3.2.1 Scope and recognition issues

For entities operating in some industries, it may not always be clear whether certain assets fall in scope of Section 13 or are covered by another section of FRS 102. Scope issues that entities may encounter include:

• classification of core inventories as property, plant and equipment or inventory. Core inventories arise in industries where certain processes or storage arrangements require a core of inventory to be present in the system at all times. For example, in order for a crude oil refining process to take place, the plant must contain a certain minimum quantity of oil which can only be taken out once the plant is abandoned;
• classification of broadcast rights as intangible assets or inventory;
• classification of emission rights as intangible assets or inventory; and
• classification of crypto-currencies.

These scope issues are discussed at Chapter 22 of EY International GAAP 2019.

3.3.1 What is included in the cost of inventories?

The cost of inventories should include all costs of purchase, costs of conversion and other costs incurred in bringing inventories to their present location and condition. [FRS 102.13.5].

Other costs should be included in the cost of inventories only to the extent that they are incurred in bringing them into their present location and condition. [FRS 102.13.11]. For example, design costs for a special order for a particular customer may be included in inventory.

3.3.2 Costs of purchase of inventories

The cost of purchase of inventories comprises the purchase price, transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services. It also includes import duties and other unrecoverable taxes. Trade discounts, rebates and other similar items should be deducted in arriving at the cost of purchase. [FRS 102.13.6].

Entities sometimes purchase inventories on deferred settlement terms. In some cases, the arrangement contains an unstated financing element, for example, a difference between the purchase price for normal credit terms and the deferred settlement amount. In these cases, the difference is usually recognised as an interest expense over the period of the financing. It is not added to the cost of inventories unless the inventory is a qualifying asset under Section 25 – Borrowing Costs – and the entity adopts a policy of capitalising finance costs. [FRS 102.13.7]. Inventories manufactured over a short period of time are not qualifying assets. Only inventories produced in small quantities over a long time period of time are likely to be qualifying assets under Section 25. Qualifying assets are discussed further in Chapter 22.

3.3.3 Costs of conversion

The cost of conversion of inventories includes costs directly related to the units of production, such as direct labour. It also includes a systematic allocation of the fixed and variable production overheads that are incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and equipment, and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour. [FRS 102.13.8]. It must be remembered that the inclusion of overheads is not optional.

The allocation of fixed production overheads should be based on the normal capacity of the production facilities. Normal capacity is defined as ‘the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance.’ While actual capacity may be used if it approximates to normal capacity, increased overheads may not be allocated to production as a result of low production or idle plant. Unallocated overheads must be recognised as an expense in the period in which they are incurred. In periods of abnormally high production, the amount of fixed overhead allocated to each unit of production is decreased, as otherwise inventories would be recorded at an amount in excess of cost. [FRS 102.13.9].

The allocation of variable production overheads should be based on the actual use of the production facilities in the period. [FRS 102.13.9].

Some entities may have an obligation to dismantle, remove and restore a production site at some future date. For example, mining companies may have obligations to decommission mines and rehabilitate the impacted area on closure of the mine. Although provisions for such obligations are not specifically addressed by Section 21 – Provisions and Contingencies, the recognition criteria within Section 21 may require entities to record a provision for these obligations. If the obligation arises as a result of production of inventory during the period, costs in respect of the obligation incurred during the period (measured in accordance with Section 21) should be included within production overheads to be allocated to the cost of inventories. [FRS 102.13.8A]. The estimated costs to dismantle, remove and restore a site which arise either when an item of property, plant or equipment is acquired or as a consequence of having used the property, plant or equipment for purposes other than to produce inventories during the period should be recognised as part of the cost of that item of property, plant and equipment. [FRS 102.17.10].

3.3.4 Costs excluded from inventories

The following are examples of costs that should not be included in the cost of inventories: [FRS 102.13.13]

1. abnormal amounts of wasted materials, labour or other production costs;
2. storage costs, unless those costs are necessary during the production process before a further production stage;
3. administrative overheads that do not contribute to bringing inventories to their present location and condition; and
4. selling costs.

These costs should be recognised as expenses in the period in which they are incurred.

