B301 Unit 5 Inventories and construction contracts

HKSSAP 22  Inventories (1998, revised in Jan 2001)                                              Top

• Inventory 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

• Inventories include:
  • Goods purchased and held for resale by a retailer, or land and other property held for resale.
  • Materials and supplies, work in progress and finished goods.
  • In case of a service provider, the costs of the service for which the enterprise has not yet recognized the related revenue. Such costs include labor and other costs of personnel directly engaged in providing the service, including supervisory personnel and attributable overheads.

• Cost components of finished products:

• costs specifically attributable to units of production (i.e. direct labour, direct expenses and sub-contracted work)
• production overheads
• other overheads bringing the product or service to its present location and condition.

• Types of cost (summary):
  • Materials (M) = Direct materials (M1) + Indirect materials (M2)
  • Labour (L) = Direct labour (L1) + Indirect labour (L2)
  • Expenses (E) = Direct factory exp (E1) + Indirect factory exp (E2) + Indirect general exp (E3)
  • Prime cost (PC) = M1+L1+E1
  • Factory overheads (FO) = M2+L2+E2
  • Manufactory cost (MC) = PC + FO
  • Total cost (TC) = MC + E3 = M + L +E

Inventory valuation methods

• 2 systems:
  • Perpetual inventory system: the quantities of goods on hand are updated immediately to achieve a better control of inventory on hand, especially for high-value items;
  • Periodic inventory system: the quantities of goods on hand are counted and updated periodically, usually for low-value items.
• HKSSAP22:
  • Either the FIFO or the weighted average cost methods should be used.
  • The LIFO method is allowed in some countries, such as the US, but not accepted in HK.
  • However, IAS 2 retains the LIFO as an allowed alternative treatment.
• Measuring the value of inventories:

• The total of the lower of cost and net realizable value of the separate items of stock and work in progress or of groups of similar items.
• Net realizable value (NRV)= the estimated selling price in the ordinary course f business less the estimated costs of completion and the estimated costs necessary to make the sale.
• The amount of write-down made last year can be reversed if the NRV exceeds its cost and the inventory items still exist at the end of the year.

• Practical problems in valuation of inventories:
  • Difficult to allocate overhead
  • Difficult to select an appropriate method
  • Determination of NRV is not always easy or straightforward.
• Disclosure requirements:
  • the accounting policies,
  • should be sub-classified in balance sheets or in notes to the financial statements in a manner which is appropriate to the business and so as to indicate the carrying amount held in each of the main categories.

HKSSAP 23  Construction contracts (1998, revised in Jan 2001)                              Top

• In line with IAS 11 (May 1998)
• "a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent."
• Length of contract: over one year is not an essential but usually exceeds one year.
• Recognition of contract revenue and costs as income and expenses only if
  • the outcome of the contract activity can be estimated reliably,
  • related costs can be measured reliably and
  • probable future economic benefits will flow to the company.
• Percentage of completion method, a more realistic view of the company's performance and financial position across the construction periods. There are various basis:
  • cost basis (costs incurred to date to total contract costs)
  • sales basis (surveys of work performed, i.e. value of work certified to total contract value)
  • physical proportion of the contract work (output measures)
  • effort-expended basis such as labour hours, machine hours, or material quantities.
• Accounting treatment:

• Profit = revenue recognized (based on % of completion method) - expenses recognized.
• Otherwise, Loss = contract price - costs to date - estimate future costs
• Anticipated contract losses: if the contract costs to date plus estimated future contract costs are in excess of the contract price, the loss should be recognized as expense immediately.

• Practical problems:
  • Contract revenue may be changed as a result of variations to the contract, penalties for the delay of completion or incentive payments for the early completion of the contract. Revision of estimates must be made annually.
  • Contract costs are the most difficult to estimate reliably, e.g. increase in salaries and wages, uncontrollable weather and the security of materials and equipment at open sites etc.
• Disclosure requirements
  • Adequate information in respect of construction contracts in the financial statements;
  • e.g., stage of completion, recognized profits or losses, amounts due to or from customers, and retention money.