International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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discussed at 3.3 below.
This basic measurement rule inevitably raises the question of what may be included in
the cost of inventory.
3.1
What may be included in cost?
The costs attributed to inventories under IAS 2 comprise all costs of purchase, costs of
conversion and other costs incurred in bringing the inventories to their present location
and condition. [IAS 2.10]. This definition allows for significant interpretation of the costs
to be included in inventory.
3.1.1
Costs of purchase
Costs of purchase include import duties and unrecoverable taxes, transport, handling
and other costs directly attributable to the inventories. [IAS 2.11].
Trade discounts and similar rebates should be deducted from the costs attributed to
inventories. [IAS 2.11]. For example a supplier may pay to its customer an upfront cash
incentive when entering into a contract. This is a form of rebate and the incentive
should be accounted for as a liability by the customer until it receives the related
inventory, which is then shown at cost net of this incentive.
3.1.2
Costs of conversion
Costs of conversion include direct costs such as direct labour and materials, as well as
an allocation of fixed and variable production overheads. It must be remembered that
the inclusion of overheads is not optional. Overheads may comprise indirect labour and
materials or other indirect costs of production. For the most part there are few problems
over the inclusion of direct costs in inventories, although difficulties may arise over the
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inclusion of certain types of overheads and over the allocation of overheads into the
inventory valuation. Overhead costs must be apportioned using a ‘systematic allocation
of fixed and variable production overheads that are incurred in converting materials
into finished goods’. [IAS 2.12]. Overheads should be allocated to the cost of inventory on
a consistent basis from year to year, and should not be omitted in anticipation of a net
realisable value problem.
Variable production overheads are indirect costs that vary directly, or nearly directly,
with the volume of production such as indirect material and indirect labour. [IAS 2.12].
Variable production overheads are allocated to each unit of production on the basis of
the actual use of the production facilities. [IAS 2.13].
Fixed production overheads are indirect costs that remain relatively constant regardless
of the volume of production, such as building and equipment maintenance and
depreciation, and factory management expenses. IFRS 16 which is mandatory for
accounting periods beginning on or after 1 January 2019 amends paragraph 12 of IAS 2
to add ‘depreciation of right-of-use assets used in the production process’ as an example
of fixed production overheads. [IAS 2.40G].
The allocation of fixed production overheads is based on the normal capacity of the
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’. [IAS 2.13]. 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 output or idle capacity. In these cases
the unallocated overheads must be expensed. Similarly, in periods of abnormally high
production, the fixed overhead absorption must be reduced, as otherwise inventories
would be recorded at an amount in excess of cost. [IAS 2.13].
In computing the costs to be allocated via the overhead recovery rate, costs such as
distribution and selling must be excluded, together with the cost of storing raw materials
and work in progress, unless it is necessary that storage costs be incurred prior to further
processing, which may occasionally be the case (see 3.1.3.A below).
Although not specifically referred to in IAS 2, when the revaluation model in IAS 16 is
applied, depreciation of property, plant and equipment is based on the revalued amount,
less the residual value of the asset and it is the revalued depreciation that, in our view,
should be utilised in inventory valuation.
IAS 2 mentions the treatment to be adopted when a production process results in the
simultaneous production of more than one product, for example a main product and a
by-product. If the costs of converting each product are not separately identifiable, they
should be allocated between the products on a rational and consistent basis. For
example, this might be the relative sales value of each of the products either at the stage
in the production process when the products become separately identifiable, or at the
completion of production. If the value of the by-product is immaterial, it may be
measured at net realisable value and this value deducted from the cost of the main
product. [IAS 2.14].
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3.1.3 Other
costs
Other costs are to be included in inventories only to the extent that they bring them into
their present location and condition. Often judgement will be necessary to make this
assessment. An example is given in IAS 2 of design costs for a special order for a
particular customer and the standard notes that it may be appropriate to include such
costs or other non-production overheads. [IAS 2.15]. However a number of examples are
given of costs that are specifically disallowed. These are:
(a) abnormal amounts of wasted materials, labour, or other production costs;
(b) storage costs, unless those costs are necessary in the production process prior to a
further production stage;
(c) administrative overheads that do not contribute to bringing inventories to their
present location and condition; and
(d) selling
costs.
[IAS 2.16].
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.
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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:
(a) 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;
(b) marketing and distribution – by analysing sales and by controlling the sales ledger;
and
(c) 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
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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 28 at 6.5). 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.1
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 28 at 10.3.2). [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 28 at 10.3.2).
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 28 at 10.3.3.F, 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 since it would not meet the normal purchase or sale exemption
(see Chapter 41 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 therefo
re 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:
(i) an amount that settles the forward contract; and
(ii) an amount that represents the ‘cost of purchase’, being the market price at the date
of purchase.
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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.
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