Proposed accounting standard likely to give charity shops a headache
June 2011
The consultation on FRED 45 does not close until 31 July 2011. Pesh Framjee presents a compelling case against the need to include on the balance sheet goods that have been donated for resale
The Accounting Standards Board has recently published FRED 45 and Exposure Draft of a new Financial Reporting Standard for Public Benefit Entities (PBEs).[1]One of the more contentious proposals requires that goods donated for resale are recognised as income at fair value when received and included in the balance sheet as stock (called inventories). The consultation period ends on 31 July 2011 and the new accounting standard will define parameters for the Charity SORP which presently requires that goods donated for resale are recognised as income when sold.
If the standard is finalised as drafted this will no longer be possible. This has caused much concern in the charity sector with the spectre of stock counts of donated goods in charity shops and depots.
The proposition in the standard is that all donations or income should be recognised when receivable and when the receiving entity has entitlement. This is of course correct and is in fact the thinking that has been applied for income recognition under the Charity SORP[2].
Are good donated for resale any different?
So should goods donated for resale be treated any differently? The accounting presently adopted needs to be carefully considered to show that in fact donated goods are treated in a way that is consistent with accounting standards and other categories of income.
There are two stages of accounting to consider:
1) The initial recognition of the income in the Income statement (SOFA).
2) The carrying value in the balance sheet.
So for example:
- A gifted building is recognised as income when receivable. At the year end if there is any indication of impairment it is written down.
- A grant or donation is recognised as income when receivable and at the year end there is a separate exercise to consider the carrying value on the balance sheet and if necessary the debt may be written down.
- A gift of investments is recognised at fair value when receivable and is then revalued at the year end.
This is the same approach that charities have used with donated goods. They appreciate that they have entitlement at the point that they have been gifted the goods, if they have been sold by the year end there is no issue about the balance sheet carrying value and the goods are recognised as income.
However, if the goods have not been sold the carrying value of stock (or inventories being the new preferred terminology) on the balance sheet has to be considered. Using the long-accepted principle that trading stock needs to be carried at the lower of cost or net realisable value charities and their auditors have accepted that there is no material ‘cost’ to include on the balance sheet. So if the first accounting entry to recognise the income in the income statement is credit income and debit stock the second accounting entry at the balance sheet date would be debit Income and credit stock with the ‘value’ of donated goods unsold. In effect, removing from both income and stock the unsold donated goods. This arrives at the treatment being used under the Charity SORP.
The crux of the issue is what is ‘cost’ when goods have been donated for resale. The accepted approach has been that the cost as defined in accounting standards is close to nil. This has meant that charities have not had the burden of carrying out stock counts for unsold donated goods.
What is the ‘cost’ of donated goods
There is no getting away from the requirement that accounting standards require that stock (inventories) must be measured at the lower of cost or net realisable value.
The proposed Financial Reporting Standard for Small and Medium Sized Entities (FRSME) states ‘An entity shall include in the cost of inventories all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.’[3]This has been the well-recognised basis of calculating cost and this is the basis for accepting that the cost of donated goods held as stock is close to nil.
The argument in FRED 45 is that the stock of donated goods should be measured at fair value at the date of acquisition. This thinking appears to be based on International Public Sector Accounting Standards (IPSAS) and prima facie it does seem reasonable to turn to IPSAS as there are many similarities between transactions in the public sector and the wider PBE sector. IPSAS 12[4] which deals with inventories states:
“A primary issue in accounting for inventories is the amount of cost to be recognized as an asset and carried forward until the related revenues are recognised.”
It then goes on to provide useful guidance on the basis of measuring the value to be included in the balance sheet.
“Measurement of Inventories
15. Inventories shall be measured at the lower of cost and net realizable value, except where paragraph 16 applies.
16. Where inventories are acquired through a non-exchange transaction, their cost shall be measured at their fair value as at the date of acquisition.
