Exposure Draft, Inventories, Section 3031 SLIDE 1 Exposure Draft, Inventories, Section 3031 This presentation provides an overview of the requirements of the Accounting Standards Board s Exposure Draft on Inventories, Section 3031. It also highlights some of the expected changes in Canadian practice as a result of the proposals. The Exposure Draft is the official version of the Board s proposals. Nothing in this presentation overrides the Exposure Draft, which contains details not covered in this presentation. An important part of the Board s process is the exposure of proposed standards for public comment, and consideration of the input received. Viewers of this presentation are encouraged to provide their comments on the specific questions set out in the Exposure Draft. Comments on the Exposure Draft proposals are requested by September 15, 2006. NEXT SLIDE: [Background] SLIDE 2 Background The Board developed the proposals as a result of its longstanding goal of significantly enhancing Canadian generally accepted accounting principles (GAAP). Specifically, the proposals will replace Section 3030, Inventories, which is one of the oldest standards in the Handbook. The Board considered International Financial Reporting Standards 1 of 12
(IFRSs) and US GAAP, both of which provide more extensive guidance on accounting for inventories than current Section 3030 and have been recently updated. The proposals are based on the International Financial Reporting Standard No. 2, Inventories, so as to avoid a second round of changes in the proposed transition to IFRSs as a result of the Board s recently adopted Strategic Plan. (For more information on the Board s Strategic Plan, please visit our web site at www.acsbcanada.org.) NEXT SLIDE: [Benefits] SLIDE 3 Benefits The proposals represent an improvement to Canadian GAAP, as they: Require inventory to be valued at the lower of cost and net realizable value, with certain exceptions; Provide more extensive guidance on the determination of cost, including allocation of overhead Narrow the permitted cost formulas Require impairment testing; and Expand the disclosure requirements to increase transparency. I will address each of these points in more detail throughout the presentation. NEXT SLIDE: [Applicability] 2 of 12
SLIDE 4 Applicability The proposals would apply to all inventories of all entities, including not-for-profit organizations, except: Work in progress arising under construction contracts Financial instruments Contributed items and services not recognized by not-for-profit organizations in accordance with contributions revenue recognition, paragraph 4410.16. This paragraph permits a not-for-profit organization to not recognize certain contributions of materials and services. The proposals scope out contributions not recognized to be consistent with this choice. [NEXT SLIDE: Measurement] SLIDE 5 Measurement The proposals require inventories to be measured at the lower of cost and net realizable value. However, there are a small number of exceptions. Not-for-profit organizations may hold inventories that are not expected to generate a cash flow, for example, inventories such as informational brochures that will be given away as part of the organization s programs. Specific provisions for not-for-profit organizations are discussed later in the presentation. The proposals provide a scope exemption from the measurement requirements for agricultural inventories up to and including the point at which they are harvested. This 3 of 12
measurement scope exemption also applies to inventories held by producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products provided that these inventories are measured at net realizable value in accordance with well-established practices in those industries. Commodity broker-traders may measure their inventories at fair value less costs to sell. In each of these cases the scope exemption is only from the measurement requirements and the other requirements of the proposals, including disclosures, apply. The proposals provide that inventories comprising agricultural produce that an entity has harvested from its biological assets are measured on initial recognition at their carrying amount at the point of harvest. For example, this carrying amount may be fair value, which becomes the cost of inventories at the point of harvest for application of the proposals. [NEXT SLIDE: Cost of inventories] SLIDE 6 Cost of inventories The proposals provide more extensive guidance than current Canadian GAAP on the determination of cost, including guidance on the allocation of overheads. Some Canadian entities will encounter significant changes in the determination of the cost of their inventories as a result of adopting the proposals. The proposals require that the cost of inventories comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. The costs of purchase include the purchase price, transport and handling costs, taxes that are not recoverable and other costs directly attributable to the purchase. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase. 4 of 12
