Concepts, Rules and Examples

Scope

This standard deals with the accounting treatment and disclosure requirements of grants received by enterprises from a government. It also mandates disclosure requirements of other forms of government assistance.

The standard specifies certain exclusions. In addition to the three exclusions contained within the definitions of the terms "government grant" and "government assistance," IAS 20, para 2, excludes the following from the purview of the standard:

1. Special problems arising in reflecting the effects of changing prices on financial statements or similar supplementary information;

2. Government assistance provided in the form of tax benefits (including income tax holidays, investment tax credits, accelerated depreciation allowances and concessions in tax rates); and

3. Government participation in the ownership of the enterprise.

The rationale behind excluding clauses 1. and 2. above seems fairly obvious (they are covered by other international accounting standards); IAS 15 addresses the effects of changing prices on financial statements, while tax benefits are dealt with by IAS 12. The reason for excluding clause 3. above, however, has been the subject of much controversy and conjecture. Authorities on the subject have offered different opinions as plausible reasons for specifically excluding "government participation in the ownership of the enterprise" from the scope of IAS 20. According to one school of thought, participation in ownership of an enterprise is normally in anticipation of a return on the investment while government assistance is provided with an economic cause in mind, for example, the public interest or public policy. Furthermore, government assistance is provided "to encourage an enterprise to embark on a course of action which it would not have taken if the assistance was not provided" (IAS 20, para 4). Thus, supporters of this school of thought argue that because the rationale behind the two government actions is vastly different, such exclusion seems proper.

According to another group of experts, the nonexclusion of government ownership from the scope of the standard would have caused great difficulty in implementing the standard in certain cases. For instance, distinguishing economic benefits provided by the government to a government corporation based on ownership criteria vis-a-vis economic benefits provided by the government to a government corporation under a normal government assistance program (under which program other enterprises also receive government grants) would be practically impossible. Thus, according to the proponents of the above line of thinking, government participation in the ownership of an enterprise is specifically excluded from the scope of IAS 20. Whatever the intent may be, with such exclusion contained in IAS 20, government participation in ownership of an enterprise would automatically be excluded from the scope of this standard. Thus, when the government invests in the equity of an enterprise (with the intention of encouraging the enterprise to undertake a line of business that it would normally not have embarked on), such government participation in ownership of the enterprise would not qualify as a government grant under this standard.

Government Grants

Government grants are assistance provided by government by transfer of resources (either monetary or nonmonetary) to enterprises. In order to qualify as a government grant, in strict technical terms, it is a prerequisite that the grant should be provided by the government to an enterprise in return for past or future compliance with conditions relating to the operating activities of the enterprise.

For quite some time now, it has been unclear whether the provisions of IAS 20 would apply even to government assistance aimed at encouraging or supporting business activities in certain regions or industry sectors, since related conditions may not specifically relate to the operating activities of the enterprise. Examples of such grants are: government grants which involve transfer of resources to enterprises to operate in a particular area (i.e., an economically backward area) or a particular industry (i.e., an agriculture-based industry that due to its low profitability may not be a popular choice of entrepreneurs). The Standing Interpretations Committee's interpretation, SIC 10, has clarified that "the general requirement to operate in certain regions or industry sectors in order to qualify for the government assistance constitutes such a condition in accordance with IAS 20.03." This has set to rest the confusion as to whether or not such government assistance does fall within the definition of government grants and thus the requirements of IAS 20 apply to them as well.

Recognition of Government Grants

Criteria for recognition.

Government grants are provided in return for past or future compliance of certain conditions. Thus grants should not be recognized until there is reasonable assurance that both

1. The enterprise will comply with the conditions attaching to the grant; and

2. The grant(s) will be received.

Some interesting issues relating to recognition and treatment of government grants are considered below.

Firstly, the receipt of the grant does not provide any assurance that, in fact, the conditions attaching to the grant have been or will be complied with by the enterprise. Thus, both conditions are equally important and the enterprise should have reasonable assurance with respect to the two conditions before a grant could be recognized.

