slide 10.1 alan melville, international financial reporting, 3rd edition, © pearson education...

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Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011

Chapter 10 - INVENTORIES AND

CONSTRUCTION CONTRACTS(IAS2 and IAS11)

ACTG 6580

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Definition of Inventories(IAS2)

Inventories are assets:

• Held for sale in the ordinary course of 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.

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Measurement of Inventories

Inventories are measured "at the lower of cost and net realizable value" (IAS2)

• Cost comprises "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".

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Conversion Costs

• Costs directly related to production (such as direct materials, direct labor) plus a systematic allocation of fixed and variable production overheads.

• Fixed production overheads are indirect costs of production which remain fairly constant (e.g. depreciation of factory buildings, costs of factory management).

• Variable production overheads are indirect costs of production which vary with volume of production (e.g. indirect materials and labor).

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Fixed Production Overheads

• Allocation of fixed production overheads to units of production is based on normal activity.

• If actual activity is less than normal, unallocated fixed overheads are recognised as an expense, not as part of cost of goods produced.

• If actual activity is greater than normal, the amount of fixed overhead allocated to each unit of production is decreased.

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Costs Excluded From the Cost of Inventories

• Abnormal amounts of wasted materials, labor or other production costs.

• Storage costs, unless necessary in the production process before a further production stage.

• Administrative overheads not incurred to bring inventories to their present location or condition.

• Selling costs.

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Cost Formulas

• The cost of inventories that are not inter-changeable should be ascertained "by using specific identification of their individual costs".

• For interchangeable items, costs are ascertained using either of the following cost formulas:– First-In, First-Out (FIFO);– Weighted average cost.

• Last-In, First-Out (LIFO) is not allowed.

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Cost Flow AssumptionsIFRS

► The same cost flow assumptions must be used for inventory with a similar nature and use even if inventory is held in different geographic locations and/or by different entities.

► LIFO method is not allowed:

► This is significant to some companies because of taxation implications. If IFRS is adopted with no changes made in the current standards and the current tax laws, then companies will have to pull the LIFO reserve back into their taxable income over a four-year period.

US GAAP

► Different cost flow assumptions may be used for inventory with a

similar nature and use.

► LIFO method is allowed:

► The IRS has a conformity rule that requires LIFO to be used for book purposes if it is used for tax purposes.

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Cost Flow AssumptionsAnalysis of companies as of 2010:

Variable Mean Median

Reserve balance (in millions) $294

$38

Net income (in millions) $686$99

LIFO reserve/operating income 65% 17%

LIFO reserve/net income129%

24%

LIFO reserve/assets4%

2%

LIFO reserve/inventory*8%

14%

*Inventory is the LIFO inventory with the reserve added back.

Analysis of companies as of 2010 using Compustat: 6,423 companies in the sample of which 4,459 companies had inventory of which 302 companies had a LIFO reserve.

► Exxon had a reserve of $21.3 billion in 2010 and $17.1 billion in 2009. In 2010, this was 53% of Exxon’s operating income, 70% of its net income and 7% of its assets.

► Carpenter Technology Corp. had a reserve balance that was 28 times its operating income and 158 times its net income in 2010.

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Lower of Cost or Market

US GAAP

• Reports at the LCM:

– Market is defined as replacement cost with a floor (NRV less normal profit margin) and a ceiling (NRV).

– NRV is defined as the estimated selling price less the estimated costs of completion and sale.

• Reversals of prior write-downs are not allowed.

IFRS

► Reports at the lower of cost or net realizable value (LCNRV):► NRV is defined as the

estimated selling price less the estimated costs of completion and sale.

► Since replacement cost would typically be less than NRV, IFRS will generally result in lower write-downs than US GAAP.

► Reversals of prior write-downs can be made and recognized in income.

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Net Realizable Value (NRV)

• The costs and NRV of inventories should normally be compared "item by item" (IAS2).

• However, similar or related items may be grouped if this is appropriate.

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Example 1 – inventory write-down

Part 1:On December 31, 2010, Jets International had an inventory of five different types of airplane parts. Given the current fuel costs, airplane parts are not as valuable as they once were. The chart on the next slide provides the cost basis, net realizable value, replacement cost and net realizable value less normal profit margin as of December 31, 2010. Jets International prepares its inventory valuation comparisons on an item-by-item basis.

