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Accounting standards and treatments

The divorce of ownership and control in businesses leads to a need for some form of assurance of the information presented by the business to the owners. The owners or shareholders of a business are generally reliant on the financial statements and annual report to satisfy themselves of the value or return from their investment in the business. In addition, there is a need for investors/stakeholders, be they shareholders, banks and other creditors or suppliers to be able to assess the viability of one business as compared to another and this is only possible if there is some consistency across the financial statements and reporting requirements.

Over the last 50 years businesses have grown and expanded in geography and complexity and as such the need for ongoing changes to standards of financial reporting and auditing continue. This is evidenced by continuing failures of businesses due to concealment of issues within the legislative and mandatory reporting requirements. For instance, Enron were able to conceal the fact that they had off balance sheet debts and overstated profits by more than $500 million. Therefore, accounting standards should seek to remove subjectivity that could lead to inaccurate information.

The International Accounting Standards Board

The IASB operate within the IFRS Foundation and are the independent standard setting body of the organisation. The IASB publish IFRSs but they also adopted the standards that were in place when they replaced the IASC. The adopted standards are IASs. There are currently 28 IASs and 13 IFRSs in force.

The main purpose of accounting standards is to try to reduce or eliminate variations in accounting practice and reporting. This should allow users of the statements to have some confidence that the financial statements adequately reflect the performance of the business and it should allow those users to compare statements with a degree of confidence.

Key Reporting Standards

Whilst there are many International standards, most these are relatively straightforward in respect of their application in financial reporting. There are however a few standards that are deemed to be more difficult to understand and require a greater amount of critical analysis to ensure that they are applied correctly, and some of these will be considered below.

IAS 2 Inventories

IAS 2 defines inventories as ‘assets:

  1. Held for sale in the ordinary course of business;
  2. In the process of production for such sale; or
  3. In the form of materials or supplies to be consumed in the production process or in the rendering of services’.

The standard provides guidance on the determination of cost and net realisable value and prescribes the valuation rule.

IAS 2 states that the cost of inventories includes costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. The table below sets out the key elements that can generally be included as cost for guidance. This list is not definitive, and each item will need to be considered as to the underlying substance of the transaction.

Costs of Purchase

Purchase price less trade discounts

Import duties

Other taxes (if not recoverable0

Transport costs

Handling costs

Costs of conversion

Direct costs of production

  • Direct labour
  • Allocation of fixed and variable overheads incurred in the conversion of materials to finished goods

EXCLUDES: abnormal wastage, storage costs, admin overheads and selling costs

A business will accumulate inventories over time and as a result the cost of each item of stock will differ depending upon the purchase price at the time or the cost of conversion. Prices may have risen, labour costs may have gone up, trade discounts may have reduced. There are many things that can change during the time that inventories accumulate in a business.

As such if there was no specified approach it would be possible for a business to manipulate the profit or loss for the year by choosing which items of stock at which value to include in cost of sales for the period.

As such the standard specifies two allowable methods for the determination of inventory use; first-in, first-out (FIFO) or weighted average cost (AVCO). Examples of both methods are shown below.


Company XYZ hold an inventory of 12,000 widgets as at 31 December 2015 bought for £100 per widget. Additional purchases and sales of widgets throughout the year were as follows:

Purchases

Sales

Date

Number

Purchase Price

Date

Number

04-Apr-17

2000

105

31-Mar-17

7,000

27-Jun-17

5000

110

02-Jun-17

4,000

06-Oct-17

6000

117

30-Sep-17

6,000

14-Dec-17

4000

106

28-Nov-17

6,000

The costs associated with the sales using the FIFO method and the AVCO method as well as the closing inventory value are shown below.

FIFO (using the above data)

Number

Cost

Sold 31 March

7000

7,000 @ £100

700,000

700,000

Sold 2 June

4000

4,000 @ £100

400,000

400,000

Sold 30 Sept

6000

1,[email protected] £100

100,000

2,000 @ £105

210,000

3,000 @ £110

330,000

640,000

Sold 28 Nov

6000

2,000 @ £110

220,000

4,000 @ £117

468,000

688,000

Inventory at 31 December 2017

6,000

2,000 @ £117

234,000

4,000 @ £106

424,000

658,000


AVCO (using the above data for the first half of the year)

Number

Price

Total Cost

Opening Inventory

12,000

100.00

1,200,000

Sold 31 March

7,000

100.00

700,000

5,000

100.00

500,000

Bought 4 April

2,000

105.00

210,000

7,000

101.43

710,000

Sold 2 June

4,000

101.43

405,714

3,000

101.43

304,286

Bought 27 June

5,000

110.00

550,000

Inventory at 30 June

8,000

106.79

854,286

As is common across all aspects of accounting for the balance sheet, the standard specifies that stock must be carried at the lower of cost and net realisable value.  This means that should there be any expected loss from the sale of an item of stock then the loss is recognised immediately rather than waiting for the item to be sold. This is in line with the idea of the balance sheet being a reasonable representation of the asset value of the business.

