Chapter 15 Inventories and Construction Contracts

1.      Objectives

1.1       Define inventories.
1.2       Explain the acceptable accounting practice with respect to the valuation of inventories and subsequent recognition as an expense, including any write-down to net realizable value.
1.3       Compute the value of inventories for inclusion in periodic financial statements.
1.4       Describe the requirements of HKAS 2 in relation to the disclosure of information regarding inventories in financial statements.
1.5       Define construction contracts.
1.6       Discuss acceptable accounting practice with respect to the valuation of construction contracts.
1.7       Compute the value of construction contracts for inclusion in periodic financial statements.
1.8       Explain how the profit or loss on a contract are recognized.
1.9       Describe the requirements of HKAS 11 in relation to the disclosure of information regarding construction contracts in financial statements.

2.      Inventories

(A)      Definitions

2.1	DEFINITION
	Inventories are assets that are: (i)         held for sale in the ordinary course of business; (ii)        in the process of production for such sale; or (iii)      in the form of materials or supplies to be consumed in the production process or in the rendering of services.

2.2       Inventories comprise the following:
(i)         Goods purchased and held for resale, e.g. merchandise purchased by a retailer and held for resale, or land and other property held for resale.
(ii)        Finished goods.
(iii)       Work-in-progress, including materials and supplies.
(iv)       In case of service provider, inventories include the costs of services.
2.3       HKAS 2 is applicable to the financial statements of those companies which hold properties for sale in the ordinary course of business, properties for such sale would meet the definition of inventories and recognition of revenue will follow HKAS 18 for sale of goods.

(B)       Measurement of inventories

2.4       Inventories should be measured at the lower of cost and net realizable value (NRV). This is a method of measurement for inventories if “cost” does not reflect the true value of the inventories. By applying the prudence concept, NRV will be used if it is lower than the “cost” of inventories.

(a)       Determination of cost of inventories

2.5       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.
2.6       Costs of purchase comprise:
(i)         Purchase price;
(ii)        Import duties/taxes, transport, handling and other costs directly attributable to the acquisition of inventories; less
(iii)       Trade discounts, rebates, subsidies, etc.
2.7       In a manufacturing environment, the concept of cost is rather complicated. HKAS 2 attempts to define cost of conversion as:
(i)         costs directly related to the units of production, e.g. direct labour, direct expenses, sub-contracted work.
(ii)        systematic allocation of fixed and variable production overheads, e.g. depreciation and maintenance of factory equipment.
(iii)       fixed production overheads are allocated to the cost of conversion based on the normal capacity of the production facilities.
(iv)       variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume for production, such as indirect materials and indirect labour. Variable production overheads are allocated to each unit of production on the basis of the actual use of the production facilities.
(v)        other cost, if any, attributable to bringing the inventories to its present location and condition should be included.
2.8      The following costs should be excluded and charged as expenses of the period in which they are incurred:
(i)         abnormal waste
(ii)        storage costs
(iii)       administrative overheads which do not contribute to bringing inventories to their present location and condition
(iv)       selling costs.

2.9

EXERCISE 1

A car manufacturer has incurred the costs listed below. 1 Invoice cost of metal used in casting frame   2 Invoice cost of engines imported from Germany   3 Import duties on the engines   4 Exchange differences on subsequent payments for engines   5 Volume discounts received from tyre suppliers   6 Cost of scraps left over from moulds after casting   7 Cost of scraps from castings due to incorrect moulds   8 Wages of assembly line workers   9 Wages of assembly line maintenance personnel   10 Wages of assembly line workers laid off due to a strike   11 Wages of security guard at the goods inwards gate   12 Wages of security guard at the goods outward gate   13 Wages of sales office cleaners   14 Wages of nurse in the first aid room   15 Running costs of canteen   16 Running costs of management dining room   17 Advertising for assembly line vacancies   18 Transportation costs of goods to company retail depots   19 Shipping costs of depot sales to foreign customers   20 Interest on bank overdraft   Required: The manufacturer needs your assistance to determine which of the costs should be included in the cost of inventories.