Secondly, the term "reasonable assurance" has not been defined in this standard. However, one of the recognition criteria for income under the IASC's Framework is existence of "sufficient degree of certainty." Furthermore, under IAS 18, revenue is recognized only when it is probable that economic benefits will flow to the enterprise. Thus, the criterion of reasonable assurance could possibly be interpreted as probable. Comparing this with the criterion for the recognition of "contingent gains" under IAS 37, it appears that there the criterion has been made more stringent than the above criterion for recognition of a government grant. In the case of recognition of a government grant, it seems the criterion has been relaxed to a degree lower than virtually certain—it has been pegged at the reasonable assurance level. However, under IAS 37 and for that matter even under the former IAS 10, which dealt with contingencies before 1999, contingent gains could only be recognized if, and only if, realization was virtually certain. In the authors' opinion, this issue needs to be considered by the IASC in case a revision of the standard is undertaken at a later point in time.

Thirdly, under IAS 20, para 10, a forgivable loan from a government is treated as a government grant when there is reasonable assurance that the enterprise will meet the terms of forgiveness of the loan. Thus, on receiving a forgivable loan from a government and on fulfilling the criterion of reasonable assurance with respect to meeting the terms of forgiveness of the loan, an enterprise would normally recognize the government grant. Some authorities on the subject have suggested that the grant would be recognized when the loan is forgiven and not when the forgivable loan is received. Under IAS 20, para 10, it is fairly obvious that "a forgivable loan from the government is treated as a grant when there is reasonable assurance that the enterprise will meet the terms for forgiveness of the loan" (emphasis added). In the authors' opinion, this implies that the recognition of the grant is to be made at the point of time when the forgivable loan is granted, as opposed to the point of time when it is actually forgiven.

Finally, IAS 20, para 11, clarifies that once a grant has been recognized, any related contingency would be treated in accordance with the former IAS 10. This would imply that for periods beginning on or after July 1, 1999, any related contingency should be treated in accordance with IAS 37 which superseded the former IAS 10 with respect to contingencies.

Recognition period.

Two broad approaches with respect to the accounting treatment of government grants have been discussed by the standard: the "capital approach" and the "income approach." The standard clearly does not support the capital approach, which advocates crediting a grant directly to the shareholders' equity. Endorsing the income approach, the standard lays down the rule for recognition of government grants as follows: Government grants should be recognized as income, on a systematic and rational basis, over the periods necessary to match them with the related costs. As a corollary, and by way of abundant precaution, the standard reiterates that government grants should not be credited directly to shareholders' interests.

The standard lays down rules for recognition of grants under different conditions. These are explained through numerical examples as follows:

1. "Grants in recognition of specific costs are recognized as income over the same period as the relevant expense." (IAS 20, para 17).

To illustrate this rule, let us consider the following example:

• An enterprise receives a grant of $30 million to defray environmental costs over a period of five years. Environmental costs will be incurred by the enterprise as follows:

  Year	Costs
  1	$1 million
  2	$2 million
  3	$3 million
  4	$4 million
  5	$5 million

  Total environment costs will equal $15 million, whereas the grant received is $30 million.

Applying the principle outlined in the standard for recognition of the grant, that is, recognizing the grant as income "over the period which matches the costs" and using a "systematic and rational basis," the total grant would be recognized as follows:

Year	Grant recognized
1	$ 30 * (1/15)=$ 2 million
2	$ 30 * (2/15) = $ 4 million
3	$ 30 * (3/15) = $ 6 million
4	$ 30 * (4/15) = $ 8 million
5	$ 30 * (5/15) = $ 10 million

2. "Grants related to depreciable assets are usually recognized as income over the periods and in the proportions in which depreciation on those assets is charged." (IAS 20, para 17)

The following example will illustrate the above rule:

• An enterprise receives a grant of $100 million to purchase a refinery in an economically backward area. The enterprise has estimated that such a refinery would cost $200 million. The secondary condition attached to the grant is that the enterprise should hire laborers locally (i.e., from the economically backward area where the refinery is located) instead of employing laborers from other parts of the country. It should maintain a ratio of 1:1 (local laborers : laborers from outside) in its labor force for the next five years. The refinery is to be depreciated using the straight-line method over a period of ten years.

• The grant will be recognized over a period of ten years. In each of the ten years, the grant will be recognized in proportion to the annual depreciation on the refinery. Thus, $10 million will be recognized as income in each of the ten years. With regard to the secondary condition of maintenance of the ratio of 1:1 in the labor force, this contingency would need to be disclosed in the footnotes to the financial statements for the next five years (during which period the condition is in force) in accordance with disclosure requirements of IAS 37.

