FUNDAMENTALS OF IFRS

Transcription

1 7.1 CHAPTER 7 Inventories (IAS 2)

2 7.2 CHAPTER SEVEN INVENTORIES (IAS 2) Introduction Inventories are assets: Inventories (IAS 2) held for sale in the ordinary course of business in the process of production for such sale; or form of materials or supplies to be consumed in the production process or in the rendering of services. Inventories encompass goods purchased and held for resale including, eg, merchandise purchased by a retailer and held for resale, or land and other property held for resale. Inventories also encompass finished goods produced, or work in progress being produced, by the entity and include materials and supplies awaiting use in the production process. Costs incurred to fulfill a contract with a customer that do not give rise to inventories (or assets in the scope of another standard) are accounted for in accordance with Revenue from Contracts with Customers. This standard distinguishes between net realisable value and fair value. Net realisable value It is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Therefore, it is the net amount that an entity expects to realise from the sale of inventory in the ordinary course of business. Fair value It is the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. It reflects the amount for which the same inventory could be exchanged between knowledgable and willing buyers and sellers in the marketplace. The point to note is that where the net realisable value is an entity-specific value, fair value is not. Net realisable value for inventories may not be equal to fair value less costs to sell. Example 1 At the end of the reporting period an entity has 5,000 quintals of inventory. The company has to sell 70% of the inventory to the Government at 125 per quintal and the remaining 30% can be sold in the market (estimated price 250 per quintal). The cost of the inventory is 150 per quintal. Per Quintal Valuation For inventory to be sold : to government in the open market Cost Net realisable value Value of inventory (lower of the above) Net realisable value is the amount that can be obtained by the entity from sale of inventory. For 70% of the inventories to be sold to the government, net realisable value is 125 per quintal. For the rest 30% to be sold in the market, the net realisable value is the amount that a buyer would normally be ready to give in an arm s length transaction, ie, 250 per quintal. The fair value of the inventory is the amount that the entity will fetch in the open market for 250 per quintal. Therefore, for the 70% net realisable value is not equal to its fair value whereas, for the rest 30% both values are the same.

3 7.3 Measurement Inventories shall be measured at lower of cost and net realisable value. Inventories are usually written down to net realisable value, item by item or in groups of similar items where it is not practical to evaluate separate items. Cost of inventories Cost of inventories will include all the direct costs incurred for acquisition, conversion and bringing the same to their present location and condition. Costs of Purchase Costs of purchase include costs directly attributable to the acquisition of finished goods, materials and services which comprise purchase price, import duties and other taxes, transportation costs, handling and other costs. In case of taxes which are subsequently recoverable by the entity from the taxing authorities are not included in the cost of inventories. Trade discounts, rebates and other similar terms need to be deducted in determining cost of purchase. Example 2 An entity purchases 1,000 units of 5 per unit. The amount of commission and transportation charges are 100 and 300 respectively. The entity estimates a normal loss of 10%. The computation of cost per unit of inventory is as follows : Particulars Total cost of inventory Amount Purchases (1,000 x 5) 5,000 Commission 100 Transportation charges 300 Total Cost 5,400 Per unit cost of inventory Total units purchased are 1,000. Normal loss is calculated at 100 units (10% on 1,000). Total number of units are 900 (1, ). Therefore, the cost per unit of inventory is 6 (5, ). Costs of conversion Costs of conversion includes direct costs related to the production process and a systematic allocation of fixed and variable overheads that are incurred in converting materials to finished goods. Variable production overheads include indirect materials and indirect labour that vary directly, or nearly directly, with the volume of production. Fixed production overheads include indirect costs that remain relatively constant regardless of the volume of production, eg, depreciation, maintenance of factory buildings and equipment, cost of factory management, etc. Allocation of fixed production overheads to the costs of conversion is based on the normal capacity of production facilities. Normal capacity is the production expected to be achieved on an average over a number of periods or seasons under normal circumstances, taking into account loss of capacity resulting from planned maintenance. Unallocated fixed overheads should be recognised as expenses in the period in which they are incurred. In case of production beyond the normal capacity, the fixed overhead per unit of production is reduced to avoid measuring inventories above cost. Variable production overheads are allocated to each unit of production on the basis of the actual use of the production facilities. Example 3 An entity pays a monthly rent of 5,000. The optimum monthly production is 1,000 units. During May 2012, the production was 960 units only. In June, the entity produced 1,150 units. continued...

