IFRS

Q&A: IAS 2 Inventories

September 30, 2016
IAS 2 Inventories

We are very likely engaged in the audit or job in valuation of inventories. During this engagement we need to identify accounting treatments, specify cost of inventory, identify cost formula, calculation of NRV.

Sometimes need to identify the effect of opening and closing inventory on gross margin and net profit in the income statement and the balance sheet figure for the inventory. And to resolve these issues, we face many questions.

What may be those questions? And what will be the answers of those questions?

Let’s try to figure out those questions and answers for a while.

What are the inventories?

Inventories include:

  • Finished goods: held for sale in the ordinary course of business
  • Work in progress (WIP): in the process of production for sale
  • Raw materials or supplies: awaiting for using in the production process

But except:

  • WIP arising under construction contracts in accordance with BAS 11 Construction Contracts
  • Financial instruments
  • Biological assets related to agricultural activity and agricultural produce at the point of harvest in accordance with BAS 41 Agriculture

Self-test

If an entity constructed a property with the intention to sell and then leases prior to sale then whether it will be recognized as inventory or as investment property?

How are inventories measured?

Inventories shall be measured at the lower of cost and NRV.

Cost of inventories includes cost of purchase, cost of conversion and other costs incurred in brining the inventories to their present location and condition.

At the time of determination of cost of purchase, import duties and taxes should be deducted if these are subsequently recovered from the taxing authority. And also trade discount, rebates and other similar items are deducted from cost of purchase.

For manufacturing company, cost of conversion of inventories is more complex to determine. Complexity arises at the time of allocation of fixed production overheads.

It is allocated on the basis of normal capacity of the production which is predetermined.

Here, normal capacity means production level expected to be achieved on average over a number of periods or seasons under normal circumstances.

After actual production there is a differences found between normal capacity and actual production which is treated as variance.

Problems arise when abnormally high or below production occurred in the company.

Complexity also arises when more than one product being produced simultaneously.

In that case if the cost of conversion of each product is not separately identifiable, then they are allocated between the products on a rational and consistent basis.

But at the time of by-product, it is very easy to determine cost of conversion by deducting net realizable value of such by-product.

Note that abnormal cost for wastage of materials or labour, storage costs, administrative overheads and selling costs are excluded from cost of inventories and recognized as expenses.

Sometimes, companies purchase inventories on deferred settlement terms which contain a fincning element.

In this case the difference between the purchase price for normal credit terms and the amount paid is recognized as interest expenses, not included with cost of inventories.

Self-test

  • If an entity does operating lease costs i.e. rentals or amortization of lease which is part of the cost of constructing a building then what will be the accounting treatment under IAS 2 Inventories?
  •  An entity purchase a property which consists land and building with the intention of demolishing the existing building with replace a new building and the entity will not use prior its demolition which will be sold in the ordinary course of the entity’s business then what will be the accounting treatment?
  • If an entity holds collectibles i.e. paintings, sculpture for short-term investment purposes and trades these collectibles in the ordinary course of business then what will be the accounting treatments?

How is NRV calculated?

Sometimes, cost of inventories may not be recovered due to damage, obsolete or price decline etc. in that case the inventories are write down to NRV item by item not on the basis of classification of inventory i.e. finished goods or all the inventories in a particular operating segment.

NRV requires estimating the price which may fluctuate and therefore need to confirm conditions exist at the end of the period.

Sometimes, materials and supplies decline not the finished goods then it’s not required to write down cost of inventories.

But if it indicates cost of finished goods exceeds NRV then materials and supplies are write-down to NRV by following replacement cost which may be the best available measure.

But if after write down the cost of inventories, the value of NRV increase then the amount of the write down is reversed but limited to the amount of the original write-down.

Self-test

When assessing net realizable value, are costs of overhead will be considered as costs necessary to make the sale?

How is cost calculated?

Standard cost method or retail cost method may be used to calculate the cost of inventories. Standard cost take into account normal levels of production.

Retail method is often used in the retail industry where inventories of large numbers are changed rapidly.

The cost of the inventory is determined by reducing the sales value of the inventory by the appropriate percentage gross margin. An average percentage for each retail department is often used.

Self-test

When applying the retail method, the impairment loss of inventories calculated using fixed margin applied to inventory valuation?

Which cost formulas will be followed?

The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using FIFO or weighted average cost formula.

Similar cost formula shall be used for similar nature and use of inventories by the entity.

Different formula is justified for different nature and use of inventories.

Note that the average cost under the WAC may be calculated on a periodic basis or when each additional shipment is received.

LIFO is not permitted under this standard.

When inventories are recognized as an expense?

When inventories are sold, the carrying amount of those inventories shall be recognized as an expense at the time of revenue recognision.

Write down or loss occurs during the period shall be recognized as an expenses and any reversal of any write down of inventories shall be reduced in the amount of inventories recognized as an expense in the period in which the reversal occurs.

Self-test

  • The circumstances under which an item of inventory must/may be allocated to PPE? Then how the expenses will be recognized?
  •  If revaluation occurred, is the “revalued depreciation” used for inventory valuation, or is historical cost-based depreciation also permitted for inventory valuation?

 Extra help:

  • Website for more resources
  • Form a study group with other students, help each other and study together
  • Work with a qualified or at least know the standard well, who is willing to help if you have questions
  • Contact with tutors

I begin with an idea and then it becomes something else.—-Pablo Picasso.

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