Workbook on IAS 2 Inventories

INTRODUCTION

Aim

The aim of this workbook is to assist the individual in understanding Inventories according to IFRS. Inventories are the subject of International Accounting Standard 2.

It does not apply to:

1. Work in progress arising from Construction Contracts
2. Financial Instruments
3. Biological assets related to agriculture and agricultural produce at the point of harvest.
4. Commodity broker-traders who measure their inventories at fair value less costs to sell. When such inventories are measured at fair value less costs to sell, changes in fair value less costs to sell are recognised in the income statement in the period of the change.
5. Producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, when they are measured at net realisable value in accordance with well-established practices in those industries. When such inventories are measured at net realisable value, changes in that value are recognised in the income statement in the period of the change.

Measurement 

Inventories must be measured at the lower of cost and net realisable value.

COST OF INVENTORIES

A key issue in accounting for inventories is the amount of cost to be recognised as an asset and carried forward until the related revenues are recognised.

The cost of inventories comprises all costs of production, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

COSTS OF PURCHASE

These comprise the purchase price, transport and handling costs. Taxes and import duties are included, unless they can be reclaimed from the authorities. Trade discounts and rebates are deducted from the costs.

COST OF CONVERSION

These are production costs, such as direct labour. They also include a systematic allocation of production overheads.

Fixed production overheads are those indirect costs that remain virtually unchanged at different levels of production. Examples are factory rent, management and administration.

Variable production overheads are those indirect costs that vary directly with different levels of production, such as indirect labour and indirect materials.

The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities. This is the average expected output over a number of periods, taking into account production reductions due to planned maintenance. 

Example: planned maintenance

Each August, you close the factory for routine maintenance and cleaning. You take account of this by dividing the fixed production overheads by the number of actual production days over the year, rather than the calendar days. On Saturdays, you work only half a day. 

Your calculation of actual production days should count each working Saturday as only half a working day.

Low production levels, or idle plant are not taken into account in determining the allocation rate of fixed production overheads. 

Unallocated overheads are recognised as an expense in the income statement, in the period that they are incurred. In periods of abnormally-high production, the overhead allocation rate is reduced, so that inventories are not measured above cost.

Example: normal overhead allocation

You factory works overtime every night and weekends for 2 months to complete a special order. 

This order is a low margin order that has a sales value of $500 per unit. 

Your direct costs are $400 per unit. 

Your normal overhead allocation would be $250 per unit. For this order, this level of allocation would create a loss of $150 per unit ($500-$400-$150). 

Normal output of the factory = 10.000 units per week. This recovers $2.5m per week (10.000 * $250) of fixed overheads.

The new level of output is 55.000 units per week.

To recover the $2.5m overhead, the overhead allocation can be reduced to 

$45.455 per unit ($2.5m/55.000)

This lower overhead allocation allows a profit of ($500-445.455) = $54.

Variable production overheads are allocated to each unit of production, based on the actual usage of the facilities.

BY-PRODUCTS

Most by-products are immaterial. If this is the case, then they are measured at net realisable value, and this value is deducted from the cost of the main product.

JOINT PRODUCTS

Where two, or more, main products are produced, but the costs of conversion cannot be separately identifiable, these costs are allocated on a rational and consistent basis.  

You may use the relative sales value of each product, either when they are complete, or when they are separately identifiable in the production process.

OTHER COSTS

Other costs can only be included in the cost of inventory if they are incurred in bringing the inventories to their present location and condition. 

These would include inward transport and storage prior to completion of production, and specific design work required for a special client. 

In limited cases, borrowing costs can be included in the cost of inventories. 

These are covered in IAS 23 Borrowing Costs. Where you buy goods on deferred settlement terms, and the price includes a financing element, that financing element is recognised as interest expense over the period of credit.

COSTS EXCLUDED FROM INVENTORIES

Examples of costs expensed in the period that they are incurred are:

- Abnormal amounts of wasted materials, labour and other production costs.

- Storage costs for finished goods.

- General administration costs.

- Selling costs.

COST OF INVENTORIES OF A SERVICE PROVIDER

Where providers of services have ‘inventories’, they usually comprise work in progress that has not yet been billed to clients. Costs relating to sales and general administrative personnel are not included, but recognised as expenses in the period that they are incurred. The cost of inventories should not include profit margins that will be charged when the work is billed.

MEASUREMENT OF COST

Standard costs should be based on normal levels of output, and should be reviewed and revised regularly.

The cost of inventories of products that are not ordinarily interchangeable and goods, or services, produced and segregated for specific projects shall be assigned by using specific identification of their individual costs.

Specific identification of cost means that specific costs are attributed to identified items of inventory. This applies for items that are segregated for a specific project, regardless of whether they have been bought or produced. 

Specific identification of costs is inappropriate when there are large numbers of items of inventory that are ordinarily interchangeable. The method of selecting those items that remain in inventories could be used to obtain predetermined effects on profit.

