www.pwc.com IFRS Ready Inventory
Table of Contents Module 1 Introduction and Overview Module 2 Measurement of Inventory Costs Module 3 Measurement of Recoverability Module 4 Additional Topics Module 5 Summary 2
Module 1 Introduction and Overview
Session Objectives This session describes the accounting for inventories under International Financial Reporting Standards (IFRS) and United States Generally Accepted Accounting Principles (US GAAP). By the end of this session, you will be able to: Identify the concept of inventory and the types of costs that should be included in the valuation of inventory Apply the formulas for measuring inventories under the specific identification, FIFO, average cost, and LIFO methods under IFRS and US GAAP Describe how to address the recoverability of inventory under IFRS and US GAAP Describe the key disclosure for inventories under IFRS and US GAAP 4
The Concept of Inventory IFRS and US GAAP contain similar definitions of inventory: Assets which (1) are held for sale in the ordinary course of business (2) are in the process of production for such sale, or (3) in the form of materials or supplies to be consumed in the production process or in the rendering of services. Inventories owned by a manufacturing company typically include: Raw materials ( RM ) Work in progress ( WIP ) Finished goods 5
Applicable Authoritative Guidance The primary IFRS guidance applicable to inventory accounting includes: IAS 2 - Inventories IAS 41 - Agriculture IFRS 6 Exploration for and Evaluation of Mineral Resources IAS 23 (revised 2007) ( IAS 23 ) Borrowing Costs The primary US GAAP and SEC guidance applicable to inventory accounting includes: ASC 330-10-30 Inventory Initial Measurement ASC 330-10-35 Inventory Subsequent Measurement ASC 835-20 Capitalization of Interest EITF 86-13 Recognition of Inventory Market Declines at Interim Reporting Dates EITF 02-16 Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor SAB Topic 5-BB Inventory Valuation Allowances AICPA LIFO Issues Paper, November 30, 1984 6
Module 2 Measurement of Inventory Costs
Inventory Costs Under both IFRS and US GAAP, inventory cost may comprise production and/or acquisition costs. For example, finished goods inventory cost for manufacturers will often include the cost of raw materials, direct labor applied to those materials, and allocated overhead. For distributors, inventory cost likely will be comprised of the purchase price, as well as any transportation costs paid by the distributor to ship the inventory from the supplier to the distributor s place of business. 8
Inventory Cost Components An entity should include in inventory the cost of direct labor employed in manufacturing an inventory item. The amount of labor cost absorbed into inventory will be based on (a) the number of labor hours required to produce a product (presuming normal production rates), multiplied by (b) the hourly cost per employee involved with production. An entity should also include in inventory indirect costs associated with the entity s manufacturing operations. These indirect costs are referred to as overhead. Overhead can comprise depreciation and maintenance of factory buildings and equipment, the cost of factory management and administration, electricity, and other similar items. Overhead should be allocated to inventory based on normal production levels. Normal production refers to a range of production levels expected to be achieved during various cycles or seasons under ordinary circumstances. 9
Example 1 Inventory Cost Components Assume that a manufacturer normally produces 925 to 1,000 units of a product per operating cycle. During the current operating cycle, (a) 950 units are produced and (b) factory costs totaled $10,000. Assume that the factory only produces one type of product. How much overhead should be allocated to each unit produced? 10
Capitalization of Borrowing Costs Certain inventory products require significant manufacturing time. A manufacturer must finance its operating costs during the construction, production or development period. In some cases, the manufacturer will do so by borrowing funds. In these circumstances, both IFRS (IAS 23) and US GAAP (ASC 835-20) indicate that borrowing costs may need to be capitalized as part of the cost of inventory, if it is a qualifying asset. 11
Capitalization of Borrowing Costs IFRS Amendments Under the amended IAS 23 (affective 1/1/2009), borrowing costs associated with qualifying assets must be capitalized as part of the cost of inventory. A company is not required to apply the standard to: - Qualifying assets measured at fair value (e.g., investment properties, biological assets). - Inventories that are routinely manufactured, or otherwise produced in large quantities on a repetitive basis. 12
Capitalization of Borrowing Costs US GAAP Under US GAAP (ASC 835-20), capitalization of borrowing costs for qualifying assets (i.e., assets that require a significant period of time to get them ready for their intended use) is mandatory. 13
Inventory Cost Formulas - IFRS Under IFRS, entities are permitted to employ one of three cost formulas when reporting inventory expense. These methods are: Specific Identification First-in, First-out ("FIFO") Weighted-Average Cost 14
Inventory Cost Formulas -- US GAAP Under US GAAP, entities are permitted to employ one of four cost formulas when reporting inventory expense: These methods are: Specific Identification First-in, First-out ( FIFO ) Weighted-Average Cost Last-in, First-out ( LIFO ) 15
Using Inventory Formulas Under IFRS (IAS 2.26), an entity must use the same cost formula for all inventories having a similar nature and use to the entity. That is, a multinational company must use a consistent inventory policy election for each class of inventory in all of its worldwide subsidiaries. US GAAP does not provide explicit guidance on this issue. Accordingly, an entity is permitted to partially adopt a cost formula (e.g., LIFO for inventories held in the United States, and FIFO elsewhere) if it has a valid business reason for not fully adopting this policy election. 16
Example 2 Inventory Cost Formulas To demonstrate the three inventory cost approaches permitted under IFRS, assume that a bicycle shop purchased three identical bikes in January (see details below). On February 1, the retailer sold Bicycle 2. Date purchased Cost Bicycle 1 Jan 1 $190 Bicycle 2 Jan 15 $195 Bicycle 3 Jan 31 $215 Total $600 What amounts could be charged to Cost of Goods Sold when employing IFRS? What other amount could be charged to Cost of Goods Sold when employing US GAAP? 17
