2.3.1.A Core inventories and spare parts – IAS 2 or IAS 16

It is our view that an item of inventory that is not held for sale or consumed in a production process should be accounted for as an item of property, plant and equipment (PP&E) under IAS 16 – Property, Plant and Equipment – if it is necessary to the operation of an asset during more than one operating cycle and its cost cannot be recouped through sale (or it is significantly impaired after it has been used to operate the asset or obtain benefit from the asset). This applies even if the part of inventory that is deemed to be an item of PP&E cannot physically be separated from other inventory.

By contrast, spare parts are classified as inventory unless they meet the definition of PP&E. The recognition of spare parts as PP&E and the accounting treatment of core inventories are discussed further in Chapter 18 at 3.1.1 and 3.1.5 respectively.

2.3.1.B Broadcast rights – IAS 2 or IAS 38

Broadcasters purchase programmes under a variety of different arrangements. Often they commit to purchasing programmes that are at a very early stage of development, perhaps merely being concepts. The broadcaster may have exclusive rights over the programme or perhaps only have the rights to broadcast for a set period of time or on a set number of occasions. IFRS is not clear on how these rights should be classified and when they should be recognised.

We believe that an entity may either treat these rights as intangible assets and classify them under IAS 38 – Intangible Assets, see Chapter 17 at 2.2.2, or classify them as inventory under IAS 2. Such rights would certainly seem to meet the definition of inventory under IAS 2. Given that the acquisition of these rights forms part of the cost of the broadcaster's programming schedule, they meet the general IAS 2 definition in that they are:

1. held for sale in the ordinary course of business;
2. in the process of production for such sale; or
3. in the form of materials or supplies to be consumed in the production process or in the rendering of services. [IAS 2.6].

When classified as inventory, the rights will need to be disclosed within current assets, even if the intention is not to consume them within 12 months. [IAS 1.68]. As with costs of other inventory the cash outflow from acquisition will be classified as an operating cash flow and the expense will be presented within cost of sales when the right is consumed.

There is also the issue of the timing of recognition of these rights. In accordance with paragraph 4.4 of The Conceptual Framework for Financial Reporting (2010) an asset is a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity. In March 2018, the IASB issued a revised Conceptual Framework for Financial Reporting. The revised framework became effective immediately for the IASB and IFRS Interpretations Committee and is effective from 1 January 2020 for entities that use the Conceptual Framework to develop accounting policies when no IFRS standard applies to a particular transaction. Paragraph 4.3 of the revised Conceptual Framework defines an asset as a present economic resource controlled by the entity as a result of past events.

Hence it is necessary to determine when control is obtained. Under IFRS, executory contracts where both parties are still to perform (such as purchase orders where neither payment nor delivery has taken place) do not generally result in the recognition of assets and liabilities. When a broadcaster initially contracts to purchase a programme it will not usually result in immediate recognition of an asset relating to that programme. At this point there will not normally be an asset under the control of the broadcaster. Factors that may be relevant in determining when the entity controls an asset include whether:

• the underlying resource is sufficiently developed to be identifiable (e.g. whether the manuscript or screenplay has been written, and whether directors and actors have been hired);
• the entity has legal, exclusive rights to broadcast, which may be in respect of a defined period or geographic area;
• there is a penalty to the licensor for non-delivery of the content;
• it is probable that content will be delivered; and
• it is probable that economic benefits will flow to the entity.

Where there is difficulty in determining when control of the asset is obtained it may be helpful to assess at what point any liability arises, since a liability will generally indicate that an asset has been acquired. In practice an entity might recognise an asset and liability for a specific broadcast right on the following trigger dates:

• when a screening certificate is obtained;
• when programming is available for exhibition;
• the beginning of the season;
• the beginning of the license period; or
• the date the event occurs (e.g. game-by-game basis).

The issue of when a licensor recognises revenue under IFRS 15 on the sale of such broadcast rights is covered in Chapter 31.

2.3.1.C Emission rights – IAS 2 or IAS 38

In order to encourage entities to reduce emissions of pollutants, governments around the world have introduced schemes that comprise tradeable emissions allowances or permits. Entities using emission rights for their own purposes may elect to record the rights as intangible assets, whether at cost, revalued amount or, under the so-called ‘net liability’ approach, as rights that are re-measured to fair value. See Chapter 17 at 11.2.

