Subsidies... a timely topic due to the EU subsidies that entrepreneurs have been obtaining for a long time, as well as the current time of the COVIN-19 epidemic, which gives the opportunity to apply, among others, for exemption from the payment of Social Insurance Institution contributions and funding under the Polish Development Fund shield.
The following note discusses the accounting aspects of subsidies. The second note, I warn you, there will be a second part, will get to the point - it will be about subsidies in the context of enterprise valuation.

Liabilities - it is generally assumed that they are divided into two main categories: equity and liabilities and provisions for liabilities - this division is crucial from the point of view of the valuation of companies and enterprises. Why these two categories? Well, in accordance with the balance sheet format presented in Annex No. 1 (for the sake of clarity, regarding entities other than banks, insurance and reinsurance companies) to the Accounting Act of September 20, 1994 (hereinafter referred to as "AA"), we have two "large" categories of liabilities A. equity and B. liabilities and provisions for liabilities.

How does the balance sheet format of Annex 1 of the AA further divide liabilities and provisions for liabilities? We have 4 items: I. Provisions for liabilities, II. Long-term liabilities, III. Short-term liabilities and IV. Accruals and accruals
Part of the accruals and accruals are the accruals of revenues referred to in the Act on Activity in Art. 41 as follows:
Paragraph 1.
Deferred income, made in compliance with the prudence principle, includes in particular:
1) the equivalent of funds received or due from contractors in respect of services to be performed in the next reporting periods;
2) cash received to finance the purchase or production of fixed assets, including fixed assets under construction and development works, if, pursuant to other acts, they do not increase own capital (funds). The amounts included in deferred income gradually increase other operating income, in parallel to depreciation or amortization write-offs on fixed assets or the costs of development work financed from these sources;
3) negative goodwill referred to in Art. 33 section 4 and art. 44b section 11.
Paragraph 2.
The provision of section 1 point 2 shall apply accordingly to fixed assets under construction, fixed assets and intangible assets accepted free of charge, including as a gift.

Let's focus on government or EU subsidies - this is the most common case (especially in the era of coronavirus). Grants may concern assets (the most common case is fixed assets) or costs. The above-mentioned Art. 41 of the AA concerns the settlement of subsidies for fixed assets, fixed assets under construction and development works. The matter is generally simple - we receive a subsidy for the purchase of a fixed asset, the asset purchased with the help of the subsidy is recorded at its acquisition cost, the subsidy received is recorded in accruals (i.e. deferred income) and then is settled in other income in parallel with depreciation write-offs.

A simple example - at the end of 20X0, company A buys a specialized machine we know that the economic useful life of the purchased machine is 7 years and that linear depreciation is appropriate for this item of fixed assets.

Assuming that the financial year is consistent with the calendar year, as at December 31, 20X0, we will recognize the machine on the asset side in property, plant and equipment at a value of 10.5 million PLN, and the received subsidy will be recognized in accrued liabilities (i.e. accrued income) in the amount of 7. million PLN. In 20X1 (i.e. the first year of use of the machine), the depreciation of the machine will amount to 1.5 million PLN (10.5/7), and in other operating income we will recognize the amount of 1 million PLN (7/7). The net value of the machine as at December 31, 20X1 will be 9 million PLN (10.5-1.5), and on this date we will recognize a subsidy of 6 million PLN (7-1) in deferred income. Over the next 6 years, we will recognize the depreciation cost of machine X and other operating income related to the settled subsidy in the amount of 1.5 million PLN and 1 million PLN, respectively. Thus, as at December 31, 20X6, the net value of the fixed asset, machine

A subsidy (or donation) may be in kind, i.e., for example, an entity may receive a technological line. Then the initial accounting should be consistent with the fair (market) value of the received technological line.
Let us pay attention to the inconsistencies of Art. 41 - from section 1 point 2) states that the subject of the subsidy should not be intangible assets, except for development works, and section 2 states that the donation may also include intangible assets...