3.3.5 Storage and distribution costs

Storage costs are not permitted to be included in the cost of inventories unless they are necessary in the production process. This appears to prohibit including the costs of the warehouse and the overheads of a retail outlet as part of inventory, as neither of these is a prelude to a further production stage.

When it is necessary to store raw materials or work in progress prior to a further processing or manufacturing stage, the cost of such storage should be included in production overheads. For example, it would appear reasonable to allow the costs of storing maturing stocks, such as cheese, wine or whisky, in the cost of production.

Although distribution costs in the general sense are obviously a cost of bringing an item to its present location, company law prohibits them from being added to the cost of stock. However, the Regulations do not define distribution costs. [1 Sch 27(4)]. The question therefore arises as to whether costs of transporting inventory from one location to another are eligible.

Costs of distribution to the customer are not allowed; they are selling costs and FRS 102 prohibits their inclusion in the carrying value of inventory. [FRS 102.13.13(d)]. It therefore seems probable that distribution costs of inventory whose production process is complete should not normally be included in its carrying value.

If the inventory is transferred from one of the entity's storage facilities to another and the condition of the inventory is not changed at either location, none of the warehousing costs should be included in inventory costs. The same argument appears to preclude transportation costs between the two storage facilities being included in inventory costs.

For large retailers, such as supermarkets, transport and logistics are essential to their ability to move goods from central distribution centres to initial points of sale at a particular location in an appropriate condition. It therefore seems reasonable to conclude that such costs are an essential part of the production process and can be included in the cost of inventory.

3.3.6 General and administrative overheads

FRS 102 specifically prohibits administrative overheads that do not contribute to bringing inventories to their present location and condition from being included in the cost of inventories. [FRS 102.13.13(c)]. Costs and overheads that do contribute should be included in costs of conversion. There is a judgement to be made about such matters, as on a very wide interpretation, any department in an entity could be considered to make a contribution to inventories. For example, the accounts department will normally support the following functions:

• production – by paying direct and indirect production wages and salaries, by controlling purchases and related payments, and by preparing periodic financial statements for the production units;
• marketing and distribution – by analysing sales and by controlling the sales ledger; and
• general administration – by preparing management accounts and annual financial statements and budgets, by controlling cash resources and by planning investments.

Only those costs of the accounts department that can be reasonably allocated to the production function can be included in the cost of conversion. Part of the management and overhead costs of a large retailer's logistical department may be included in cost if it relates to bringing the inventory to its present location and condition. These types of cost are unlikely to be material in the context of the inventory total held by organisations. In our view, an entity wishing to include a material amount of overhead of a borderline nature must ensure it can sensibly justify its inclusion under the provisions of FRS 102 by presenting an analysis of the function and its contribution to the production process similar to the bulleted section above.

3.3.7 Borrowing costs

In limited circumstances, borrowing costs may be included in the cost of inventories. Section 25 allows entities to adopt an accounting policy of capitalising borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. [FRS 102.25.2]. Qualifying assets are assets that necessarily take a substantial period of time to get ready for their intended use or sale, and may include inventories. [FRS 102 Appendix I]. Inventories that are manufactured in large quantities on a repetitive basis are unlikely to meet the definition of qualifying assets. However, any manufacturer that produces small quantities of inventories over a long period of time will have an accounting policy choice as to whether to include borrowing costs in the cost of these inventories. This is discussed further in Chapter 22.

3.3.8 Inventories acquired through a non-exchange transaction

Entities may sometimes enter into non-exchange transactions whereby the entity gives value to or receives value from another entity without directly receiving or giving approximately equal value in exchange. [FRS 102 Appendix I].

Where inventories are acquired through a non-exchange transaction, their cost should be measured at their fair value as at the date of acquisition. [FRS 102.13.5A]. For entities other than public benefit entities, the fair value of inventories acquired through a non-exchange transaction should be determined by reference to the guidance in the Appendix to Section 2, which is discussed in Chapter 4.

