PRACTICAL GUIDE IAS 2: INVENTORIES www.consultasifrs.com/uk 2014 www.consultasifrs.com 1 ConsultasIFRS is an online firm specialized in advisory on IFRS.
PRACTICAL GUIDE IAS 2 Inventories Our only goal is to exceed your expectations The objective of this Standard is to prescribe the accounting treatment for inventories. A primary issue in accounting for inventories is the amount of cost to be recognised as an asset and carried forward until the related revenues are recognised. This Standard provides guidance on the determination of cost and its subsequent recognition as an expense, including any write-down to net realisable value. It also provides guidance on the cost formulas that are used to assign costs to inventories. Inventories shall be measured at the lower of cost and net realisable value. Net realisable value 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. Over 4,000 accounting questions and answers "online" on IFRS The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. The cost of inventories 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. However, 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 specific identification of their individual costs. Quality, excellence, and dedication, our key intangible asset When inventories are sold, the carrying amount of those inventories shall be recognized as an expense in the period in which the related revenue is recognized. The amount of any write-down of inventories to net realizable value and all losses of inventories shall be recognized as an expense in the period the write-down or loss occurs. The amount of any reversal of any write-down of inventories, arising from an increase in net realizable value, shall be recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs. 2014 www.consultasifrs.com 2
Examples Costs of purchase that should be included in purchase cost PURCHASE COST YES NO Purchase Price discounts/rebates on purchase price penalty charge for overdue payments travel expenses of the purchasing department Taxes VAT real property transfer tax import duties Transport forwarding charges for external transport transport insurance storage rental fee charged for intermediate storage internal storage costs after receiving materials internal transport between stock locations other costs costs for a letter of reference (e.g. quality certificate for drugs) costs for commission, brokerage Items that should be capitalised as conversion cost. Conversion cost YES NO social security costs for staff in production voluntary security contributions salaries of construction department Christmas bonus, vacation bonus factory supplies, auxiliary material external consulting (e.g. process reengineering) depreciation of plant and machines costs of legal assistance (e.g. patent infringement ) costs of leasing a machine costs of scrap production (exceeds normal level) development of a new production process real property tax rework of finished products (because of quality defects) salaries of the sales department costs of maintaining a canteen in the factory warranty cost internal transport costs (gas, depreciation, wages) costs for using a patent research for new products wages of purchase department audit fees ordinary maintenance of the factory restructuring of the whole plant 2014 www.consultasifrs.com 3
Inclusion of import duties in inventory when inventory is held in a customs free zone Cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition [IAS2.7]. Should the estimated import duties on inventory held in a customs-free zone be included in the cost of inventories? Case A car dealer imports cars, bringing them initially into a customs-free zone. The cars remain there until they are sold and delivered to customers, at which point import duties will become payable by the importer. Solution Import duties are not included in the inventory valuation for inventory held in a customs-free zone. Import duties do not arise from shipping the cars to the customs-free zone. Therefore, they are not included in the inventory valuation at that point. Import duties payable are included in the cost of inventory when the cars leave that zone. Treatment of volume rebates - IAS 2 Inventories Trade discount, rebates and other similar items should be deducted in determining the purchase cost of inventory [IAS2.11]. How should an entity recognise a rebate from a supplier? Background Entity A operates as a wholesaler of cameras of two different manufacturers. A receives rebates from both manufacturers. The rebate from manufacturer B is calculated as 10% of A`s sales of B`s cameras, if the total sales volume exceeds 10.0 million euro per year. The rebate from manufacturer C is calculated as 10% of A`s purchases from C, if the total purchase exceeds 10.0 millions euro per year. Both manufacturers grant their rebates by sending a credit note after A has issued its financial statements. Sales in 201 Purcahes 201 Inventories at the year 201 end (before discount) Inventories at the year 200 end (before discount Camera B 11.9 9.9 0.5 2.5 Camera C 8.3 10.3 2.6 0.6 2014 www.consultasifrs.com 4
