To value of stocks of service providers have inventories is the cost of production of such
services. These costs consist of the labour and other costs of personnel directly engaged in
providing the service, including supervisory personnel, and attributable overheads. Labour
and other costs relating to sales and general administrative personnel are not included but
are recognised as expenses in the period in which they are incurred. The cost of inventories
of a service provider does not include profit margins or non-attributable overheads that are
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often factored into prices charged by service providers.1
4 COST FORMULAS
The cost of inventories, other than those dealt with in paragraph 23, shall be assigned by using the
first-in, first-out (FIFO) or weighted average cost formula. An entity shall use the same cost formula
for all inventories having a similar nature and use to the entity. For inventories with a different
nature or use, different cost formulas may be justified.
The Standard does not permit the use of the last-in, first-out (LIFO) formula to measure the cost of
inventories.
When inventories are sold, the carrying amount of those inventories shall be recognised as an
expense in the period in which the related revenue is recognised. The amount of any write-down of
inventories to net realisable value and all losses of inventories shall be recognised as an expense in
the period the write-down or loss occurs. The amount of any reversal of any write-down of
inventories, arising from an increase in net realisable value, shall be recognised as a reduction in
the amount of inventories recognised as an expense in the period in which the reversal occurs.
Some inventories may be allocated to other asset accounts, for example, inventory used as a
component of self-constructed property, plant or equipment. Inventories allocated to another asset
in this way are recognised as an expense during the useful life of that asset.
Para 37: Information about the carrying amounts held in different classifications of inventories and
the extent of the changes in these assets is useful to financial statement users. Common
classifications of inventories are merchandise, production supplies, materials, work in progress and
finished goods. The inventories of a service provider may be described as work in progress.
Para 38: The amount of inventories recognised as an expense during the period, which is often
referred to as cost of sales, consists of those costs previously included in the measurement of
inventory that has now been sold and unallocated production overheads and abnormal amounts of
production costs of inventories. The circumstances of the entity may also warrant the inclusion of
other amounts, such as distribution costs.
Some entities adopt a format for profit or loss that results in amounts being disclosed other than
the cost of inventories recognised as an expense during the period. Under this format, an entity
presents an analysis of expenses using a classification based on the nature of expenses. In this
case, the entity discloses the costs recognised as an expense for raw materials and consumables,
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labour costs and other costs together with the amount of the net change in inventories for the
period.2
IAS 11 defines profit or loss recognition principles for different scenarios surrounding construction
contracts, namely
a) Profitable contracts;
b) Contracts whose profit may not measured with certainty; and
c) Loss making contracts.
Alternative method of accounting for such contracts is a trade-off between the accruals/matching
principle and the prudence/realisation concepts when accounting for construction contracts and
often have to exercise professional judgement and expertise in determining what amounts should
be reported in the accounts.
7.1 Definitions
IAS 11 (paragraph 3) defines a construction contract as “a contract specifically negotiated for the
construction of an asset or a combination of assets that are closely interrelated or interdependent
in terms of their design, technology and function or their ultimate purpose or use”.
Examples of a single asset would be a bridge, tunnel, building or ship, oil refineries, power plants,
chemical works, etc. Although the examples in the standard are building/civil engineering based a
contract to develop software would also be covered by the IAS. Contracts for services are covered
by IAS 18 ‘Revenue’ (covered in module 1).
• fixed price the contractor agrees to a fixed contract price, or a rate per unit of output, which
may be subject to cost escalation claims (e.g. allowing for inflation)
• Cost plus contract the contractor is reimbursed for allowable costs, plus a percentage of these
costs or a fixed fee.
A contract may extend to more than one year but this is not an essential feature.
The contractor will not wish to bear the full cost of financing the project and the contract agreement
will require that the customer will be invoiced for work done as the contract progresses. These
amounts are referred to as “Progress billings”. These amounts will normally be invoiced during the
contract after work has been done and may be net of retentions. Retentions are usually a
percentage of the amount billed (often 5% but sometimes considerably higher) that under the
terms of the contract, the customer does not pay until the contract is completed.