For public benefit entities and entities within a public benefit entity group, Section 34 and the related Appendix B provide additional guidance on non-exchange transactions. As part of their normal business operations, public benefit entities may receive donations of cash, goods and services, and legacies which would meet the definition of non-exchange transactions. Public benefit entities and entities within a public benefit entity group should recognise inventories acquired through a non-exchange transaction at fair value only when required by Section 34. [FRS 102.13.5A]. Accounting for non-exchange transactions by public benefit entities and entities within a public benefit entity group is discussed further in Chapter 31 at 6.

3.3.9 Joint products and by-products

A production process may result in more than one product being produced simultaneously, for example when joint products are produced or where there is a main product and a by-product. If the costs of raw materials or converting each product are not separately identifiable, they should be allocated between the products on a rational and consistent basis. This may be, for example, based on the relative sales value of each of the products, either at the stage in the production process when the products become separately identifiable, or once production is complete. If the value of the by-product is immaterial, as is often the case, it should be measured at selling price less costs to complete and sell, with this amount then deducted from the cost of the main product. [FRS 102.13.10].

3.3.10 Service providers

FRS 102 deals specifically with the inventories of service providers – effectively their work in progress. For this type of business, FRS 102 requires the labour and other costs of personnel directly engaged in providing the service, including supervisory personnel and attributable overheads, to be included in the costs of inventories. However, labour and other costs relating to sales and general administrative personnel must be expensed as incurred. Inventories should not include profit margins or non-attributable overheads. [FRS 102.13.14].

As discussed at 3.3.3 above, FRS 102 requires attributable overheads to be allocated to the cost of inventories based on normal levels of capacity. Determining a normal level of activity may be difficult in the context of service industries where the ‘inventory’ is intangible and based on work performed for customers that has not yet been recognised as income. Entities must take care to establish an appropriate benchmark to avoid the distortions that could occur if overheads were attributed on the basis of actual ‘output’.

3.3.11 Inventories held for distribution at no or nominal consideration

Inventories held for distribution at no or nominal consideration includes items such as advertising and promotional material, and also items that may be distributed to beneficiaries by public benefit entities. [FRS 102 Appendix III.36].

FRS 102 requires inventories held for distribution at no or nominal consideration to be measured at the lower of cost adjusted, when applicable, for any loss of service potential and replacement cost. [FRS 102.13.4A].

IFRS requires advertising and promotional activities to be expensed as incurred, unless the entity has paid in advance for advertising goods or services that have not yet been made available to the entity, in which case a prepayment asset is recognised. [IAS 38.69-70]. In contrast, FRS 102 requires advertising and promotional material (being inventory held for distribution at no or nominal value) to be carried at the lower of cost (adjusted for any loss of service potential) and replacement cost. [FRS 102.13.4A]. FRS 102 provides no further guidance on how, or at what unit of account, service potential should be measured. It does not specify whether this should be at the individual asset level (e.g. the extent to which an individual catalogue is expected to generate future revenue for the entity) or based on a class of promotional material (e.g. the extent to which all catalogues printed for a particular year / season are expected to generate future revenue for the entity). In our view, an entity wishing to recognise a material inventory balance for advertising and promotional expenditure must ensure that it can sensibly justify how the entity will derive future benefit from the use of the materials.

The measurement basis described above (i.e. lower of cost adjusted for loss of service potential and replacement cost) is an application of fair value accounting as permitted by Schedule 1 to the Regulations, however for inventories held for distribution at no or nominal value (particularly items distributed to beneficiaries by public benefit entities) there is unlikely to be a significant difference between replacement cost and fair value. [FRS 102 Appendix III.37].

The carrying amount of inventories held for distribution at no or nominal consideration should be recognised as an expense when the inventories are distributed. [FRS 102.13.20A].

3.3.12 Agricultural produce harvested from biological assets

Inventories comprising agricultural produce that an entity has harvested from its biological assets should be measured on initial recognition, at the point of harvest, at either: [FRS 102.13.15]

• their fair value less estimated costs to sell; or
• the lower of cost and estimated selling price less costs to complete and sell.

For the purposes of applying Section 13, this amount becomes the cost of the inventories at that date.

3.3.13 Cost measurement methods

FRS 102 allows the use of standard costing methods, the retail method or most recent purchase price for measuring the cost of inventories if the result approximates cost. [FRS 102.13.16].