3. "Grants related to nondepreciable assets may also require the fulfillment of certain obligations and would then be recognized as income over periods which bear the cost of meeting the obligations. " (IAS 20, para 19)

To understand this rule, let us consider the following case study:

• ABN Inc. was granted 1000 acres of land, on the outskirts of the city, by a local government authority. The condition attached to this grant was that ABN Inc. should clean up this land and lay roads by employing laborers from the village in which the land is located. The government has fixed the minimum wage payable to the workers. The entire operation will take three years and is estimated to cost $60 million. This amount will be spent as follows: $10 million each in the first and second years and $40 million in the third year. The fair value of this land is presently $120 million.

• ABN Inc. would need to recognize the fair value of the grant over the period of three years in proportion to the cost of meeting the obligation. Thus, $120 million will be recognized as follows:

  Year	Grant recognized
  1	$ 120 * (10/60)= $20 million
  2	$ 120 * (10/60)= $20 million
  3	$ 120 * (40/60)= $80 million

4. "Grants are sometimes received as part of a package of financial or fiscal aids to which a number of conditions are attached." (IAS 20, para 19)

When different conditions attach to different components of the grant, the terms of the grant would have to be evaluated in order to determine how the various elements of the grant would be earned by the enterprise. Based on that assessment, the total grant amount would then be apportioned.

For example, an enterprise receives a consolidated grant of $120 million. Two-thirds of the grant is to be utilized to purchase a college building for students from third-world or developing countries. The balance of the grant is for subsidizing the tuition costs of those students for four years from the date of the grant.

The grant would first be apportioned as follows:

Grant related to assets (2/3)	=	$ 80 million, and
Grant related to income (1/3)	=	$ 40 million

The grant related to assets would be recognized in income over the useful life of the college building, for example, ten years, using a systematic and rational basis. Assuming the college building is depreciated using the straight-line method, this portion of the grant (i.e., $80 million) would be recognized as income over a period of ten years at $8 million per year.

The grant related to income would be recognized over a period of four years. Assuming that the tuition subsidy will be offered evenly over the period of four years, this portion of the grant (i.e., $40 million) would be taken to income over a period of four years at $10 million per year.

5. "A government grant that becomes receivable as compensation for expenses or losses already incurred or for the purpose of giving immediate financial support to the enterprise with no future related costs should be recognized as income of the period in which it becomes receivable, as an extraordinary item, if appropriate." (IAS 20, para 20)

Sometimes grants are awarded for the purposes of giving immediate financial support to an enterprise, for example, to revive a commercial insolvent business (referred to as "sick unit" in third-world countries). Such grants are not given as incentives to invest funds in specified areas or for a specified purpose from which the benefits will be derived over a period of time in the future. Instead such grants are awarded to compensate an enterprise for losses incurred in the past. Thus, they should be recognized as income in the period in which the enterprise becomes eligible to receive such grants.

A grant may be awarded to an enterprise to compensate it for losses incurred in the past for operating out of an economically backward area that has been hit by an earthquake recently. During the period the enterprise operated in that area, the area experienced an earthquake and thus the enterprise incurred massive losses. Such a grant received by the enterprise should be recognized as income in the year in which the grant becomes receivable. Also, since the losses suffered are extraordinary in nature, the grant may need to be presented as an extraordinary item in the financial statements.

Nonmonetary Grants

A government grant may not always be given in cash or cash equivalents. Sometimes a government grant may take the form of a transfer of a nonmonetary asset, such as grant of a plot of land or a building in a remote area. In these circumstances the standard prescribes the following optional accounting treatments:

1. To account for both the grant and the asset at the fair value of the nonmonetary asset, or

2. To record both the asset and the grant at a "nominal amount."

Presentation of Grants Related to Assets

Presentation on the balance sheet.

Government grants related to assets, including nonmonetary grants at fair value, should be presented in the balance sheet in either of the two ways

1. By setting up the grant as deferred income, or

2. By deducting the grant in arriving at the carrying amount of the asset.

To understand this better, let us consider the following case study:

• Natraj Corp. received a grant related to a factory building which it bought in 1998. The total amount of the grant was $3 million. Natraj Corp. purchased the building from an industrialist identified by the government. The factory building was located in the slums of the city and was to be repossessed by a government agency from the industrialist, in case Natraj Corp. had not purchased it from him. The factory building was purchased for $9 million by Natraj Corp. The useful life of the building is not considered to be more than three years mainly because it was not properly maintained by the industrialist.