4 7.4 CHAPTER SEVEN INVENTORIES (IAS 2)... continued Fixed production overhead per unit is 5 (5,000 1,000). In May, fixed production overhead per unit is (5, ). However, this Standard stipulates an increase in the amount of fixed overhead allocated to each unit of production as a consequence of low production. Instead, the unallocated amount of fixed production overhead of 200 [5 x (1, )] shall be recognised as an expense in Statement of Profit or Loss. Therefore, the cost of inventories does not include the above amount of unallocated overheads. In June, the number of units produced is more by 150 units (1,150 1,000) than the normal capacity. In this case, the fixed overhead allocated per unit would be reduced to (5,000 1,150) in order to ensure that measurement of inventories do not exceed its cost. The following two examples will help understand the several aspects of cost determination during the conversion stage. Example 4 uses the FIFO cost formula and normal loss is a percentage on number of units introduced. Example 5 uses Weighted Average cost formula and normal loss is a percentage on number of units produced. Example 4 ABC Ltd provides the following information regarding the production in September During the month, 2,000 units were introduced into process 1 at a cost of 60,000. The normal loss was estimated at 5% of the units introduced which are expected to fetch 25 per unit, based on past experience. A total of 1,400 units were produced and transferred to the next process. 460 units were partially complete and 140 units were scrapped. It was estimated that in respect of the various factors of production, the partially complete units had reached the following stages of production Materials 100%; Labour and Overheads 50% Additional cost incurred during the month Indirect materials 17,000; Labour 33,400; Variable overheads 16,700 The units scrapped realised 40 per unit. The normal operating capacity is 2,000 units and fixed overhead relating to these is 4,000. There was no opening WIP (work in progress) for this process. Statement of Equivalent Units Materials Labour Overhead 1 2 Particulars Total Completion Units Completion Units Completion Units Completion Units Units Opening WIP 0 Normal loss 100 Abnormal loss % % 40 50% 20 50% 20 Finished units 1, % 1, % 1, % 1, % 1,400 Closing WIP % % % % 230 Total 2,000 1,900 1,900 1,650 1,650 Normal loss is 100 units (5% on 2,000). The units which were partially complete form the closing WIP. *Abnormal loss is the number of units lost over and above normal loss. Units scrapped were 140, out of which 100 units were estimated. Therefore, abnormal loss is 40 ( ) units. For computation of equivalent units, first the respective percentage of completion have been multiplied by the total units dedicated to losses, finished units, opening and closing WIP and then the units are summed up. Cost per Unit Particulars Total cost Cost per unit Material 1 60,000 Less: Scrap (100 X 25) (2,500) 57, Material 2 17, Labour 33, Overhead *20, Total 127, *The amount of overhead is 20,000 which is the summation of variable overhead of 16,700 and fixed overhead of 3,300 [(4,000 2,000) 1,650]. The normal capacity is 2,000 units whereas, the equivalent units for overhead are 1,650 which means that the entity has produced below normal capacity by 350 units (2,000 1,650). An amount of 700 [(4,000 2,000) 350)] of fixed overheads which are unallocated would be charged to Statement of Profit or Loss. continued...

