1. Inventories, Construction Contracts & Leases
IAS 2, 11 & 17

2. Scope of IAS 2 – Inventories
Deals with
Amount of cost to be recognised as an asset and carried forward until related revenues are recognised
Recognition of inventories as an expense
Writing down inventories to Net Realisable Value (NRV)

3. What constitutes “inventories”?
Inventories include assets held for sale in the ordinary course of business (finished goods)
assets in the production process for sale in the ordinary course of business (work in process)
materials and supplies that are consumed in production (raw materials)

4. Exclusions from IAS 2
IAS 2 excludes certain inventories from its scope
work in process arising under construction contracts - IAS 11
financial instruments - IAS 39
biological assets related to agricultural activity and agricultural produce at the point of harvest - IAS 41

5. Fundamental Principle of IAS 2
Inventories are required to be stated at
the lower of cost and net realisable value (NRV)

6. Measurement of Inventories
Cost should include all
costs of purchase (including taxes, transport, and handling) net of trade discounts received
costs of conversion (including fixed and variable manufacturing overheads) and
other costs incurred in bringing the inventories to their present location and condition

7. But not…. Inventory cost should not include: abnormal waste
storage costs
administrative overheads unrelated to production
selling costs
foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency
interest cost when inventories are purchased with deferred settlement terms

8. Inventory costing methods
The standard cost and retail methods may be used for the measurement of cost, provided that the results approximate actual cost
For inventory items that are not interchangeable, specific costs are attributed to the specific individual items of inventory
For items that are interchangeable, IAS 2 allows the FIFO or weighted average cost formulas
The LIFO formula, ( allowed prior to the 2003 revision of IAS 2) is no longer allowed

9. Retail method
Discounted selling price In some cases, where such large numbers of rapidly changing individual items are held, the only practical method of arriving at a figure to represent cost is to value the items at current selling price less the normal gross profit margin.
For example, in the case of a department store, a valuation by reference to the ticketed selling price of the stock reduced by the appropriate departmental mark-up.
This method of valuation is acceptable if it can be demonstrated that it gives a reasonable approximation of the actual cost.
Whilst this method may lead to some undervaluation where the original ticketed selling price has already been reduced, other stock may never reach its ticketed selling price and to that extent would be overvalued.

10. Consistency of measurement
The same cost formula should be used for all inventories with similar characteristics as to their nature and use to the enterprise
For groups of inventories that have different characteristics, different cost formulas may be justified

11. Write-Down to Net Realisable Value
NRV is the
estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale
Any write-down to NRV should be recognised as an expense in the period in which the write-down occurs
Any reversal should be recognised in the income statement in the period in which the reversal occurs

12. Disclosure Notes to the accounts should disclose:
Accounting policies used and cost formula employed
Total carrying amount of inventories in the BS classified into categories
Carrying amount of inventories less costs to sell
Amount of inventories recognised as expense in the period
Amount of any write-down recognised as an expense in the period
Amount of any reversal of write down in the period

13. Construction Contracts – IAS 11
Deals with the treatment of recognition of revenue and costs in construction contracts
What is a Construction Contract?
A construction contract is a contract specifically negotiated for the construction of an asset or a group of interrelated assets
It does not have to last for MORE than a year.
What is important is that it begins in one accounting period and ends in a different accounting period

14. Types of Contract There are 2 types of contract Fixed Price Contract
A contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.
Cost Plus Contract
A contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of those costs or a fixed fee.

15. Construction of more than one asset
If a contract covers two or more assets, the construction of each asset should be accounted for separately if -
separate proposals were submitted for each asset
portions of the contract relating to each asset were negotiated separately and
costs and revenues of each asset can be measured.
If not, then the contract should be accounted for in its entirety

16. Contract Revenue Contract Revenue The amount specified in the contract
Subject to variations in contract work, incentive payments and claims IF
They are expected to give rise to revenue and
They can be reliably measured
Types of uncertainty which can affect measurement of contract revenue
Agreed variation (increase/decrease)
Cost escalation clauses in fixed price contract (increase)
Penalties for delays (decrease)
Variation in number of units in fixed price per unit contract (increase/decrease)

17. Contract Costs Contract Costs Contract costs should include
costs that relate directly to the specific contract
plus costs that are attributable to the contractor's general contracting activity to the extent that they can be reasonably allocated to the contract
plus such other costs that can be specifically charged to the customer under the terms of the contract

18. Costs that relate directly to the specific contract
Costs that relate directly include -
Site labour costs
Costs of materials used in construction
Depreciation of plant & equipment
Costs of moving plant, materials, etc
Costs of hiring plant & equipment
Costs of design & technical assistance related directly to the contract
Estimated costs of rectification work
Claims from third parties

19. General contracting activity & Specifically chargeable costs
Costs that relate to general contracting activities
Should be allocated
Systematically
Rationally and
Consistently
Based on normal levels of construction activities
Specifically chargeable costs ONLY if in contract
General admin costs – if in contract
R&D – if in contract
Never
Selling Costs
Depreciation of idle plant & equipment not used on any particular contract

20. Recognition of revenue and costs
Percentage Completion Method
Recognised according to the stage of completion of the contract at the BS date
Only when the outcome of the activity can be estimated with certainty
If a loss is predicted it should be recognised IMMEDIATELY
Reliable estimates can only be made under certain conditions

21. Conditions for reliable estimates
Fixed Price Contracts
Probable economic benefit will flow to the entity
Total contract revenue can be reliably measured
Stage of completion at BS date and costs to complete can be measured reliably
Costs attributable to contract can be identified and measured
Cost Plus Contracts
The percentage of completion method is application of accruals method
Revenue is matched to costs and
Attributed to proportion of work completed.

