OVERVIEW
Objective
¾
To prescribe the accounting treatment for inventories under historical cost.¾
To provide practical guidance on: determination of cost;
expense recognition (including any write-down to net realisable value); cost formulas.
BASICS
NET REALISABLE VALUE COST
RECOGNITION
¾ Objective ¾ Scope ¾ Definitions ¾ Measurement
¾ Meaning of cost ¾ Components of cost ¾ Techniques
¾ Cost formulas
¾ As an expense ¾ As an asset
¾ Need for ¾ Considerations ¾ Materials ¾ Timing
1
BASICS
1.1
Objective
¾
To prescribe the accounting treatment for inventories.¾
Primary issue – the amount of cost to be recognised as an asset and carried forward until related revenue is recognised.¾
IAS 2 provides guidance on: cost determination;
subsequent recognition as expense (including any write-down to net realisable
value);
cost formulas used to assign costs to inventories.
1.2
Scope
¾
All inventories except: contract work in progress (IAS 11); financial instruments (IASs 32 and 39);
biological assets related to agricultural activity and agricultural produce at the
point of harvest (IAS 41).
¾
These inventories are entirely outside the scope of IAS 2. Some inventories that are within the scope of the Standard with regard to disclosure, but not measurement.¾
The measurement provisions of IAS 2 do not apply to inventories held by: producers of agricultural and forest products, agricultural produce after harvest,
and minerals and mineral products, to the extent that they are measured at net realisable value in accordance with well-established industry practices;
commodity broker-traders who measure their inventories at fair value less costs to
sell.
Commentary
1.3
Definitions
¾
Inventories are assets: held for resale in the ordinary course of business (e.g. merchandise
purchased by retailer); or
in the process of production for resale (e.g. finished goods, work in
progress, raw materials); or
in the form of materials or supplies to be consumed in the production
process or rendering of services.
¾
Net realisable value is the estimated selling price in ordinary course of business less the estimated cost of completion, and estimated costs necessary to make the sale.1.4
Measurement
¾
Inventories are measured at the lower of cost and net realisable value.2
COST
2.1
Meaning of cost
¾
Cost includes all costs involved in bringing the inventories to their present location and condition.¾
Componentsof cost: purchase costs costs of conversion other costs.
2.2
Components
of cost
Purchase costs
Conversion costs
Other costs
¾
Purchase price¾
Importduties/non-refundable taxes
¾
Transport/handling¾
Deduct tradediscounts/rebates.
¾
Direct production costs¾
Production OverheadsBased On normal capacity – i.e. expected on average under normal circumstances
¾
Joint product costs(deduct net realisable value of by-products).
¾
Only if incurred in bringing inventories to present location and condition e.g. non-production overheads (e.g. storage in whiskey distillers) and specific design costs¾
The following expenditures are excluded: abnormal amounts of wasted materials, labour and other production costs; storage costs unless necessary to the production process;
administrative overheads; and selling costs.
¾
For service providers the cost of inventories consists primarily of labour including supervisory personnel and attributable overheads.Commentary
But not profit margins or non-production costs that are often factored into prices charged by service providers.
2.3
Techniques for measurement of cost
¾
Two costing methods can be used for convenience if results approximate actual cost.Standard cost
Retail method
¾
Takes into account normal levels of materials, labour, efficiency and capacity utilisation.¾
Standards must be regularly reviewed and revised as necessary.¾
For inventories of large numbers of rapidly changing items with similar margins.¾
Reduces sales value by appropriate percentage gross margin.¾
This is a practical means of measurement for financial reporting purposes.This is a management tool which may
need to be adapted to conform to IAS 2. An average percentage for each retail department is often used.
2.4
Cost formulas
2.4.1
Specific identification
¾
Specific identification of individual costs is required for: items not ordinarily interchangeable; and
goods/services produced and segregated for specific projects.
Commentary
2.4.2
Formulae
¾
Formulae are permitted where specific identification of individual costs to individual items is not practicable.¾
Formulae permitted are: First-in, first-out (FIFO) Weighted average.