5 continued... Process Particulars Dr Cr Balance Material 1 60,000 60,000 Material 2 17,000 77,000 Labour 33, ,400 Overhead 20, ,400 Normal loss 2, ,900 Finished goods 100,198* 27,702 Abnormal loss 2,863** 24,839 *The cost of finished goods is 100,198 (1, ). **The cost of abnormal loss units is 2,863 ( ). Abnormal Loss Particulars Dr Cr Balance Process account 2,863 2,863 Scrap sold 1,600 1,263* *The entity incurs a loss by selling the abnormal loss units since their cost of 2,863 exceeds the amount received by selling those at 1,600 (40 40). Example 5 ABC Ltd provides the following details relating to process 2 for the month of March 2012 : Opening stock was of 60 units (Material 1 700, Material 2 800, Labour 1,000 and Overhead 1,200). Transfer from Process 1 1,100 units at 5,500. Transfer to Process units Additions made to Process 2 Direct material 2,410; Labour 7,155; Overhead 9, units were scrapped, but the normal loss was estimated at 15% on production. Units scrapped realised 1 per unit; Normal capacity 900 units; Fixed Overhead 1,500; Closing WIP 160 units Degree of completion Particulars Material Labour and overhead Opening stock 80% 60% Scrapped units 100% 70% Closing stock 70% 60% Statement of Equivalent Units Materials Labour Overhead 1 2 Particulars Total Completion Units Completion Units Completion Units Completion Units Units Opening WIP % 60 80% 48 60% 36 60% 36 Normal loss 150 Abnormal gain* (30) 100% (30) 100% (30) 70% (21) 70% (21) Finished units % % % % 820 Closing WIP % % % 96 60% 96 Total 1,160 1, Normal loss is 150 units (15% on 1,000), which is calculated on the number of units produced, ie, 1,000 units (60 + 1, ). The units which were partially complete form the closing WIP. *Abnormal gain is the difference between the number of units anticipated to be lost and the units actually scrapped at the end of the process. Total units scrapped were 120, whereas 150 units were estimated from before. Therefore, number of units of abnormal gain is 30 ( ). For computation of equivalent units, first the respective percentage of completion have been multiplied by the total units dedicated to losses, finished units, opening and closing WIP and then the units are summed up. The percentage of completion for material 1 in process 2 is 100%. continued...

6 7.6 CHAPTER SEVEN INVENTORIES (IAS 2)... continued Cost per Unit Particulars Total cost Cost per unit Material 1 (5, ) 6,200 Less: Scrap (150 X 1) (150) 6, Material 2 (2, ) 3, Labour (7, ,000) 8, Overhead (9, , ,500) 12,150* Total 29, * The amount of overhead is 12,150 which is the summation of variable overhead of 9,450 and 1,200 (opening WIP) and fixed overhead of 1,500. The production is higher than the normal capacity which requires the entity to reduce the per unit allocation of fixed overhead from 1.67 (1, ) to 1.61 (1, ). Process Particulars Dr Cr Balance Opening WIP 3,700 3,700 Material 1 5,500 9,200 Material 2 2,410 11,610 Labour 7,155 18,765 Overhead 10,950 29,715 Normal loss ,565 Finished goods 27,438* 2,127 Abnormal gain 935** 3,062 *The cost of finished goods is 27,438 [( ) 31.18]. **The cost of abnormal gain units is 935 ( ). Abnormal Gain Particulars Dr Cr Balance Process account Loss of profit on sale of scrapped units (30 1)] * *There is a net saving of 905 after adjusting the loss from sale of scrapped units. Often more than one product is produced simultaneously, either joint products or a main product and by-product(s). Allocation of costs of conversion should be made separately, if separate identification is possible, otherwise a rational and consistent basis should be used. The allocation may be based, eg, on the relative sales value of each product either at a stage in the production process when the products become separately identifiable, or at the completion of production. Most by-products, by their nature, are immaterial. When this is the case, they are often measured at net realisable value and this value is deducted from the cost of the main product. As a result, the carrying amount of the main product is not materially different from its cost. Example 6 This is in continuation to Example 5 with the following additional information. The production process has given rise to 4 products A, B, C and D. Products A B C D Units (Nos.) Additional cost after further processing 8,000 7,500 9,000 10,500 Sale Value after processing Sale Value at the split-off point Percentage of composition (finished units) 45% 30% 20% 5% Total number of units produced after process 2 is 880 units ( ). The joint cost is 85,000. continued...

