Gripping GAAP Inventories Chapter 13 Inventories ‘Main references: IAS 2; IFRS 13; IFRS 15, IAS 16 (incl. amendments to 10 December 2018) Contents 1. Introduction 2. Scope 3. The recognition and classification of inventory 4. Recording inventory movement: periodic vers perpetslayremit 4.1. Overview 42. Perpetual system 43 Periodic system Example 1: Perpetual versus periodic system 44. Stock counts, inventory balances and missing inventory 4.1. The perpetual system and the use of stock counts 44.2. The periodic system and the use ofstock counts Example 2: Perpetual versus periodic system and missing inventory Example 3; Perpetual and periodic system: stock loss duc to theft and profits 443. Presenting inventory losses . Initial measurement: cost ‘5.1 Overview 5.2. Purchase costs 5.2.1 Overview 5.2.2. Transaction taxes and import duties Example 4: Transaction taxes and import duties Transport costs, 5.2.3.1 Overview 5.2.3.2 Transport carriage inwards 5.2.3.3. Transpord/ carriage outwards Example 5: Transport costs Rebates Example 6: Rebates Discount received Example 7: Discounts Finance costs Example 8: Deferred settlement terms Imported inventory 5.2.7.1 Spot rates [Example 9: How o convert foreign eurency into a Toca euréncy, 5.2.7.2. Transaction Dates Example 10: Imported inventory — transaction dates Conversion cosis (manufactured inventory) : 53.1, Overview ‘ 5.3.2 Conversion costs are split into direct costs and indirect costs Example 11: Conversion costs, 53.3. The ledger accounts used by a manufacturer 1 Overview at 2 Accoiinting forthe mioveriente: two systems 3 Calculating the amount to transfer: three cost formulae Example 12: Manufoeturing journal entries 5.3.4 Manufacturing cost per unit" Chapter 13 653 ina ‘Scanned with |CamScanner| “ Gripping GAAP ees Inventories T 5 | | Contents continued: ‘5.3.5 "Variable manuftcturing costs (costs that vary directly wich production) Example 13: Variable manufacturing costs 5.3.6 Fixed manufacturing costs (costs that do not vary directly with production) Example 14: Fixed manufacturing costs and tlie use of a suspense account Example 15: Fixed manufacturing cost suspense account —3 scenarios Under-production leads to iunder-absorption of FMCs Example 16: FMC application rate + under-absorption Over-production leads to over-absotption of FMCs Example 17: FMC application rate + over-absorption Budgeted versus actual fixed manufacturing rates summarised Example 18: Fixed manufacturing costs — over-absorption Example 19: Fixed manufbeturing costs ~ und=t-absorption 5.3.7. Joint and by-products Example 20: Joint and by-products Other costs | 5.4.1 General rule for capitalisation of other costs | 5.4.2, Capitalisation of borrowing costs | | : 5.4.3 Other costs that may never be capitalised | | Example 21: All manufacturing costs including other fosts, . Subsequent measurement: inventory movements (cost formulae) 6.1 Overview | 6.2. Specific identification formula (SI) ered eee eee | 6.3 ° First-in, first-out formula (FIFO) | Example 23: FIFO purchases | | | Example 24: FIFO sales 6.4 Weighted average formula (WA) i Example 25: WA purchases | Example 26: WA sales Git 6.5. The cost formula in a manufacturing environment Example 27: Manufacturing ledger accounts — FIFO vs WA formulae |. Subsequent measurement: year-end 7.1 Overview 7.2 Net realisable value Example 28: Net realisable value and events after reporting period Example 29: Net realisable value based on purpose ofthe inventory 7.3 Inventory write-downs Example 30: Lower of cost or net realisable value! write-downs 7.4 Reversals of inventory write-downs Example 31: Lower of cost or net realisable Value: reversal of write-downs 7.5. Presenting inventory write-downs and reversals of write-downs Example 32: Lower of cost or net realisable value ~ involving raw materials Disclosure | | 8.1 Accounting policies 8.2. Statement of financial position and supporting notes | 8.3 Statement of comprehensive income and supporting notes Example 33! Disclosure ~ comparison between the nature and faction method Example 34: Disclosure of cost of sales and inveniory'related depreciation Example 35: Disclosure of inventory asset and related accounting policies 9, Summary 1 ‘Scanned with |CamScannerZ Gripping GAAP Invontorios The standard that explains how we account for inventories is IAS 2 Jnventories, Its main focus is on the determination of the cast of the inventories, and when to recognise this cost as an inventory expense (e.g. when the revenue is recognised or when it needs to be written-down). Interestingly, unlike other standards that show us how to account for assets, such as IAS 16 Property, plant and equipment and 1AS 38 Intangible assets, this standard does not deal.