Under Option 1: Set up the grant as deferred income.

• The grant of $3 million would be set up initially as deferred income in 1998.

• At the end of 1998, $1 million would be recognized as income and the balance of $2 million would be carried forward in the balance sheet.

• At the end of 1999, $1 million would be taken to income and the balance of $1 million would be carried forward in the balance sheet.

• At the end of 2000, $1 million would be taken to income.

Under Option 2: The grant will be deducted from carrying value.

The grant of $3 million is deducted from the gross book value of the asset to arrive at the carrying value of $6 million. The useful life being three years, annual depreciation of $2 million per year is charged to the income statement for the years 1998, 1999, and 2000.

The effect on the operating results is the same whether the first or the second option is chosen.

Under the second option, the grant is indirectly recognized in income through the reduced depreciation charge of $1 million per year, whereas under the first option, it is taken to income directly.

Presentation in the cash flow statement.

When grants related to assets are received in cash, there is an inflow of cash to be shown under the investing activities section of the cash flow statement. Furthermore, there would also be an outflow resulting from the purchase of the asset. IAS 20, para 28, specifically requires that both these movements should be shown separately and not be netted. The standard further clarifies that such movements should be shown separately regardless of whether or not the grant is deducted from the related asset for the purposes of the balance sheet presentation.

Presentation of Grants Related to Income

The standard allows a free choice between two presentations.

Option 1:	Grant presented as a credit in the income statement, either separately or under a general heading other income
Option 2:	Grant deducted in reporting the related expense

The standard does not show any bias towards any one option. It acknowledges the reasoning given in support of each approach by its supporters. The standard considers both methods as acceptable. However, it does recommend disclosure of the grant for a proper understanding of the financial statements. The standard recognizes that the disclosure of the effect of the grants on any item of income or expense may be appropriate.

Repayment of Government Grants

When a government grant becomes repayable, for example, due to nonfulfillment of a condition attaching to it, it should be treated as a change in estimate, under IAS 8, and accounted for prospectively (as opposed to retrospectively).

Repayment of a grant related to income should

1. First be applied against any unamortized deferred income (credit) set up in respect of the grant, and

2. To the extent the repayment exceeds any such deferred income (credit), or in case no deferred credit exists, the repayment should be recognized immediately as an expense.

Repayment of a grant related to an asset should be

1. Recorded by increasing the carrying amount of the asset or reducing the deferred income balance by the amount repayable, and

2. The cumulative additional depreciation that would have been recognized to date as an expense in the absence of the grant should be recognized immediately as an expense.

When a grant related to an asset becomes repayable, it would become incumbent upon the enterprise to assess whether any impairment in value of the asset (to which the repayable grant relates) has resulted. For example, a bridge is being constructed through funding from a government grant and during the construction period, because of nonfulfillment of the terms of the grant, the grant became repayable. Since the grant was provided to assist in the construction, it is possible that the enterprise may not be in a position to arrange funds to complete the project. In such a circumstance, the asset is impaired and may need to be written down to its recoverable value, in accordance with IAS 36.

Government Assistance

Government assistance includes government grants. IAS 20 deals with both accounting and disclosure of government grants and disclosure of government assistance. Thus government assistance comprises government grants and other forms of government assistance (i.e. those not involving transfer of resources).

Excluded from the government assistance are certain forms of government benefits that cannot reasonably have a value placed on them, such as free technical or other professional advice. Also excluded from government assistance are government benefits that cannot be distinguished from the normal trading transactions of the enterprise. The reason for the second exclusion is obvious: although the benefit cannot be disputed, any attempt to segregate it would necessarily be arbitrary.

Loans at zero or low interest are a form of government assistance. They should not have a value attributed to them in the financial statements, since the benefit could only be quantified by imputing interest costs, which is arbitrary. Thus, an enterprise that is currently benefiting from such assistance (e.g., in the form of low interest), but is likely to borrow funds in the near future at commercial rates of interest, would need to disclose when the full interest is going to commence.

Disclosures

IAS 20, para 39, prescribes the following disclosures:

1. The accounting policy adopted for government grants, including the methods of presentation adopted in the financial statements;

2. The nature and extent of government grants recognized in the financial statements and an indication of other forms of government assistance from which the enterprise has directly benefited; and

3. Unfulfilled conditions and other contingencies attaching to government assistance that has been recognized.