FIFO formula
Weighted average formula
¾
Assumes that items purchased (or manufactured) first are sold first.¾
Therefore inventory at period end is most recently purchased or produced.¾
Determined from weighted average cost of: items at beginning of period; and cost of similar items purchased/
produced during the period.
¾
May be calculated on a periodic basis or on each additional shipment.¾
Used, for example, for: cars on a production line; retail produce with a “sell
by” (or “best before”) date.
¾
Used for like items used inproduction/sold without regard to when received.
Commentary
In practice these formulas are likely to produce similar results when price changes are small and infrequent and there is a fairly rapid turnover of inventories.
Example 1
XYZ sells telephones and is valuing its inventory at FIFO cost price at 31 December. A record of the transactions is shown below.
Bought Sold
$ $
January 10 @ $20 each 200
April 10 @ $24 each 240 May 8 @ $45 each 360 October 20 @ $30 each 600 November 20 @ $60 each 1,200
___ _______ _______
40 1,040 1,560
___ _______ ________
Required:
Solution
Example 2
Freya sets up in business on 1 September buying and selling CD players. These were purchased during the month as follows.
Quantity Price per unit
5 September 200 $150
16 September 80 $185
On 24 September Freya sold a consignment of 250 CD players for $50,000.
Required:
Calculate (a) gross profit and (b) total value of closing inventory using each of the following inventory valuation methods:
(i) FIFO; and
(ii) weighted average cost.
Solution
(a) Gross profit
(i) (ii)
FIFO Weighted
average
$ $
Proceeds 50,000 50,000
Less Cost
______ ______
Gross profit
______ ______
2.4.3
Consistency
¾
An entity must use the same cost formula for all inventories having a similar nature and use within the entity.¾
Different cost formulae may be used for inventories that have different characteristics.3
NET REALISABLE VALUE
3.1
Need for
¾
Costs of inventories may not be recoverable due to: damage; obsolescence;
decline in selling price; or
an increase in estimated costs to completion/to be incurred.
¾
Any necessary write down to net realisable value is usually on an item by item basis.Commentary
Assets are not carried in excess of amounts expected to be realised from their sale or use.
3.2
Considerations
¾
Estimates of net realisable value take into consideration: fluctuations of price or cost relating to events after the period end; the purpose for which inventory is held.
3.3
Materials
¾
Materials for use in production are not written down to below cost unless cost of finished products will exceed net realisable value.3.4
Timing
Example 3
Barnes is trying to calculate the year-end inventories figure for inclusion in his accounts. Details of his three stock lines are as follows.
Product Cost Realisable Selling
value expenses
$ $ $
Alpha 100 120 25
Beta 50 60 5
Omega 75 85 15
Required:
Calculate the value of closing inventory which Barnes should use for his accounts.
Solution
$ Alpha
Beta Omega
____
____
4
RECOGNITION
4.1
As an expense
¾
When inventories are sold, their carrying amount is recognised as an expense in the period in which related revenue is recognised.¾
Any write-down to net realisable value and all losses are recognised in the period the write-down/loss occurs.¾
Any reversal of any write-down is recognised as a reduction in expense in the period the reversal occurs.4.2
As an asset
¾
Although mentioned in IAS 18, it is appropriate to consider here the “substance over form” issue of “consignment inventory”.¾
A consignment sale is one under which the recipient (buyer) undertakes to sell the goods on behalf of the shipper (seller).¾
The IAS 18 issue is whether and when revenue should be recognised in the accounts of the shipper. An implication of this is which party should record the inventory as an asset?Commentary
This is very common in the car industry. Consignment inventory is held by the dealer but legally owned by the manufacturer.
¾
This will depend on whether it is the dealer or the manufacturer who bears the risks and benefits from the rewards of ownership.¾
Treatment – Is the inventory an asset of the dealer at delivery? If yes – the dealer recognises the inventory in the statement of financial position
with the corresponding liability to the manufacturer
If no – do not recognise inventory until transfer of title has crystallised
(manufacturer recognises inventory until then).