7 ... continued Other Costs Profitability after Further Processing Product Sale value Share of Additional processing Total Profit / after further joint cost cost after split-off cost (Loss) processing point A 44,352 44,534 8,000 52,534 (8,182) B 19,800 15,834 7,500 23,334 (3,534) C 8,800 20,233 9,000 29,233 (20,433) D 4,180 4,398 10,500 14,898 (10,718) Total 77,132 85, ,000 (42,868) Profitability at Spilt-off Point Product Sale value at split-off point Share of joint cost Profit/(Loss) at split-off point A 8,910 44,534 (35,624) B 3,168 15,834 (12,666) C 4,048 20,233 (16,185) D 880 4,398 (3,518) Total 17,006 85,000 (67,994) Decision regarding futher processing Product Profit/(Loss) after further processing Profit/(Loss) at split-off point Further processing A (8,182) (35,624) Yes B (3,534) (12,666) Yes C (20,433) (16,185) No D (10,718) (3,518) No Other costs include costs incurred in bringing the inventories to the required location and condition. It may be appropriate to include non-production overheads or the costs of designing products for specific customers in the cost of inventories. Some costs are expensed off rather than being included in the cost of inventories. Examples of such costs are abnormal loss; storage; administrative overheads; selling; and borrowing. Storage costs would be included in the cost of inventories, only if this expenditure is required in the production process before another production stage. Administrative overheads would become a part of the inventory cost if it is incurred for bringing the inventories to their present location and condition. Borrowing costs are generally charged as an expense but can be a part of cost of inventories in limited circumstances as mentioned in IAS 23 Borrowing Costs. As per the definition of a qualifying asset, cheese, wine etc take a substantial period of time to be ready for sale, but then again treatment of borrowing costs related to these are guided by IAS 41 Agriculture. But in the case of customised products borrowing costs may be capitalised. Example 7 An entity got an assignment to construct a ship which would take an estimated time period of 3 years. For the construction of this ship, the entity arranges a loan of 100 at 10% p.a. The borrowing cost amounting to 10 per year would be capitalised because, in this case, the borrowing cost can be easily related to the inventory and can be monitored along the period of 3 years till it is sold. 7.7 Interest expense Purchase of inventories might be on deferred settlement terms. In that case, the presence of a financing element should be disclosed and recognised as interest expense in the face of Statement of Profit or Loss. The amount related to interest expense would be the difference between the purchase price for the normal credit terms and the amount paid.

8 7.8 CHAPTER SEVEN INVENTORIES (IAS 2) Example 8 An entity purchases inventories always at 6 months credit. The price is generally 10% higher than the amount, it purchase for cash. The additional price paid is to be treated as interest costs. During 2012, it purchased inventories at 500 instead of 475 as it had to pay interest for the credit period of 6 months. This interest expense cannot be included in the cost of inventories as this is a financing element. It would be recognised in Statement of Profit or Loss. Techniques for the measurement of cost Various techniques of measurement of cost may be used for convenience such as standard cost method or retail method, provided that the results approximate actual cost. Standard cost method considers normal levels of materials and supplies, labour, efficiency, and capacity utilisation subject to regular revision. The retail industry generally uses the retail method for measuring inventories, since there are huge rapidly changing items with similar margins for which other costing methods are impracticable to use. The cost of inventories is determined by reducing the sales value of the inventory by the appropriate percentage gross margin. The retail method of inventory valuation used by retail stores in which inventory is taken at retail price and then reduced to cost price by the use of margin percentage. Example 9 The closing inventory of ABC Ltd includes inventory purchased at 90,000 of different grades, which were sorted out with their selling rate as under (all grades yield the same rate of profit) : Grade Units Selling price X 5, Y 3, Z 2,000 5 Cost per unit Grade Units Total selling price Profit Cost Cost per unit X 5,000 60,000 6,000 54, Y 3,000 30,000 3,000 27, Z 2,000 10,000 1,000 9, Total 100,000 Less: Cost of purchase 90,000 Profit 10,000 The percentage of profit on sales is 10% (10, , ). Therefore, for each grade, profit is calculated at 10% on its total selling price. The total cost for each grade is determined by deducting the profit from their individual total selling price, which when divided by the number of units gives per unit cost. Cost Formulas There are three different cost formulas that can be used depending upon the nature of inventories: Specific Identification; First In First Out; and Weighted Average. For items that are not ordinarily interchangeable in nature, and goods or services produced and segregated for specific projects, regardless of whether they have been bought or produced, Specific Identification method should be used. However, this cost formula is inappropriate for large number of ordinarily interchangeable inventories. In that case, two other cost formulas can be used, first-in first-out or weighted average method. Whichever formula an entity chooses, the same has to be used for inventories of a similar nature and use to the entity. For example, merely a difference in geographical location does not justify the use of a separate cost formula. Specific identification is a method which requires an entity to identify each unit of inventory with the unit cost and retain the identification until the inventory is sold. This method provides