Solution:     Included in cost of inventories 1 Invoice cost of metal used in casting frame   2 Invoice cost of engines imported from Germany   3 Import duties on the engines   4 Exchange differences on subsequent payments for engines   5 Volume discounts received from tyre suppliers   6 Cost of scraps left over from moulds after casting   7 Cost of scraps from castings due to incorrect moulds   8 Wages of assembly line workers   9 Wages of assembly line maintenance personnel   10 Wages of assembly line workers laid off due to a strike   11 Wages of security guard at the goods inwards gate   12 Wages of security guard at the goods outward gate   13 Wages of sales office cleaners   14 Wages of nurse in the first aid room   15 Running costs of canteen   16 Running costs of management dining room   17 Advertising for assembly line vacancies   18 Transportation costs of goods to company retail depots   19 Shipping costs of depot sales to foreign customers   20 Interest on bank overdraft

 

(b)       Valuation methods

2.10     Where inventories consists of a number of identical items purchased at different times, an appropriate method for determining the value of inventories must be selected. Methods of valuing inventories include:
(i)         actual unit cost
(ii)        weighted average cost
(iii)       first-in-first-out (FIFO)
(iv)       last-in-first-out (LIFO)
(v)        standard cost
(vi)       replacement cost, etc.
2.11     Actual unit cost should be used for inventories of items that are not interchangeable between each other.
2.12     However, specific identification is impractical where there are large numbers of items that are ordinarily interchangeable. In such circumstances, FIFO and weighted average cost are the benchmark treatments.
2.13     It must be noted that LIFO is not allowed for the measuring of inventories cost under HKAS 2.

(C)      The determination of net realizable value

2.14	KEY POINT
	NRV is the estimated selling price in the ordinary course of business less: (i)         the estimated costs of completion; and (ii)       the estimated costs necessary to make the sale.

2.15     The principle situations where NRV is likely to be less than cost include:
(i)         where there has been an increase in costs or a fall in selling price;
(ii)        where inventories have been deteriorated physically;
(iii)       where products have become obsolete;
(iv)       where a company, as part of its marketing strategy, has decided to manufacture and sell products at a loss;
(v)        where there have been errors in production or purchasing;
(vi)       where inventories held are unlikely to be sold within the normal turnover and therefore an increase in risk of selling them at below cost.
2.16     HKAS 2 requires that the comparison of cost and NRV needs to be done in respect of each item of inventory separately or by groups or categories of similar inventory items. To compare the total realizable value of inventories with the total cost could result in an unacceptable setting off of foreseeable losses against unrealized profits.

2.17

EXAMPLE 1

The following illustration shows the different effects that can be obtained by applying the rule of “lower of cost and net realizable value” to individual item of inventories, groups of items and to the total inventories:       Individual Major Total   Cost NRV Item Groups Inventories   $ $ $ $ $ Group 1           Item A 4,000 6,000 4,000     Item B 8,000 5,000 5,000     Item C 5,000 5,000 5,000     Item D 10,000 6,000 6,000       27,000 22,000 20,000 22,000   Group 2           Item E 2,000 3,000 2,000     Item F 16,000 26,000 16,000     Item G 10,000 10,000 10,000     Item H 20,000 12,000 12,000       48,000 51,000 40,000 48,000   Total inventories 75,000 73,000 60,000 70,000 73,000 As mentioned above the valuation of $73,000 which arises from the application of the rule to the cost of total inventories is unacceptable as it results in setting off unrealized losses ($15,000) against unrealized profits ($13,000). The current accepted accounting practice ignores unrealized gains. The correct valuation of inventories is $60,000 by strict application of the rule according to the Standard. Provided that the individual inventory items of the groups are sold together, it is acceptable to value the inventories at $70,000 in practice.

2.18

EXERCISE 2

(a)       Materials costing $12,000 bought for processing and assembly for a profitable special order. Since buying these items, the cost price has fallen to $10,000. (b)       Equipment constructed for a customer for an agreed price of $18,000. This has recently been completed at a cost of $16,800. It has now been discovered that, in order to meet certain regulations, conversion with an extra cost of $4,200 will be required. The customer has accepted partial responsibility and agreed to meet half the extra cost. Required: Determine the inventory value for the above situations.

(D)      Recognition as an expense

2.19     When inventories are sold, the carrying amount of those inventories should be recognized as an expense in the period in which the related revenue is recognized.
2.20     The amount of any written-down of inventories to NRV and all losses of inventories should be recognized as an expense in the period the write-down or loss occurs.
2.21     The amount any reversal of any write-down of inventories, arising from an increase in net realizable value, should be recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs.