It should also be noted that the standard excludes construction contracts which are dealt with separately under IAS 11.

IAS 17 Leases

IAS 17 defines a lease as ‘an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time’.

There are two types of leases. A finance lease which conveys the risks and rewards that someone might normally associate with ownership of the lease and an operating lease which is any other type of lease that is not a finance lease.

The standard provides a list of examples that would normally lead to a finance lease classification, but these are not always conclusive, so it is important to look at the features in the agreement to understand if the lease is transferring the risks and rewards of ownership.

Because a finance lease confers risks and rewards it can be treated as asset ownership and accounted for accordingly. The asset should be included in assets and the lease liability in liabilities.  The amount at which the asset should be included is the lower of the fair value of the asset or the present value of the minimum lease payments. The asset will then be treated in accordance with IAS 16.

The lease payments need to be split between the amount that reduces the liability and the interest or finance charge. This finance charge should be charged to accounting periods to spread the expense in a proportionate manner over the period of the liability and there are a number of methods that can be used to do this; the actuarial method, the sum of digits method and the level spread method. The use of these methods is shown in the examples below.

XYZ manufacturing purchase a machine on a finance lease with a fair value of £20,000. The company is required to make four payments of £6,654 which fall on 31 March each year and the interest rate implicit in the lease is 12.5%.

Level Spread Method

The total finance charge is the difference n=between the fair value of £20,000 and the lease payments of £26,616. This finance charge of £6,616 is spread evenly over the 4 years of the lease giving an annual finance charge of £1,654

Sum of Digits Method

Year

Digit

Finance Charge

Annual Charge

2016

4

4/10 x £6,616

2,646

2017

3

3/10 x £6,616

1,985

2018

2

2/10 x £6,616

1,323

2019

1

1/10 x £6,616

662

10

6,616

The sum of digits method is used to provide a reasonable approximation to the actuarial method is the implicit interest rate is not known.

Actuarial Method

0.35

Year

Liability b/f

Finance Charge @12.5%

Lease Payment

Liability c/f

2016

20,000

2,500

6,654

15,846

2017

15,846

1,981

6,654

11,173

2018

11,173

1,397

6,654

5,915

2019

5,915

739

6,654

1

The actuarial method is the most accurate measure and ensures that the interest charged to the profit and loss is the actual interest on the outstanding liability but cannot be used if the rate is not known.

It should be noted that the IASB are currently developing a new lease standard to supersede IAS17 and it is expected that this will make significant changes to the accounting treatment of leases. It is expected that this new standard will require the treatment of both finance and operating leases to be the same.

IAS 38 Intangible Assets

IAS 38 defines an intangible asset as ‘an identifiable, non-monetary asset without physical substance’. The standard is clear that the item must be an asset first and foremost. That means that the item must be able to demonstrate future economic benefit and the business must have control of that future economic benefit, i.e., own the asset.

The key difference with an intangible asset is that unlike property, plant and equipment, it does not have any physical substance. Examples of intangible assets are goodwill, patents, trademarks and copyrights. None of these assets have any physical substance but they all can still potentially have value.

It is possible to have acquired intangible assets as well as internally generated intangible assets. The standard specifically states however, that internally generated goodwill cannot be classified as an intangible asset.

An acquired intangible asset is relatively straightforward to value as the cost can be recognised in the same way as the cost of a tangible asset is recognised; purchase price including import duties after deducting trade discounts etc. but an internally generated intangible asset is a little harder and so the standard uses guidelines for this.

The standard splits the asset into two phases; the research phase and the development phase.

Research cover activities aimed at gaining new knowledge and ways to apply that knowledge but because at this stage of investment a business cannot demonstrate that the research has a future economic benefit the costs cannot be treated as an asset and must be accounted for as an expense as incurred.

However, in the development phase, the standard accepts that it may be possible to determine future economic benefits. The standard is specific in that if a set of defined criteria can be demonstrated then the project must be accounted for as an intangible but any project that does not meet all the criteria must be accounted for directly as an expense. It is also not possible to change the treatment of past expenditure that has already been written off as an expense.

After the determination of an intangible asset the standard very much allows the treatment of the asset to be similar to the treatment of any asset as per IAS 16. The asset can be carried at cost or revalued but note that the asset can only be revalued if there is an active market for the asset. Most intangibles are unique and so this is unlikely to be the case. Revaluation are accounted for in a revaluation reserve as for tangible assets.

Bibliography

Melville, A., 2014. International Financial Reporting: A Practical Guide. 4th ed. Harlow: Pearson Education Limited.


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