Summary OF PAS 2 Inventories PDF

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SUMMARY OF PAS 2 INVENTORIES Objective of PAS 2 The objective of PAS 2 is to prescribe the accounting treatment for inventories. It provides guidance for determining the cost of inventories and for subsequently recognising an expense, including any write-down to net realisable value. It also provides guidance on the cost formulas that are used to assign costs to inventories.

Scope Inventories include assets held for sale in the ordinary course of business (finished goods), assets in the production process for sale in the ordinary course of business (work in process), and materials and supplies that are consumed in production (raw materials). [PAS 2.6]

However, PAS 2 excludes certain inventories from its scope: [PAS 2.2] I. work in process arising under construction contracts (see PAS 11) II. financial instruments (see PAS 39) III. biological assets related to agricultural activity and agricultural produce at the point of harvest (see PAS 41).

Also, while the following are within the scope of the standard, PAS 2 does not apply to the measurement of inventories held by: [PAS 2.3]  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 (above or below cost) in accordance with well-established practices in those industries. When such inventories are measured at net realisable value, changes in that value are recognised in profit or loss in the period of the change.  commodity brokers and dealers 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.

Fundamental Principle of PAS 2 Inventories are required to be stated at the lower of cost and net realisable value (NRV). [PAS 2.9]

Measurement of Inventories Cost should include all: [PAS 2.10]  costs of purchase (including taxes, transport, and handling) net of trade discounts received  costs of conversion (including fixed and variable manufacturing overheads) and  other costs incurred in bringing the inventories to their present location and condition PAS 23 Borrowing Costs identifies some limited circumstances where borrowing costs (interest) can be included in cost of inventories that meet the definition of a qualifying asset. [PAS 2.17 and PAS 23.4] Inventory cost should not include: [PAS 2.16 and 2.18]  abnormal waste  storage costs  administrative overheads unrelated to production  selling costs  foreign exchange diferences arising directly on the recent acquisition of inventories invoiced in a foreign currency  interest cost when inventories are purchased with deferred settlement terms. The standard cost and retail methods may be used for the measurement of cost, provided that the results approximate actual cost. [PAS 2.21-22] For inventory items that are not interchangeable, specific costs are attributed to the specific individual items of inventory. [PAS 2.23] For items that are interchangeable, PAS 2 allows the FIFO or weighted average cost formulas. [PAS 2.25] The LIFO formula, which had been allowed prior to the 2003 revision of PAS 2, is no longer allowed.

The same cost formula should be used for all inventories with similar characteristics as to their nature and use to the entity. For groups of inventories that have diferent characteristics, diferent cost formulas may be justified. [PAS 2.25]

Write-Down to Net Realisable Value NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale. [IAS 2.6] Any write-down to NRV should be recognised as an expense in the period in which the write-down occurs. Any reversal should be recognised in the income statement in the period in which the reversal occurs. [PAS 2.34] Expense Recognition PAS 18 Revenue addresses revenue recognition for the sale of goods. When inventories are sold and revenue is recognised, the carrying amount of those inventories is recognised as an expense (often called cost-of-goodssold). Any write-down to NRV and any inventory losses are also recognised as an expense when they occur. [PAS 2.34] Disclosure Required disclosures: [PAS 2.36]  accounting policy for inventories  carrying amount, generally classified as merchandise, supplies, materials, work in progress, and finished goods. The classifications depend on what is appropriate for the entity  carrying amount of any inventories carried at fair value less costs to sell  amount of any write-down of inventories recognised as an expense in the period  amount of any reversal of a writedown to NRV and the circumstances that led to such reversal  carrying amount of inventories pledged as security for liabilities  cost of inventories recognised as expense (cost of goods sold). PAS 2 acknowledges that some enterprises classify income statement expenses by nature (materials, labour, and so on) rather than by function (cost of goods sold, selling expense, and so on). Accordingly, as an alternative to disclosing cost of goods sold expense, IAS 2 allows an entity to disclose operating costs recognised during the period by nature of the cost (raw materials and consumables, labour costs, other operating costs) and the

amount of the net change in inventories for the period). [PAS 2.39] This is consistent with PAS 1, which allows presentation of expenses by function or nature.

ADDITIONAL LECTURE NOTES Whose inventory is it? Goods in transit

 Shipping terms determine when title to goods passes to the purchaser. a. FOB (free on board) shipping point—title passes to the buyer with the loading of goods at the point of shipment. b. FOB destination—legal title does not pass until the goods are received by the buyer.  Goods shipped FOB shipping point belong to the buyer while they are in transit and should normally be included in the buyer’s inventory while in transit.  Goods shipped FOB destination belong to the seller while in transit and are normally included in the seller’s inventory.

Goods on consignment  Goods held by the dealer (consignee) for which title is held by the shipper (consignor).  Consigned goods are included in the inventory of the consignor.