Emerging Issues Committee Abstracts of Issues Discussed No. 144, Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor, provides additional guidance on accounting for cash received from the seller. The proposals provide detailed guidance on the costs of conversion which include direct costs such as labour, material and direct overheads, and an allocation of fixed and variable production overheads. The proposals also provide guidance on joint products and by-products as the production process may result in more than one output being produced simultaneously. If the cost relating to the individual products cannot be identified, total production costs are allocated between the products on a rational and consistent basis. One possible method is to allocate the total production costs based on relative selling prices. If a production process results in products that are incidental to the primary products, the cost allocated to these by-products may be based on their net realizable value. Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. These may include non-production overheads or the costs of designing products for specific customers. The proposals also provide examples of costs excluded from the cost of inventories and recognized as expenses in the period in which they are incurred such as abnormal amounts of wasted materials, labour and other production costs, and selling costs. Unlike Section 3030 which focuses on a manufacturing concern, the proposals are broader as they address the cost of inventories of a service provider. Specifically, these costs consist primarily of the labour and other costs of personnel directly engaged in providing the service, including supervisory personnel, and attributable overheads. NEXT SLIDE: [Formulas and techniques to measure cost] 5 of 12
SLIDE 7 Formulas and techniques to measure cost Where possible, cost is determined on an individual item basis. This determination is appropriate for unique items such as custom-built furnishings, property developments and antiques. For many types of inventories it is not possible to identify the costs of a specific unit of inventory, because there are large numbers of inventory items that are interchangeable. Here the proposals require the use of either the first-in, first-out (FIFO) or weighted average cost formula. The use of the last-in, first-out (LIFO) basis of cost determination will no longer be acceptable under Canadian GAAP. This elimination of LIFO may create a US-Canadian GAAP difference for entities using LIFO for US GAAP. In addition, the proposals require an entity to use the same cost formula for all inventories having a similar nature or use to the entity. For inventories with a different nature or use, different cost formulas may be justified. The proposals also address the techniques for the measurement of the cost of inventories. Specifically, the proposals suggest that the standard cost method or the retail method be used for convenience, but only if the results approximate cost. Standard costs must be reviewed regularly and adjusted to take into account changes in circumstances. Some applications of the retail method currently may not approximate cost and this could result in a significant change. NEXT SLIDE: [Impairment] 6 of 12
SLIDE 8 Impairment As noted earlier, the proposals require measurement of inventories at the lower of cost and net realizable value, with a few specified exceptions. Entities are not currently required to measure their inventories at the lower of cost and net realizable value. While most use a lower of cost and market approach, market is not always defined as net realizable value. Some companies in Canada have measured some or all of their inventories at the lower of cost and replacement cost. The US GAAP approach is broadly consistent with IAS 2, in that the lower of cost and market value is used to value inventories. However, US GAAP has a different definition of market and these proposals will result in a US-Canadian GAAP difference in many cases where inventories have been written down from cost to market. An entity writes down its inventories to their net realizable value when their cost is not recoverable. Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and estimated costs necessary to make the sale. The proposals describe that an entity normally writes down inventories on an item by item basis, although, in some cases it evaluates similar products in groups. The proposals also provide additional guidance on net realizable value, including how the write-down takes into account the intended use of the items and events occurring after the balance sheet date. The proposals require recognition of a reversal of a previous write-down of inventories arising from an increase in net realizable value. This reversal occurs 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 reversal is limited to the amount of the original write-down. Such a reversal is inconsistent with current Canadian GAAP impairment 7 of 12
provisions for other assets and it conflicts with US GAAP that prohibits reversal of a write-down on the grounds that it would create a new cost basis. NEXT SLIDE: [Disclosures] SLIDE 9 Disclosures The proposals require more extensive disclosure than are currently required or generally provided in practice. This is to help users understand the significance and effect of inventories on financial statements. The requirements include disclosure of: the accounting policies adopted in measuring inventories, including the cost formula used; the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity. The carrying amounts of inventories carried at net realizable value and at fair value less costs to sell are required to be separately disclosed so that the amount of inventories not valued at cost is apparent; the amount of inventories recognized as an expense during the period. This requirement is often referred to as cost of sales, for those entities presenting an analysis of expenses based on their function within an entity. An alternative format is permitted for those entities using a classification based on the nature of the expense (for example, wages, rent, etc.). The proposals include an illustrative example of this alternative format; the amount of any write-downs of inventories recognized as an expense in the period; and 8 of 12