Standard costs should take into account normal levels of materials and supplies, labour, efficiency and capital utilisation. They must be reviewed regularly and revised where necessary. [FRS 102.13.16].

The retail method measures cost by reducing the sales value of the inventory by the appropriate percentage gross margin. This method is typically used in businesses with high volumes of various line items of inventory, where similar marks-ups are applied to ranges of inventory items or groups of items. It may be unnecessarily time-consuming to determine the cost of the period-end inventory on a conventional basis. Consequently, the most practical method of determining period-end inventory may be to record inventory on hand at selling prices, and then convert it to cost by removing the normal mark-up.

A judgemental area in applying the retail method is in determining the margin to be removed from the selling price of inventory in order to convert it back to cost. The percentage has to take account of circumstances in which inventories have been marked down to below original selling price. Adjustments have to be made to eliminate the effect of these markdowns so as to prevent any item of inventory being valued at less than both its cost and its net realisable value. In practice, however, entities that use the retail method apply a gross profit margin computed on an average basis appropriate for departments and/or ranges, rather than applying specific mark-up percentages.

As noted above, FRS 102 also allows the use of the most recent purchase price as a cost measurement method. This method arrives at the cost of stock by applying the latest purchase price to the total number of units in stock. IAS 2 is silent on the use of this methodology. In practice, the use of the most recent purchase price is not a common method of measuring the cost of inventory. Where it is used, care should be taken to ensure that the result does approximate to the actual cost of inventories.

Items of inventory that are not interchangeable (i.e. where one item of inventory cannot easily be replaced with another item of inventory held by the entity) and goods or services produced and segregated for specific projects should have their costs specifically identified. [FRS 102.13.17]. These costs should be matched with the goods or services physically sold. Due to the clerical effort required, this is likely to be feasible only where there are relatively few high value items being bought or produced. Consequently, it would normally be used where inventory comprised items such as antiques, jewellery and vehicles in the hands of dealers.

When inventory comprises a large number of ordinarily interchangeable items, FRS 102 requires inventory to be measured using either a first-in, first-out (FIFO) or a weighted average cost formula. [FRS 102.13.18]. The FIFO method assumes that when inventories are sold or used in a production process, the oldest are sold or used first. Consequently, the balance of inventory on hand at any point represents the most recent purchases or production. The weighted average method involves the computation of an average unit cost by dividing the total cost of units by the total number of units. The average unit cost then has to be revised with every receipt of inventory, or at the end of predetermined periods. In practice, where it is not possible to value inventory on an actual costs basis, the FIFO method is generally used. However, the weighted average method is widely used in computerised inventory systems. In times of low inflation, or where inventory turnover is relatively quick, the FIFO and weighted average methods give similar results.

The last-in, first-out (LIFO) method of measuring the cost of inventory is not permitted by FRS 102. [FRS 102.13.18]. The LIFO method assumes that when inventories are sold or used in a production process, the most recent purchases are sold or used first. This method is an attempt to match current costs with current revenues so that the profit and loss account excludes the effects of holding gains. However, this results in inventories being stated on balance sheet at amounts which may bear little or no relationship to recent cost levels.

FRS 102 makes it clear that the same cost formula should be used for all inventories having a similar nature and use to the entity. However, different cost formulas may be justified for inventories with a different nature or use. [FRS 102.13.18].

3.3.14 Additional company law considerations

As an alternative to the historical cost accounting rules set out above, the Regulations allow that where materials and consumables inventories are of a kind that are constantly being replaced they may be recorded at a fixed quantity and value if: [1 Sch 26, 1 Sch 26 (LLP)]

• their overall value is not material to the company; and
• their quality, value and composition are not subject to material variation.

This treatment is not generally permitted by Section 13 and would be appropriate only if the result approximated the cost of inventories as determined by applying the measurement requirements of Section 13.

3.4.1 Selling price less costs to complete and sell

Section 32 – Events after the End of the Reporting Period – states that ‘the sale of inventories after the end of a reporting period may give evidence about their selling price at the end of the reporting period for the purpose of assessing impairment at that date.’ [FRS 102.32.5(b)(ii)]. Events that have impacted selling prices after the end of the reporting period, such as damage to inventories as a result of a warehouse fire post year end, would not be relevant to the assessment of impairment at end of the reporting period. Other than this, FRS 102 gives no guidance on how to determine selling price or what costs should be included when assessing costs to complete and sell.