Inventory Write-down Example

► What is the amount of write-down (if any) required using US GAAP? Please provide the necessary journal entry.

► What is the amount of write-down (if any) required using IFRS? Please provide the necessary journal entry.

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Cost NRV RC NRV-NPM

Part 1 $ 10,000 $ 20,000 $ 15,000 $ 12,000

Part 2 $ 20,000 $ 19,000 $ 18,000 $ 17,000

Part 3 $ 5,000 $ 3,000 $ 4,000 $ 2,000

Part 4 $ 8,000 $ 15,000 $ 12,000 $ 11,000

Part 5 $ 15,000 $ 12,000 $ 9,000 $ 11,000

Inventory Write-down ExamplePart 1 (continued):

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Original cost NRV RC

NRV-NPM

US GAAPmarket

US GAAPLCM

IFRS LCNRV

Part 1 $10,000 $20,000 $15,000 $12,000 $15,000 $10,000 $10,000

Part 2 20,000 19,000 18,000 17,000 18,000 18,000 19,000

Part 3 5,000 3,000 4,000 2,000 3,000 3,000 3,000

Part 4 8,000 15,000 12,000 11,000 12,000 8,000 8,000

Part 5 15,000 12,000 9,000 11,000 11,000 11,000 12,000

Total $58,000 $50,000 $52,000

Example 1:

Part 1 solution:


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Part 1 solution (continued):US GAAP: IFRS:

Original cost 58,000 Original cost $58,000LCM 50,000 LCNRV 52,000Write-down $8,000 Write-down $6,000

US GAAP journal entry: IFRS journal entry:

COGS $8,000 Inventory write-down expense $6,000 Inventory $8,000 Inventory valuation allowance $6,000

The amount of inventory write down in this example is $8,000 using US GAAP because the LCM is less than the original cost. The amount is to be recorded in the income statement to COGS and directly to inventory because a future reversal of write-downs is not permitted. Using IFRS, the write-down is $6,000 because the LCNRV is less than the original cost. The write-down is not required to be recorded in a specific income statement account. A valuation allowance is used because future reversals of write-downs are permitted.


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Inventory Write-down Reversal Example

Example 1 – write-down reversal

Part 2:The airline industry’s business was so terrible during 2011 that Jets International still had the same five parts in its inventory as of December 31, 2011. However, fuel prices have decreased, so the outlook is more optimistic. As of the end of the year, Jets International’s original cost basis, net realizable value, replacement cost and net realizable value less the normal profit are as shown on the next slide.

► What is the amount of write-down reversal (if any) required using US GAAP? Please provide the necessary journal entry.

► What is the amount of write-down reversal (if any) required using IFRS? Please provide the necessary journal entry.

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Original Cost NRV RC NRV-NPM

Part 1 $ 10,000 $ 21,000 $ 16,000 $ 13,000

Part 2 $ 20,000 $ 20,000 $ 19,000 $ 18,000

Part 3 $ 5,000 $ 4,000 $ 9,000 $ 3,000

Part 4 $ 8,000 $ 16,000 $ 11,000 $ 12,000

Part 5 $ 15,000 $ 14,000 $ 10,000 $ 12,000

Part 2 (continued):

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Example 1:

Part 2 solution:


Original Cost

IFRS LCNRV December 31,

2010 NRV

IFRS LCNRV December 31,

2011

Part 1 $ 10,000 $10,000$21,000

$10,000

Part 2 20,000 19,00020,000

20,000

Part 3 5,000 3,0004,000

4,000

Part 4 8,000 8,00016,000

8,000

Part 5 15,000 12,00014,000

14,000

Total $ 58,000 $ 52,000 $56,000

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Part 2 solution (continued):No reversal of a write-down is permitted using US GAAP.

IFRS:December 31, 2011 LCNRV $56,000December 31, 2010 LCNRV 52,000Write-down $ 4,000

Journal entry:

Inventory valuation allowance $4,000Inventory write-down expense $4,000

Since the LCNRV at December 31, 2011 exceeds the LCNRV at December 31, 2010 by $4,000, this amount is recorded as a reversal to the previous write-down.