the amount of any reversals of any write-downs together with the circumstances or events that led to that reversal. NEXT SLIDE: [Transition] SLIDE 10 Transition The proposals have been drafted without specific transitional provisions; thus, an entity would apply the requirements of the recently updated ACCOUNTING CHANGES, Section 1506, to changes in accounting policy resulting from the application of the proposals. Specifically, Section 1506 states that changes in accounting policy shall be applied retrospectively except to the extent that it is impracticable to determine the periodspecific effects or the cumulative effect of the change. Retrospective application is applying a new accounting policy to transactions, other events and conditions as if that policy had always been applied. Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. Adopting the new inventory accounting standard may result in more than one change in accounting policy. For example, an entity may have to change its overhead allocation practice and compute impairment write-downs based on net realizable value rather than on replacement cost or some other amount. In adopting the new Section an entity applies each accounting policy change retrospectively. If it determines that retrospective application is impracticable for a specific accounting policy change, Section 1506 provides an alternate transition basis for that specific policy change. (The definition of impracticable can be found in Section 1506.) In practice, for example, an entity might conclude that it is able to restate its inventories from the LIFO method of cost determination to the FIFO method. On the other hand, the 9 of 12
entity might conclude that it is impracticable to recreate the necessary information to determine the cumulative effect, at the beginning of the current period, of the adjustments for overhead allocation of its inventories to align with the requirements of the proposals. The proposals specifically ask whether respondents agree that proposed Section 3031 should be applied retrospectively in accordance with ACCOUNTING CHANGES, Section 1506. If not, respondents are asked to explain why not and suggest alternative transitional provisions. NEXT SLIDE: [Not-for Profit Organizations] SLIDE 11 Not-for-Profit Organizations The proposals provide specific guidance for not-for-profit organizations (NFPOs) for contributions of materials and services. They deal specifically with the option of accounting for these contributions consistently with Section 4410, CONTRIBUTIONS REVENUE RECOGNITION. As a result, the organization may choose to either not recognize items of inventory that have been contributed or to measure such inventories at fair value at the date of contribution. In addition, the proposals provide guidance for NFPOs for inventories held for reasons other than sale. NFPOs may hold inventories whose future economic benefits or service potential are not directly related to their ability to generate net cash flows. For example, consistent with its mandate to provide services to certain groups in society, an NFPO may have inventories which are held for distribution at no charge or for a nominal charge, or held for consumption in the production process of goods to be distributed at no charge or for a nominal charge. These inventories would have a net realizable value of nil or close to nil. As a result, NFPOs would measure these types of inventories at the lower of cost and current replacement cost, instead of at the lower of cost and net realizable value. 10 of 12
NEXT SLIDE: [Plans for finalizing the proposals] SLIDE 12 Plans for finalizing the proposals The Board expects to issue a final standard in the first quarter of 2007 that will be effective for interim and annual financial statements for fiscal years beginning on or after July 1, 2007, with earlier application encouraged. The Board will redeliberate these proposals to take into account comments received on the Exposure Draft. The Board will provide updates about its redeliberations on its website. NEXT SLIDE: [Further Information] SLIDE 13 Further information Thank you for taking the time to view this presentation. We hope it is helpful to you in understanding the Exposure Draft, Inventories, Section 3031. The Exposure Draft, which includes a number of questions on which the Board is specifically seeking input, and its accompanying Background Information and Basis for Conclusions document are available on the Board s web site at www.acsbcanada.org under Documents for Comment. The Board developed the proposals to converge with an existing IFRS and the opportunities for respondents to the Exposure Draft to influence specific details in the final standard are very limited, since the principles and requirements have already been deliberated and decided upon by the International Accounting Standards Board. This being the case, the Canadian Accounting Standards 11 of 12
Board is primarily interested in knowing whether there is any reason why the proposed guidance would lead to inappropriate results if applied in Canada. Thus, respondents are encouraged to provide their comments on the specific questions set out in the Exposure Draft. Comments are requested by September 15, 2006. The Board also welcomes comments on this presentation, which can be sent to ed.accounting@cica.ca. END 12 of 12