PAS 2 and 39 (Inventories)

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26/07/200

PICPA / ACPACITax Implications of New Accounting

Standards (PAS 2 and 39)*18 July 2006

*connectedthinking

Agenda

1. Introduction

2. Summary of key changes of PAS 2 and 39 from old GAAP and

related tax effects

3. Application of PAS 2 and 39 – common issues and examples

4. Question and answer



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Summary of Key Changes – PAS 2 and 39

art2

18 July 2006

Page 6Tax Implications of New Accounting Standards

Isla Lipana & Co./PricewaterhouseCoopers Philippines


Changes Accounting Implications Tax Implications

LIFO no longer allowed Inventories valued at LIFO need to

be revalued using acceptable

valuation method under PFRS

LIFO also not allowed.

BIR approval for change of

inventory valuation must be

secured within 90 days from start

of taxable year

Inventory needs to be carried

at lower of cost or net

realizable value (selling price

less cost to sell/completion).

Reversal of write-down nowallowed by PAS (not allowed

by previous GAAP)

Difference between cost and net

realizable value treated as a

reconciling item for income tax

purposes

Forex loss can no longer be

capitalized as part of

inventory cost under PAS 21

PAS 2 - Inventories



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18 July 2006





Requires measurement and

recognition of the fair value of

derivatives, including

embedded derivatives

Mark to market/derivative gains or

losses (unrealized in nature) need

to be measured at each reporting

date

Temporary differences and fair

value adjustments are not taxable

income/deductible losses.

Financial assets/liabilities

need to be measured initially

at FV less cost of

transaction. Subsequently,

assets must be measured at

FV as follows:

Fair value adjustments of financial

assets and liabilities will be

charged/credited to operations

(except available for sale financial

assets which is part of the equity

accounts)

Gain or loss to be recognized upon

realization. Necessary to

determine whether realized gain or

loss is capital or ordinary.

Capital loss deductible only to the

extent of capital gains

PAS 39 - Financial Instruments: Recognition and Measurement

18 July 2006





1. Assets/liabil ities at FV

through profit and loss - at FV

(market);

2. Held to maturity

investments - at amortized

cost using the effective

interest method

3. Loans and receivables -

same as 2 above

4. Available for sale financial

assets - at FV (market)

Application of effective interest

method will create temporary

difference between actual amount

of interest received/paid and

amount reported under effective

interest method.

Fair value adjustments are timing

differences and are taxable

income/ deductible losses once

realized.

PAS 39 - Financial Instruments: Recognition and Measurement



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Application of PAS – common issues and examples

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18 July 2006



PAS 2 - Inventories

Application of PAS –common issues and examples



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18 July 2006



Inventory Valuation

Accounting TreatmentGeneral rule - the cost of inventories shall be determined by

using specific identification, FIFO or weighted average cost

formula.

• This cost formula shall be used for all inventories having a

similar nature and use to the entity.

• Different cost formulas may be used on inventories with

different nature or use. (PAS 2, Par. 25).

• LIFO is no longer allowed.


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Inventory Valuation

Tax Treatment

• LIFO is not acceptable for income tax purposes pursuant to Item

X(B)(2.1) of RAMO 1-00 dated March 17, 2000.

• In case an entity will change its inventory valuation method

pursuant to PAS 2, it should secure permission from the BIR on

the change in accounting method (Section 41 of the Tax Code

and Section 168 of RR 2).

• If an entity previously uses LIFO for accounting and a different

valuation method for tax, the effect of the change of inventory

valuation shall be a reconciling item in the income tax return in

the year of change.




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Inventory Valuation

Accounting Treatment

• Inventories shall be measured at the lower of cost and net

realizable value (PAS 2, Par. 9).

“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

(PAS 2, Par. 6).


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Inventory Valuation

Tax Treatment

Section 145 of RR 2:

The law provides two tests to which each inventory must conform:

1. It must conform as nearly as possible to the best accounting

practice in the trade or business; and

2. It must clearly reflect the income.

• Inventory practice should be consistent from year to year

• An inventory that can be used under the best accounting

practice showing the financial position of the taxpayer is, as a

general rule, regarded as clearly reflecting his income




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Inventory Valuation

Tax TreatmentSection 145 of RR 2 (continued):

3. Any goods in an inventory which are unsalable at normal

prices or unusable or unusable in the normal way because of

damage, imperfections, shop wear, changes of style, odd or

broken lots, or other similar causes, including second hand

goods taken in exchange, should be valued at “bona fide”

selling prices.

• “Bona fide” selling price means actual offerings of goodsduring a period ending not later than 30 days after inventory

date.


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Inventory Valuation

Section 96, RR 2

Losses generally

• Must be evidenced by closed and completed transactions.

