Long-term production: loss-free valuation of work in progress in tax accounts

Loss-free valuation of work in progress in tax accounts

Both for German statutory and tax accounting for long term production, profit recognition will follow the completed contract method - percentage of completion method is not applicable. Thus partly finished work is as a rule to be recognised on the balance sheet date at the acquisition or production cost incurred up to that point. If it is already clear that the expected sales proceeds are not going to cover the manufacturer’s full costs plus an average profit, an impairment must be made in the financial statements by reverse costing. If this cannot completely cover the anticipated losses, the rule is that a provision for expected losses from uncompleted contracts is to be formed.

However, provisions for expected losses are generally not permitted in the tax accounts under section 5(4a) of the Income Tax Act [Einkommensteuergesetz–EStG]. Nevertheless, losses from uncompleted contracts may be recognised up to the amount of the acquisition or production cost already incurred by means of impairment valuation on work in progress.

The Federal Fiscal Court holds the view that the valuation of inventories has nothing to do with the recognition of uncompleted contracts that concern these inventories. Therefore a partial write-down to the lower market value calculated according to loss-free measurement is permitted if impairment is expected to be permanent. In doing so, the partial write-down takes precedence over any provision for losses from uncompleted contracts not permitted in the tax accounts.

Recognition of losses on reverse costing

For a long time it was disputed whether, in the event of a partial write-down by way of reverse costing, impending losses were to be recognised in full or only according to the percentage of completion.

The Federal Fiscal Court decided that the entire impending loss expected from the order must be recognised, regardless of the effective degree of completion as of the balance sheet date (Federal Fiscal Court dated 7/9/2005, VIII R 1/03).

The background to this is the definition of impairment value [Teilwert]: a potential acquirer of the entire business would, when valuing the volume of orders, deduct all expenses still to be incurred until completion from the sales proceeds they can achieve on the market. This particularly applies if it is not economically viable to terminate production or scrap the partially finished work.

The Federal Ministry of Finance Circular of 14/11/2000 (BStBl. I 2000, 1514), according to which only the loss proportionate to the degree of completion may be recognised, is no longer applicable today. It is no longer included on the list of currently applicable Circulars or under H 6.7 of the official income tax guidance (EStH).

The original Federal Fiscal Court judgement related to the loss-free valuation of unfinished buildings in the construction industry. But we consider that the principles can equally be applied to partly finished machinery and plant.

When partial write-downs typically do not apply

Partial write-downs are typically not permissible if:

• there is no obligation to complete the work and the partially finished work can be economically exploited in another way
• separate milestones have already been accepted and partial profit already recognised for them or
• contracts were calculated at a loss from the outset (H 6.7 EStH).

Practical tips on loss-free valuation

As a result, expected losses from uncompleted contracts may already be recognised in the tax accounts, too, by partial write-downs of work in progress on the balance sheet date. The impairment is, however, to be limited to the amount of the acquisition or production cost.

Anticipated losses are to be recognised in full, according to Federal Fiscal Court case law, and not only according to their degree of completion. But the taxpayer bears the burden of proof including presenting and determining the relevant facts for the circumstances pertaining to lower attributable value.

Losses beyond the acquisition or production costs may not be recognised in the tax accounts by forming provisions for impending losses from uncompleted contracts. 

If you have any queries about the valuation of inventories or getting partial write-downs accepted in a tax audit, our Grant Thornton Germany experts will be glad to assist you. 

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