5
DISCLOSURE
5.1
In financial statements
¾
Accounting policies adopted in measuring inventories including cost formula used;5.1.1
Carrying amounts
¾
Total carrying amount – in appropriate classifications (e.g. merchandise, raw materials, work in progress, finished goods);¾
Carrying amount at fair value less costs to sell;¾
Carrying amount of inventories pledged as security for liabilities.5.1.2
Expense in the period
¾
The amount of inventories recognised as an expense;¾
The amount of any write-down;Illustration 1
Accounting policies Inventories
Raw materials and purchased finished goods are valued at purchase cost. Work in progress and manufactured finished goods are valued at production cost. Production cost includes direct production costs and an appropriate proportion of production overheads and factory depreciation. Movements in raw material inventories and purchased finished goods are accounted for using the FIFO (first in, first out) method. The weighted average cost method is used for other inventories.
An allowance is established when the net realisable value of any inventory item is lower than the value calculated above.
10. Inventories
In millions of CHF 2006 2005
Raw materials, work in progress and sundry supplies 3 102 3 187
Finished goods 5 164 5 193
Allowance for white-off at net realisable value (237) (218)
8 029 8 162
Inventories amounting to CHF 114 million (2005: CHF 112 million) are pledged as security for financial liabilities.
Nestl
é Consolidated accounts 2006
5.2
Expense recognition
¾
The amount of inventories recognised as an expense during the period is often referred to as “cost of sales”.EITHER OR
¾
Cost of inventories recognised as anexpense:
¾
Operating costs, applicable to revenues, recognised as an expense, classified by nature. measurement of inventory sold; unallocated production
overheads;
abnormal production costs.
¾
Costs recognised as an expense for: raw materials and consumables labour costs
other operating costs.
¾
Net change in inventories. This corresponds to the “cost of sales” or“by function” format of the statement of comprehensive income.
Key points
³
Value at lower of cost and net realisable value (NRV).³
NRV is selling price less cost to complete and sell.³
Cost includes all costs to bring inventories to their present condition and location.³
If specific cost is not determinable, use FIFO or weighted average.³
Cost of inventory is recognised as an expense in the period in which therelated revenue is recognised.
³
Any write-down is charged to expense. Any reversal in a later period is credited to income by reducing that period’s cost of goods sold.³
Required disclosures include: accounting policy carrying amount
−
by category−
at fair value−
pledged as security for liabilities amount of any reversal of a write-down
³
cost charged to expense for the period.FOCUS
You should now be able to:
¾
describe and apply the principles of inventory valuation;EXAMPLE SOLUTIONS
Solution 1 — FIFO
This is a “long-hand” solution.
Inventory after
Received Issued transaction
January 10 @ $20 each 10 @ $20 200
_____
April 10 @ $24 each 10 @ $20 200
10 @ $24 240
___ _____
20 440
___ _____
May 8 @ $20 2 @ $20 40
10 @ $24 240
___ _____
12 280
___ _____
October 20 @ $30 2 @ $20 40
10 @ $24 240 20 @ $30 600
___ _____
32 880
___ _____
November 2 @ $20 12 @ $30 360
10 @ $24 8 @ $30
___ ___
40 20
___ ___
Solution 2 — Freya
(a)
Gross profit
WORKING
Unit Unit
Units price $ Units price $
FIFO 200 × 150 30,000 Weighted 200 × 150 30,000 50 × 185 9,250 average 80 × 185 14,800
_________ _____ _________
39,250 280 44,800
_________ _____ _________
Therefore 1 160
Therefore 250 40,000
(i) (ii)
FIFO Weighted
average
$ $
Proceeds
Less Cost (W) (39,250) 50,000 (40,000) 50,000 Gross profit ______ 10,750
______
______ 10,000 ______
(b)
Closing inventory value
(i)
(iii) FIFO Weighted average
30 × 185 = $5,550 30 × 160 = $4,800
Solution 3 — Net realisable value
$ Alpha
Beta Omega
NRV Cost NRV
120 – 25 = 85 – 15 =
95 50 70
____
215