• The amount of loss must be reduced by the amount of any

insurance or other compensation received, and by the

salvage value, if any, of the property.




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Inventory Valuation

Example:Company A manufactured Product X at cost of P100,000.

Product X is usually sold to customers at P110,000 at a 5%

discount.

Delivery cost is estimated to be P10,000.

Question?

How much should be the carrying value of Product X foraccounting and tax purposes?


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Inventory Valuation

Example:

Carrying amount of Product X for accounting purposes:

Cost = P100,000

NRV = P94,500 (P110,000 selling price – P5,500 discount –

P10,000 delivery cost)

Carrying amount is P94,500 – lower of cost or NRV

Difference between cost and NRV = P5,500 (charged to cost of

sales)




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Inventory Valuation

Example (continued):• Inventory write-down of P5,500, charged to cost of sales, is not

deductible for income tax purposes. Under the tax rules, cost of

sales represents the actual cost of producing / purchasing the

inventory.

• Write-down of Cost to the Net Realizable Value charged to cost

of sales shall only be deductible once realized.

• Any recovery in the value of the inventory will also not be

recognized as a taxable income.


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Cost of Inventories


Deferred payment costs

Foreign exchange differencesSelling costs

Unrelated administrative overheadOther costs to bring inventories to

present location and condition

Storage costsCost of conversion

Abnormal wasteCost of purchase

ExcludesIncludes




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Cost of Inventories

Tax TreatmentSection 146, RR 2

• For merchandise purchased, cost means the invoice price less

trade or other discounts, except strictly cash discounts,

approximating a fair interest rate, which may be deducted or not

at the option of the taxpayer, provided a consistent course is

followed.

• To this net invoice price should be added transportation or

other necessary charges incurred in acquiring possession of thegoods.


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Cost of Inventories

Accounting treatment for inventory purchases with deferred

settlement terms

• Recognize interest related to inventories purchased with

deferred settlement terms as expense over financing period.

Difference between purchase price of inventory and present

value of liability is recognized as imputed interest expense.

Tax treatment

• Inventory still valued based on actual cost

• Interest expense as reconciling item for income tax purposes




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Cost of Inventories

Example – Purchase of inventory under deferred settlement:

Purchase price of merchandise = P100,000

Payment terms = 5 years

Discounted at present value = P80,000

Assumed annual amortization of interest = P4,000


Inventory valuation:

P100,000P80,000

Tax Accounting

Reconciling item in ITR: P4,000 non-deductible interest expense

18 July 2006



Write-down of Inventories


• The amount of any write-down of inventories to NRV and all losses

of inventories shall be recognized as an expense in the period when

the write-down or loss occurs. (PAS 2, Par. 34)

Tax Treatment

• Write-down of inventories to NRV is not yet deductible for income

tax purposes unless realized

• Inventory losses due to normal business operations (i.e.

obsolescence) are deductible for income tax purposes

• Write-off of inventories must be accompanied by BIR Certification

of Inventory Destruction




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18 July 2006



PAS 39 – Financial Instruments: Recognition andMeasurement


18 July 2006



Financial Instrument Defined

A financial instrument is any contract that gives rise to a

financial asset of one entity and a financial liability or

equity instrument of another entity. (PAS 32, Par. 11)




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Categories of Financial Instruments

A. Financial asset or financial liability at fair value throughprofit

or loss

Classified as held for trading if it is:

• Acquired or incurred principally for the purpose of selling or

repurchasing it in the near term;

• Part of a portfolio of identified financial instrument; or

• A derivative (except for a derivative that is a designated and

effective hedging instrument)


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B. Held-to-maturity investments – a non-derivative financial

assets with fixed or determinable payments and fixed maturity

that an entity has the positive intention and ability to hold to

maturity other than:

• those that the entity upon initial recognition designates as at fair

value through profit or loss• those that the entity designates as available for sale; and

• those that meet the definition of loans and receivables




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C. Loans and Receivables – a non-derivative financial assets with

fixed or determinable payments that are not quoted in an active

market, other than:

• those that the entity intends to sell immediately or in near term

classified as held for trading, and those that the entity upon initial

recognition designates as at fair value through profit or loss;

• those that the entity upon initial recognition designates as

available for sale; or

• those for which the holder may not recover substantially all ofits

initial investment, other than because of credit deterioration

classified as available for sale.


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D. Available-for-sale financial assets – non-derivative financial

assets that are designated as available for sale or are not

classified as (a) loans and receivables, (b) held-to-maturity

investments or (c) financial assets at fair value through profit or

loss.




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Initial Measurement


Imputed interest is not a taxable

income or deductible expense.

Difference between actual amount of

loan and PV is recognized as interest

income or expense.

Financial assets or liabilities with no

provision for payment of interest shall

be recognized at inception date of the

loan at present value (PV) – effective

interest rate method.

