1. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Chapter 16 Inventories and construction contracts

2. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Contents Inventories Inventory systems Accounting for inventories under IAS Construction contracts under IAS

3. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Learning objectives Explain the composition of inventories Describe five inventory cost assumptions, i.e. unit cost, first in first out (FIFO), last in, first out (LIFO), weighted average and base inventory Show the effect on annual profit and profit trends of using different inventory cost assumptions Discuss IAS 2 requirements relating to inventories Define construction contracts, attributable profit and foreseeable losses Appraise IAS 11 requirements relating to construction contracts Calculate amounts to be disclosed in financial statements relating to construction contracts Compare IAS 2 and 11 with other GAAP requirements Identify the disclosure requirements of IAS 2 and 11

4. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Inventories Commercial companies Manufacturing companies Service companies

5. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Inventories for commercial companies Merchandise: goods purchased for resale without transformation

6. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Inventories for manufacturing companies Raw materials, parts, components and consumables: goods that, once incorporated in the production process, become integrally and physically part of the product Manufacturing supplies: items used in supporting production and not part of the product

7. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Inventories for manufacturing companies (cont’d) Work in progress (WIP): products still in the manufacturing process at the close of the day Semi-finished goods: items that are finished with regard to one stage of production but are nonetheless not sellable in that condition. Finished goods: completed products ready for sale

8. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Inventories for service companies Work in progress: accumulated costs incurred in fulfilling a contract and not yet billed

9. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA An overview of possible methods to determine the value of the inventory Unit cost First in, first out (FIFO) Last in, last out (LIFO) Weighted average Base inventory

10. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Unit cost Here we assume that we know the actual physical units that have moved in or out. Each unit must be individually distinguishable, e.g. by serial numbers. In these circumstances, impractical in most cases, we simply add up the recorded costs of those units sold to give cost of sales and of those units left to give stock

11. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Data for the illustration of the following different methods for inventory valuation Purchases: –January 10 units at €25 each –February 15 units at €30 each –April 20 units at €35 each Sales: –March 15 units at €50 each –May 18 units at €60 each

12. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA First in, first out (FIFO) Here it is assumed that the units moving out are the ones that have been in the longest (i.e. came in first). The units remaining will therefore be regarded as representing the latest units purchased.

13. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.1 feedback €Cost of sales € January 10 at €25= 250 February 15 at €30= 450 February total 25 700 March – 10 at €25 (Jan.) = 250 – 5 at €30 (Feb.) = 150400 March total 10 300 April+ 20 at €35= 700 April total 30 1 000 May – 10 at €30 (Feb.) = 300 – 8 at €35 (Apr.)= 280580 May total 12 at €35 420___ 980

14. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.1 feedback (cont’d) Sales: –750 + 1080 = 1830 Purchases: –250 + 450 + 700 = 1400

15. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.1 feedback (cont’d) Sales1 830 Purchases1 400 Closing inventory420 Cost of sales980 Gross profit850

16. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Last in, first out (LIFO) The units moving out are the ones which came in most recently. The units remaining will therefore be regarded as representing the earliest units purchased.

17. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.2 feedback € Cost of sales € January 10 at €25= 250 February 15 at €30= 450 February total 25 700 March – 15 at €30 (Feb.) = 450 March total 10 250 April+ 20 at €35= 700 April total 30 950 May – 18 at €35 (Apr.) = 630 – 2 at €35 & 10 = 320____ at €25 1 080

18. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.2 feedback (cont’d) Sales1 830 Purchases1 400 Closing inventory320 Cost of sales1 080 Gross profit750

19. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Weighted average Apply the average cost, weighted according to the different proportions at the different cost levels, to the items in inventory.

20. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.3 feedback € Cost of sales € January 10 at €25= 250 February 15 at €30= 450 February total 25 at €28*= 700 March– 15 at €28= 420 March total 10 at €28 280 April+ 20 at €35= 700 April total 30 at €32⅔ ** 980 May– 18 at € 32⅔= 588 May total 12 at € 32⅔= 392____ 1 008

21. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.3 feedback (cont’d) Working: (10 x 25) + (15 x 30) = 28* (10 + 15) (10 x 28) + (20 x 35) = 32⅔** (10 + 20)

22. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.3 feedback (cont’d) Sales1 830 Purchases1 400 Closing inventory392 Cost of sales1 008 Gross profit822

23. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Base inventory This approach is based on the argument that a certain minimum level of inventory is necessary in order to remain in business at all. Thus, it can be argued that some of the inventory viewed in the aggregate, is not really available for sale and should therefore be regarded as a fixed asset. This minimum level defined by management, remains at its original cost and the remainder of the inventory above this level is treated, as inventory, by one of the other methods.

24. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.4 feedback Cost of sales € February 15 at €30= 450 March 15 at €30= 450 March total 0 0 April+ 20 at €35= 700420 April total 20= 700 May– 18 at €35= 630 May total 2 at €35= 70____ 1 080

25. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.4 feedback (cont’d) Sales1 830 Purchases 1 150 Closing inventory70 Cost of sales1080 Gross profit750

26. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Inventory systems Each company needs a system to record the physical and monetary movements in the inventory. A company needs to keep track of the beginning inventory, the purchases, the goods sold and the closing inventory. Two inventory recording systems exist: –the periodic inventory system –the perpetual inventory system

27. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA The periodic inventory system Within this system inventory is determined by a physical count at a specific date. As long as the count is made frequently enough for reporting purposes, it is not necessary to maintain extensive inventory records. The inventory shown in the balance sheet is determined by the physical count and is priced in accordance with the inventory method used. The net charge between the beginning and ending inventories enters into the computation of costs of goods sold.

28. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA The perpetual inventory system In a perpetual system, inventory records are maintained and updated continuously as items are purchased and sold. The system has the advantage of providing inventory information on a timely basis but requires the maintenance of a full set of inventory records. Audit practice will certainly require that a physical check of perpetual inventory records be made periodically.

29. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Accounting for inventories under IAS 2 Scope Definitions Measurement Disclosure

30. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA IAS 2 – scope Applies to all inventories, except: –work in progress arising under construction contracts; –financial instruments; –biological assets related to agricultural activity and agricultural produce at the point of harvest (see IAS 41, Agriculture)

31. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA IAS 2 – scope (cont’d) Does not apply to the measurement of inventories held by: –producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realisable value in accordance with well-established practices in those industries –commodity broker-traders who measure their inventories at fair value less costs to sell

32. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA IAS 2 – definitions Inventories are assets: –held for sale in the ordinary course of the business; –in the process of production for such sale; or –in the form of materials or supplies to be consumed in the production process or in the rendering of services

33. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA IAS 2 – measurement Inventories shall be measured at the lower of cost or net realisable value –the cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition –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

34. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Cost of inventory Cost of purchases + costs of conversion + other costs incurred in bringing the inventory to the present location and condition

35. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Cost of inventory (cont’d) Cost of purchase = Purchase cost + Import duties and other non-recoverable taxes + Transport and handling costs + + Other costs directly attributable to acquisition – trade discounts/rebates

36. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Cost of inventory (cont’d) Conversion cost includes –cost directly related to the units of production, such as direct labour –systematic allocation of fixed and variable production overheads that are incurred in converting materials to finished goods –the allocation of fixed production overheads is based on the normal capacity of the production facilities

37. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Cost of inventory (cont’d) Other costs are costs incurred in bringing the inventories to their present location and condition. –costs which can not be included are e.g.: abnormal amounts of waste storage costs administrative overhead selling costs

38. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Cost formulas allowed for inventory valuation by IAS 2 The cost of inventories of items that are not ordinarily interchangeable and goods and services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs The cost of other inventories shall be measured by FIFO, or weighted average cost

39. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Net realisable value 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 The amount of any write-down on inventories to net realisable value will be recognized as an expense in the period the write-down occurs

40. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Net realisable value (cont’d) –When inventories are sold, the carrying amount of those inventories shall be recognized as an expense in the period in which the related revenue is recognized. The amount of any write-down of inventories to net realisable value and all losses of inventories shall be recognized 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 recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs (para. 34 IAS 2).

41. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.5 An entity has three products in its inventory with values as follows: ProductCostNRV A1012 B1115 C12 9 Total3336 At what value should the inventory be stated in the balance sheet in accordance with IAS 2?

42. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.6 Determine the valuation of inventory items A and B from the following data: AB Direct labour charge per item24 Fixed production overheads total €50 000 and normal capacity of production is 5 200 of A and 10 200 of B but this is reduced by 200 A and 200 B for planned maintenance. The target of production was 6 000 A and 12 000 B. It is estimated that B will sell at twice the value of A. Variable production overheads are calculated as €10 000 in total and are to be allocated on a machine hour basis. Each A item takes two hours of machine time and each B item one hour.

43. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.7 Calculate the cost of inventories in accordance with IAS 2 from the following data relating to Unipoly Company for the year ended 31 May 20X7. € Direct cost of can opener per unit1 Direct labour cost of can opener unit1 Direct expenses cost of can opener unit600 000 Production overheads per year200 000 Selling overheads per year300 000 Interest payments per year100 000 There were 250 000 units in finished goods at the year end. You may assume that there were no finished goods at the start of the year and that there was no work in progress. The normal annual level of production is 750 000 can openers, but in the year ended 31 May 20X7 only 450 000 were produced because of a labour dispute.

44. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.8 Which of the following costs can be included in the cost of inventory in accordance with IAS2? Reference to paras 9–20 of IAS 2 will help in completing this activity. Discounts on purchase price Travel expenses of buyers Import duties Transport insurance Commission and brokerage costs Storage costs fret receiving materials that are necessary in the production process Salaries of sales department Warranty cost Research for new products Audit and tax consultation fees

45. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA IAS 2 disclosure The accounting policies adopted in measuring inventories, including the cost formulas used The total carrying amount of inventories and the carrying amount in classifications appropriate to the enterprise The carrying amount of inventories carried at fair value less costs to sell The amount of any write down of inventories recognized as an expense in the period in accordance with para. 34

46. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA IAS 2 disclosure (cont’d) The carrying amount of inventories pledged as security for liabilities The cost of inventories recognized as an expense during the period The amount of any reversal of any write down that is recognized as a reduction in the amount of inventories recognized as an expense in the period in accordance with para. 34 The circumstances or events that led to the reversal of a write down of inventories in accordance with para. 34

47. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Construction contracts – accounting issues at stake Construction contracts generally last over a long period of time, certainly longer than one accounting period. Such contracts involve all the difficulties discussed earlier in the context of inventories, with one major addition. This is the question of profit allocation over the various accounting periods.

48. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.9 Zen entity is contracted to Alpha for $2m to construct a building. The following data are available in relation to the contract: 20X520X620X7 Costs incurred during year500 000700 000300 000 Year end estimate costs to complete1 000 000300 000 Bills raised during year400 000700 000900 000 Cash received during year200 000500 0001 200 000 Show the profit to be included in the accounts under both the percentage- of completion method and completed-contract method assuming that degree of completion is based on costs incurred.

49. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.9 feedback Under the completed-contract method the profit of 500 000 will not be recognized under 20X7 whereas under the percentage-of-completion method it will be allocated to each accounting year as follows: 20 x 5 500 000 x 500 000 – previously recognized (0) 166 667 1500 000 20 x 6 1200 000x 500 000 – 166 667233 333 1500 000 20 x 7 1500 000 x 500 000 – 233 333 – 166 667 100 000 1500 000500 000

50. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA IAS 11 – construction contracts Scope Definitions Recognition of revenues and costs related to construction contracts Measurement Disclosure

51. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Construction contract – definitions A construction contract is 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. IAS 11 defines two types of construction contracts –fixed price contract –cost plus contract

52. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Fixed price contract A fixed price contract is a construction 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

53. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Cost plus contract A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee.

54. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Combining versus segmenting contracts Many contracts can cover the construction of a number of assets and in these cases each asset must be treated as a separate contract if: –separate proposals have been submitted for each asset –each asset has been subject to separate negotiations and the contractor and customer have been able to accept or reject that part of the contract relating to each asset –the costs and revenues of each asset can be identified

55. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Combining versus segmenting contracts (cont’d) A group of contracts may in substance be a single construction contract and is required to be treated as such when: –the group of contracts is negotiated as a single package –the contracts are so clearly interrelated that they are in effect part of a single project with an overall profit margin –the contracts are performed concurrently or in a continuous sequence

56. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Contract revenue Contract revenue should comprise: –the initial amount of revenue agreed in the contract; and –variations in contract work claims and incentive payments: to the extent that it is probable that they will result in revenue; and they are capable of being reliably measured

57. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Contract revenue (cont’d) The amount of contract revenue may increase or decrease from one period to the next e.g.: –a contractor and a customer may agree variations or claims that increase or decrease contract revenue in a period subsequent to that in which the contract was initially agreed; –the amount of revenue agreed in a fixed price contract may increase as a result of cost escalation clauses;

58. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Contract revenue (cont’d) –the amount of contract revenue may decrease as a result of penalties arising from delays caused by the contractor in the completion of the contract; or –when a fixed price contract involves a fixed price per unit of output, contract revenue increases as the number of is increased

59. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Contract costs Contract costs comprise: –costs that relate directly to the specific contract –costs that are attributable to contract activity in general and can be allocated to the contract –such other costs as are specifically chargeable to the customer under the terms of the contract

60. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Contract costs (cont’d) Not to be included in contract costs: –general administration costs for which reimbursement is not specified in the contract –selling costs –research and development costs for which reimbursement is not specified in the contract –depreciation of idle plant and equipment that is not used on a particular contract

61. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Recognition of costs and revenues When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract shall be recognized as revenue and expenses respectively by reference to the stage of completion of the contract activity at the balance sheet date = percentage of completion method

62. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Recognition of costs and revenues (cont’d) In case of a fixed price contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied –total contract revenue can be measured reliably –it is probable that the economic benefits associated with the contract will flow to the entity

63. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Recognition of costs and revenues (cont’d) –both the contract costs to complete the contract and the stage of contract completion at the balance sheet date can be measured reliably –the contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates

64. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Recognition of costs and revenues (cont’d) In case of a cost plus contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied: –it is probable that the economic benefits associated with the contract will flow to the entity; and –the contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably

65. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Recognition of costs and revenues (cont’d) When the outcome of a construction contract cannot be estimated reliably: –revenue shall be recognized only to the extent of contract costs incurred that it is probable will be recoverable; and –contract costs shall be recognized as an expense in the period in which they are incurred

66. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Use with International Financial Reporting and Analysis, Third Edition By David Alexander, Anne Britton & Ann Jorissen ISBN 1844806685 © 2007 Thomson Learning Recognition of expected losses When it is probable that total contract costs will exceed total contract revenue, the expected loss shall be recognized as an expense immediately The amount of such a loss is determined irrespective of: –whether work has commenced on the contract; –the stage of completion of contract activity; or –the amount of profits expected to arise on other contracts which are not treated as a single construction contract

67. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Stage of completion The stage of completion of a contract is determined by the method that measures reliably the work performed and this could be: –proportion that costs incurred for work performed to date bear to total estimated costs –surveys of work performed; or –completion of a physical proportion of the contract work

68. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Determining the percentage of completion Input measures: –labour hours –machine hours –material costs Output measures: –units produced –units delivered

69. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Disclosure An entity shall disclose: –the amount of contract revenue in the period; –the methods used to determine the contract revenue recognized in the period; and –the methods used to determine the stage of completion of contracts in progress

70. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Disclosure (cont’d) An entity shall disclose each of the following for contracts in progress at the balance sheet date –the aggregate amount of costs incurred and recognized profits (less recognized losses) to date; –the amount of advances received; and –the amount of retentions

71. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.11 The following data are available in respect of a construction contract: – Costs to date $2m – Total contract revenue expected $2m – Further costs to completion $0.5m How should this contract be treated in the accounts?

72. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Illustration and Activity 16.12 Record the following information in the financial statements Contract FContract P Contract revenue500350 Contract expenses450400 Billings500200 Payments in advance of billings25– Contract costs incurred600400 Foreseeable additional losses-60

73. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.13 The following data are available in respect of five contracts in progress at the end of year 1 by Gamma Entity. Identify how each contract should be shown in the accounts in accordance with IAS 11. Contracts ABCDETotal Contract revenue recognized145520380200551 300 Contract expenses recognized110450350250551 215 Expected losses403070 Contract costs incurred in period1105104502501001 420 Contract costs recognized as contract expenses 110450350250551 215 Contract costs relating to future activity6010045205 Progress billings100520380180551 235 Payments in advance of billings802025125

74. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.14 Show how these contracts need to be included in the financial statements Contract AContract B Contract revenue recognized1 000400 Contract expenses recognized600400 Foreseeable additional losses200 Progress billings700100 Payments made by the customer50080

75. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Illustration of changes in estimates of costs A construction contract with revenue of £15m is initially estimated to have total costs of £9m and is expected to take four years to complete. In year 2 the costs are re-estimated at £10m the increased cost being attributed as follows, £0.6m to year 3 and £0.4m to year 4. if we assume the initial costs were attributed as follows, £2m year 1, £2.5m year 2, £3m year 4 and £1.5m year 4 we can calculate the stage of completion of the contract both before and after the re-estimate.

76. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Illustration (cont’d) Year 1 £mYear 2 £mYear 3 £mYear 4 £m Initial estimate Revenue 15 Contract costs to date 2 4.5 7.5 9 Contract costs to complete _ 7__ _ 4.5 _1.5 –__ _ 9__ 9__ Profit estimate 6 6 6 6 % complete 22.2% 50% 83.3% 100% Profit recognized in year 1.33 1.67 2 1 Re-estimate Revenue 15 Contract costs to date 2 4.5 8.1 10 Contract costs to complete __7__ _ 5.5 1.9 –__ __ 9__ 10__ Profit estimate 6 5 5 5 % complete 22.2% 45% 81% 100% Profit recognized in year 1.33 0.92 1.8 0.95

77. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity 16.15 An enterprise is involved in two construction contracts the outcome of which cannot be assessed with reliability for which the following data are available: –Contract A contract costs incurred 30 000 all probably recoverable –Contract B contract costs incurred 100 000, similar contracts have shown a loss of 15% on contract sale price due to pending legislation affecting the construction. Contract sale price 1m. Identify how these two contracts should be treated in the accounts of the enterprise

78. International Financial Reporting and Analysis, 5th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Activity feedback 16.15 Contract A : –Contract revenue 30 000 –Contract costs 30 000 Contract B: –Contract revenue 0 –Contract costs recognised as expense 150 000