9 satisfactorily cost data for the closing inventory and cost of sales. It can be adopted only when the sales of inventory can be identified with specific purchase transactions. For example, this method is used for special purpose items like electric motors purchased for large pumps and compressors. 7.9 Example 10 An entity is involved in the following transactions : Date Rate Opening inventory Purchases Issues January , , , , We assume that the business keeps careful records of each unit in its inventory. It is ascertained that 2,000 units issued to production on 17 January are taken from the purchase of 6,000 units on 7 January and 500 units taken from the opening stock of 1,000 units as on 1 January. Cost of Production Units Rate Amount 2, , Cost of Closing Inventory 3,500 Units Rate Amount , ,000 3, ,000 8,000 13,500 The cost of inventories other than those that are dealt using special identification of their individual costs shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula. 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. Example 11 Inventories used in one operating segment may have a use to the entity different from the same type of inventories used in another operating segment. However, a difference in geographical location of inventories (or in the respective tax rules), by itself, is not sufficient to justify the use of different cost formulas. The FIFO formula assumes that the items of inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. Under the Weighted Average Cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. Net Realisable Value (NRV) If the inventories are damaged or obsolete (partially or wholly) or their selling prices have declined, the amount realisable may be less than the amount recognised as cost. Sometimes, it may so happen that the estimated costs of completion or the selling costs have increased. These circumstances call for a write down of the inventories below cost to the NRV as assets these should not be carried in excess of what they are expected to realise from their sale or use.

10 7.10 CHAPTER SEVEN INVENTORIES (IAS 2) Example 12 At the end of reporting period on 31 March 2012 an entity realised that the closing inventory (purchased at 5 per unit) is not that it would choose to acquire at the market place. An equivalent product is available for 4 per unit. The closing inventory, in its present physical form, can be sold at 2.25 per unit. If the entity wants to replace the existing inventory by the new equivalent product, it has to pay an additional amount of 1.50 per unit. The entity has the following two options Sell the stock at 2.25 per unit and reacquire the stock at 4 per unit. In this case, it has to incur an additional cost of 1.75 (4 2.25) per unit; or Replace the stock by paying at 1.50 per unit. Obviously, the 2 nd option is cheaper. Therefore, the value of inventory is 2.50 (4 1.50) per unit. Write down of inventories shall be done item by item. Wherever possible, it can be done in groups if the items are similar in nature or related to each other. Any amount of write down shall be charged as an expense in the period of such write down. reversal of previous write down shall be adjusted with the cost of sales. Example 13 An entity has items of inventory which relate to the same product line. They have similar end uses which are produced and marketed in the same geographical area, and cannot be practicably evaluated separately from other items in that product line. In this case, it is appropriate for the entity to write inventories down after the items are grouped. Net realisable value is purely an estimated figure which is based on the most reliable evidence available. While making these estimates, fluctuations of price or costs directly relating to events occurring at the end of the period to the extent that such events, confirm conditions existing at the end of the period are taken into consideration. Example 14 ABC Ltd, a tea manufacturing company, had one batch of its inventory damaged after the end of the reporting period. The reason for the damage was faulty packing which was present in that inventory at the reporting date. The price of the inventory has to be reduced from 500 to 100 per kg after incurring an additional cost of 5 per kg. The inventory should be valued at 95 (100 5) per kg. Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. However, when a decline in the price of materials indicates that the cost of the finished products exceeds net realisable value, the materials are written down to net realisable value. In such circumstances, the replacement cost of the materials may be the best available measure of their net realisable value. At each subsequent period, the net realisable value needs to be reassessed. When the circumstance that led to the write down of inventories no longer exist or when there is clear evidence that the changed economic circumstances lead to an increase in the net realisable value, the amount of write down is reversed but maximum to the extent of the original write down. This is done to ensure that the valuation of inventories is always at lower of cost or net realisable value. This is possible only when inventories are specifically identifiable. For example, when an item of inventory is carried at its net realisable value as a result of decline in its selling price, it is still on hand in a particular period and its selling price has gone up. The sale of inventories after the reporting period may give evidence about their net realisable value at the end of the reporting period. This is an adjusting event as per IAS 10, which requires an entity to adjust the amount recognised as inventories in Statement of Financial Position to reflect adjusting events after the reporting period. The amount of write down of inventories to net realisable value as well as all the losses of inventories is recognised as an expense in the period when the write down or loss occurs. The