The subsidy may cover costs already incurred or costs that will be incurred. The general rule is simple - the subsidy should be recognized in other operating income in the periods in which the costs related to the subsidy are incurred. If I have already incurred costs in previous periods, which now, for example, the government decides to compensate, I should immediately recognize the entire subsidy received in other operating income. Why there? This is mentioned in Art. 3 section 1 point 32) of the Act, which defines other operating costs and revenues as costs and revenues indirectly related to the entity's operating activities, in particular costs and revenues related to: (…)
h) transferring or receiving assets free of charge, including by donation, in including cash for purposes other than subsidies to sales prices, purchase or production of fixed assets, fixed assets under construction or intangible assets.

What if I first receive a subsidy for costs and then incur these costs (a rather rare case)? I should suspend the subsidy received in accrued income and write it off accordingly to other operating income in the periods of incurring costs. So, if, for example, in February 20X0 I received a subsidy for costs to be incurred in March and April 20X0, the subsidy received should be recognized in other operating income in March and April, respectively...

What can't be done? If we received a subsidy for the purchase of a fixed asset, we cannot recognize the entire subsidy received immediately in other operating income - we must recognize it throughout the entire depreciation period of the fixed asset. Of course, we cannot record the amount received directly in equity - e.g. reserve capital or supplementary capital. Note, however, that in fact the entire value of the subsidy received will increase the level of equity, but only after the end of the depreciation period of the fixed asset (or intangible asset) that is the subject of the subsidy.

Going beyond Polish accounting, we have International Accounting Standard 20 (IAS 20 Accounting for Government Grants and Disclosure of Government Assistance). It is generally compliant with the Act, but we have one exception. Well, apart from the close arrangement described in the AA (i.e. the value of the subsidy after liabilities and the value of the fixed asset after assets separately), we have an additional option of alternative settlement - the close arrangement: the net value of the fixed asset will be recorded at the acquisition cost less the value of the subsidy received - i.e. there will be no deferred income. In the extreme case (government generosity...) of the level of subsidy equal to the acquisition cost, this could mean that the net value of the asset would be recorded at zero...

Returning to our example of a specialized machine purchased at the end of 20X0 for 10.5 million PLN (with a subsidy of 7 million PLN and a depreciation period of 7 years), according to the alternative approach, we would recognize the specialized machine at a value of 3.5 million PLN and the depreciation would be annually in the amount of 0.5 million PLN. And so, as of December 31, 20X6, in our "close formation", the net value of machine X would be 0.5 million PLN; as a reminder, in the "open order", machine

IAS 20 is more detailed regarding the need to repay the grant. If, for various reasons, we have not complied with the terms of the subsidy and we must return it (in whole or in part), then:

• in the "closed order", the value of the returned subsidy (in whole or in part) first reduces the accruals of revenues, and any surplus is written off as costs (from the point of view of the AA, other operating costs);

• in a "compact arrangement", the value of the returned subsidy first increases the net value of the "subsidized" fixed asset, and then an additional depreciation cost is recognized so that the total depreciation of the fixed asset is at the level of depreciation in the absence of the subsidy.

In our example, if at the end of 20X5 we had to return the subsidy in full amount of 7 million PLN, then:

• in a staggered pattern, taking into account that the unsettled value of the subsidy in deferred income (after 5 years) is 2 million PLN, we first reduce this 2 million PLN to zero and write off the surplus of 5 million PLN (7-2) as costs; note that the 5 million PLN that will now appear in costs will be a mirror image of 5 million PLN that previously appeared in revenues - 5 years x 1 million PLN;

• in a compact formation, first we add 7 million PLN to 1 million PLN of the net value of machine we receive 8 million PLN; and now we are to make an additional depreciation write-off so that the total amortization is the same as in the situation without the subsidy - we already have amortization of 2.5 million PLN (10.5 - 8; without the subsidy, the total amortization would be 7.5 million PLN (5 years x 1.5 million PLN annual depreciation) - that is, we recognize an additional depreciation cost of 5 million PLN (7.5 - 2.5). 

What else is a subsidy under IAS 20? The subsidy also applies to receiving a loan or credit with an interest rate below the market level. The value of the subsidy is exactly equal to the difference between the funds received under a preferential credit or loan and the fair value of the financial liability under this credit or loan.