Solution A rebate of 1.2 million euro from B should be considered as a separate asset, which is credited to the income statement as deduction of selling costs. This rebate is driven by the sales of the period and should therefore be considered in the net income of the period. As the rebate is sales related, it is regarded as a deduction from selling costs. A rebate of 1.0 million euro from C should be considered as a separate asset, which is credited to the cost of sales (0.75 million euro) as well as to the cost of inventories (0.25 million euro). This rebate is driven by the purchases of the period and should therefore be allocated to the cost of cameras purchased and sold within the period as well as to cameras purchased, but not yet sold. As the rebate is purchase related, it is regarded as a deduction from the cost of sales. Cost of imported goods IAS 2.10 establish: The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Let s see the following practical example: Sports Goods Inc. buys bicycles from various countries and exports them to Latin America. Sports Goods Inc. has incurred these expenses during 2013: (1) Cost of purchases (based on vendors invoices) (2) After-sales warranty costs (3) Trade discounts on purchases (4) Sales commission payable to sales agents (5) Import duties (6) Salaries of accounting department (7) Freight and insurance on purchases (8) Other handling costs relating to imports (9) Brokerage commission payable to indenting agents for arranging imports Question: Which costs are permitted under IAS 2 to be included in cost of inventory? 2014 www.consultasifrs.com 5
Answer Items (1), (3), (5), (7), (8), and (9) are permitted to be included in cost of inventory under IAS 2. Salaries of accounting department, sales commission, and after-sales warranty costs are not considered cost of inventory under IAS 2 and thus are not allowed to be included in cost of inventory. Consignment stock and sale and repurchase agreements A seller may enter into an arrangement with a distributor where the distributor sells inventory on behalf of the seller. Such consignment arrangements are common in certain industries, such as the automotive industry. IAS 18 Revenue requires entities to recognize revenue (and therefore derecognize inventory) only if the substantial risks and rewards of ownership have been transferred to the customer. Similarly, entities may enter into sale and repurchase agreements with a customer where the seller agrees to repurchase inventory under particular circumstances. For example the seller may agree to repurchase any inventory that the customer has not sold to a third party after six months. IAS 18 gives some guidance on when revenue can be recognized in these types of transaction in the illustrative examples to the standard. There is no other specific guidance on these types of inventories in IFRS and so entities need to ensure they adopt an appropriate and consistent accounting policy for derecognizing inventory and recognizing revenue that reflects the commercial substance of these transactions. Example - Notes to the financial statements of BMW Group as of December 31, 2012 [extract] Accounting policies [extract] Revenue recognition Profits arising on the sale of vehicles for which a Group company retains a repurchase commitment (buy-back contracts) are not recognized until such profits have been realized. The vehicles are included in inventories and stated at cost. Net realizable value Practical example disclosures IAS 2 carries substantial guidance on the identification of net realizable value, where this is below cost and therefore inventory must be written down. The cost of inventory may have to be reduced to its net realizable value if it has become damaged, is wholly or partly obsolete, or if its selling price has declined. The costs of inventory may not be recovered from sale because of increases in the costs to complete, or the estimated selling costs [IAS 2.28]. However the costs to consider in making this assessment should only comprise direct and incremental costs to complete and sell the inventory and will not include any profit margin on these activities. They will also not include overheads or the costs of the distribution channel, such as shops, since these costs will be incurred regardless of whether or not any sale of this inventory actually takes place. The only situation in which the costs of a shop might be included in these selling costs is the exceptional case where one shop is entirely dedicated to selling impaired goods. Writing inventory down to net realizable value should normally be done on an item-by-item basis. IAS 2 specifically states that it is not appropriate to write down an entire class of inventory, such as finished goods, or all the inventory of a particular segment. However, it may be necessary to write 2014 www.consultasifrs.com 6