It may also be appropriate to recognise emission rights, whether granted by the government or purchased by an entity, as inventory in accordance with IAS 2 if they are held for sale in the ordinary course of business or to settle an emissions liability in the ordinary course of business. If the purchased emission rights are recognised as inventories, they are subsequently measured at the lower of cost or net realisable value in accordance with IAS 2, unless they are held by commodity broker-traders.

Broker-traders account for emission rights as inventory. A broker-trader may recognise emission rights either at the lower of cost and net realisable value, or at fair value less costs to sell as permitted by IAS 2. An integrated entity may hold emission rights both for own-use and for trading. An entity accounts for these emission rights separately.

2.3.1.D Bitcoin and other crypto-currencies

In recent years, numerous cryptocurrencies (e.g. Bitcoin) and crypto-tokens have been launched. Crypto-assets each have their own terms and conditions, and the purpose for holding them differs between holders. As a result, the holders of a crypto-asset will need to evaluate their own facts and circumstances in determining which IFRS recognition and measurement requirements should be applied. However, the IFRS Interpretations Committee has discussed how IFRS Standards apply to holdings of a subset of crypto-assets with the following characteristics:

• a digital or virtual currency recorded on a distributed ledger that uses cryptography for security;
• not issued by a jurisdictional authority or other party; and
• does not give rise to a contract between the holder and another party.

For the purpose of their discussion, the Committee referred to crypto-assets with these characteristics as ‘cryptocurrency’. In June 2019, the Committee concluded that IAS 2 applies to cryptocurrencies when they are held for sale in the ordinary course of business. If IAS 2 is not applicable, an entity applies IAS 38 to holdings of cryptocurrencies.¹

The Committee observed that a holding of cryptocurrency would meet the definition of an intangible asset in IAS 38 on the grounds that: a) it is capable of being separated from the holder and sold or transferred individually; and b) it does not give the holder a right to receive a fixed or determinable number of units of currency. Other crypto-assets that do not have the characteristics of cryptocurrency considered by the Committee (and therefore not in scope of the agenda decision) may also meet the relatively wide definition of an intangible asset. The accounting for crypto-assets as intangible assets is discussed in Chapter 17 at 11.5.

However not all intangible assets are within the scope of IAS 38 as the standard is clear that it does not apply to items that are in the scope of another standard. For example, IAS 38 excludes from its scope intangible assets held by an entity for sale in the ordinary course of business, which are within scope of IAS 2, [IAS 38.3(a)], and financial assets as defined in IAS 32 – Financial Instruments: Presentation. [IAS 38.3(e)].

The Committee considered the definition of a financial asset in accordance with IAS 32 and concluded that a holding of cryptocurrency is not a financial asset. This is because a cryptocurrency is not cash. Nor is it an equity instrument of another entity. It does not give rise to a contractual right for the holder and it is not a contract that will or may be settled in the holder's own equity instruments. The definition of a financial asset in accordance with IAS 32 is discussed in Chapter 45 at 2.

Although this is often assumed, IAS 2 does not require inventory to be tangible. IAS 2 defines inventory as assets:

1. held for sale in the ordinary course of business;
2. in the process of production for such sale; or
3. in the form of materials or supplies to be consumed in the production process or in the rendering of services. [IAS 2.6].

The Committee observed that cryptocurrencies could be held for sale in the ordinary course of business, for example, by a commodity broker-trader. In that circumstance, a holding of cryptocurrency is inventory for the entity, and IAS 2 applies to that holding.

Whether cryptocurrencies and other crypto-assets are held for sale in the ordinary course of business would depend on the specific facts and circumstances of the holder.

In practice, cryptocurrencies and other crypto-assets are generally not used in the production of inventory and, thus, would not be considered materials and supplies to be consumed in the production process. However, in limited circumstances, we believe that a crypto-asset could be held for consumption in the rendering of a service. For example, a crypto-asset, not readily convertible to cash, that only entitles the holder to a specific service (e.g. server capacity) could be considered inventory if the holder uses the underlying service to deliver its own services in the ordinary course of its business.