“ with when to recognise costs as an inventory asset. Inventory is an asset that the entity either ultimately intends to sell or is an asset that is in the form of ‘materials and supplies" that the entity intends to use in the production process or in providing a service (often called ‘consumable stores’). Inventories can be tangible or intangible. Notice that the classification of inventories, as with all otfer asset classifications, depends on intentions. For example, if we owned the following 3 properties, but have a different intention for each, we would have to classify and ace em separately as follows: © Property that we purchased’ with the intention of using as our factory: classified as property in terms of IAS 16 Property, plant and equipment; © Property that we purchased with the intention of holding for capital, appreciation: this would be classified as investment property in terms of IAS 40 Investment property; and + Property that we purchased with the would be sntion of selling in the ordinary course of business: this would be classified as inventories in terms of IAS 2 Inventories. ‘The type of inventory that a business has depends on the nature of the business, for instance, whether the business is a retailer, manufacturer, or perhaps a combination thereof, Classes of Inventory according to business-typer Retailer Manufacturer: ~ Merchandise ~ Finished goods (or ‘merchandise for sale’) + Work-in-progress + Raw materials ‘Note: A farther category of inventories is consumable stores, being ‘materials end supplies” that the entity intends using in the production process or in providing a service.. In the case of retailers and manufacturers, inventories ofien represent:a significant portion of the entity's total assets (inventory is presented as a current asset in the SOFP). As an item of inventory is sold, a relevant portion of the cost of inventory must be removed from the inventory asset and expensed. Inventory that is sold is generally called cost of sales, and is expensed in profit or loss. This expense is often the biggest expense that a retailer or ‘manufacturer has, thus it also significantly affects an entity’s profit or loss. ‘The principles regarding inventories that we need to consider include: © when to recognise and classify the purchase of an asset as inventory (section 3); * how to record inventory movements using the periodic or perpetual system (section 4); ‘+ how to measure inventory on initial recognition (section 5); + how to measure inventory subsequently: = how to measure the ‘cost of inventory sold expense! (i.e. how to measure the cost of individual items of inventory as they are sold) — this is often referred to as. the ‘measurement of the inventory movements and involves the use of one-of the cost formulae (SI, FIFO anid WA formulae) (section 6), - how to measure the cost of inventory that remains unsold at year-end (section 7); when to derecognise inventory (this occurs when itis either sold or scrapped); how to disclose inventories in the financial statements (section 8). © Chapter 13 less ‘Scanned with |CamScannerinvontorien. Gripping GAAP. ET [EX Scope poem bi ’ JAS 2 applies to all assets that mect the definition of inventories exzept for the following: © Financial instruments (these are accounted for in terms of IFRS 9 Financial instruments and IAS 32 Finansial instruments: Presentation) * Biological assets related to agricultural activity and agricultural produce at the point of harvest (these are accounted for in terms of IAS 41 Agriculture), "8577 (wets Although IAS 2 does apply to the following assets, its measurement requirements do not: © producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realisable value in accordance with well-established practices in those industries.’ When such inventories re measured at net realisable value, changes in that value are =ecognised in profit or loss 1m the period of the change. © commodity broker-traders* who measure their inventories at fair value less costs to sell. When such inventories are measured at fair value less costs to sell, changes in fair value less costs to sell are recognised in profit or loss in the period of the change. "8524 “Commodity brokers are similar to investment bankers, except that, instead of trading in equities, ‘commodity brokers buy) and sell commodidtes (ie. products or services), such as wheat, cattle. ete. ‘Changes Fo TAS 2 since the ew XFRS 18 Revenue from contracts with customers was lanued ASSES I + Before the publication of IFRS 15 Revenue from contracts with customer, TAS 2 clorified that costs incurred by service provider would be recognized os inventory to the ax-cnt that the related revenie ‘ould not be recognised. ‘This has now been removed from IAS 2 (previously pare 8 of TAS 2). + After the pblicaion of FERS 18,TAS 2 was azo amended to clarify thet an costs that are not able to be Sccounted for in terms of LAS 2 Inventories or in terms of ary other stendard (eg. TAS 16 Properey, plane End equipment) mist be accounted for in terns of TRS 19 instead, oo tze8 + TAS 16 a [ic Recognition and Classification of Inventory poe “The focus of IAS 2 is on how to measure the inventory {| GO An aaset ies asset, and how and when this inventory asset should || & subsequently be resognised as an expense. \t Recognited: when it meets the oxzet TAS 2 does not explain when inventory should be || definticn and recognition eriteri recognised. However, LAS 2's definition of inventory | §eGeprd,c,imeentory: when it (see pop-up below) states, amongst other things, that +> y inventory is an asset. Thus, we look to the Conceptual Framewori (CF) because it provides guidance on when to recognise an asset. The CF states that we must initially,recognise an item as an asset when the CF's definition of an asset and related recognition criteria are met (see chapter 2). : ee sl [Ee wmewr wetted So, if an item meets the asset definition and recognition criteria, per the CF, we resognise it as an asset. When |2 snesser ets recognising it as an asset, we then decide what type of asset |" "held fer sale in the ordinery tourse to classify it as (inventory, investment property, plant etc): it |, of business: or would be classified as an inventory asset if it meets the |) * in, jhe process of Production for inventory defini to be consumed in the production Process Orin the rendering of | a ‘ ie i mn given in IAS 2 (see pop-up alangside). |. - inthe orm of moterils o suplies d services. If we look carefully at this definition of inventory, we see that it essentially includes what: Peer retailers commonly refer to as merchandise; i ¢ manufacturers commonly refer to as raw materials, wark in progress and finished goods; & various entities commonly refer to as consumable stores. Chapter 13 ‘Scanned with |CamScannerGripping GAAP Inventories Looking at the inventory: definition again, we also see that it clarifies that, other than consumables, an asset may only be classified as inventory if it is held for sale (or held in the process of manufacture for the eventual sale) in the ordinary course of business. Thus, if our ordinary business involves buying and selling properties, we would classify these properties as inventories. However, if our ordinary business does not involve the buying and selling of properties and yet we happen to buy a property that we intend to sell as soon as we can make a profit, although our intention is to sell it, we would not classify this property as inventory because it will not be sold as part of our ordinary business activities. Inventory assets are subsequently recognised either as expenses or as other assets as follows: * inventory is subsequently recognised as an expense in the periods in which: ~ the inventory is sold and the related revenue is recognised, or = the inventory is written down to net realisable value; or ‘* inventory is subsequently recognised as part of another asset if the inventory was used in the manufacture of the other asset (e.g. a self-constructed plant), in which case the cost of this inventory will eventually be expensed (e.g. when depreciating the plant). **!524~# 4.1 Overview ‘The movement of inventory refers to the purchase, and subsequent sale of inventory. However, the focus of thi#section is the sale of inventory. Entities often experience high volumes of inventory sale transactions, The perpetual system, which requires processing a separate journal entry for each one of these transactions, can be difficult for certain entities, especially smaller entities. Thus, s simpler system, called the periodic system, was devised. This system processes a single journal entry to record the sales transaction at the end of a period. ‘These systems are not laid down in IAS 2, and thus the exact mechanisms of how to record inventory movements under these two systems differ slightly from entity to entity. Essentially, however, the difference between these two systems is simply that: © Under the perpetual system, we perpetually (i.e. continually) update our ledger to account for the cost of each ‘inventory purshase transaction’ and for the cost of each ‘inventory sale transaction’; whereas a if Inder the periodic system, although we update our ledger to account for the cost-of each entory purshase transaction’, we do not update it to account for the cost of each ‘inventory sale transaction’ but, instead, we record the foal cost of all ‘inventory sale transactions’ for a period (¢.g. the period could be a month or a year) as a single transaction. Although the periodic system is simpler, the ability to detect any theft of inventory is generally not possible. This means that the gross profit calculated under the perpetual system may differ from that calculated under the periodic system. ‘The final profit or loss, calculated in the profit or loss account will, however, be the same. This is explained under section 4.4. The periodic system is generally used by smaller businesses that do not have the necessary computerised accounting systems to run a perpetual system, However, with the proliferation ‘of computerised accounting packages, most businesses nowadays, and certainly most of the larger manufacturing businesses, would normally apply the perpetual system. 