down an entire product line or group of inventories in a given geographical area that cannot be practicably evaluated separately. Service contracts usually accumulate costs on a contract-bycontract basis and net realizable value must be considered on this basis [IAS 2.29]. Estimates of net realizable value must be based on the most reliable evidence available and take into account fluctuations of price or cost after the end of the period if this is evidence of conditions at the end of the period [IAS 2.30]. A loss realized on a sale of a product after the end of the period may well provide evidence of the net realizable value of that product at the end of the period. However if this product is, for example, an exchange traded commodity and the loss realized can be attributed to a fall in prices on the exchange after the period end date then this loss would not, in itself, provide evidence of the net realizable value at the period end date. Estimates of net realizable value must also take into account the purpose for which the inventory is held. Therefore inventory held for a particular contract has its net realizable value based on the contract price, and only any excess inventory held would be based on general selling prices. If there is a firm contract to sell and this is in excess of inventory quantities that the entity holds or is able to obtain under a firm purchase contract, this may give rise to a provision that should be recognized in accordance with IAS 37 - Provisions, Contingent Liabilities and Contingent Assets [IAS 2.31]. IAS 2 explains that materials and other supplies held for use in the production of inventories are not written down below cost if the final product in which they are to be used is expected to be sold at or above cost [IAS 2.32]. This is the case even if these materials in their present condition have a net realizable value that is below cost and therefore would otherwise require write down. Thus, a whisky distiller would not write down an inventory of grain because of a fall in the grain price, so long as it expected to sell the whisky at a price which is sufficient to recover cost. If a decline in the price of materials indicates that the cost of the final product will exceed net realizable value then a write down is necessary and that their replacement cost may be the best measure of their net realizable value [IAS 2.32]. If an entity writes down any of its finished goods, the carrying value of any related raw materials must also be reviewed to see if they too need to be written down. Often raw materials are used to make a number of different products. In these cases it is normally not possible to arrive at a particular net realizable value for each item of raw material based on the selling price of any one type of finished item. If the current replacement cost of raw materials is less than their historical cost, a provision is only required to be made if the finished goods into which they will be made are expected to be sold at a loss. No provision should be made just because the anticipated profit will be less than normal. 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 net realizable value because of changed economic circumstances, the amount of the write-down is reversed. The reversal cannot be greater than the amount of the original write-down, so that the new carrying amount will always be the lower of the cost and the revised net realizable value [IAS 2.33]. 2014 www.consultasifrs.com 7
Practical Example disclosures: Farabella Chile The following example shows the disclosures performed by Farabella Chile, a department store: Example of Disclosure Requirements The financial statements should disclose: (a) the accounting policies adopted in measuring inventories, including the cost formula used; (b) the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity; (c) the carrying amount of inventories carried at fair value less costs to sell; 2014 www.consultasifrs.com 8
(d) the amount of inventories recognized as an expense during the period; (e) the amount of any write-down of inventories recognized as an expense in the period; (f) the amount of any reversal of any write-down that is recognized as a reduction in the amount of inventories recognized as expense in the period; (g) the circumstances or events that led to the reversal of a write-down of inventories; and (h) the carrying amount of inventories pledged as security for liabilities [IAS 2.36]. IAS 2 does not specify the precise classifications that must be used to comply with (b) above. However it states that information about the carrying amounts held in different classifications of inventories and the extent of the changes in these assets is useful to financial statement users, and suggests suitable examples of common classifications such as merchandise, production supplies, materials, work-in-progress, and finished goods [IAS 2.37]. The Following example shows inventories disclosures made by Farabela Chile in its 2012 financial statements: 2014 www.consultasifrs.com 9
The amount of inventory recognized as an expense in the period is normally included in cost of sales; this category includes unallocated production overheads and abnormal costs as well as the costs of inventory that has been sold. However, the circumstances of the entity may warrant the inclusion of distribution or other costs into cost of sales [IAS 2.38]. Hence when a company presents its profit or loss based upon this function of expense or cost of sales method it will normally be disclosing costs that are greater than those that have been previously classified as inventory, but this appears to be explicitly allowable by the standard. Some entities adopt a format for profit or loss that results in amounts other than the cost of inventories being disclosed as an expense during the period. This will happen if an entity presents an analysis of expenses using a classification based on the nature of expenses. The entity then discloses the costs recognized as an expense for raw materials and consumables, labor costs and other costs together with the amount of the net change in inventories for the period [IAS 2.39]. This issue is addressed in the following example taken from International Airlines Group 2012 financial statements: 2014 www.consultasifrs.com 10