22. Reliable estimates When can reliable estimates be made?
Only when a contract has been agreed which establishes the following:
The enforceable rights of each party
The consideration that is to be exchanged
Terms and manner of settlement

23. Stage of completion Determining the stage of completion
The stage of completion of a contract can be determined in a variety of ways
proportion that contract costs incurred for work performed to date bear to the estimated total contract costs
surveys of work performed
completion of a physical proportion of the contract work

24. Example
EXAMPLE
Stage of completion

25. If outcomes cannot reliably be predicted
In such cases then
Only recognise revenue to the extent that contract costs are expected to be recovered
Recognise costs as expenses in period in which they are incurred
This is likely to be the case near start of contract

26. Non-recoverable contract costs
If contract costs cannot be recovered recognise as expense immediately
Circumstances would be:
Contract not fully enforceable
Completion is subject to litigation
Contract relates to properties which will probably be expropriated or condemned
Customer cannot meet obligations under contract
Contractor cannot complete contract
Losses on contracts should be recognised as soon as they are foreseen

27. Disclosures Disclosures amount of contract revenue recognised
method used to determine revenue
method used to determine stage of completion
for contracts in progress at balance sheet date:
aggregate costs incurred and recognised profit
amount of advances received
amount of retentions

28. Presentation Presentation
The gross amount due from customers for contract work should be shown as an asset
The gross amount due to customers for contract work should be shown as a liability

29. Classification of Leases
A lease is a FINANCE lease if
It transfers substantially all the risks and rewards incident to ownership
All other leases are OPERATING leases
Classification is made at the inception of the lease
Classification depends on the substance of the transaction rather than the form

30. Classification of Leases - 1
Situations that would normally lead to a lease being classified as a finance lease include the following
the lease transfers ownership of the asset to the lessee by the end of the lease term
the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable
the lease term is for the major part of the economic life of the asset, even if title is not transferred
at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset

31. Classification of Leases - 2
the lease assets are of a specialised nature such that only the lessee can use them without major modifications being made.
if the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee
gains or losses from fluctuations in the fair value of the residual fall to the lessee
the lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent

32. Land and Buildings
Land and buildings elements would normally be considered separately
The minimum lease payments are allocated between the land and buildings elements in proportion to their relative fair values
The land element is normally classified as an operating lease unless title passes to the lessee at the end of the lease term
The buildings element is classified as an operating or finance lease by applying the classification criteria

33. Accounting by Lessees - 1
The following principles should be applied in the financial statements of lessees:
At commencement of the lease term
FINANCE leases should be recorded as an asset and a liability at the lower of the fair value of the asset and the present value of the minimum lease payments
i.e. discounted at the interest rate implicit in the lease or at the enterprise's incremental borrowing rate
Therefore:
Dr Asset Account
Cr Lessor (liability) account

34. Accounting by Lessees - 1
FINANCE lease payments should be apportioned between the finance charge and the reduction of the outstanding liability
The rule being that the finance charge be allocated so as to produce a constant periodic rate of interest on the remaining balance of the liability
The depreciation policy for assets held under FINANCE leases should be consistent with that for owned assets
If there is no reasonable certainty that the lessee will obtain ownership at the end of the lease - the asset should be depreciated over the shorter of the lease term or the life of the asset

35. For OPERATING leases
The lease payments should be recognised as an expense in the income statement over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern of the user's benefit
Incentives (e.g. rent free periods) for the agreement of a new or renewed operating lease should be recognised by the lessee as a reduction of the rental expense over the lease term, irrespective of the incentive's nature or form, or the timing of payments

36. Apportionment of Rental Payments
When a lessee makes a rental payment it consists of 2 parts
Interest charge on the finance provided
Repayment of Capital Cost
The principal part will be debited to the Liability account to reduce outstanding liability

37. How to decide capital/interest split?
Sum-of-digits method
Assigns a digit to each instalment.
Last instalment = 1, penultimate = 2, etc
Add up digits
n(n + 1) / 2
Therefore for 12
(12 X 13) / 2 = 156 / 2 = 78
Interest charge for each instalment =
Digit applicable to the instalment
Sum of the Digits

38. How to decide capital/interest split?
Actuarial method
At beginning of lease capital invested = fair value of asset, less any deposit paid
This amount reduces by each instalment, therefore interest is greater in earlier part of lease as more capital is outstanding
Straight line method
Total finance cost
Number of instalments

39. Example
On 1st January 20X0 Bacchus Co. buys bottling machine under a finance lease
Cash price is $7,710 and amount to be paid is $10,000
Agreement required immediate payment of $2,000
Balance to be settled in 4 equal annual instalments
Commencing 31 December 20X0
Charge of $2,290 = interest of 15% calculated on remaining balance of the liability during each accounting period
Depreciation is on 20% straight-line per annum
Assumes Zero residual value
So Equal instalments must be
($10,000 - $2,000) / 4 = $2,000