Basic Concept of Inventory Costing

IAS 2 establishes that the lower of cost and net realisable value should be the basis for the valuation of inventories. In contrast to IFRS dealing with property, plant and equipment (IAS 16) or investment property (IAS 40), there is no option for revaluing inventories to current replacement cost or other measures of fair value, presumably due to the far shorter period of time over which such assets are held, thereby limiting the cumulative impact of inflation or other economic factors on reported amounts. However, note measurement exceptions in application of IAS 2 discussed above.

The cost of inventory items that are ordinarily interchangeable, and goods or services produced and segregated for specific projects, are generally assigned carrying amounts by using the specific identification method. For most goods, however, specific identification is not a practical alternative. In cases where there are a large number of items of inventory and where the turnover is rapid, the standard prescribes two inventory costing formulas, namely the First‐In, First‐Out (FIFO) and the weighted‐average methods. A third alternative, the Last‐In First‐Out (LIFO) costing method, was designated as being unacceptable.

FIFO and weighted‐average cost are the only acceptable cost flow assumptions under IFRS. Either method can be used to assign cost of inventories, but once selected an entity must apply that cost flow assumption consistently (unless the change to the other method can be justified under the criteria set forth by IAS 8). Furthermore, an entity is constrained from applying different cost formulas to inventories having similar nature and use to the entity. On the other hand, for inventories having different natures or uses, different cost formulas may be justified. Mere difference in location, however, cannot be used to justify applying different costing methods to otherwise similar inventories. Note that where a change in cost formula is made, this is likely to represent a change in accounting policy rather than a change in accounting estimate and will therefore need to be retrospectively applied under the requirements of IAS 8 (see Chapter 7).

Ownership of Goods

Inventory can only be an asset of the reporting entity if it is an economic resource of the entity at the date of the statement of financial position. In general, an entity should record purchases and sales of inventory when legal title passes. Although strict adherence to this rule may not appear to be important in daily transactions, proper inventory cut‐off at the end of an accounting period is crucial for the correct determination of the periodic results of operations. To obtain an accurate measurement of inventory and cost of goods sold in the financial statements (which will be based upon inventory quantities), it is necessary to determine when title passes.

The most common error made for inventories is to assume that title is synonymous with possession of goods on hand. This may be incorrect in that:

1. The goods on hand may not be owned; and
2. Goods that are not on hand may be owned.

Situations which are more likely to cause confusion about proper ownership are:

1. Goods in transit;
2. Consignment sales;
3. Product financing arrangements; and
4. Sales made with the buyer having generous or unusual right of return.

Accounting for Inventories

The major objectives of accounting for inventories are the matching of appropriate costs against revenues to arrive at the correct gross profit and the accurate representation of inventories on hand as assets of the reporting entity at the end of the reporting period.

The accounting for inventories is done under either a periodic or a perpetual system. In a periodic inventory system, the inventory quantity is determined periodically by a physical count. Next, a cost formula is applied to the quantity so determined to calculate the cost of ending inventory. Cost of goods sold is computed by adding beginning inventory and net purchases (or cost of goods manufactured) and subtracting ending inventory.

Alternatively, a perpetual inventory system keeps a running total of the quantity (and possibly the cost) of inventory on hand by recording all sales and purchases as they occur. When inventory is purchased, the inventory account (rather than purchases) is debited. When inventory is sold, the cost of goods sold and reduction of inventory are recorded. Periodic physical counts are necessary only to verify the perpetual records and to satisfy the tax regulations in some jurisdictions (tax regulations may require that a physical inventory count be undertaken at least annually).

Valuation of Inventories

According to IAS 2, the primary basis of accounting for inventories is cost. Cost is defined as the sum of all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

For raw materials and merchandise inventory that are purchased outright and not intended for further conversion, the identification of cost is relatively straightforward. The cost of these purchased inventories will include all expenditures incurred in bringing the goods to the point of sale and putting them in a saleable condition. These costs include the purchase price, import duties and other taxes which are not recoverable by the entity from a taxing authority, e.g., VAT, Goods and Services Tax, transportation costs, insurance and handling costs. Trade discounts, rebates and other such items are to be deducted in determining inventory costs; failure to do so would result in valuing inventories at amounts in excess of true historical costs. Exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency are not permitted to be included in the costs of purchase of inventories.

