ACCOUNTING FOR INVENTORY (IAS 2) Definition Inventories are currents assets Held for sale in ordinary course of business In the process of the production for such sales (WIP) In the form of materials to be consumed in production process Measurement of inventory The standard IAS 2 stated that inventory should be measured at the lower of i. Cost ii. Net realizable value Objective of IAS 2 The objective of IAS 2 is to prescribe the accounting treatment of inventories. It provides guidance for determining the cost of inventories and for subsequent recognition of an expense including any write down to Net Realizable Value. It also provides guidance on the cost formula that are used to assign cost to inventories Recognition of Inventory as an Expense Inventory may be recognised as an expense when: a) Inventory is sold, its carrying amount is recognised as an expense.Cost of Sales/Cost of Goods Sold b) Write-downs to net realizable value c) Losses of inventory e.g. loss by fire or theft Disclosures The IAS requires the financial statements to disclose the following: a) the accounting policies adopted and cost formula used; b) the carrying amount of inventories: the total amount and the amount in classifications appropriate to the entity; c) the carrying amount of inventories carried at fair value less costs to sell; d) the amount of inventories recognised as an expense during the period; e) any write-down of inventories recognised as an expense in the period; f) any reversal of any write-down recognised as a reduction in the amount of inventories recognised as an expense in the period; g) the circumstances or events that led to the reversal of a write-down of inventories; h) The carrying amount of inventories pledged as security for liabilities. Page 1 Cost of inventories The cost of inventories will consist of all costs of: 1. Purchase 2. Costs of conversion 3. Other costs incurred in bringing the inventories to their present location and condition The above costs are discussed in detail below: 1. Costs of Purchase It includes the following: purchase price import duties and other taxes, excluding those subsequently recoverable from the taxation authorities transport, handling and other costs directly attributable to the acquisition of materials, finished goods and services Note Trade discounts / rebates are deducted if not already deducted from the purchase price. Example 1 XYQ Ltd purchased raw materials for Tshs 125 million less a rebate of 2%. It paid Tshs 25 million as import duty, including Tshs10 million towards countervailing duty. According to local tax laws, it will get a credit of the amount paid towards countervailing duty, while determining its excise duty liability. It spent ocean freight of Tshs3 million, clearing agent’s charges of Tshs2 million, Tshs4 million on warehouse rent and Tshs1.5 million on the watchman’s salary. Required: Determine the cost of materials 2. Costs of Conversion Costs of conversion Costs of conversion of inventories consist of two main parts. 1. Costs directly related to the units of production, eg direct materials, direct labor e.g. a worker spent 6 hours on completing the article; the wages paid to the worker for the time can be directly related to the units of production 2. Fixed (allocated based on normal capacity) and variable production overheads that are incurred in converting materials into finished goods, allocated on a systematic basis. Fixed Production Overheads Allocation is based on normal capacity. Normal capacity is the expected average over a number of periods, after taking into account the loss of capacity due to normal maintenance. Page 2 If there is a low production, overhead allocated to each unit is not increased. Unallocated overheads are recognised as an expense in the period in which they are incurred. Example 2 ZANZY Co’s normal capacity is 100,000 units per annum. Budgeted fixed production overheads are Tshs 200,000 per annum. Raw material and wages per unit are Tshs15. Actual production is 98,000 units and actual fixed overheads are Tshs 203,000. Required: Determine the Inventory value Other Costs Other costs any other costs should only be recognised if they are incurred in bringing the inventories to their present location and condition. Example 4 A product is manufactured according to the specifications given by the customer. Material cost is Tshs300 million and wages are Tshs130 million. Professional fees of Tshs25 million are paid for having the product designed. Required: Determine total cost Costs excluded from the Cost of Inventory The standard lists types of cost which would not be included in cost of inventories. Instead, they should be recognised as an expense in the period they are incurred. 1. Abnormal amounts of wasted materials, labor or other production costs 2. Storage costs (except costs which are necessary in the production process before a further production stage) 3. Administrative overheads not incurred to bring inventories to their present location and conditions 4. Selling costs e.g. commission paid to salesmen 5. Borrowing costs, except to the extent permitted by IAS 23 – Borrowing costs Measurement of inventories Inventories shall be measured at the lower of cost and net realizable value. Measure at a lower of Cost and NRV Net Realizable value (NRV) Selling price………………………….xxx Less: Cost to complete…………………… (xxx) Page 3 Cost of selling ……………………….