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Main Disclosures Relating to Inventories

• Accounting policies adopted, including any cost formula used

• Total carrying amount of inventories and analysis of carrying amount into appropriate classifications

• Amount of inventories recognised as an expense in the period

• Amount of any write-down to NRV or any reversal of previous write-down.

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Construction Contracts

IAS11 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".

Construction contracts include:

• Contracts for the rendering of services that are directly related to the construction of assets (e.g. contracts for the services of project managers and architects);

• Contracts for the destruction or restoration of assetsand for the restoration of the environment after the demolition of assets.

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Contract Revenue

• The initial amount of revenue agreed in the contract

• Plus or minus the revenue associated with agreed variations in the contract work

• Plus amounts claimed by the contractor as reimbursement for costs not included in the contract price (e.g. costs arising from delays caused by the customer)

• Plus incentive payments to which the contractor is entitled for meeting or exceeding performance targets

• Minus penalties arising from delays or other problems caused by the contractor.

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Contract Costs

• Costs that relate directly to the specific contract (e.g. materials, labor, plant hire, depreciation of equipment used in the construction work)

• Costs that relate to contract activity in general and can be allocated to the contract (e.g. insurance, construction overheads)

• Other costs that are specifically chargeable to the customer under the terms of the contract.

Excluded costs include general administration or research and development costs for which reimbursement is not specified in the terms of the contract and selling costs.

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Recognition of Contract Revenue and Expenses

IAS11 requires that contract revenue and expenses are recognized "by reference to the stage of completion of the contract activity at the end of the reporting period“ – Percentage of completion. The stage of completion may be determined by:

• Comparing the costs incurred for the work performed to date with the estimated total contract costs

• Carrying out a survey of the work performed to date

• Considering the physical proportion of the contract work completed.

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IFRS

► The completed-contract method is not permitted. If the criteria for using the percentage-of-completion method are not met, then the entity recognizes revenue to the extent that costs are incurred (as long as the costs are likely to be recovered) and recognizes costs as incurred.

US GAAP

► If the percentage-of-completion criteria aren’t met, then the completed-contract method is used.

► The AICPA Accounting Trends and Techniques for 2010 reported that of 500 companies sampled for 2009, 124 had long-term construction contracts. Of these 124 companies, 20 used completed-contract accounting.

Completed-contract method

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Example 2 – revenue on construction contract

ALNP Construction Company (ALNP) has entered into a contract with total expected revenue of $5.6 million. ALNP expects that total costs will be $4.9 million. Below are the costs, billings and cash collections for each of the three years of the contract (amounts in millions).

► Prepare all necessary journal entries for the three years under the scenarios on the next slide. Use construction in progress (CIP) as a clearing account for your journal entries.

► Also provide the balances of the various accounts that will be reported on the financial statements each year.

Year 1 Year 2 Year 3

Costs this year $1.40 $1.65 $1.85

Billings this year $1.30 $2.40 $1.90

Cash collected this year

$1.00 $2.20 $2.40

Revenue on Construction Contract Example

Based on surveys of the stage of completion, it was determined the contract was 30% complete in year 1, 65% complete in year 2 and 100% complete in year 3.

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Example 2 (continued):

Two scenarios:

1. The company reports using IFRS and meets the criteria necessary to use the percentage-of-completion method. ALNP uses the revenue-cost approach.

2. The company reports using IFRS and does not meet the criteria necessary to use the percentage-of-completion method. ALNP is not able to reliably estimate its revenue until the final year of the contract.

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Example 2 solution:

The first scenario uses the percentage-of-completion, revenue-cost approach since that is the only approach allowed using IFRS.

The second scenario uses the method whereby the entity recognizes revenue to the extent that costs are incurred and recognizes costs as incurred.

Journal entries and account balances are shown on the next slides.