As these billings (sometimes called progress payments) are not for the completed project they are
not credited directly to sales or turnover, as would happen with a completed sale, but are recorded
for each invoice raised as:
Dr Debtors
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Cr Contract account
When cash is received from the customer it is recorded in the normal way i.e.:
Dr Bank
Cr Debtors
Businesses should keep a separate ‘contract account’ for each construction contract in progress.
Progress billings can be thought of as potential sales or turnover to be recognised. Progress billings
invoiced, however, are not necessarily the same as turnover. In order to keep a record and control
of costs it is usual to keep a separate record for each contract. Typical costs are wages and
salaries, materials, hire of equipment, depreciation charges, sub-contractors’ charges and
allocation of overheads.
The ‘contract account’ is essentially a holding account in the balance sheet to which all invoices
relating to the contract are posted during the year. At the year-end, relevant amounts are
transferred out to the profit and loss account.
Construction contracts include contracts for rendering services which are directly related to the
contract e.g. architectural, engineering, etc. and contracts for demolition or restoration of assets,
and restoration of environments. (Para 5).
A variation (para 13) is an instruction from the customer for a change in the scope of work e.g.
change in design. This may result in an increase or decrease in revenue. Variations should be
included as part of total revenue when it is probable that the customers will approve both the
variation and the monetary value.
A claim (para 14) occurs when the contractor seeks recompense from the customer for costs not
included in the contract price arising from, for example, delays caused by the customer or errors in
specification. Because of their contentious nature claims are only included as part of revenue when
negotiations have reached an advanced stage such that it is probable that the customer will accept
the claim.
Incentive payments (para 15) are additional amounts paid to the contractor if specified
performance standards are met or exceeded e.g. early completion. These should be included only
when the contract is sufficiently advanced that it is probable that the specified standard will be met
and that the amount of the incentive payment can be measured reliably.
Possible penalties through failure to meet performance standards should also be considered and
included if they can be measured reliably. Note that penalties are viewed as a reduction in
turnover and not as additional costs. Penalties should be deducted from revenue when it is
probable they will be incurred.
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Permissible costs follow the same rules as in IAS 2.
The following costs are excluded (para 20) and may be charged directly to income statement of
respective accounting period
a) General administration;
b) Selling costs;
c) Research and development; and
d) Depreciation of idle plant and equipment that is not used on a particular contract.
The accumulation of contract costs normally starts when the contract begins. However, costs
incurred in securing a contract are also included if they can be separately identified and measured
reliably and it is probable that the contract will be obtained (para 21).
When costs of securing a contract have been written-off to the profit and loss account this
treatment cannot be reversed in a subsequent period when the contract is secured i.e. once
written-off the costs stay written-off.
Example 6
Mega Builders Ltd (MBL) has 3 contracts in progress at 30 June 2007, A, B and C.
All contracts commenced during the year. The following information is available:
Contract A B C
Due to the nature of the contracts MBL can usually reliably estimate the outcome when the
contract is 40% complete. All costs are considered recoverable.
Required:
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Calculate the turnover and cost of sales to be included in the profit and loss account of MBL for
the year to 31 December 2005.
Solution
A and B are profitable and C is loss making contracts. A is profitable and its outcome can be
estimated reliably. B is also profitable but the outcome cannot be estimated reliably.
As the outcome cannot be estimated reliably, no profit is recognised. Turnover is restricted to the
extent of contract costs incurred that it is probable will be recoverable.
In both (a) and (b) the turnover figure must be entered into the accounts. This is done by:
Dr Contract account
Cr P/L – turnover
Being revenue recognised for the year
Calculate the turnover for each contract for the year to 30 June 2007.
The turnover for each contract is as follows:
Contract A – profitable and reliable estimate
% completion x total contract value = 80% x 8,000,000=6,400,000
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Contract B – profitable but no reliable estimate
Turnover restricted to costs incurred that it is probable will be receivable = 360,000.
Contract costs that are not probable of being recovered are recognised as an expense immediately.
No revenue is recognised in respect of these items.
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8 BALANCE SHEET
8.1
If the balance on the ‘contract a/c’ is a debit i.e. an asset, it is presented as ‘Gross Amount Due
from Customers’ under current assets (para 42). If the balance is a credit, it is presented as ‘Gross
Amount due to Customers’ (para 42) (a current liability).