Recognized at contract amount or

transaction value.

Financial assets or liabilities are

recognized at fair market values

(FMV). Transaction costs are

included in the case of financial asset

or liability not at fair value through

profit or loss.

Tax TreatmentAccounting Treatment

18 July 2006



Financial Instrument

Example:

A non-interest bearing notes receivable of P60,000 due in 3 yearly

installments of P20,000. Imputed interest rate of 10%. Present value of the

loan at Year 1 is P49,737.04.


49,737.0410,262.9660,000.00

18,181.821,818.1820,000.0018,181.823

16,528.933,471.0720,000.0034,710.742

15,026.304,973.7020,000.0049,737.041

PrincipalInterestAmortizationBalance Year

PaymentOutstanding



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Example (continued):

1. Entry to record notes receivable

Dr. Notes receivable 49,737.04

Dr. Interest expense 10,262.96

Cr. Cash 60,000.00

2. Entry to record installment payment on Year 1

Dr. Cash 20,000.00

Cr. Notes receivable 20,000.00

Ann ual accret ion of interest income usin g ef fect ive interest method


Cr. Interest income 4,973.70


Recon itemin ITR

Recon item

in ITR

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Example (continued):


Dr. Cash 20,000.00





Dr. Cash 20,000.00





Recon itemin ITR

Recon item

in ITR



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18 July 2006



Imputation of Interest Income

Filinvest Development Corporation vs CIR [CA-GR SP No. 72992

dated December 16, 2003

Issue:

Imputation of interest income on Filinvest Development

Corporation’s (FDC) non-interest bearing cash advances based onSection 43 (now Section 50) of the Tax Code

Facts:

• FDC extended several cash advances to its affiliates with nostipulation on interest.

• The CIR imputed interest income on the said advances.

• The CTA upheld the imputation of interest made by the CIR.


18 July 2006




Filinvest Development Corporation vs CIR [CA-GR SP No. 72992

dated December 16, 2003

CA held:

• Section 43 (now Section 50) of the Tax Code is not applicable in thecase of FDC.

• There is no showing that FDC’s advances to its affiliates are

designed to evade payment of taxes or that FDC deliberatelydevised a scheme to avoid the payment thereof.

• No interest shall be due unless it has been stipulated in writing.

• There is no implementing revenue regulation authorizing the CIR toimpute a theoretical or imaginary interest income.




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Section 50 of Tax Code

Allocation of Income and Deductions:

In the case of two or more entities, the BIR is authorized to distribute,

apportion, or allocate gross income or deductions between or amongsuch entities if it determines that such distribution, apportionment or

allocation is necessary in order to prevent evasion of taxes or clearly to

reflect the income of said entities.


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Requisites for Deductibility of Interest Expense (RR 13-00)

1. An indebtedness exists.*

2. The interest has been paid or incurred.*

3. The indebtedness must be that of that of the taxpayer.*

4. The indebtedness is connected with the taxpayer’s trade, business or

exercise of profession.*

5. The interest was paid or incurred during the taxable year.*

6. The interest is stipulated in writing and must be legally due. [Filinvest

Development Corporation vs CIR (CA-G.R. SP No. 72992 dated December 16,2003) and Article 1956 of the Civil Code]

7. The indebtedness is not between related taxpayers.*

8. The interest was not incurred to finance petroleum exploration.*

9. If incurred on an indebtedness to acquire property, the interest was nottreated as a capital expenditure. (Sec 79 of RR 2)


*[Sec 34(B)(1)of the Tax Code]



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Subsequent Measurement


Amortization of interest income or

interest expense are non-taxable or

not deductible for income taxpurposes.

Financial assets or liabilities on

amortized cost (loans and receivables

and assets held to maturity)

Gain or loss arising from changes in

fair values of the financial asset are

non-taxable or not deductible for

income tax purposes. Said gain or

loss is recognized for tax purposes

when actually realized or incurred on a

closed and completed transaction

(e.g. upon sale or exchange).

Financial assets at fair value through

profit and loss are charged to P&L


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Impairment loss


If securities become worthless during

the taxable year and are capital

assets, the loss resulting therefrom

shall be considered as a loss from the

sale or exchange of the capital assets

(Section 34(D)(4) of the Tax Code).

Impairment loss is recognized for a

financial asset measured other than at

fair value. Such impairment is

recognized in the P&L.




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18 July 2006



Sale or disposition of financial asset


Gain or loss on the sale or disposition

of a financial asset is the difference

between the consideration received

and the unadjusted carrying value of

the financial asset (based on

transaction value).

Gain or loss from the sale or

disposition of a financial asset is the

difference between the consideration

received and the carrying value of the

financial asset.


