Inventories IAS 2 IAS 2 Overview Objective and

Inventories: IAS 2

IAS 2 - Overview • • Objective and scope Measurement Expense recognition Disclosure 2

IAS 2 - Objective and Scope • The objective of this Standard is to prescribe the accounting treatment for inventories. • Standards for what costs are recognized as inventory costs and when these costs are transferred to the SOPL as expense 3

IAS 2 - Objective and Scope IAS 2 applies to all inventories, expect: a) Work in progress arising under construction contracts, including directly related service contracts (see IAS 11 Construction Contracts) b) Financial instruments (see IAS 39 Financial Instruments) c) Biological assets related to agricultural activity and agricultural produce at the point of harvest (see IAS 41 Agriculture) 4

IAS 2 - Objective and Scope Inventories are assets: (a) Held for sale in the ordinary course of business (b) In the process of production for such sale, or (c) In the form of materials or supplies to be consumed in the production process or in the rendering of services 5

IAS 2 - Measurement • Inventories are measured at the lower of cost and net realizable value (LC and NRV) • Net Realizable Value: is the estimated selling price less the estimated cost of completion and sale. • Need to know: - what costs are included - what cost formulas are permitted - how net realizable value is determined 6

IAS 2 - Measurement • 1. 2. 3. Costs included: Purchase costs Conversion costs Other inventoriable costs 7

IAS 2 - Measurement • Purchase costs – purchase price and all costs directly attributable to their acquisition such as non-refundable taxes, transportation and handling, reduced by volume discounts and rebates – if purchase arrangement effectively contains an unstated financing element, – eg a difference between the purchase price for normal credit terms and the deferred settlement amount, the difference is recognised as interest expense over the period of the financing (ie it is not added to the cost of the inventories) 8

IAS 2 - Measurement • Conversion costs - direct labor, indirect variable and fixed production overhead costs - variable production overhead: allocate to inventory based on actual usage - fixed production overhead: allocate to production based on normal operating capacity (except when abnormally high production) 9

IAS 2 - Measurement • Allocate fixed production overheads on – normal capacity if low or normal production – actual production (units) if abnormally high production (so that inventory is not measured above cost) – note: unallocated overheads are expensed when incurred • Allocate variable production overheads on actual production 10

Example • Ex: Fixed production (FP) overheads = CU 900, 000. 200, 000 units produced. Normal capacity = 250, 000 units. Allocation rate: CU 900, 000 ÷ 250, 000 units normal capacity = CU 3. 6 per unit produced. Allocate to inventories: CU 3. 6 × 200, 000 units = CU 720, 000. Unallocated overheads of CU 180, 000 are expense (ie CU 900, 000 less CU 720, 000 in inventory). 11

Example • Ex: Same as previous Ex except 300, 000 units produced. Normal capacity = 250, 000 units. Allocation rate: CU 900, 000 ÷ 300, 000 units actual production = CU 3 per unit produced. Allocate to inventories: CU 3 × 300, 000 units = CU 900, 000 12

Example - wastage • Ex: Total costs of a production run = CU 100, 000 (including a cost of normal wastage of CU 2, 000). The weakening of operating controls while the ownermanager was in hospital caused the wastage of raw materials to increase to CU 7, 000 per production run. The abnormal wastage cost of CU 5, 000 (CU 7, 000 – CU 2, 000) is not included in the cost of inventory but recognised as an expense. 13

IAS 2 - Measurement • Joint products - Allocate between products on a rational basis such as relative sales value of products when they become separable - If minor in value, do not allocate: measure byproduct at net realizable value and deduct this amount from main product costs 14

• Ex: A production process costs CU 100, 000 (including allocated overheads). It mixes base chemicals to produce: – 5, 000 litres of product A (sales value = CU 250, 000); and – 1, 000 litres of by-product C (sales value = CU 2, 000). Cost per litre of A = CU 19. 60 (ie CU 100, 000 less CU 2, 000 SP of C) ÷ 5, 000 litres = CU 19. 60. 15

• Ex: Same as in the previous Ex except, instead of by-product ‘C’ there is a joint product ‘B’. Total costs = CU 300, 000 to produce: – 5, 000 litres of A (sales value = CU 250, 000); and – 4, 000 litres of B (sales value = CU 400, 000). Allocate joint process costs on relative sales values. 16

Ex continued: Cost per litre of A = CU 23. 08 & B = CU 46. 15. Calculation A: CU 250, 000 SP of A ÷ CU 650, 000 combined SP of A & B × CU 300, 000 costs = CU 115, 385 cost of 5, 000 litres of A. CU 115, 385 ÷ 5, 000 litres = CU 23. 08. Calculation B: CU 400, 000 SP of B ÷ CU 650, 000 combined SP of A & B × CU 300, 000 costs = CU 184, 615 cost of 4, 000 litres of B. CU 184, 615 ÷ 4, 000 litres = CU 46. 15. 17

