International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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(see Chapter 17 at 6.2.3).
3.2
Measurement of cost
IAS 2 specifically allows the use of the standard cost method, or of the retail method,
provided that the chosen method gives a result which approximates to cost. Standard
costs should take into account normal levels of materials and supplies, labour, efficiency
and capacity utilisation. They must be regularly reviewed and revised where necessary.
[IAS 2.21]. Normal levels of activity are discussed in 3.1.2 above.
The retail method is often used in the retail industry for measuring inventories with high
volumes of rapidly changing items with similar margins. [IAS 2.22]. It may be unnecessarily
time-consuming to determine the cost of the period-end inventory on a conventional
basis. Consequently, the most practical method of determining period-end inventory
may be to record inventory on hand at selling prices, and then convert it to cost by
adjusting for a normal margin.
Judgement is applied in the retail method in determining the margin to be removed from
the selling price of inventory in order to convert it back to cost. The percentage has to
take account of circumstances in which inventories have been marked down to below
original selling price. Adjustments have to be made to eliminate the effect of these
markdowns so as to prevent any item of inventory being valued at less than both its cost
and its net realisable value. In practice, however, entities that use the retail method
apply a gross profit margin computed on an average basis appropriate for departments
and/or ranges, rather than applying specific mark-up percentages. This practice is, in
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fact, acknowledged by IAS 2, which states that, ‘an average percentage for each retail
department is often used’. [IAS 2.22].
3.2.1 Cost
formulas
Items that are not interchangeable and goods or services produced for specific projects
should have their costs specifically identified and these costs will be matched with the
goods physically sold. [IAS 2.23]. In practice this is a relatively unusual method of
valuation, as the clerical effort required does not make it feasible unless there are
relatively few high value items being bought or produced. Consequently, it would
normally be used where the inventory comprised items such as antiques, jewellery and
automobiles in the hands of dealers. This method is inappropriate where there are large
numbers of items that are interchangeable, as specific identification of costs could
distort the profit or loss arising from these inventories through the method applied to
selecting items that remain in inventories. [IAS 2.24].
Where it is necessary to use a cost-flow assumption (i.e. when there are large numbers
of ordinarily interchangeable items), IAS 2 allows either a FIFO (first-in, first-out) or a
weighted average cost formula to be used. [IAS 2.25].
The standard makes it clear that the same cost formula should be used for all inventories
having a similar nature and use to the entity, although items with a different nature and
use may justify the use of a different cost formula. [IAS 2.25]. For example the standard
acknowledges that inventories used in one operating segment may have a use to the
entity different from the same type of inventories used in another operating segment.
However, a difference in geographical location of inventories (or in their respective tax
rules) is not sufficient, by itself, to justify the use of different cost formulas. [IAS 2.26].
An entity may choose, as a result of particular facts and circumstances, to change its cost
formula, for instance, from a FIFO-based cost formula to a weighted average cost
formula. The change in a cost formula represents a change in the basis on which the
value of the inventory has been determined, rather than a change in valuation of the
inputs used to determine the cost of the inventory. An accounting policy is defined in
IAS 8 as including specific bases applied by an entity in preparing and presenting
financial statements. Therefore a change in the cost formula represents a change in
accounting policy which should only be made if it results in the financial statements
providing reliable and more relevant information. [IAS 8.14]. If material, the change in
accounting policy will have to be dealt with as a prior period adjustment in accordance
with IAS 8 (see Chapter 3 at 4.4).
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
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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.
3.3
Net realisable value
IAS 2 carries substantial guidance on the estimation of net realisable value. When this is
below cost, inventory must be written down.
The cost of inventory may have to be reduced to its net realisable value if the inventory
has become damaged, is wholly or partly obsolete, or if its selling price has declined. The
costs of inventory may not be recovered from sale because of increases in the costs to
complete, or the estimated selling costs. [IAS 2.28]. However the costs to consider in making
this assessment should only comprise direct costs to complete and sell the inventory.
IAS 2 requires that selling costs are excluded from the cost of inventory and are
expensed as incurred. [IAS 2.16]. Selling costs include direct costs that are only incurred
when the item is sold, e.g. sales commissions, and indirect costs, which are those
overheads that enable sales to take place, including sales administration and the costs
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of retail activities. Some selling costs, such as certain sales commissions, may require
capitalisation and amortisation under IFRS 15, rather than being expensed immediately
as incurred (see Chapter 28 at 10.3.1). Of course, the selling price of inventory takes
account of the expected costs of sale. If inventory is not impaired then the distinction
between direct and indirect selling costs is not relevant as both are excluded from the
cost of inventory. [IAS 2.16]. It is clear that costs to be reflected in the write down to NRV
must be incremental but paragraph 28 does not distinguish between direct and indirect
costs. This allows for different interpretations. In practice there may be few incremental
increases in indirect costs that will cause inventory to be sold at a loss.
Writing inventory down to net realisable value should normally be done on an item-by-
item basis. IAS 2 specifically states that it may be appropriate to group similar or related
items but it is not appropriate to write down an entire class of inventory, such as finished
goods, or all the inventory of a particular segment. However, it may be necessary to
write down an entire product line or group of inventories in a given geographical area
if the items cannot be practicably evaluated separately. [IAS 2.29].