(E)       Disclosure requirements

2.22     The financial statements should disclose:
(i)         the accounting policies which have been used in measuring inventories, including the cost formula used.
(ii)        the total carrying amount of inventories and the carrying amount in classifications appropriate to the enterprise.
(iii)       the carrying amount of inventories carried at NRV.
(iv)       the amount of any reversal of any write-down that is recognized as income in the period.
(v)        the circumstances or events that led to the reversal of a write-down of inventories.
(vi)       the carrying amount of inventories pledged as security for liabilities.
2.24     The Tenth Schedule to the Companies Ordinance requires that inventories in trade or work in progress, if material, the manner in which the computation of such amount has to be shown.
2.25     In general, inventories shown in the balance sheet are usually subdivided into the following categories:
(i)         merchandise;
(ii)        production supplies;
(iii)       materials;
(iv)       work-in-progress; and
(v)        finished goods.

3.      Construction Contracts

3.1

DEFINITION

(a)        A “construction contract” is a contract specially 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. (建造合同，是指爲建造一項或數項在設計、技術、功能、最終用途等方面密切相關的資産而訂立的合同。) (b)       Payments on account (progress payments) (工程進度款) – are all amounts received and receivable at the accounting date in respect of contracts in progress. (c)        HKAS 11 recognises two types of construction contracts which are distinguished based on their pricing arrangements: (i)         Fixed-price contracts (固定造价合同); and (固定造价合同，是指按照固定的合同价或固定单价确定工程价款的建造合同。) (ii)        Cost-plus contracts (成本加成合同). (成本加成合同，是指以合同约定或其他方式议定的成本为基础，加上该成本的一定比例或定额费用确定工程价款的建造合同。) (d)        Fixed-price contracts are contracts for which the price is not usually subject to adjustments because of costs incurred by the contractor. There are two types of cost-plus contracts: (i)         Cost-without-fee contract – the contractor is reimbursed for allowable or otherwise defined costs with no provision for a fee. (ii)       Cost-plus-fixed-fee contract – contractor is reimbursed for costs plus a provision for a fee. The contract price on a cost-type contract is determined by the sum of the reimbursable expenditures and a fee.

(A)       Contract revenue

3.2	KEY POINT
	Contract revenue should comprise: (i)         the initial amount of revenue agreed in the contract; and (ii)        variations in contract work, claims and incentive payments: (a)        to the extent that it is probable that they will result in revenue; and (b)        they are capable of being reliably measured.

3.3       Contract revenue is measured at the fair value of the consideration received or receivable. Changes in estimates may increase or decrease the amount of contract revenue in the year of change and subsequent periods. For example:
(i)         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;
(ii)        the amount of revenue agreed in a fixed price contract may increase as a result of cost escalation clauses;
(iii)       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
(iv)       when a fixed price contract involves a fixed price per unit of output, contract revenue increases as the number of units is increased.

(B)       Contract costs

3.4       Contract costs should comprise:
(i)         costs that relate directly to the specific contract;
(ii)        costs that are attributable to contract activity in general and can be allocated to the contract; and
(iii)       such other costs as are specifically chargeable to the customer under the terms of the contract.
3.5       Costs that relate directly to a specific contract include:
(i)         site labour costs, including site supervision;
(ii)        costs of materials used in construction;
(iii)       depreciation of plant and equipment used on the contract;
(iv)       costs of moving plant, equipment and materials to and from the contract site;
(v)        costs of hiring plant and equipment;
(vi)       costs of design and technical assistance that is directly related to the contract;
(vii)      the estimated costs of rectification and guarantee work, including expected warranty costs; and
(viii)     claims from third parties.
3.6       Costs that may be attributable to contract activity in general and can be allocated to specific contracts include:
(i)         insurance;
(ii)        costs of design and technical assistance that is not directly related to a specific contract; and
(iii)       construction overheads.

(C)      Recognition of contract revenue and expenses

3.7       Revenue and expenses may be recognized when the outcome of a contract can be estimated reliably.

3.8

KEY POINT

(a)       If the expected outcome is a profit, revenue and expenses will be recognized according to the stage of completion of the contract. (b)       If the expected outcome is a loss, the whole loss to completion should be recognized immediately. (c)        When the outcome of a construction contract cannot be estimated reliably: (i)         Revenue should be recognised only to the extent of contract costs incurred that it is probable will be recoverable; and (ii)       Contract costs should be recognised as an expense in the period in which they are incurred.