11 amount of reversal of a previous write down is recognised as a reduction in the amount of inventories recognised as an expense in the period in which such reversal takes place. As mentioned earlier, when inventories are sold, the carrying amount of inventories is recognised as an expense in the period in which its related revenue is recognised. Example 15 An entity manufactured a new premium segment car in It failed to grab a significant market share. At the end of the period, the price fell and the entity writes down the value of these cars as inventories at their net realisable value. In 2012, due to some changes in the design of the car, a rise in the net realisable value was estimated. In order to give effect to this rise in the net realisable value, the previous write down is being reversed. Cars manufactured (Nos.) 15 Cost of manufacturing 1,200 Net realisable value at 31 December ,150 Cars unsold at 31 December 2011 (Nos.) 8 Estimated net realisable value in ,175 Cars unsold at 31 December 2012 (Nos.) 3 At 31 December 2011, the amount recognised as closing inventory was 9,200 (8 1,150). The amount of write down is 400 [8 (1,200 1,150)] which is the amount by which the cost is higher than its net realisable value. At 31 December 2012, the amount of closing inventory recognised is 3,525 (1,175 3). These cars were manufactured in The net realisable value has increased to 1,175 for which the entity needs to recognise 75 [3 X (1,175 1,150)] worth of reversal of the previous write down in Statement of Profit or Loss The purpose for which the inventory is held is also a valid consideration for computation of these estimates. For example, an entity might be into several contracts which it has to satisfy at the contract determined prices even if there is a fluctuation in the market selling prices. It might be a case that an entity may have fewer inventories than what is mentioned in the contract and it satisfies the contract by purchasing them from the market at general selling prices. This may lead to an onerous contract which is guided by IAS 37. By the expression onerous contract, it means a contract where the benefits arising out of the contract is less than the costs of fulfilling the contract. The amount for which the provision is to be made is lower of the penalty to be paid for exiting the contract and the excess of costs over the benefits from the contract. Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. But in case the cost of materials goes down to an extent whereby costs exceed the net realisable value, the inventories are written down to their net realisable value. In these circumstances, the replacement cost of the materials is the best available measure of the net realisable value. Example 16 The closing inventory of an entity includes an item which was purchased at wholesale price for 15 each, but the unit price has fallen to 12 each. In effect, the company has to reduce its retail selling price per unit from 18 to about 16. In this case, though the unit price has fallen to 12 from 15, the inventory will be valued at 15 because it will not exceed the revised selling price of 16. Some inventories may be allocated to other asset accounts, eg, inventory used as a component of self-constructed property, plant or equipment. Inventories allocated to another asset in this way are recognised as an expense during the useful life of that asset.