Introduction – Inventories
An Inventory is a list, but as raw materials, work-in-progress and finished good are detailed on lists or inventories, the term inventories is now commonly used to mean the items on those lists.
The calculation of the amounts at which inventories are stated in the accounts in one of the most important and difficult areas in financial reporting. Relatively small variations in the values at which inventories are stated can have significant impact on reported profits, while the proper valuation of inventories involves the exercise of judgement.
The determination of profit for an accounting year requires the matching of costs with related revenues. The cost of unsold or unconsumed inventories will have been incurred in the expectation of future revenue. It is appropriate to carry forward this cost to be matched with the revenue when it arises. If there is no reasonable expectation of sufficient future revenue to cover cost incurred e.g. as a result of deterioration, obsolescence or a change in demand, the irrecoverable cost should be charged to revenue in the year under review. Thus, inventories need to be stated at the lower of cost and net realisable value.
Inventories are assets:
- Held for resale in the ordinary course of business
- In the process of production for resale e.g. raw materials, work-in-progress and finished goods
- In the form of materials or supplies to be consumed in the production process or of services
Cost shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.
Cost of purchase comprises purchase price including import duties, non-returnable taxes, transport and handling costs and any other directly attributable costs, less trade discounts, rebates and subsidies.
Cost of conversion comprises:
- Costs which are directly related to units of production e.g. direct labour, direct expenses and sub-contracted work
- Production overheads
- Other overheads, if any attributable in the particular circumstances of the business to bringing the product or service to its present location and condition
Production overheads: overheads incurred in respect of materials, labour or services for production, based on the normal capacity as expected on average under normal circumstances, taking one year with another. Each overhead should be classified according to function e.g. production, selling or administration so as to ensure the inclusion, in cost of conversion, of those overheads including depreciation which relate to production, notwithstanding that these may accrue wholly or partly on a time basis.
Net realisable value is: the estimated selling price in the ordinary course of business less: (a) The estimated costs of completion and (b) Estimated costs necessary to make the sale.
Fair Value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.
INVENTORIES ARE MEASURED AT THE LOWER OF COST AND NET REALISABLE VALUE FOR EACH SEPARATE ITEM IN THE PERIODIC FINANCIAL STATEMENTS. SIMILAR ITEMS MAY BE GROUPED TOGETHER FOR VALUATION PURPOSES.
The accounting policies which have been used in calculating the cost and net realisable value are disclosed in the statements and reports. A suitable description of the amount at which inventories are stated in accounts might be “at the lower of cost and net realisable value”.
In general, inventories should be sub-classified in the Statement of Financial Position or in the notes in the financial statements so as to indicate the amounts held in each of the main categories in the standard Statement of Financial Position formats
METHODS OF COSTING
It is frequently not practicable to relate expenditure to specific units of inventory. The ascertainment of the nearest approximation to cost gives rise to two problems:
- The selection of an appropriate method for calculating the related costs where a number of identical items have been purchased or made at different times i.e.:
- First In, First Out (FIFO)
- Last In, First Out (LIFO)
- Weighted Average
- The selection of an appropriate method for relating costs to inventories i.e.:
- Job costing
- Batch costing
- Process costing
- Standard costing
In selecting the methods referred to above, management must exercise judgement to ensure that the methods chosen provide the fairest practical approximation to ‘actual cost’.
FIFO: The assumption underlying it is that the first inventory item to be bought is the first to be sold. The closing inventory is, therefore, the most recently acquired. In a period of rising prices, this method will result in a high stock valuation. This will represent the actual cost of the inventory as long as the issues to production/sales have followed a first-in, firstout pattern.
LIFO: The underlying assumption is that the last inventory to be bought is the first to be sold. The value of the closing inventory is, therefore, that of the earliest inventory acquired.
It should be noted that LIFO is no longer permitted as a valuation method by IAS 2.
Weighted Average: The underlying assumption in charging out inventory sold is that the value of the closing inventory is the average price paid for it over the period. It is calculated by dividing the total value of purchases by the total number of units/tonnes purchased. In times of rising price levels, this method gives a lower valuation to unsold inventory than FIFO above and a higher valuation than LIFO and vice versa when price levels fall.
Job costing is a costing method where costs are incurred for a specific order undertaken for a customer’s special requirements and each order is for a short duration e.g. Manufacturing a sailing boat.
Batch costing is a costing method where costs are incurred for a specific order undertaken but the costs apply to similar articles e.g. bean processing and pea processing.
Process costing is a costing method where goods are produced from continuous operations e.g. pentium chip making.
Standard costing is a budgetary control technique which compares standard costs and standard revenues with actual results obtained.
Absorption costing is a costing method which charges a proportion of fixed overheads for the period against the items produced.
Direct costing or Marginal costing is a costing system which does not charge a proportion of fixed overheads for the period against the items produced i.e. the inventory is charged with variable costs and valued on that basis.
Production Overheads IAS 2 requires that the cost of inventory should include production overheads. The production overheads should be absorbed into inventory based on the normal production capacity.