Conditional sales, installment sales, and repurchase agreements  If title to the goods is retained by the seller, the seller may report as an asset the cost of the goods less the purchaser’s equity in the goods such as established by collections.  Generally however, in the usual case where the possibilities of default or return are low, the seller, in anticipation of contract completion and ultimate passing of title, will recognize the transaction as a regular sale and remove the goods from reported inventory at the time of sale.  Repurchase agreements result in no sale being recorded; the inventory is thus not removed from the books, and instead the “seller” records a liability for the proceeds of the “sale”, which more accurately in substance is a short-term loan secured by inventory as collateral.

Inventory cost formulas The purpose of an inventory valuation method is to allocate the total inventory cost of good available for sale during the period between cost of goods sold and ending inventory.

Specific identification  Required for inventories that are not ordinarily interchangeable and goods or services produced and segregated for specific projects.  The original cost of each item is identified, resulting in actual costs being accumulated for the specific items on hand and sold.  This method is consistent with the physical fow of goods (though note, it is not required that one has to choose a cost-fow method which corresponds to the actual, underlying physical fow of goods).  Though theoretically attractive and useful when each inventory item is unique and has a high cost, it is frequently not economically feasible (even if taking into account advances in technology), particularly where inventory is composed of a

great many items or identical items acquired at diferent times and at diferent prices.  It is subject to manipulation, as seller has the fexibility of selectively choosing specific items of higher/lower-costing inventory depending on particular income goals at the time of sale.  It is the least common method observed in practice.

Average cost method  This method assigns the same average cost to each unit.  Based on the assumption that goods sold should be charged at an average cost, with the average being weighted by the number of units acquired at each price.  It provides the same cost for similar items of equal utility.  It does not permit profit manipulation.  Its limitation is that inventory values may lag significantly behind current prices in periods of rapidly rising or falling prices.

First-in, first-out method (FIFO)  The first goods purchased are the first goods sold.  Using the FIFO method, the accountant computes the cost of goods sold and ending inventory as if the first items purchased are the first to be sold, leaving the most recently purchased items in inventory.  This often matches the physical fow of goods.  FIFO afords little opportunity for profit manipulation.  FIFO best approximates the current replacement value of ending inventory.

Comparison of methods: cost of goods sold and ending inventory The average cost method:   Difers from the other methods in that no assumption is made about the sale of specific units.

 Rather, all sales are assumed to be of the “average” unit at the average cost per unit.  The gross profit margin tends to follow a similar pattern to FIFO in response to changing prices.  Generally provides inventory values similar to FIFO values, since average costs are heavily infuenced by current costs.

FIFO:  In a period of rising prices, matches oldest low-cost inventory with rising sales prices, thus expanding the gross profit margin.  In a period of declining prices, oldest high-cost inventory is matched with declining sales prices, thus narrowing the gross profit margin.  Inventories are reported on the balance sheet at or near current costs. Specific identification:  Can produce any variety of results depending on which particular units are selected for shipment.

Inventory systems Periodic inventory system  An inventory system in which only revenue is recorded each time a sale occurs; the inventory balance is determined by a periodic physical inventory.  Using the periodic system, items must be physically counted to determine quantities on hand.  Quantities of items sold are determined indirectly by subtracting the units on hand from the sum of the units in the beginning inventory and units purchased during the year.

Perpetual inventory system  An inventory system which provides a continuous summary of goods on hand.  Entries for sales, cost of goods sold, and the reduction of inventory are recorded for each sales transaction.  A continuous record of quantities in inventory and items sold is maintained.  Benefits of a perpetual system. 1. Provides a continuous check and control mechanism on inventory. 2. Facilitates purchasing and production planning 3. Ensures adequate on-hand inventories 4. Helps identify and measure the magnitude of inventory shrinkage. 5. Advances in, and cost reductions relating to, technology have made perpetual systems much more feasible, and it’s a good thing – today’s fast paced, competitive business environment magnifies the importance of a perpetual system’s benefits.

Purchase commitments  A lock on the inventory purchase price in advance. An executory contract (an exchange of promises about future actions).  No journal entry is required to record an asset and liability at the commitment date.  However, when price declines take place subsequent to the commitment and it is outstanding at the end of an accounting period, the loss is recorded just as losses with goods on hand are recognized (i.e., as with LCM, in the period in which the inventory price decline took place).  Acquisition of the goods in a subsequent period is also recorded. 1. Purchases are recorded at current market value. 2. Diference between current market value of goods and total amount owed per the purchase commitment is refected by the removal of the estimated loss on purchase commitments account (a balance sheet account created above).

 Current loss recognition is not appropriate when: 1. Commitments can be cancelled, 2. Commitments provide for price adjustment, 3. Hedging transactions prevent losses, or 4. Declines do not suggest reductions in sales prices.  If, prior to delivery, the market price increases, the estimated loss on purchase commitments account is reduced and a gain is recorded, though such “recovery” can only be recognized to the extent of the original loss recorded. Using inventory information for financial analysis Inventory balances are often used to measure a company’s efficiency in using that asset to generate sales. Inventory turnover evaluates the inventory position and the appropriateness of its size (cost of goods sold/ average inventory). Number of days’ sales in inventory gives average time it takes to turn over the inventory (Average inventory/ average daily cost of goods sold) (or number of days in the year/ inventory turnover rate).

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