The impact of interest costs as they relate to the valuation of inventories (IAS 23) is discussed in Chapter 10. IAS 23 requires capitalisation of financing costs incurred during the manufacture, acquisition or construction of qualifying assets. However, borrowing costs will generally not be capitalised in connection with inventory acquisitions, since the period required to get the goods ready for sale will generally not be significant. On the other hand, when a lengthy production process is required to prepare the goods for sale, the provisions of IAS 23 would be applicable, and a portion of borrowing costs would become part of the cost of inventory. In practice, such situations are rare, and IAS 23 allows an exemption for inventories that are manufactured, or otherwise produced, in large quantities on a repetitive basis.

Conversion costs for manufactured goods should include all costs that are directly associated with the units produced, such as labour and overhead. The allocation of overhead costs, however, must be systematic and rational, and in the case of fixed overhead costs (i.e., those which do not vary directly with level of production) the allocation process should be based on normal production levels. In periods of unusually low levels of production, a portion of fixed overhead costs must accordingly be charged directly to operations and not taken into inventory.

Costs other than material and conversion costs are capitalised only to the extent they are necessary to bring the goods to their present condition and location. Examples might include certain design costs and other types of preproduction expenditures if intended to benefit specific classes of customers. On the other hand, all research costs and most development costs (per IAS 38, as discussed in Chapter 11) would typically not become part of inventory costs. Also generally excluded from inventory would be such costs as administrative overheads (which do not contribute to bringing the inventories to their present location and condition), selling expenses, abnormal cost of wasted materials, non‐production labour or other expenditures, and storage costs (unless necessary in the production process), which must be treated as period costs and expensed in the Income Statement. Included in overhead, and thus allocable to inventory, would be such categories as repairs, maintenance, utilities, rent, indirect labour, production supervisory wages, indirect materials and supplies, quality control and inspection and the cost of small tools not capitalised.

Specific Identification

The theoretical basis for valuing inventories and cost of goods sold requires assigning the production and/or acquisition costs to the specific goods to which they relate. For example, the cost of ending inventory for an entity in its first year, during which it produced 10 items (e.g., exclusive single‐family homes), might be the actual production cost of the first, sixth and eighth unit produced if those are the actual units still on hand at the date of the statement of financial position. The costs of the other homes would be included in that year's profit or loss as cost of goods sold. This method of inventory valuation is usually referred to as specific identification.

Specific identification is generally not a practical technique, as the product will generally lose its separate identity as it passes through the production and sales process. Its use is limited to those situations where there are small inventory quantities, typically having high unit value and a low turnover rate. Under IAS 2, specific identification must be employed to cost inventories that are not ordinarily interchangeable, and goods and services produced and segregated for specific projects. For inventories meeting either of these criteria, the specific identification method is mandatory and alternative methods cannot be used.

Because of the limited applicability of specific identification, it is more likely to be the case that certain assumptions regarding the cost flows associated with inventory will need to be made. One of accounting's peculiarities is that these cost flows may or may not reflect the physical flow of inventory. Over the years, much attention has been given to both the flow of physical goods and the assumed flow of costs associated with those goods. In most jurisdictions, it has long been recognised that the flow of costs need not mirror the actual flow of the goods with which those costs are associated. For example, a key provision in an early US accounting standard stated that:

… cost for inventory purposes shall be determined under any one of several assumptions as to the flow of cost factors; the major objective in selecting a method should be to choose the one which, under the circumstances, most clearly reflects periodic income.

Under the current IAS 2, there are two acceptable cost flow assumptions. These are: (1) the FIFO method and (2) the weighted‐average method. There are variations of each of these cost flow assumptions that are sometimes used in practice, but if an entity presents its financial statements under IFRS it has to be careful not to apply a variant of these cost flow assumptions that would represent a deviation from the requirements of IAS 2. Furthermore, in certain jurisdictions, other costing methods, such as the LIFO method and the base stock method, continue to be permitted.

First‐In, First‐Out

The FIFO method of inventory valuation assumes that the first goods purchased will be the first goods to be used or sold, regardless of the actual physical flow. This method is thought to parallel most closely the physical flow of the units for most industries having moderate to rapid turnover of goods. The strength of this cost flow assumption lies in the inventory amount reported in the statement of financial position. Because the earliest goods purchased are the first ones removed from the inventory account, the remaining balance is composed of items acquired closer to period end, at more recent costs. This yields results similar to those obtained under current cost accounting in the statement of financial position, and helps in achieving the goal of reporting assets at amounts approximating current values.

However, the FIFO method does not necessarily reflect the most accurate or decision‐relevant income figure when viewed from the perspective of underlying economic performance, as older historical costs are being matched against current revenues. Depending on the rate of inventory turnover and the speed with which general and specific prices are changing, this mismatch could potentially have a material distorting effect on reported income. At the extreme, if reported earnings are fully distributed to owners as dividends, the entity could be left without sufficient resources to replenish its inventory stocks due to the impact of changing prices. (This problem is not limited to inventory costing; depreciation based on old costs of plant assets also may understate the true economic cost of capital asset consumption and serve to support dividend distributions that leave the entity unable to replace plant assets at current prices.)

