What affects the revenue recognition of inventories?
The application of the accrual basis of accounting.
What are the key issues affecting inventories?
The key issue affecting inventories is the identification of which costs should be:
(1) Carried forward in the statement of financial position
(2) Expensed as part of cost of sales.
IAS 2 applies to all inventories except the following:
WIP under construction contracts
Financial instruments (e.g. shares, bonds)
Biological assets.
Certain inventories are exempt from the standard's measurement rules, i.e.
those held by: producers of agricultural, forest and mineral products plus commodity-broker traders.
Inventories definition
Inventories are assets held for sale in the ordinary course of business, in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services.
Inventories can include
(1) goods purchased and held for resale; (2) finished goods; (3) WIP being produced and (4) raw materials awaiting use.
Measurement
Inventories to be valued at lower of cost and NRV
Cost
Cost includes all costs incurred in bringing the inventories to their present location and condition.
It includes the cost of purchase, cost of conversion and other costs in bring the inventories to their present location & condition.
Cost of purchase =
purchase price PLUS important duties and other non-recoverable taxes PLUS transport, handling and other directly attributable costs LESS trade discounts, rebates and similar amounts.
Cost of conversion
consists of two parts. (1) costs directly related to the units of production, e.g. direct materials, direct labour; (2) fixed and variable production overheads that are incurred in covering materials into finished goods, allocated on the basis of normal p
Other costs incurred in bringing the inventories to their present location and condition include
(1) Abnormal amounts of wasted materials, labour or other production costs; (2) storage costs except those necessary in the production process; (3) administrative overheads and (4) selling costs.
Fixed production overheads
indirect costs of production that remain relatively constant regardless of the volume of production such as depreciation and maintenance.
Variable production overheads
indirect costs of production that vary directly, or nearly directly with the volume of production, such as indirect materials and labour.
IAS 2 emphasises that fixed production overheads must be allocated to items of inventory on the basis of
the normal capacity of the production facilities.
What is normal capacity?
Normal capacity is the expected achievable production based on the average over several periods/seasons, under normal circumstances.
The above figure should take account of the capacity lost through planned maintenance.
If it approximates to the normal ca
As a result:
(1) Low production or idle plant will not result in a higher fixed overhead allocation to each unit.
(2) Unallocated overheads must be recognised as an expense in the period in which they were incurred.
(3) When production is abnormally high, the fixed pr
Techniques for the measurement of cost
Two techniques are mentioned by the standard, both of which produce results that approximate to cost, and so both of which may be used for convenience.
(1) Standard costs
(2) Retail method
Standard costs:
these are set up to take account of normal levels of raw materials used, labour time etc. they are reviewed and revised on a regular basis.
Retail method:
this is often used in the retail industry where there is a large turnover of inventory items, which nevertheless have similar profit margins. The only practical method of inventory valuation may be to take the total SP of inventories and deduct an overall
Cost formulae - attributing specific costs to items that are not interchangeable/specific projects
It is possible to attribute specific costs to items that are not interchangeable and to items produced for specific projects or customers and it is these costs which are used in arriving at inventory valuations.
But many inventories include items that are interchangeable with each other, in which case
case it is not possible to identify a specific cost for a specific item. In these cases, cost formulae should be used, which make assumptions about which of the items produce have been sold and which are still held in inventory, and therefore about the co
Only two cost formulae are allowed under IAS 2
1. FIFO
2. WAC
FIFO
Assumes a physical flow of items whereby those produced earliest at the first to be sold. The items produced most recently are the ones in inventory, to be measure at the most recent production cost.
WAC
Calculates an average cost of production (either at the end of each period or after each new batch has been produced, depending on the circumstances of the company) and measures inventories at the average cost.
Net realisable value
selling price less costs to complete/sell.
As a general rule NRV should not fall below cost however, there are a number of reasons why:
1. Increase in costs/fall in SP;
2. Physical deterioration;
3. Obsolescence;
4. Strategic decision to manufacture and sell at a loss'
5. Errors in production/purchasing.
So what should we do if NRV falls below cost
When NRV falls below cost, the inventory is written down to its recoverable amount and the fall in value is charged to profit or loss. The write-down may be of such size. Incidence or nature that it must be disclosed separately.
At the end of each period
NRV must be reassessed and compared again with cost. This may result in the reversal of all or part of the original write-down.
Revenue Recognition
Once an item has been sold, it cannot remain in inventories (no longer meets the definition of an asset - CF). Its carrying amount is recognised as an expense and the related revenue of recognised.