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Derivatives and hedging instruments


Income/losses from derivatives and

hedging instruments shall be

recognized only when the transaction

covered by the instrument has already

been closed and completed.

The difference between the

transaction and fair values of the

derivatives and hedging instruments is

not taxable.

Derivatives/hedging instruments are

measure at fair values.

Gains or losses on re-measurement to

fair values are included in P&L unless

the derivatives will qualify as cash

flow hedges or hedge of net

investment in a foreign operation

which is recognized as part of equity.




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Illustrative Interest rate swap transaction

Counterparty A Bank

Fixed interest rate

(actual loan)

Transaction with interest

Counterparty B

Floating interest

rate

Fixed interest rate

18 July 2006



Derivatives and hedging Instruments

Accounting entries – Swap transaction:

Example: A bank enters into an interest rate swap transaction by paying a

fixed interest rate per annum and receives floating interest rate per quarter

1. At transaction date - Memorandum entry only (“off-books”); reference

asset of the swap transaction (i.e. loan) is only notional.

• There is no interest accrual for the trading book. The interest rate element

is addressed via the daily marking-to-market

2. Mark-to-market valuation at cut-off date

In case the bank recognizes a positive mark -to-market fair value on the

swap, it will recognize a gain in the income statement.

Dr. Unrealised MTM Gain on Trading (B/S) xxx

Cr. Profit and loss account – IRS (P/L) xxx


Recon item

in ITR



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In case the bank recognizes a negative mark-to-market fair value on the

swap, it will recognize a loss in the income statement.

Dr. Profit and loss account – IRS (P/L) xxx

Cr. Unrealized MTM Loss on Trading (B/S) xxx

Note: The entries to record the swap transaction at fair/market value are

normally reversed in the next business day.

3. At settlement/payment date of the swap, the actual gain or loss on the

swap transaction is recognized.


Recon item

in ITR

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a. If the swap has a positive fair value

Dr. Cash (B/S) xxx

Cr. Gain on swap transaction (P/L) xxx

b. If the swap has a negative fair value

Dr. Loss on swap transaction (P/L) xxx

Cr. Cash (B/S) xxx


Taxable item

in ITR

Deductible

item in ITR



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Accounting entries – Option transaction:

Example: A bank (buyer of the option) enters into a currency option

transaction.

1. At trade/contract date - Memorandum entry only (“off-books”)

2. Recording of option premium (Bank has buy option)

Dr. Profit and loss account – Option (P/L) xxx

Cr. Option Premium Payable (B/S) xxx


Recon itemIn ITR; not yet

realized

18 July 2006





3. Mark-to-market valuation at cut-off date

In case the bank recognizes a positive mark -to-market fair value on the

option, it will recognize a gain in the income statement.

Dr. Option Premium Asset (B/S) xxx

Cr. Profit and loss account – Option (P/L) xxx

In case the bank recognizes a negative mark-to-market fair value on the

swap, it will recognize a loss in the income statement.

Dr. Profit and loss account – Option (P/L) xxx

Cr. Option Premium Liability (B/S) xxx

Note: The entries to record the option transaction at fair/market value are

normally reversed in the next business day.


Recon itemin ITR

Recon item

in ITR



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4. On exercise date of the options, the memorandum entry at the date of

transaction will be reversed.

• The actual gain or loss on the transaction is a taxable/deductible item on

exercise date.


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Taxation of derivatives and hedging instruments

BIR Rulings on swap transactions (BIR Ruling Nos. 137-97;146-95; DA9-01; DA 381-98)

• gains or losses on swap transactions are recognized on a realized

basis for tax purposes

• only net swap receipts/payments are subject to income tax/GRT

• not subject to DST as the reference asset/principal is not an actual

loan agreement but merely notional; also derivatives are not subject toDST pursuant to Section 199(h) of the Tax Code (as amended by RA

9243 or the amended DST law)




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Taxation on sale of stock options

• Sale of stock options is subject to capital gains tax

• Section 22 (Definitions on “Tax on Income”) of the Tax Code defines“shares of stock” to include warrants and/or options to purchase shares

of stock

• Sale of stock options is not subject to documentary stamp tax


18 July 2006




Taxation on exercise of stock options (employer-employee transaction)

• Exercise of stock option at an exercise price lower than market value

of the stock gives rise to a taxable event for the person (e.g. employee)exercising the option

• Employer is required to withhold tax (WT on compensation) on thebenefit derived by its employee upon exercise of the stock option.

• DST on original issuance of shares of stock (P1.00 for every P200 of

the par value of shares)




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Reclassification


Gains or losses arising from

reclassification of financial assets and

liabilities shall have no tax effect.

Reclassification of financial assets

and liabilities.


Question and Answer

art4



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Thank you.

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PAS 2 and 39 (Inventories)

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