The requirement to measure inventories at the lower of cost and selling price less costs to complete and sell under FRS 102 is similar to the requirement under IFRS to carry inventories at the lower of cost and net realisable value. Entities may therefore choose to look to IFRS for further guidance in this area.

IFRS defines net realisable value as ‘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.’ [IAS 2.6].

IFRS is explicit 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]. Whilst this is not explicit in FRS 102, we consider that this is consistent with the measurement principle of FRS 102. As such, we would not expect a whisky distiller, for example, to 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 sufficient to recover cost. Conversely, if a provision is required in respect of finished goods, then work in progress and raw materials should also be reviewed to see if any further provision is required.

In estimating net realisable value, IFRS requires that entities should take into consideration the purpose for which inventory is held. For example, the net realisable value of inventory held to satisfy firm sales contracts is based on that contract price. [IAS 2.31]. This reflects the fact that net realisable value, unlike fair value, is an entity specific value. In our view, selling price less costs to complete and sell is also an entity specific measure intended to reflect the amount that the entity actually expects to make from selling particular inventories.

In our view, costs to complete and sell should comprise only direct and incremental costs to complete and sell the inventory and should not include any profit margin on these activities. They should 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 cost of a shop might be considered to be included in these selling costs might be when one shop is entirely dedicated to selling impaired goods.

3.4.2 Reversal of impairment of inventory

As noted at 3.4 above, FRS 102 requires entities to assess inventories for impairment at the end of each reporting period. When the circumstances that previously caused inventories to be written down no longer exist, or when there is clear evidence of an increase in selling price less costs to complete and sell because of changed economic circumstances, the amount of the write down is reversed. The amount of the reversal cannot be greater than the amount of the original write down. This means that the new carrying amount of inventories following the reversal of an impairment will be the lower of its cost and the revised selling price less costs to complete and sell. [FRS 102.27.4].

3.6.1 Presentation of inventories

As discussed in Chapter 6 at 5, UK companies and qualifying partnerships applying Schedule 1 to the Regulations are permitted to use ‘adapted formats’ as an alternative to the statutory formats as set out in section B of Part 1 of Schedule 1. FRS 102's presentation requirements for adapted formats are similar but not identical to formats included in IAS 1 – Presentation of Financial Statements. The two alternatives are set out below.

Where entities apply the statutory balance sheet formats, they are required by Schedule 1 to the Regulations to present inventories on the face of the balance sheet. Inventories should be further analysed, either on the face of the balance sheet or within the notes to the accounts, into:

• raw materials and consumables;
• work in progress;
• finished goods and goods for resale; and
• payments on account.

The classifications used in the disaggregation may be adapted dependent upon the nature of the company's business. [1 Sch 4(1)]. In practice, most companies present the disaggregation as a note to the financial statements.

Where ‘adapted formats’ are used, FRS 102 requires that inventories are shown on the face of the balance sheet. [FRS 102.4.2A]. Inventories should be further analysed, either in the statement of financial position or the notes, between amounts of inventories: [FRS 102.4.2B]

• held for sale in the ordinary course of business;
• in the process of production for such sale; and
• in the form of materials or supplies to be consumed in the production process or in the rendering of services.

3.6.2 Disclosure of inventories

FRS 102 requires an entity to disclose the following: [FRS 102.13.22]

• 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;
• impairment losses recognised or reversed in profit or loss in accordance with Section 27 (see Chapter 24); and
• the total carrying amount of inventories pledged as security for liabilities.

The Triennial review 2017 removed the requirement to disclose the amount of inventories recognise as an expense in the period.

The disclosure requirements of FRS 102 are similar to those required by IFRS, although IAS 2 also contains additional disclosure requirements not replicated in Section 13.

Where an entity has included borrowing costs in cost of inventories (see 3.3.7 above), the disclosure requirements of Section 25 will also be relevant. See Chapter 22 at 3.7.