The ‘Gross Amount Due to/from customers’ comprises (paras 43 & 44):-
If the balance is a debit (‘Gross Amounts Due from Customers’), the customer still owes us for costs
incurred and/or work completed but not invoiced. – it is therefore an asset.
If the amount is a credit (‘Gross Amounts Due to Customers’), we have invoiced the customer too
much and owe them money back and/or we are unable to recover all costs incurred– it is therefore
a liability.
Example 6
In order to work out the balance sheet we need to have additional information.
Contract A B C
Contract value 8,00 5,00 4,50
0 0 0
Contract cost to date 5,60 360 3,50
0 0
Cost to completion 1,40 4,14 2,50
0 0 0
Progress billing 6,00 400 3,80
0 0
invoiced
Progress billing 5,10 - 3,50
0 0
received
% completion 80% 8% 60%
Required:
Calculate the amounts to appear in the balance sheet of MBL as at 31 June 2007 and prepare
extracts from the profit and loss account and balance sheet of MBL for the year to 31 December
2005.
Solution
Contract A B C
Progress billing invoiced 6,000 400 3,800
Progress billings received 5,100 - 3,500
Trade Debtors 900 400 300
Costs incurred 5,600 360 3,500
Profit/(Loss) recognized 800 - (890)
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Progress billings invoiced (6,000 (400 (3,800
) ) )
Amount due from/ 400 (40) (1,190
)
(customers)
Turnover 9,370,000
Cost of sales 9,460,000
Gross Profit/ (loss) (90,000)
Current assets
Trade receivables 1,600,000
Gross amounts due to customers 400,000
Current liabilities
Gross amount due to customer (1,230)
Note: the amount due to customers on contract B and C have been added together. This is the
correct presentation.
Never net off amounts due from/ (to) to give a single amount.
Reliable estimates
One issue we have not covered is how we decide whether an estimate is reliable or not. The
standard gives the following guidance.
The outcome can be estimated reliably (para 23) when:
(a) Total contract revenue can be assessed reliably;
(b) It is probable that the economic benefits will flow to the company (i.e. the customer will pay);
(c) Both contract costs to complete and stage of completion can be measured reliably; and
(d) Contract costs can be clearly identified and measured reliably.
For a contract in its early stages or where these are significant risks remaining (e.g. on a contract using
new technology or techniques) it will probably not be possible to meet criterion (c) above and the
overall outcome cannot be estimated reliably. Such a contract will fall into the profitable not reliable
category.
Exercise 7
A contractor entered into a contract in 2004 which is due to be completed by 2006. Relevant
information is:
Monetary values in millions
Year 2004 2005 2006
Contract 15,00 15,00 15,00
price 0 0 0
Variation - 200 400
Penalty - - (100)
% 35% 80% 100%
completion
Variations and the penalty can be assumed to be measured reliably at each relevant balance sheet
date. Assume that the contract is profitable overall and the outcome can be estimated reliably at
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each balance sheet date.
Solution
Item Year 2004 2005 2006
Contract revenue 15,00 15,00 15,000
0 0
Variation - 200 400
Penalty - - (100)
Total contract revenue 15,00 15,20 15,300
0 0
% Completion 35% 80% 100%
Total revenue to be 5,250 12,16 15,300
0
recognized
Less: recognized - (5,250 (12,160
) )
previously
To be recognized in the 5,250 6,910 3,140
year
9 DISCLOSURE
The principal disclosures (para 39 and 40) are as follows:
(a) contract turnover for the year;
(b) methods used to determine turnover (usually stage of completion);
(c) methods used to determine the stage of completion;
(d) aggregate amount of costs incurred and recognised profits (less recognised losses) to date;
(e) the amount of advances received (if any);
(f) The amount of retentions (if any).
Advances received are amounts received by the contractor before the related work is performed
(para 41). Retentions are amounts of progress billings which are not paid until the satisfaction of
conditions specified in the contract for the payment of such amounts or until defects have been
rectified (para 41).
Remember that gross amounts due from/ (to) customers should be shown on the balance sheet as
assets/liabilities.
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