Hey! Today we are going to look at one of the most common areas in any business – inventories. You know that costs for goods that remain unsold at the year-end must be carried forward and matched with future revenue. But how shall these costs of unsold items be measured? Standard IAS 2 on inventories covers this area. What are inventories? Inventories are assets that are held for sale in the ordinary business. Or, inventories are also assets in the process of production for such sale, production of goods or rendering services. Inventories comprise merchandise, production supplies, materials, work in progress and finished goods. Be careful, because IAS 2 does NOT speak about the following items: work in progress in construction contracts, financial instruments and biological assets (e.g. milk, harvest, etc.) – we will cover these areas in future lessons. How shall we measure inventories? Inventories shall be measured at lower of cost and net realizable value. What can be included in the costs of inventories? Costs of inventories include: costs of purchase: purchase price, import duties and non-refundable taxes, transport, handling, but less any trade rebates and discounts costs of conversion: costs directly related to units of production (direct labor, direct expenses, subcontracted work) and systematic allocation of fixed and variable production overheads incurred in converting materials into finished goods other costs: only to the extent incurred in bringing the inventory to its present location and condition What cannot be included in the costs of inventories? Examples of expenses that have to be accounted for directly to profit or loss (and not included in the cost of inventories) are: abnormal waste, storage costs (but these are in some cases allowable), administrative overheads, selling expenses and similar items. How to determine the costs of inventories at the year-end? Production process might be very complex and involve lots of stages. Therefore, it is not always possible to relate expenditure to specific units of inventory. As a result, several methods have been developed to reliably estimate the actual cost of inventories and the year-end. IAS 2 allows you to use just a few of them: FIFO (first-in-first-out): The cost of inventories is calculated on the basis that the quantities actually in the warehouse at the year-end represent the latest purchases or production. Weighted average: Here, average price of inventories is calculated as total cost of units divided by the total number of such units. The price is recalculated each time a purchase is made. Then, items that are dispatched from the warehouse are removed at the actual weighted average price. Are some other techniques of cost measurement allowed by IAS 2? Except for weighted average or FIFO, IAS 2 allows application of standard cost and retail method techniques to approximate costs of inventory. Standard costs: This technique of cost measurement takes normal levels of materials and supplies, labor, efficiency and capacity utilization into account. Standard cost shall be regularly reviewed and revised. Retail method: This method is very often utilized in the retail industry where inventories are in large quantities and fast moving. Here, sales value of inventory is reduced by the appropriate percentage gross margin. LIFO (last-in-first-out) is prohibited by IAS 2. What is net realizable value? Net realizable value is the estimated selling price of inventories in ordinary course of business less estimated cost of completion and less estimated costs necessary to make the sale. What happens if inventories’ cost is greater than their net realizable value? Net realizable value is indeed sometimes lower than cost. For example, when inventories were damaged, became obsolete, errors in production happened, selling prices fell, etc. In such a case, a company writes the value of inventories down in its accounting records. The accounting entry is as follows: Dr. Expense for inventories’ write-down (profit or loss) / Cr. Inventories Of course, appropriate disclosures in the notes to the financial statements must be made.
Posted on: Thu, 11 Jul 2013 09:44:25 +0000
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