(xxx) NRV……………………………………..xxx Example 5 PQ manufactures components for the retail industry. The inventory is currently valued at cost The cost structure of the equipment is as follows Cost per unit Selling price per unit Production process, 1st stage 1,000 1,050 Conversion cost, 2nd stage 500 Finished product 1,500 1,700 The selling costs are Tshs 10 per unit and PQ has 100,000 unit at the first stage of production and 200,000 units of finished products. Shortly after the year end a competitor released a new model and this resulted in PQ having to reduce its selling price to Tshs 1,450 for the finished product and Tshs 950 for first stage of the production. REQUIRED: Calculate the value of closing inventory to be included in PQ’s financial statements at the reporting period Cost Formula A cost formula is required to determine the value of material issued and material remaining in inventory. The selection of the correct cost formula depends upon the nature of the items. Specific Identification Method This method is applied to items that are not ordinarily interchangeable and goods and services produced and segregated for specific projects. Specific costs are attributed to the items of inventory. Example 6 For special made-to-order furniture, specific costs of material and labor used therein are identified and included in the cost. Other Methods Allowable under IAS 2 Either of the following two methods is to be used for items not covered under the specific identification method above. This means that the two methods are for ordinarily interchangeable goods and services. First in First Out (FIFO): This method assumes that the item which came first into inventory (by way of purchase or production) went out first (as sales or consumption). This means that the items remaining in hand are those which were purchased the last. Page 4 This is an assumption for the purpose of determining the cost, and the actual movement of the goods may or may not be in that manner. However, generally, the storekeepers ensure that the oldest items are moved out first. Weighted Average: Total cost of material (opening inventory plus subsequent purchases) is divided by the total quantity (opening inventory plus subsequent purchases). This is done either after every purchase or periodically. Weighted Average = Total cost of material Total quantity of material Note The Last In First Out method (LIFO) is not permitted by IAS 2 Example 7 The following details are available from Bakers Point Ltd: Date Details Quantity Rate (Tshs) 01/4/2012 Opening inventory 500 20,000 04/4/2012 Purchase 150 22,000 08/4/2012 Issue 200 Determine the value of the inventory as at 8 April 2012 under the FIFO and Weighted Average methods. Example 8 The following details are available from Bakers Point Ltd: Date Details Quantity Rate (Tshs) 01/4/2012 Opening inventory 500 20,000 04/4/2012 Purchase 150 22,000 08/4/2012 Issue 600 Determine the value of the inventory as at 8 April 2012 under the FIFO and Weighted Average methods. b) Approximation Techniques for the Measurement of Costs Page 5 As seen above, normally cost is to be determined for the measurement of inventories. However, the IAS provides for some alternatives where, instead of actual costs, some alternative amounts may be used. These are called approximation ‘techniques’ and are discussed below: i) Standard Cost Method: Standards based on the normal level are decided for the elements of cost such as materials, labor and overheads. The standard costs are used for the valuation of inventories and the issues of materials. ii) Retail Method: Retailers sometimes use this method if there are large numbers of rapidly-changing items with similar margins for which it is impracticable to use other costing methods. Sales value is taken as a starting-point, and the gross margin percentage is deducted from that, to arrive at the value of inventory. Example 9 XLS Inc, a dealer in garments, has thousands of items in inventory. It applies the retail method. Its average gross margin is 20%. The sales price of a carton of 10 shirts is Tshs130,000. Required: Determine the value of each shirt Net Realizable Value Net realizable value is the estimated selling price in the ordinary course of business, less estimated costs of completion and estimated costs necessary to make the sale. IAS 2 Pare 6 Costs are compared with the realizable value since the inventories are to be measured at the lower of the two. This is based on the view that assets should not be carried at a value which is in excess of their realizable value Example 10 All Amounts in TSh. ‘000’ Group Sales Costs to Quantit Cost per price per Completi Selling Item y unit unit on costs P 1 500 2 5 Q 2 280 5 8 P 3 320 3 9 P 4 170 4 8 Q 5 460 2 7 Required: Determine the value of inventory Page 6 2 2 2 2 2 1 4 3 4 2