The measurement of cryptocurrencies and other crypto-assets that meet the definition of inventory is addressed at 3.4 below.

If an entity has made judgements regarding its accounting for holdings of cryptocurrencies, and those judgements have a significant effect on the amounts recognised in the financial statements, those judgements should be disclosed in line with the requirements of paragraph 122 of IAS 1 – Presentation of Financial Statements.² Such judgements may relate to the classification of cryptocurrency as inventory or intangible assets, and may also be relevant to holdings of other crypto-assets outside the scope of the Interpretations Committee's discussions.

2.3.1.E Transfers of rental assets to inventory

An entity may, in the course of its ordinary activities, routinely sell items that had previously been held for rental and classified as property, plant and equipment. For example, car rental companies may acquire vehicles with the intention of holding them as rental cars for a limited period and then selling them. IAS 16 requires that when such items become held for sale rather than rental they be transferred to inventory at their carrying value. [IAS 16.68A]. Revenue from the subsequent sale is then recognised gross rather than net, as discussed in Chapter 18 at 7.2.

2.3.1.F 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. Under IFRS 15, revenue would generally not be recognised for stock delivered to the consignee because control has not yet transferred (see Chapter 30 at 6), and the seller would continue to account for the consignment inventory until control has passed.

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. IFRS 15 contains complex guidance, explained in Chapter 30 at 5, which can result in the entity accounting for such arrangements as financing arrangements, as leases, or as a sale with a right of return.

Where an arrangement is accounted for as a financing arrangement, the seller will continue to recognise the inventory on its balance sheet and will also recognise a financial liability for the consideration received. If IFRS 15 requires the arrangement to be accounted for as a lease, the arrangement must be accounted for in accordance with IFRS 16 – Leases. If the seller is considered to be acting as lessor in a finance lease, the inventory subject to the arrangement would be derecognised and the seller would instead recognise a finance lease receivable. If the seller is considered to be acting as lessor in an operating lease, the seller would continue to recognise the inventory on balance sheet. For arrangements that are considered to be a sale with a right of return, inventory will be derecognised and the seller will instead recognise a right of return asset. Sales with a right of return are considered further at 2.3.1.G below.

The entity will also have to consider appropriate disclosure for material amounts of inventory that is held on consignment or sale and return at a third party's premises.

2.3.1.G Sales with a right of return

An entity may provide its customers with a right to return goods that it has sold to them. The right may be contractual, or an implicit right that exists due to the entity's customary business practice, or a combination of both. Offering a right of return in a sales agreement obliges the selling entity to stand ready to accept any returned product. Under IFRS 15, the potential for customer returns needs to be considered when an entity estimates the transaction price because potential returns are a component of variable consideration. IFRS 15 also requires that the selling entity recognise the amount received or receivable that is expected to be returned to the customer as a refund liability, and recognise a return asset for its right to recover goods returned by the customer. The carrying value of the return asset is presented separately from inventory. Sales with a right of return are discussed further in Chapter 30 at 9.

3.1.3.A Storage and distribution costs

Storage costs are not permitted as part of the cost of inventory unless they are necessary in the production process. [IAS 2.16(b)]. 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.

Where it is necessary to store raw materials or work in progress prior to a further processing or manufacturing stage, the costs 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 are obviously a cost of bringing an item to its present location, the question arises as to whether costs of transporting inventory from one location to another are eligible.

Costs of distribution to the customer are not allowed as they are selling costs, which are prohibited by the standard from being included in the carrying value of inventory. [IAS 2.16(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 may be included in inventory costs. It follows that transportation costs between the two storage facilities should not be included in the carrying value of inventory.

A question arises about the meaning of ‘production’ in the context of large retailers with distribution centres, for example supermarkets. As the transport and logistics involved are essential to their ability to put goods on sale at a particular location in an appropriate condition, it seems reasonable to conclude that such costs are an essential part of the production process and can be included in the cost of inventory. The circumstances of the entity may warrant the inclusion of distribution or other costs into cost of sales even though they have been excluded from the cost of inventory. [IAS 2.38]. Disclosure is discussed at 6 below.