Module 3 Measurement of Recoverability
Measuring Recoverability IFRS Under IFRS, inventories must be measured at the lower of cost or net realizable value ( NRV ) except for inventories in certain specialized industries. NRV represents the estimated selling price for an inventory item in the ordinary course of business, less the estimated costs of completion (as applicable) and the estimated costs necessary to make the sale. 19
Measuring Recoverability US GAAP Under US GAAP, inventories are measured at the lower of cost or market (replacement cost). There are limits on the range in which market may be reported. ceiling Net realizable value (estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal) Market (replacement cost) floor Net realizable value less normal profit margin 20
Example 3 Measuring Recoverability To demonstrate how to measure inventory under IFRS and US GAAP, consider the following three scenarios. Assume in all cases that the original cost of inventory is $130: Scenario 1 Scenario 2 Scenario 3 NRV of $100 NRV of $90 NRV of $100 Replacement cost of $90 Replacement cost of $100 Replacement cost of $80 NRV less profit margin of $80 NRV less profit margin of $80 NRV less profit margin of $90 21
Measuring Recoverability -- Timing Under IFRS, a new assessment of NRV must be made in each subsequent period until the inventory is sold. When the circumstances that previously caused inventories to be written down below cost no longer exist or when there is clear evidence of an increase in NRV because of changed economic circumstances, the amount of the writedown is reversed (the reversal is limited to the amount of the original write-down). Under US GAAP, inventory write-downs can never be reversed. 22
Unit for Measuring Recoverability -- IFRS Under IFRS, when an entity is determining which is lower, cost or NRV, the unit of account is generally the individual inventory item might be a group of similar or related items if certain criteria are met 23
Unit for Measuring Recoverability US GAAP US GAAP also suggests that the appropriate unit of account likely will be an individual inventory item when performing this recoverability assessment. However, US GAAP does allow for the rule of lower of cost or market to be applied directly to the totals of the entire inventory, rather than to the individual inventory items, if specific criteria are met. 24
Example 4 Recoverability An electronics retailer holds 100 identical televisions in its inventory. The cost of each television set was $600. Each television s NRV is $500 and its NRV less a normal profit margin is $400. However, due to changes in technology, each television s replacement cost is $350. Assuming that the retailer operates under 1) US GAAP and 2) IFRS, at what value should the retailer record its inventory? a. $35,000 b. $40,000 c. $50,000 d. $60,000 25
Reporting Above Cost US GAAP Circumstances in which an entity is permitted to report inventory above cost are extremely limited. To account for inventory at an amount above cost, ASC 330 requires three conditions to be met: The entity is unable to determine the approximate cost of the inventory item, The inventory item is immediately marketable at quoted market prices, The inventory item is interchangeable IFRS Not allowed 26
Module 4 Additional Topics
Relieving Inventory Under both IFRS and US GAAP, the reported value of inventories should be relieved and charged against cost of goods sold when the goods are sold (i.e., when the risk of ownership is transferred to the customer). 28
Example 5 Disclosure Which of the following disclosures is required under IFRS only? a. If material, the amounts from the liquidation of a LIFO layer b. The circumstances or events that led to the reversal of a write-down of inventories c. The accounting policies adopted in measuring inventories d. Presentation of major categories of inventory 29
Module 5 - Summary
Summary of Key Differences Topic IFRS US GAAP Allowable cost formulas Consistency of group policies for cost formulas Measurement of inventories Reversals of previous inventory write-downs Unit of account when testing inventory for recoverability Reporting inventories at above cost When measuring the cost of inventory, an entity can elect to use one of three methods: FIFO, Weighted- Average Cost, or Specific Identification. IFRS prohibits the use of the LIFO approach. An entity must use the same cost formula for all inventories having a similar nature and use to the entity. Inventories are measured at the lower of cost or net realizable value ( NRV ). Reversal of previous inventory writedowns can be required depending on specific facts and circumstances. When assessing the recoverability of inventory, an entity generally must examine each piece of inventory separately (i.e., each individual piece of inventory represents the unit of account). Inventories may be reported above cost at companies operating in certain specialized industries (e.g., agriculture, mining, and broker dealer) Also permits the use of FIFO, Weighted-Average Cost, or Specific Identification but also allows for the LIFO method as well. US GAAP does not provide explicit guidance on this issue. Accordingly, an entity is permitted to partially adopt a cost formula (e.g., LIFO for inventories held in the United States, and FIFO elsewhere) if it has a valid business reason for not fully adopting this policy election. Inventories are measured at the lower of cost or market (replacement cost), except that market cannot (a) exceed NRV (the ceiling ) or (b) be less than NRV less a normal profit margin ( floor ) Inventory write-downs can be can never be reversed. Also suggests that the appropriate unit of account likely will be an individual inventory item when performing this recoverability assessment. However, US GAAP does allow for the rule of lower of cost or market to be applied directly to the totals of the entire inventory, rather than to the individual inventory items, if specific criteria are met. Specifically, this policy election is only permitted when, for certain goods, no loss of income is expected to take place as a result of a reduction of cost prices because others forming components of the same general categories of finished products have a market equally in excess of cost. If this approach is elected, it must be applied consistently from year to year. Inventories rarely will be reported above cost (exceptions are extremely limited)
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