Financial Reporting

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Inventories

Entities in various shapes and forms will have inventory: manufacturing companies, retail outlets, major PLC’s – there are lots and lots of such entities. Students of financial reporting papers that examine IAS 2 will think of the standard as largely basic – but is it?

This article by Steve Collings takes a look at IAS 2 and what it is all about.

Firstly, it is important to understand exactly what ‘inventories’ are. Inventories are assets:

• Held for resale in the ordinary course of business;

• In the process of production for resale; or

• In the form of material or supplies to be consumed in the production process or the rendering of services.

Students will be familiar with the core aspect of IAS 2, which is to value inventories at the lower of cost or net realisable. This is a very familiar phrase and is common in most GAAP (UK SSAP 9 also requires such a valuation).

Cost

It is important that students understand what constitutes ‘cost’ under IAS 2. Under the provisions of IAS 2, cost comprises the following:

• Purchase costs

• Costs of conversion

• Other costs

Purchase costs are the actual cost of the inventories but should also include any non-refundable taxes or import duties. In addition, transport and handling costs should be brought into the cost of inventories. Where an entity receives discounts or rebates then these should be deducted from the actual cost of inventories. Remember, therefore, it is important that students understand that there may be more to the cost of an item of inventory than initially meets the eye.

Costs of conversion are costs such as direct production costs or production overheads.

Other costs should only be recognised in inventory valuation if such costs have been incurred in bringing inventories to their present location and condition.

Costs should not include:

• Abnormal amounts of wasted materials, labour and other production costs;

• Storage costs unless necessary to the production process;

• Administrative overheads; and

• Selling costs.

Net Realisable Value

Net realisable value is the estimated selling price of inventories in the ordinary course of business less the estimated costs of completion and estimated costs which would be incurred in making the sale.

Measuring Cost

There are two costing methods which can be used in measuring cost – standard cost and the retail method.

Standard cost takes into account normal levels of materials, labour, efficiency and capacity utilisation. Entities that apply standard cost will need to regularly review their standards and should be revised if deemed necessary.

The Retail Method is often used for measuring inventories of large numbers of rapidly changing items that have similar margins and for which it would not be practical to use other costing methods. The retail method works by reducing the sales value of the inventory by the appropriate percentage gross profit margin.

Where specific identification of individual costs to individual items is not practicable, then IAS 2 permits two formulae:

• First-in, first-out (FIFO); and

• Weighted average.

It should be noted at this point that students who have studied other financial reporting papers under UK GAAP (SSAP 9) will have come across an additional permitted formulae, being that of last-in, first-out (LIFO) which is still permitted under UK GAAP. Students studying international streams should be aware that IAS 2 does not permit the use of LIFO. This formulae was prohibited because it does not assign up to date costs to inventory.

FIFO

FIFO assumes that items purchased or manufactured first are subsequently sold first resulting in inventory at the reporting date should be the most recently purchased or produced inventory. FIFO is often used in the food industry where products have a ‘sell by’ date.

Weighted Average

This formulae assumes a weighted average and is determined from weighted average costs of items at the beginning of the period and the cost of similar items purchased or produced during the period.

Worked Example 

Gabriella Inc started in business on 1 September 2008 buying and selling chairs. During the month of September, Gabriella Inc recorded their inventory as follows:

Purchases 

5 September purchased 200 chairs at $150 per chair.

16 September purchased a further 80 chairs at $185 per chair.

Sales

Gabriella Inc sold 250 chairs on 24 September for $50,000.

Required

Calculate the gross profit made on the chairs and determine the value of closing inventory for Gabriella Inc using FIFO and weighted average formulae.

Solution

FIFO – Gross Profit Calculation

200 chairs @ $150 per chair = $30,000

50 chairs @ $185 per chair = $ 9,250

250 $39,250

Sales value ($50,000)

Gross profit $10,750

Weighted Average – Gross Profit Calculation

200 chairs @ $150 per chair = $30,000

80 chairs @ $185 per chair = $14,800

280 $44,800

Now we work out how much 1 chair would be as (44,800 / 280) = $160, therefore we sold 250 chairs on 24 September, so the ‘cost’ using a weighted average formulae would be (250 chairs @ $160 per chair) is $40,000. We can now work out the gross profit as follows:

Sales value $50,000

Cost (weighted average) ($40,000)

Gross Profit $10,000

Closing Inventory Value – FIFO

We have bought 280 chairs and sold 250 chairs, resulting in 30 chairs left in inventory, so:

30 chairs x $185 = $5,550

Closing Inventory Value – Weighted Average 

30 chairs x $160 = $4,800

Consignment Issues

Students dealing with financial reporting papers will often hear the phrase ‘substance over form’ and this is a particular important concept to comply with when dealing with consignment issues.

A consignment sale is one where the buyer agrees to sell goods on behalf of the shipper. This is extremely common in the motor industry – for example a dealership will sell vehicles on behalf of the manufacturer.

Care needs to be taken with these issues because the key question in such transactions is who is to record consignment inventory as an asset in their statement of financial position?

Under the concept of ‘substance over form’ we have to look at who bears the risks and rewards of ownership of the inventory. So in our example above, does the motor dealer record the vehicles as inventory in their statement of financial position or not?

If the risks and rewards of ownership pass to the dealer then the dealer will recognise the inventory in their statement of financial position together with a corresponding liability to the manufacturer.

If, on the other hand, the dealer does not bear the risks and rewards of ownership then they will not recognise the inventory in their statement of financial position. Instead, the manufacturer will recognise the inventory in their statement of financial position.

Conclusion 

This article has looked in some depth at the provisions laid down in IAS 2. You can see that there is more to the standard than simply saying that an item of inventory should be valued at the lower of cost or net realisable value. Students need to be able to address what components comprise cost and what determines net realisable value. Students should also have an appreciation as to how to account for consignment issues.

Steve Collings FMAAT ACCA DipIFRS is Audit and Technical Manager at Leavitt Walmsley Associates Ltd and a partner in AccountancyStudents.co.uk. He is also the author of ‘The Core Aspects of IFRS and IAS’.