4.2 Perpetual system ‘The perpetual system is used by businesses that have more sophisticated needs large businesses and manufacturing concerns), or have access to computerised accounting systems that can accommodate this ‘real-time’ processing. ‘The perpetual system uses two accounts: © an inventory account (an asset); and © acest of sales account (an expense). ‘Scanned with |CamScannerGripping GAAP Both these accounts are perpetually (constantly) updated for each purchase and each sale of inventory, as and when these ‘occur. Thus, the balance in the inventory account on any one day reflects what we should physioally have on hand on that day and similarly the cost of sales account reflects the latest cumulative cost of sales. ‘The fact that our inventory account reflects what the closing (The perpetual system: eed by ter ees + Uses the fo lowing ledger accounts, ‘ore continoutly updated: inventory account & cost of scles account + ten detect missing stock eg. from theft ‘balance souls’ be means that a physical stock count ean then be used to che-k our closing balance. This stock count is performed at the end of the period (normally at year-end). This comparison between the balance in the inventory account and the results of the physical count will thus be able to identify any missing inventory, which is then recorded as a separate expense (e.g. inventory loss due to theft). 9 4.3 Periodic system Computerised accounting packages have made the perpetual system far more popular among businesses. However, small businesses, which may not have access to these packages, will use the periodic system. Thus, the periodic system is still important to understand. Under the periodic system, we do continually update our ledger accounts for the cost of each inventory purchase, but ‘we do not continually update our ledger accounts for the cost iste bymaler emits sche flonase iets rt { purchases eccount | Sony cea Reon uses a physical stock count to Seca Mey See ut bem mniihtea oar of each sale of inventory. Instead, the entity processes one single journal entry to account for the total cost ofall the inventory sales during the period, where this amount is calculated as a balancing figure after performing a stock count. This stock count is done periodically, generally at year-end. It involves physically counting all the items of inventory on hand. We then calculate the total cost of all items of inventory on hand by multiplying the number of units counted by the cost per unit. This total cast of the inventory on hand (per the stock count) is then used as our inventory closing balance. ‘Once we have determnined our inventory closing balance, we can balance beck to our costof sales. We do this by comparing this inventory closing balance'with the total of our inventory opening balance plus the cost of our inventory purchased during the year (ie. opening balance + purchases ~ closing. balance). All inventory that is ‘missing’ is assumed to have been sold and thus the cost of the ‘missing inventory’ is recognised, by way of one single entry, as the total cost of all the ‘inventory sale transactions’ during the period (i.e. the total cost of sales). Thus, we are overlooking the possibility that some of this inventory may not have been sold but could, for example, have been stolen instead -This ‘means that this periodic system is not designed to automatically detect and separately record stock theft ‘and thus this system is not as accurate as the perpetual system. | For example, an entity with no inventory on hand at the beginning of a year, records each of the inventory purchases during the year, totalling C5 000. The entity then counts the inventory on hand at year-end and calculates the cost thereof to be C2 000. In this case, the entity will record the difference ‘0fC3 000 as the cost of sales forthe year. * In summary, when using the periodic system, we need a physical stock count to determine the value of our closing inventory, which we then use to balance backwards to the cost of sales. ‘The periodic system uses three accounts: a purzhases acount in which we continually record the cost of ail purchases in the period; ‘an inventory acount in which we periodically record the cbst of inventory on handl on a specific date (generally year-end). This cost is calculated alter doing a physical stock count (please note that this account is nor continuously updated for eost of purchases an¢ cost of sales); a cost of sales account which we use to calculate the cost of sales during the period (by ‘comparing the information in the purchases account fnd the balances in the inventory account) (this account is nor continuously updated for the cost of sales during the period). ‘Scanned with |CamScanner