3.1.3.B General and administrative overheads

IAS 2 specifically disallows administrative overheads that do not contribute to bringing inventories to their present location and condition. [IAS 2.16(c)]. Other costs and overheads that do contribute are allowable as costs of production. There is a judgement to be made about such matters, as under a very broad interpretation any department could be considered to make a contribution. For example, the accounts department will normally support the following functions:

1. 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;
2. marketing and distribution – by analysing sales and by controlling the sales ledger; and
3. 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 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 can be related 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. 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 IAS 2 by presenting an analysis of the function and its contribution to the production process similar to the above.

3.1.3.C Borrowing costs and purchases on deferred terms

IAS 2 states that, in limited circumstances, borrowing costs are to be included in the costs of inventories. [IAS 2.17]. IAS 23 – Borrowing Costs – requires that borrowing costs be capitalised on qualifying assets but the scope of that standard exempts inventories that are manufactured in large quantities on a repetitive basis. [IAS 23.4, 8]. In addition, IAS 23 clarifies that inventories manufactured over a short period of time are not qualifying assets. [IAS 23.7]. However, any manufacturer that is producing small quantities over a long time period has to capitalise borrowing costs. This is further discussed in Chapter 21.

IAS 2 also states that on some occasions, an entity might purchase inventories on deferred settlement terms, accompanied by a price increase that effectively makes the arrangement a combined purchase and financing arrangement. Under these circumstances the price difference is recognised as an interest expense over the period of the financing. [IAS 2.18].

Entities might also make prepayments for inventory, particularly raw materials in long-term supply contracts, raising the question of whether there is a financing component that should be accounted for separately.

If a purchaser accretes interest on long-term prepayments by recognising interest income, this will result in an increase in the cost of inventories and, ultimately, the cost of sales. The Interpretations Committee considered this in July 2015, noting that IAS 16 and IAS 38 include similar requirements to IAS 2 when payment for an asset is deferred (see Chapter 18 at 4.1.6 and Chapter 17 at 4.2).

Historically there has been no explicit requirement in IFRS to accrete interest income but the Interpretations Committee noted that IFRS 15 includes the requirement that the financing component of a transaction should be recognised separately in circumstances of both prepayment and deferral of payment (see Chapter 29 at 2.5). They concluded, therefore, that when a financing component is identified in a long-term supply contract of raw materials, that financing component should be accounted for separately. They acknowledged that judgement is required to identify when individual arrangements contain a financing component.³

3.1.3.D Service providers

Before IFRS 15 became effective, IAS 2 included the notion of work in progress (or ‘inventory’) of a service provider. However, this was consequentially removed from IAS 2 and replaced with the relevant requirements in IFRS 15. Costs to fulfil a contract, as defined in IFRS 15, are divided into two categories: (a) costs that give rise to an asset; and (b) costs that are expensed as incurred (see Chapter 31 at 5.2). [IFRS 15.95‑96]. When determining the appropriate accounting treatment for such costs, IAS 2 (or any other more specific IFRS) is considered first and if costs incurred in fulfilling the contract are within the scope of this standard, those costs should be accounted for in accordance with IAS 2 (or other IFRS). If costs incurred to fulfil a contract are not within the scope of IAS 2 or any other applicable standard, an entity would need to consider the criteria in IFRS 15 for capitalisation of such costs (see Chapter 31 at 5.2).

IFRS 15 does not specifically deal with the classification and presentation of contract costs. Entities therefore need to apply the requirements in IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors – to select an appropriate classification. As discussed in Chapter 31 at 5.3.6, we believe that costs to fulfil a contract should be presented as a separate asset in the statement of financial position.

3.1.3.E Forward contracts to purchase inventory

The standard scopes out commodity broker-traders that measure inventory at fair value less costs to sell from its measurement requirements (see 2.3 above). If a broker-trader had a forward contract for purchase of inventory this contract would be accounted for as a derivative under IFRS 9 – Financial Instruments – since it would not meet the normal purchase or sale exemption (see Chapter 45 at 4.2) and when the contract was physically settled, the inventory would likewise be shown at fair value less costs to sell. [IAS 2.3(b)]. However, if such an entity were not measuring inventory at fair value less costs to sell it would be subject to the measurement requirements of IAS 2 and would therefore have to record the inventory at the lower of cost and net realisable value. This raises the question: what is cost when such an entity takes delivery of inventory that has been purchased with a forward contract?