IAS 2 - Measurement • Other inventoriable costs – limited to costs to bring the inventories to their present location and condition – borrowing costs included if for a qualifying inventory item (if produced in large volumes on a repetitive basis, borrowing costs may, but are not required to be capitalized) 18

IAS 2 - Measurement Do not add to inventory cost: • Costs of abnormal waste • Storage or warehousing costs unless necessary for next stage of production • Administrative overheads not associated with production • Selling costs • Financing charges above purchase price for normal credit terms • Exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency 19

IAS 2 - Measurement • Cost formulas permitted should: - Assign recent costs to ending inventory - Correspond closely with the actual physical flow of the goods and services - Three permitted: Specific identification, First-in, first-out, and weighted average - The Standard does not permit the use of the last-in, first-out (LIFO) formula to measure the cost of inventories. 20

IAS 2 - Measurement Specific identification: l IASB requires in cases where inventories are not ordinarily interchangeable or for goods and services produced or segregated for specific projects. u Cost of goods sold includes costs of the specific items sold. u Used when handling a relatively small number of costly, easily distinguishable items. u Matches actual costs against actual revenue. u Cost flow matches the physical flow of the goods. 21

IAS 2 - Measurement FIFO and weighted average: • FIFO – cost of latest purchases ends up in cost of ending inventory, cost of earliest purchases are in cost of goods sold • Weighted average – weighted average cost of all goods available for sale ends up in both ending inventory and cost of goods sold 22

IAS 2 - Measurement • An entity shall use the same cost formula for all inventories having a similar nature and use to the entity. • For inventories with a different nature or use, different cost formulas may be justified. 23

IAS 2 - Measurement • Inventories reported at the LC and NRV • Why? So not reported at more than the future cash flows into the company from their sale • NRV = the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs to make the sale 24

IAS 2 - Measurement LC and NRV example: • Cost • Selling price • Cost to complete • Cost to sell NRV: $84 - $5 - $8. 40 = LC and NRV = $ 80 $ 84 $ 5 10% of SP $70. 60 25

IAS 2 - Measurement • Write-downs are recognized in profit or loss • Subsequent write-ups permitted to maximum of prior write-downs if: - changed economic circumstances and NRV has increased, prior situation no longer exists • Reversals also taken to profit or loss 26

IAS 2 – Expense Recognition • Carrying amount of inventory sold is expense in same period as the related revenue • Inventory adjustments (losses, write-downs to lower of cost and NRV, write-down reversals, etc. ) are recognized as an adjustment to the expense recognized in the period 27

LCNRV Illustration of LCNRV: Jinn-Feng Foods computes its inventory at LCNRV (amounts in thousands). LO 1

LCNRV Methods of Applying LCNRV LO 1

LCNRV Methods of Applying LCNRV u In most situations, companies price inventory on an itemby-item basis. u Tax rules in some countries require that companies use an individual-item basis. u Individual-item approach gives the lowest valuation for statement of financial position purposes. u Method should be applied consistently from one period to another. LO 1

Recording Net Realizable Value Illustration: Data for Ricardo Company Cost of goods sold (before adj. to NRV) Ending inventory (cost) Ending inventory (at NRV) Loss Method Loss Due to Decline to NRV COGS Method Cost of Goods Sold € 108, 000 82, 000 70, 000 12, 000 Inventory (€ 82, 000 - € 70, 000) Inventory 12, 000 LO 1

Recording Net Realizable Value Partial Statement of Financial Position LO 1

Recording Net Realizable Value Income Statement

LCNRV Use of an Allowance Instead of crediting the Inventory account for net realizable value adjustments, companies generally use an allowance account. Loss Method Loss Due to Decline to NRV Allowance to Reduce Inventory to NRV 12, 000 LO 1

Use of an Allowance Partial Statement of Financial Position LO 1

LCNRV Recovery of Inventory Loss u Amount of write-down is reversed. u Reversal limited to amount of original write-down. Continuing the Ricardo example, assume the net realizable value increases to € 74, 000 (an increase of € 4, 000). Ricardo makes the following entry, using the loss method. Allowance to Reduce Inventory to NRV Recovery of Inventory Loss 4, 000 LO 1

IAS 2 - Disclosures needed for: • Accounting policies applied • Inventory remaining on statement of financial position • Inventory costs recognized in profit or loss 37

IAS 2 - Disclosure Balance sheet related disclosures: • Carrying amount in each category of inventory (materials, WIP, finished goods, production supplies, merchandise) and in total • Carrying amount of any inventory measured at fair value less costs to sell • Carrying amount of inventory pledged as collateral for liabilities 38

IAS 2 - Disclosure Income statement related disclosures: • Amount of inventory recognized as an expense (usually cost of sales/cost of goods sold) • Amount of write-downs to NRV or other losses • Amount of any write-down reversals • Circumstances that resulted in reversals 39