A simple example illustrating this type of subsidy - company B receives a zero-interest loan from a government institution in the amount of 12.1 million PLN, which is to be repaid in two years; let's assume the market interest rate is 10%. In such a situation, the value of the subsidy is equal to 2.1 = 12.1 - 12.1 x (1+10%)^(-2) = 12.1 - 10 - i.e. the funds received minus the present value of the payment of 12.1 million PLN for two years. This value of 2.1 million PLN will be recognized in accrued income at the moment of receiving the loan. How will it be settled? The value of 1 million PLN and 1.1 million PLN should be settled in other operating income in years 1 and 2, respectively. The values ​​were calculated as follows:

• 1 year – fair value of the liability at the beginning of 1 year 10 million PLN x 10% = 1 million PLN;

• Year 2 - fair value of the liability at the beginning of year 2 11 million PLN x 10% = 1.1 million PLN.

The fair value of the liability at the beginning of year 2 is 12.1 x (1+10%)^(-1) - the present value of the payment 12.1 million PLN per year with an interest cost of 10%. Please note that the financial costs of the loan recognized in the profit and loss account will be exactly 1 million PLN and 1.1 million PLN in years 1 and 2, respectively. As a consequence, the effect of the loan received on preferential terms on the entity's net result will be zero.

What does US GAAP say about grant settlements? To the best of my knowledge, there are no strict regulations regarding grant accounting in US GAAP. At the same time, given the "cult" of fair market value in US GAAP, the compact arrangement allowed as an alternative in IAS 20 (artificially lowering the initial value of the asset that is the subject of the grant) is not allowed.

Why the third dimension of subsidies?

Art. 3 section 1 point 20) AA defines liabilities as the obligation to provide services of a reliably determined value resulting from past events, which will result in the use of the entity's existing or future assets.
This means that we have three conditions:
1. The occurrence of a past event
2. The obligation to perform a benefit (resulting from a past event), which will result in the use of the entity's existing or future assets
3. The benefit is of a reliably determined value
Provisions and, in accordance with point 21), are liabilities, whose maturity date or amount is uncertain. The situation with equity is a bit worse - there is no clear definition in the AA. We can use the definition of net assets in Art. 3 section 1 point 29) of the AA, which states that net assets mean the entity's assets less liabilities, corresponding in value to its own capital (fund). The conclusion is simple - everything that is not a liability should be included in equity on the liabilities side.

As we know, subsidies settled in the AA are part of deferred income, which are to be included in the group of liabilities, liabilities and provisions for liabilities. And here we have a philosophical problem. The second condition - "an obligation to perform a performance (resulting from a past event) that will result in the use of the entity's existing or future assets" - is usually not met. We have received a subsidy and generally we should meet the conditions of the subsidy agreement (e.g. operation of the entity for a certain period of time or maintaining employment), but this does not constitute an obligation to provide services - we are not obliged in connection with the subsidy agreement to pay anyone money or to provide services. Of course, the fulfillment of the third condition - the benefit is of a reliably determined value - is equally questionable - we do not have a benefit, so it is difficult to talk about the reliably determined value of the benefit.

Generally, subsidies recognized in deferred income are not liabilities - they are simply an accounting entry. Assuming the conditions of the received subsidy are met, the value of the subsidy initially disclosed in the deferred income will gradually increase equity - other operating revenues increase the net result for the period, and the net result affects equity. This means that we can risk the thesis that subsidies recognized in deferred income are equity spread over time - this time is the depreciation period of the fixed asset subject to depreciation. In our example of specialized machine and after 7 years (at the end of 20X7), the entire value of the subsidy of 7 million PLN will be transferred to our equity capital.

So what categories of liabilities do we have? We have liabilities (and provisions for liabilities), we have equity... And we have a third category - subsidies recognized in accruals - temporarily in liabilities, and finally in equity. By the way, it is worth noting that subsidies in the AA are not so "isolated" after all. In addition to subsidies for the purchase of fixed assets, negative goodwill also appears in deferred income. It is settled similarly to subsidies (an interesting topic for a separate post). But an important caveat - just as AA and IAS 20 present similar visions on the settlement of subsidies (except for the alternative "compact arrangement"), the concepts of settling negative goodwill in AA and IAS/IFRS are completely different...

The analysis of subsidies recognized in the financial statements of the valued enterprise may be important in the company valuation process and the enterprise sale process - either by determining the normalized level of operating profits or by estimating the financing structure of the valued enterprise and determining its debt level. But more about that on another occasion...