COST FORMULAS

The cost of inventories should be measured on a first-in, first-out (FIFO) or weighted-average cost basis. 

Last-in, first-out (LIFO) is not an acceptable method. 

All inventories of a similar nature should use the same measurement system, regardless of their geographical location, or tax system.

Example:

Your group produces mobile phones. Your European subsidiaries use FIFO, your Asian subsidiaries use weighted-average cost and your US subsidiaries use LIFO for inventory valuation. 

For IFRS group accounts, all inventories need to be valued using FIFO or weighted-average cost (though not a mixture of the two).

FIFO

FIFO assumes that the first items bought are the first items sold. Therefore, at the end of the period, any items in inventory are the items purchased (or produced) most recently.

WEIGHTED-AVERAGE COST

The weighted-average cost is calculated from the inventory at the start of the period, plus any items bought (or produced) during the period.

The “Retail Method’’

The retail method is often used in the retail industry for measuring inventories of large numbers of rapidly changing items with similar margins for which it is impracticable to use other costing methods. 

The cost of the inventory is determined by reducing the sales value of the inventory by the appropriate percentage gross margin. 

The percentage used takes into consideration inventory that has been marked down to below its original selling price. An average percentage for each retail department is often used.

NET REALISABLE VALUE

There is a risk that inventories will be sold for less than their cost. 

Reasons include:

- General fall in market prices for the goods.

- Damage to the goods.

- Obsolescence.

- Additional costs needed to complete manufacture.

(Please see the following 4 examples)

If the price at which inventories will be sold is less than the current cost, allowing for completion costs, the value of the inventory will be reduced to its net realisable value. 

This recognises the future loss immediately.

Items should be reviewed individually for write-downs to net realisable value.

Inventories are usually written down to net realisable value item by item. 

In some circumstances, however, it may be appropriate to group similar or related items. This may be the case with items of inventory relating to the same product line that have similar purposes or end uses, are produced and marketed in the same geographical area, and cannot be practicably evaluated separately from other items in that product line. 

Service providers generally accumulate costs in respect of each service for which a separate selling price is charged. Therefore, each such service is treated as a separate item.

Estimates of net realisable value should be based the best evidence available. Events after the period that have an impact on price or costs should be taken into account.

Where inventories are only going to be used for existing contracts, the selling prices of those contracts are the bases for decisions.

Where inventories are more than those needed to fulfil existing contract orders, general selling prices should be considered for the valuation of the extra inventory.

Materials used in production are not written down below cost, if the finished goods (in which they will be incorporated) will be sold at a profit. 

If the price of the finished goods does decline, as the result in the fall in the price of materials, then the materials will be written down in value. The replacement costs of the materials may be the best valuation of their net realisable value.

REVIEWS OF NET REALISABLE VALUE

A review of net realisable value of ALL inventory should be made in each period. Where selling prices have improved and written-down items remain in inventory, write-downs can be partly, or wholly, reversed.

The new carrying value is the lower of cost and net realisable value.

RECOGNITION AS AN EXPENSE

When inventories are sold, the carrying amounts of the inventories are recognised as an expense in the period that the revenue is recognised.

Any write-down or reversal of write down of inventories to net realisable value is recognised as an expense immediately it is incurred. 

Any inventory transferred to other asset accounts, such as parts of self-constructed property, are recognised and expensed over the useful life of that asset.

DISCLOSURE

The financial statements shall disclose:

1. the accounting policies adopted in measuring inventories, including the cost formula used;
2. the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity;
3. the carrying amount of inventories carried at fair value less costs to sell;
4. the amount of inventories recognised as an expense during the period;
5. the amount of any write-down of inventories recognised as an expense in the period; 
6. the amount of any reversal of any write-down that is recognised as a reduction in the amount of inventories recognised as expense in the period;
7. the circumstances or events that led to the reversal of a write-down of inventories; and
8. the carrying amount of inventories pledged as security for liabilities.

Information about the carrying amounts held in different classifications of inventories and the extent of the changes in these assets is useful to financial statement users. 

Common classifications of inventories are merchandise, production supplies, materials, work in progress and finished goods. 

The inventories of a service provider may be described as work in progress.

The amount of inventories recognised as an expense during the period, which is often referred to as cost of sales, consists of those costs previously included in the measurement of inventory that has now been sold and unallocated production overheads and abnormal amounts of production costs of inventories. 

The circumstances of the entity may also warrant the inclusion of other amounts, such as distribution costs.

Some entities adopt a format for the income statement that results in amounts being disclosed other than the cost of inventories recognised as an expense during the period.

Under this format, an entity presents an analysis of expenses using a classification based on the nature of expenses. In this case, the entity discloses the costs recognised as an expense for raw materials and consumables, labour costs and other costs together with the amount of the net change in inventories for the period.