3.9       Commentary

Situation	How is revenue measured?	How are costs measured for recognition in the income statement?	Comments
Profit is being taken	By reference to the stage of completion method	The costs incurred in reaching the stage of completion are taken to the income statement as cost of sales. Often this is achieved by applying the percentage completion to the total costs that are expected to occur over the life of the contract.	Revenue > costs therefore profit is recognised.   If the same % completion is applied to revenue and costs then this will result in that percentage of the total estimated profit being recognised.
Loss making contracts	By reference to the stage of completion method	As a balancing figure to interact with the revenue that has been recognised and generate the required loss.	Loss may be recognised at any stage of a contract. E.g. an enterprise may have signed a contract that it knows will make a loss. In such a case the loss should be recognised when the contract is signed.
Contracts where the outcome is uncertain	To equal the cost figure	The costs incurred in the period should be expensed	Revenue = costs The usual source of uncertainty is that the contract is still quite young. E.g. it may be deemed imprudent to take profit on a 10 years contract when it is only 1 year old.

(D)       Meaning of “can be estimated reliably”

(a)       Fixed price contracts

3.10     In the case of a fixed price contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied:
(i)         Total contract revenue can be measured reliably;
(ii)        it is probably that the economic benefits associated with the contract will flow to the enterprise;
(iii)       both the contract costs to complete the contract and the stage of contract completion at the balance sheet date can be measured reliably; and
(iv)       the contract costs attributable to the contract can be reliably identified and measured reliably so that actual contract costs incurred can be compared with prior estimates.

(b)       Cost plus contracts

3.11     In the case of a cost plus contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied:
(i)         It is probable that the economic benefits associated with the contract will flow to the enterprise; and
(ii)        the contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably.

(E)       Determine the stage of completion

3.12     HKAS 11 indicates several ways in which the percentage of completion of a contract may be arrived at:
(i)         the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs;
(ii)        surveys of work performed; or
(iii)       completion of a physical proportion of the contract work.
3.13     It is important to remember that progress payments and advances received from customers often do not reflect the work performed.
3.14     When the stage of completion is determined by reference to the contract costs incurred to date, only those contract costs that reflect work performed are included in costs incurred to date. Examples of contract costs which are excluded are:
(i)         contract costs that relate to future activity on the contract such as costs of materials that have been delivered to a contract site or set aside for use in a contract but not yet installed, used or applied during contract performance, unless the materials have been made specially for the contract; and
(ii)        payments made to subcontractors in advance of work performed under the subcontract.

3.15

EXAMPLE 2 – Percentage of completion method

A construction contractor has a fixed price contract for $9,000,000 to build a bridge. The initial amount of revenue agreed in the contract is $9,000,000. The contractor’s initial estimate of contract costs is $8,000,000. It will take 3 years to build the bridge. By the end of year 1, the contractor’s estimate of contract costs has increased to $8,050,000. In year 2, the customer approves a variation resulting in an increase in contract revenue of $200,000 and estimated additional contract costs of $150,000. At the end of year 2, costs incurred include $100,000 for standard materials stored at the site to be used in year 3 to complete the project. The contractor determines the stage of completion of the contract by calculating the proportion that contract costs incurred for work performed to date bear to the latest estimated total contract costs. A summary of the financial data during the construction period is as follows;   Year 1 Year 2 Year 3   $000 $000 $000 Initial amount of revenue agreed in contract 9,000 9,000 9,000 Variation - 200 200 Total contract revenue 9,000 9,200 9,200 Contract costs incurred to date 2,093 6,168 8,200 Contract costs to complete 5,957 2,032   Total estimated contract costs 8,050 8,200 8,200 Estimated profit 950 1,000 1,000 Stage of completion 26% 74% 1005 The stage of completion for year 2 (74%) is determined by excluding from contract costs incurred for work performed to date the $100,000 of standard materials stored at the site for use in year 3. The amounts of revenue, expenses and profit recognized in the income statement in the three years are as follows:   To date Recognised in prior years Recognised in current year   $000 $000 $000 Year 1       Revenue (9,000 x 26%) 2,340   2,340 Expenses (8,050 x 26%) 2,093   2,093 Profit 247   247         Year 2       Revenue (9,200 x 74%) 6,808 2,340 4,468 Expenses (8,200 x 74%) 6,068 2,093 3,975 Profit 740 247 493         Year 3       Revenue (9,200 x 100%) 9,200 6,808 2,392 Expenses 8,200 6,068 2,132 Profit 1,000 740 260

 

3.16

EXERCISE 3

Softfloor Limited make café bars. The projects generally take a number of months to complete. The company has three contracts in progress at the year ended 30 April.   A B C   $000 $000 $000 Costs incurred to date 200 90 600 Costs to complete 200 110 200 Contract price 600 300 750 Progress billings 40 70 630 Softfloor calculates the percentage of completion by using the costs incurred compared to the total costs. Required: Calculate the degree of completion and the profit/(loss) to be recognized for each contract.