Estimates of net realisable value must be based on the most reliable evidence available
and take into account fluctuations of price or cost after the end of the period if this is
evidence of conditions existing at the end of the period. [IAS 2.30]. A loss realised on a
sale of a product after the end of the period may well provide evidence of the net
realisable value of that product at the end of the period. However if this product is, for
example, an exchange traded commodity, and the loss realised can be attributed to a fall
in prices on the exchange after the period end date, then this loss would not, in itself,
provide evidence of the net realisable value at the period end date.
Estimates of net realisable value must also take into account the purpose for which the
inventory is held. Therefore inventory held for a particular contract has its net realisable
value based on the contract price, and only any excess inventory held would be based
on current market prices. If there is a firm contract to sell quantities in excess of
inventory quantities that the entity holds or is able to obtain under a firm purchase
contract, this may give rise to an onerous contract liability that should be provided for
in accordance with IAS 37 – Provisions, Contingent Liabilities and Contingent Assets
(see Chapter 27). [IAS 2.31]. For inventory such as unused office supplies that are held for
internal use and not sale to third parties, the replacement cost is the best available
measure of their net realisable value.
IAS 2 explains that materials and other supplies held for use in the production of
inventories are not written down below cost if the final product in which they are to be
used is expected to be sold at or above cost. [IAS 2.32]. This is the case even if these
materials in their present condition have a net realisable value that is below cost and
would therefore otherwise require write down. Thus, a whisky distiller would not write
down an inventory of grain because of a fall in the grain price, so long as it expected to
sell the whisky at a price which is sufficient to recover cost. If a decline in the price of
materials indicates that the cost of the final product will exceed net realisable value then
a write down is necessary and the replacement cost of those materials may be the best
measure of their net realisable value. [IAS 2.32]. If an entity writes down any of its finished
goods, the carrying value of any related raw materials should also be reviewed to see if
they too need to be written down.
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Often raw materials are used to make a number of different products. In these cases it
is normally not possible to arrive at a particular net realisable value for each item of raw
material based on the selling price of any one type of finished item. If the current
replacement cost of those raw materials is less than their historical cost, a provision is
only required to be made if the finished goods into which they will be made are
expected to be sold at a loss. No provision should be made just because the anticipated
profit will be less than normal.
When the circumstances that previously caused inventories to be written down below
cost no longer exist, or when there is clear evidence of an increase in net realisable
value because of changed economic circumstances, the amount of the write-down is
reversed. The reversal cannot be greater than the amount of the original write-down,
so that the new carrying amount will always be the lower of the cost and the revised net
realisable value. [IAS 2.33].
Extract 22.2 below shows how CRH plc describes its inventory valuation policies,
including estimation of net realisable value.
Extract 22.2: CRH plc (2017)
Accounting Policies [extract]
Other Significant Accounting Policies [extract]
Inventories and construction contracts – Note 17 [extract]
Inventories are stated at the lower of cost and net realisable value. Cost is based on the first-in, first-out principle (and weighted-average, where appropriate) and includes all expenditure incurred in acquiring the inventories and bringing
them to their present location and condition. Raw materials are valued on the basis of purchase cost on a first-in, first-out basis. In the case of finished goods and work-in-progress, cost includes direct materials, direct labour and
attributable overheads based on normal operating capacity and excludes borrowing costs.
Net realisable value is the estimated proceeds of sale less all further costs to completion, and less all costs to be
incurred in marketing, selling and distribution. Estimates of net realisable value are based on the most reliable
evidence available at the time the estimates are made, taking into
consideration fluctuations of price or cost directly
relating to events occurring after the end of the period, the likelihood of short-term changes in buyer preferences,
product obsolescence or perishability (all of which are generally low given the nature of the Group’s products) and
the purpose for which the inventory is held. Materials and other supplies held for use in the production of inventories
are not written down below cost if the finished goods, in which they will be incorporated, are expected to be sold at
or above cost.
3.4
Measurement of crypto-assets in scope of IAS 2
As discussed at 2.3.1.D above, crypto-assets each have their own terms and conditions
and, as a result, the holders of a crypto-asset will need to evaluate these terms and
conditions to determine which IFRS recognition and measurement requirements should
be applied. In some cases, crypto-assets may meet the definition of inventory.
Generally, IAS 2 requires inventory to be measured at the lower of cost and net
realisable value. [IAS 2.9]. However, commodity broker-traders have the choice to
measure their inventories, if these are considered to be commodities, at fair value less
costs to sell. [IAS 2.3(b)].
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3.4.1
Crypto-assets: Cost or lower net realisable value
The costs of purchased crypto-asset inventories would typically comprise the purchase
price, irrecoverable taxes and other costs directly attributable to the acquisition of the
inventory (e.g. blockchain processing fees). The cost of inventory excludes anticipated
selling costs as well as storage expenses [IAS 2.16] (e.g. costs of holding a wallet or other
crypto-account).
The cost of crypto-assets recorded as inventory may not be recoverable if those crypto-
assets have become wholly or partially obsolete (decline in interest or application) or if
their selling prices have declined. Similarly, the cost of crypto-asset inventory may not
be fully recoverable if the estimated costs to sell them have increased.
An entity holding crypto-asset inventory will need to estimate the net realisable value
at each reporting period. For crypto-assets quoted on a crypto-asset exchange, the net