17. Inventories shall be measured at the lower of cost and current replacement cost where they are held for:
(a) Distribution at no charge or for a nominal charge; or
(b) Consumption in the production process of goods to be distributed at no charge or for a nominal charge.”
Paragraph 16 of IPSAS 12 appears to be the basis of the requirements in FRED 45 (the donation of goods would be a non exchange transaction). However, there are some important considerations which need to be factored in. Public sector bodies do not normally receive goods donated for resale. Recognising this IPSAS 12 specifically excludes ‘Government Business Enterprises’ (GBEs) from its scope and requirements. In essence, this is because GBEs are seen to be similar to trading enterprises’[5] and the normal rules for trading enterprises are seen to be relevant. When a charity trades in bought in or donated goods the unsold stock of these goods would be trading stock and the normal rules for valuing trading stock should apply.
It therefore seems that the requirement to deem the cost to be the fair value at time of acquisition in the case of donated stock is not a requirement under IPSAS for normal trading situations. On this basis it would not be unreasonable to conclude that the approach in paragraph 16 of IPSAS 12 should not apply to trading stock held for resale.
The valuation of inventories
FRED 45 addresses the first part of the accounting – the recognition of income from non exchange transactions but does not address the issue of the valuation of inventories in the balance sheet. Presumably because it is addressed in the FRSME and the intention is that the PBE standard is to be a ‘differences only’ standard – identifying where there are omissions in FRSs that need addressing for PBEs. It would be useful if the fundamental principle that inventories are valued at the lower of cost and net realisable value is reiterated in FRED 45 and the principles in IPSAS 12 should be used to provide PBE specific guidance on the measurement of cost.
In effect bearing in mind the derogation for trading enterprises IPSAS and UK GAAP seem to indicate specific treatment for three key categories of stock or inventories held by PBEs:
a) Normal (trading) inventories should be valued at the lower of cost (defined as costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition) and net realisable value)
b) Inventories acquired through non exchange transactions (which are not held for trading) should be measured at fair value at the time of acquisition.
c) Inventories held for distribution or use in providing goods and services on a nominal or no charge basis should be valued at the lower of cost as defined in a) or replacement cost.
This treatment which would be consistent with the Charity SORP and the present treatment adopted by charities is in line with IPSAS and FRSs. If in fact FRED 45 was to address the PBE specific issues of valuing inventories and used the treatment under a) to c) above then it would align itself with IPSAS and IFRS and would also address the considerable concerns in the charity sector.
Why are charities so concerned about this?
Some who are not very familiar with the realities of the charity retail sector have suggested that this is much ado about nothing and it should be possible to use simple estimation techniques. In fact with any stock carried in the balance sheet there are two issues for preparers and auditors of accounts to address:
1) Has the right quantity been recorded for stock held at the balance sheet date?
2) Has the right value been recorded for this stock at the year end?
Accounting and auditing standards 1) above would normally require stock counts and checks that the stock exists and has been recorded in the correct period.
In the case of 2) the usual position is to first consider the ‘cost. It is also normal to consider after-date sales to consider the net realisable value. So in the situation of a charity retail operation it should be possible to arrive at the fair value of the stock held at the year end by considering the expected or achieved sales price.
However the work involved in counting the stock and then valuing it appears to be underestimated. Some of the difficulties include:
a) Charities are increasingly using schemes where they sell donated items as agents for the donor. Care will be needed to ensure that these items which are at the shops or depots are not included in the year end stock value as they do not belong to the charity.
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b) The year-end stock value should include (if material) the value of additional work that has been carried out on the stock items before the balance sheet date (mending, cleaning, ironing). Therefore in considering the balance sheet value and net realisable value it will be necessary to understand whether such work was material and was carried out before or after the balance sheet date.
c) Some stock is sold in as individual items and some is sold in bulk as rags. The value is of course different and this is not always apparent at the outset. It is quite common for items that were originally ‘valued’ and marked for sale to be disposed of through the bulk rag trade if they do not sell.
d) Some charities do not know what is in the containers at the year end and do not sort the donated goods for some time after receipt. This is not simply a case of estimating a value for a bin bag. The mind boggles at the thought of a stock count at a busy charity retail outlet at 31 December.
e) Many charity shops are operated by volunteers and charities have been expressing real concerns about the burdens of stock counts, the extra work and time diverted from raising income.