On delivery, the cash paid (i.e. the fixed price agreed in the forward contract) is in substance made up of two elements:

1. an amount that settles the forward contract; and
2. an amount that represents the ‘cost of purchase’, being the market price at the date of purchase.

This ‘cost of purchase’ represents the forward contract price adjusted for the derivative asset or liability. For example, assume that the broker-trader was purchasing oil and the forward contracted price was $40 per barrel of oil, but at the time of delivery the spot price of oil was $50 and the forward contract had a fair value of $10 at that date. The oil would be recorded at the fair value on what is deemed to be the purchase date of $50. The $40 cash payment would in substance consist of $50 payment for the inventory offset by a $10 receipt on settlement of the derivative contract, which would be separately accounted for. This is exactly the same result as if the entity had been required to settle the derivative immediately prior to, and separate from, the physical delivery of the oil. The requirement to recognise inventory at the amount of cash paid ($40) plus the fair value of the derivative at the settlement date ($10), when the normal sale and purchase exemption does not apply and the derivative is not designated as part of a hedge relationship, was confirmed by the Interpretations Committee in the March 2019 agenda decision addressing physical settlement of contracts to buy or sell a non-financial item.⁴

If the entity purchasing the oil in the example above is not a broker-trader, and the acquisition meets the normal purchase or sale exemption given in IAS 32, the purchase of oil would be recognised at the entity's cost thereof; in terms of IAS 2, that is $40 per barrel of oil.

3.1.3.F Drug production costs within the pharmaceutical industry

After the development stage, pharmaceutical companies often commence production of drugs prior to obtaining the necessary regulatory approval to sell them. As long as the regulatory approval has been applied for and it is believed highly likely that this will be successfully obtained then it is appropriate to be recognising an asset and classifying this as inventory. Prior to this application for regulatory approval being made any costs would need to be classified as research and development costs rather than inventory and the criteria within IAS 38 assessed to determine if capitalisation was appropriate (see Chapter 17 at 6.2.3).

3.2.1.A First-in, first-out (FIFO)

In the vast majority of businesses it will not be practicable to keep track of the cost of identical items of inventory on an individual unit basis; nevertheless, it is desirable to approximate to the actual physical flows as far as possible. The FIFO method probably gives the closest approximation to actual cost flows, since it is assumed 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. [IAS 2.27]. This can best be illustrated in the context of a business which deals in perishable goods (e.g. food retailers) since clearly such a business will use the first goods received earliest. The FIFO method, by allocating the earliest costs incurred against revenue, matches actual cost flows with the physical flow of goods reasonably accurately. In any event, even in the case of businesses which do not deal in perishable goods, this would reflect what would probably be a sound management policy. In practice, the FIFO method is generally used where it is not possible to value inventory on an actual cost basis.

3.2.1.B Weighted average cost

The weighted average method, which like FIFO is suitable where inventory units are identical or nearly identical, involves the computation of an average unit cost by dividing the total cost of units by the number of units. The average unit cost then has to be revised with every receipt of inventory, or alternatively at the end of predetermined periods. [IAS 2.27]. In practice, weighted average systems are widely used in packaged inventory systems that are computer controlled, although its results are not very different from FIFO in times of relatively low inflation, or where inventory turnover is relatively quick.

3.2.1.C Last-in, first-out (LIFO)

LIFO, as its name suggests, is the opposite of FIFO and assumes that the most recent purchases or production are used first. In certain cases this could represent the physical flow of inventory (e.g. if a store is filled and emptied from the top). However it is not an acceptable method under IAS 2. LIFO is an attempt to match current costs with current revenues so that profit or loss excludes the effects of holding gains or losses. Essentially, therefore, LIFO is an attempt to achieve something closer to replacement cost accounting for the statement of profit or loss, whilst disregarding the statement of financial position. Consequently, the period-end balance of inventory on hand represents the earliest purchases of the item, resulting in inventories being stated in the statement of financial position at amounts which may bear little relationship to recent cost levels. Unlike IFRS, US GAAP allows LIFO and it is popular in the US as the Internal Revenue Service officially recognises LIFO as an acceptable method for the computation of tax provided that it is used consistently for tax and financial reporting purposes.