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($ amounts in millions) Year 1 Year 2 Year 3 Total

Costs this year $1.40 $1.65 $1.85 $4.90

Billings this year $1.30 $2.40 $1.90 $5.60

Cash collected $1.00 $2.20 $2.40 $5.60

Percentage complete 30% 65% 100%


Example 2 solution (continued):

For each scenario:

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Scenario 1: Percentage-of-completion, revenue-cost approach

Year 1 Year 2 Year 3 Total

Revenue to date $1,680,000 $3,640,000 $5,600,000

Costs to date $1,470,000 $3,185,000 $4,900,000

Gross profit to date $ 210,000 $ 455,000 $ 700,000

Revenues this year $1,680,000 $1,960,000 $1,960,000 $5,600,000

Costs this year $1,470,000 $1,715,000 $1,715,000 $4,900,000

Gross profit this year $ 210,000 $ 245,000 $ 245,000 $ 700,000


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Example 2 solution (continued): Year 1 Year 2 Year 3

CIP 1,400 1,650 1,850

Cash 1,400 1,650 1,850

To record costs incurred.

A/R 1,300 2,400 1,900

Billings on CIP 1,300 2,400 1,900

To record billings.

Cash 1,000 2,200 2,400

A/R 1,000 2,200 2,400

To record collections.


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Example 2 solution (continued): Year 1 Year 2 Year 3

CIP 210 245 245

Construction expense 1,470 1,715 1,715

Construction revenue 1,680 1,960 1,960

To recognize revenue and expense.

Billings on CIP 5,600

CIP 5,600

To record completion of contract.


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Balance sheet account balances at December 31


Assets:

Cash $ (400,000) $ 150,000 $700,000

A/R 300,000 500,000

CIP 1,610,000 3,505,000

Billings on CIP (1,300,000) (3,700,000)

Costs and recognized profit in excess of billings

310,000

Liabilities:

Billing in excess of costs and recognized profits 195,000

Equity:

Retained earnings (ignoring effects of taxes) 210,000 455,000

700,000

Revenue on Construction Contract ExampleExample 2 solution (continued):

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Income statement accounts for the year ended December 31

Year 1 Year 2 Year 3 Cumulative

Revenues $1,680,000 $1,960,000 $1,960,000 $ 5,600,000

Expenses (1,470,000) (1,715,000)

(1,715,000)

(4,900,000)

Net income (ignoring taxes) $ 210,000 $ 245,000 $ 245,000 $ 700,000



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Scenario 2: Recognize revenues to extent costs are incurred and recognize costs as incurred: (assume reliability not reached until last year of contract)


CIP1,400 1,650 1,850

Cash 1,400 1,650 1,850

To record costs incurred.

A/R1,300 2,400 1,900

Billings on CIP 1,300 2,400 1,900

To record billings.

Cash1,000 2,200 2,400

A/R 1,000 2,200 2,400

To record collections.

Note: All amounts are in dollars.


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Construction expense 1,400 1,650 1,850

Construction revenue 1,400 1,650 1,850

To record revenue and expense.

Billings on CIP

5,600

CIP 4,900

Construction revenue 700

To record completion of contract.

Note: All amounts are in dollars.

Revenue on Construction Contract ExampleExample 2 solution (continued):

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Balance sheet account balances at December 31


Assets:

Cash $ (400,000) $ 150,000 $700,000

A/R 300,000 500,000

CIP 1,400,000 3,050,000

Billings on CIP (1,300,000) (3,700,000)

Unbilled contract costs 100,000

Liabilities:

Billing in excess of costs650,000

Equity:

Retained earnings (ignoring effects of taxes) 700,000



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Income statement accounts for the year ended December 31


Revenues $1,400,000 $1,650,000 $2,550,000

Expenses 1,400,000 1,650,000

(1,850,000)

Net income (ignoring taxes) $ –

$–

$ 700,000



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Recognition of Expected Losses

• If at any stage it is probable that total contract costs will exceed total contract revenue, the expected loss must be recognized immediately.

• Although expected profits are spread over the period of the contract, expected losses are accounted for as soon as they become probable.

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Disclosures Required by IAS11

• The amount of contract revenue recognized during

the accounting period

• The methods used to determine contract revenue

• The methods used to determine stage of completion

• For contracts in progress at the end of the reporting period:

– The total costs incurred to date and total recognized profits/losses to date

– The amount of any advances received

– The amount of any retentions.

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