Accounting treatment of certain inventories which are out of IAS 2 scope IAS 2 does not apply to the measurement of inventories held by: (a) producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realizable value in accordance with well-established practices in those industries. When such inventories are measured at net realizable value, changes in that value are recognized in profit or loss in the period of the change. (b) commodity broker-traders who measure their inventories at fair value less costs to sell. When such inventories are measured at fair value less costs to sell, changes in fair value less costs to sell are recognized in profit or loss in the period of the change. The inventories referred to in paragraph (a) are measured at net realizable value at certain stages of production. This occurs, for example, when agricultural crops have been harvested or minerals have been extracted and sale is assured under a forward contract or a government guarantee, or when an active market exists and there is a negligible risk of failure to sell. These inventories are excluded from only the measurement requirements of this Standard. Broker-traders are those who buy or sell commodities for others or on their own account. The inventories referred to in paragraph (b) are principally acquired with the purpose of selling in the near future and generating a profit from fluctuations in price or broker-traders margin. When these inventories are measured at fair value less costs to sell, they are excluded from only the measurement requirements of this Standard. It is important to distinguish the difference between the exemption made for (a) mineral inventories and agricultural inventories after harvest and (b) inventories of broker-traders. Mineral inventories and agricultural inventories after harvest are carried in accordance with industry practice at net realizable value at certain stages of production. This basis would be appropriate when agricultural crops have been harvested or minerals extracted and the sale of the inventory is assured under a forward contract or a government guarantee, or because there is an active market in the produce and there is a negligible risk that the produce will not be sold. Agricultural produce at the point of harvest and inventories of broker-traders are carried at fair value less costs to sell as they are held with the purpose of selling in the near future and generating a profit from the fluctuations in price or brokers traders margin. These measurement bases are not the same. Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated selling costs. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. In other words, net realizable value is the amount that an entity expects to realize from the sale of inventory in the ordinary course of business. Fair value (less selling costs) is the amount that could be obtained for the same inventory from a knowledgeable willing party in the marketplace. The difference is that net realizable value for inventories may not be equal fair value less costs to sale. 2014 www.consultasifrs.com 11
Fair values are the appropriate measurement bases for broker-traders, because they have access to ready markets. Net realizable value is appropriate for producers, because they may not have such access. Example Difference between net realizable value and fair value less costs to sell An entity holds mineral inventories. It could sell the stock on the open market for $ 100 per ton after selling costs. The entity is currently in a forward contract to sell the stock at $ 120 per ton. In this situation, fair value less selling costs is $ 100 per ton, but net realizable value is $ 120 per ton. Example Net realizable value and fair value less costs to sell may differ between producer and a broker trader entity. A producer in Brazil holds agricultural produce that it can sell locally for $ 100 per ton or to a broker in Uruguay for $ 500 per ton. The broker can sell the produce in Uruguayan s market at $ 800 per ton. In this situation, to the extent that the producer will sell to the broker, both the fair value and the net realizable value for the producer is $ 500 per ton. For the broker, the fair value and the net realizable value is $ 800 per ton. In this situation, the values are different as between the producer and the broker, because the producer does not have access to the market in Uruguay and must sell either on the local market or to the broker. The Technical summary has been prepared by IFRS Foundation staff and has not been approved by the IASB. For the requirements reference must be made to International Financial Reporting Standard which can be obtained if pay the subscription to IASB www.ifrs.org The examples included in this application guide have been prepared by ConsultasIFRS team. You are not allowed to copy, forward, edit, translate, modify, use or copy any content. 2014 www.consultasifrs.com 12
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