 

(F)       Combination and segmentation of construction contracts

3.17     The accounting requirements discussed above are usually applied separately to each construction contract. However, in certain circumstances, it is necessary to apply HKAS 11 to the separately identifiable components of a single contract or to a group of contracts together in order to reflect the substance of a contract or a group of contracts.
3.18     The construction of each asset covered by a contract should be treated as a separate construction contracts when
(i)         separate proposals and negotiation have been made or each asset; and
(ii)        the costs and revenues of each asset can be separately identified.
3.19     A group of contracts should be combined as a single construction contract where:
(i)         the group of contracts is negotiated as a single package;
(ii)        the contracts are closely inter-related with a single overall profit margin; and
(iii)       the contracts are performed concurrently or continuously (e.g. a housing development).

3.20

EXAMPLE 3

The following two-year construction contracts, 50% completed at the end of 2007, run concurrently through 2007 and 2008.   Alpha Beta Alpha + Beta   $m $m $m Revenues 1,200 800 2,000 Costs (800) (1,000) (1,800) Total profit/(loss) 400 (200) 200 The profit figures for 2007 and 2008 if they are separate contracts and if they are combined are shown below: Separate contract     Alpha Beta Total   $m $m $m 2007 – Profit 200 (200) Nil 2008 – Profit 200 Nil 200 Combined contract     Alpha + Beta   Total   $m   $m 2007 – Profit 100   100 2008 – Profit 100   100

 

(G)      Disclosure requirements

3.21     An enterprise should disclose:
(i)         the amount of contract revenue recognized as revenue in the period;
(ii)        the methods used to determine the contract revenue recognized in the period; and
(iii)       the method used to determine the stage of completion of contracts in progress.
3.22     An enterprise should disclose each of the following for contracts in progress at the balance sheet date:
(i)         the aggregate amount of costs incurred and recognized profits (less recognized losses) to date;
(ii)        the amount of advanced received; and
(iii)       the amount of retentions.
3.23     An enterprise should present:
(i)         the gross amount due from customers for contract work as an asset; and
(ii)        the gross amount due to customers for contract work as a liability.

 

3.24

EXAMPLE 4 – Contract disclosure

A contractor has reached the end of its first year of operations for the year 2004. All its contract costs incurred have been paid for in cash and all its progress billings and advances have been received in cash. Contract costs incurred for contracts B, C and E include the cost of materials that have been purchased for the contract but which have not been used in contract performance to date. For contracts B, C and E, the customers have made advances to the contractor for work not yet performed. The status of its five contracts in progress at the end of first year 2004 is as follows:   A B C D E Total   $m $m $m $m $m $m Contract revenue 145 520 380 200 55 1,300 Contract expenses 110 450 350 250 55 1,215 Expected losses - - - 40 30 70 Recognised profits less recognized losses   35   70   30   (90)   (30)   15 Contract costs incurred in the period   110   510   450   250   100   1,420 Contract costs incurred recognized as contract expenses in the period   110   450   350   250   55   1,215 Contract costs that relate to future activity recognized as an asset   -   60   100   -   45   205 Contract revenue (see above)   145   520   380   200   55   1,300 Progress billings 100 520 380 180 55 1,235   45 - - 20 - 65 Advances - 80 20 - 25 125 Payments received 100 600 400 180 80 1,360 The amounts to be disclosed in accordance with HKAS 11 are as follows:   $m Contract revenue recognized as revenue in period 1,300 Contract costs incurred and recognized profits (less recognized losses) to date (see working below)   1,435 Advances received 125 Gross amount due from customers for contract work - presented as an asset (see working bellow)   220 Gross amount due to customers for contract work - presented as a liability (see working below)   (20) Working: The amount to be disclosed are calculated as follows:   A B C D E Total   $m $m $m $m $m $m Contract costs incurred 110 510 450 250 100 1,420 Recognised profits less recognized losses   35   70   30   (90)   (30)   15   145 580 480 160 70 1,435 Progress billings 100 520 380 180 55 1,235 Due from customers (note (1))   45   60   100   -   15   220 Due to customers (note (2)) - - - (20) - (20) Note: (1)        The gross amount due from customers for contract work is the net amount of costs incurred plus recognized profits less the sum of recognized losses and progress billings for all contracts in progress for which costs incurred plus recognized profits (less recognized losses) exceeds progress billings. (2)        The gross amount due to customers for contract work is the net amount of costs incurred plus recognized profits less the sum of recognized losses and progress billings for all contracts in progress for which progress billings exceed costs incurred plus recognized profits (less recognized losses).