The following example illustrates the basic principles involved in the application of FIFO:

Given these data, the cost of goods sold, and the ending inventory balance are determined as follows:

Notice that the total of the units in cost of goods sold and ending inventory, as well as the sum of their total costs, is equal to the goods available‐for‐sale and their respective total costs.

The unique characteristic of the FIFO method is that it provides the same results under either the periodic or perpetual system. This will not be the case for any other costing method.

Weighted‐Average Cost

The other acceptable method of inventory valuation under revised IAS 2 involves averaging and is commonly referred to as the weighted‐average cost method. The cost of goods available‐for‐sale (beginning inventory and net purchases) is divided by the units available‐for‐sale to obtain a weighted‐average unit cost. Ending inventory and cost of goods sold are then priced at this average cost. For example, assume the following data:

The weighted‐average cost is €780/300, or €2.60. Ending inventory is 125 units at €2.60, or €325; cost of goods sold is 175 units at €2.60, or €455.

When the weighted‐average assumption is applied to a perpetual inventory system, the average cost is recomputed after each purchase. This process is referred to as a moving average. Sales are costed at the most recent average. This combination is called the moving‐average method and is applied below to the same data used in the weighted‐average example above.

Cost of goods sold is 75 units at €2.10 and 100 units at €2.70, or a total of €427.50.

Net Realisable Value

As stated in IAS 2:

Net realisable value is 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.

The utility of an item of inventory is limited to the amount to be realised from its ultimate sale; where the item's recorded cost exceeds this amount, IFRS requires that a loss be recognised for the difference. The logic for this requirement is twofold: first, assets (in particular, current assets such as inventory) should not be reported at amounts that exceed net realisable value; and second, any decline in value in a period should be reported in that period's results of operations to achieve proper matching with current period's revenues. Were the inventory to be carried forward at an amount in excess of net realisable value, the loss would be recognised on the ultimate sale in a subsequent period. This would mean that a loss incurred in one period, when the value decline occurred, would have been deferred to a different period, which would clearly be inconsistent with several key accounting concepts.

IAS 2 states that estimates of net realisable value should be applied on an item‐by‐item basis in most instances, although it makes an exception for those situations where there are groups of related products or similar items that can be properly valued in the aggregate. As a general principle, item‐by‐item comparisons of cost to net realisable value are required, preventing unrealised “gains” on some items (i.e., where the net realisable values exceed historical costs) to offset the unrealised losses on other items, thereby reducing the net loss to be recognised. Since recognition of unrealised gains in profit or loss is generally prohibited under IFRS, revaluation of inventory declines on a grouped basis would be an indirect or “backdoor” mechanism to recognise gains that should not be given such recognition. Accordingly, the basic requirement is to apply the tests on an individual item basis.

Other Valuation Methods

Techniques for measurement of cost of inventories, such as the retail method or the standard cost method, may be used for convenience if the results approximate cost and where the application of the above methods is not practical.

Disclosure Requirements

IAS 2 sets forth certain disclosure requirements relative to inventory accounting methods employed by the reporting entity. According to this standard, the following must be disclosed:

1. The accounting policies adopted in measuring inventories, including the costing methods (e.g., FIFO or weighted‐average) employed.
2. The total carrying amount of inventories and the carrying amount in classifications appropriate to the entity.
3. The carrying amount of inventories carried at fair value less costs to sell (inventories of commodity broker‐traders).
4. The amount of inventories recognised as an expense during the period.
5. The amount of any write‐down of inventories recognised as an expense in the period.
6. The amount of any reversal of any previous write‐down that is recognised in profit or loss for the period.
7. The circumstances or events that led to the reversal of a write‐down of inventories to net realisable value.
8. The carrying amount of inventories pledged as security for liabilities.

The type of information to be provided concerning inventories held in different classifications is somewhat flexible, but traditional classifications, such as raw materials, work in progress, finished goods and supplies, should normally be employed. In the case of service providers, inventories (which are really similar to unbilled receivables) can be described as work in progress.

In addition to the foregoing, the financial statements should disclose either the cost of inventories recognised as an expense during the period (i.e., reported as cost of sales or included in other expense categories), or the operating costs, applicable to revenues, recognised as an expense during the period, categorised by their respective natures.

Costs of inventories recognised as expense include, in addition to the costs inventoried previously and attaching to goods sold currently, the excess overhead costs charged to expense for the period because, under the standard, they could not be deferred to future periods.