There have been suggestions that it might be permissible to argue that if it is not possible or practical to count and value stock or that if the cost outweighs the benefit then including unsold donated goods as stock will not be necessary. There are some real concerns with this approach. As shown above it is possible to do stock counts and arrive at a carrying value for stock. Auditors may have a different approach to their clients in considering what is practical. This approach would also mean that some charities would value unsold donated goods whilst others would not – it could also mean that a charity may include some but not all of its donated goods.
Notwithstanding the qualitative and subjective characteristics of the term ‘materiality’ (discussed below) most auditors, and indeed preparers of accounts, attribute a monetary value when they consider whether an item is material. This is usually defined as a percentage of income or net assets or some similar benchmark. Another aspect is that auditing guidelines require auditors to attend stock counts where stock is material. For charities with significant retail operations the carrying value of stock on the balance sheet will be a large number if it is carried at fair value based on selling price, rather than cost as conventionally defined. There is therefore a real concern that some auditors may push for stock counts and valuation. The cost to the charity in time and resources and increased audit fees does not appear to have been considered in the impact assessment of FRED 45.
Accounting standards use a more subjective basis for defining materiality “Information is material—and therefore has relevance—if its omission or misstatement could influence the economic decisions of users made on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement.”[6] Questions to consider are – would the donors to a charity such as Oxfam or Shelter be influenced by whether unsold donated goods were included on the balance sheet or not? Would they think it was wrong that the income was recognised at the time of sale rather than when the donated goods were received? The Charity SORP has advocated this treatment since 1995 and this issue has never arisen as being a matter of concern to users of accounts in the numerous consultations and round table discussions on the SORP.
In conclusion, existing custom and practice has worked, is practical and can be justified under accounting standards so why are we trying to fix something that does not seem to be broken. Especially when the “fix” is seen by so many as impractical, costly to implement and not really making a difference to the users of accounts.
[1] See Caritas June 2011 http://www.charitiesdirect.com/caritas-magazine/article.php?ArticleID=1017
[2] See paragraphs 104 et seq of the Charity SORP: www.charity-commission.gov.uk/Library/guidance/sorp05textcolour.pdf
[3] See paragraph 13.5 of the proposed FRSME www.frc.org.uk/images/uploaded/documents/Part%202%20Web%20Optimized.pdf
[5] IPSAS 1 explains: “Government Business Enterprises (GBEs) include both trading enterprises, such as utilities, and financial enterprises, such as financial institutions. GBEs are, in substance, no different from entities conducting similar activities in the private sector. GBEs generally operate to make a profit, although some may have limited community service obligations under which they are required to provide some individuals and organisations in the community with goods and services at either no charge or a significantly reduced charge.”
[6] See paragraph 3.16 of the proposed FRSME www.frc.org.uk/images/uploaded/documents/Part%201%20Web%20Optimized.pdf
Author: Pesh Framjee
Pesh Framjee Pesh Framjee, Head of the non-profit unit at Crowe Clark Whitehill is Special Adviser to CFDG and is a member of the Charity SORP Committee. He has worked with charities for over 35 years and advises charities on financial, governance and strategic matters.
jeanette Wilkins, 29/09/2011
The cost of resource to deal with this will be horrific. This would add process, the need for definitions of stock and manpower to handle it- all of which will add huge cost to the operation with zero benefit. It will be another case of adding work to a charity which is the last thing we need when stock is already costly enough to obtain. No where near as problematic but a question I hope we don't have to answer. How would stock be valued ie at lowest worse case rag cost ?