Cost of Inventories (IAS 2)

Under IAS 2, inventories are measured at the lower of cost (see below) and net realisable value (IAS 2.9).

The cost of inventories comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition (IAS 2.10). See also a separate page on cost formulas for interchangeable inventories.

The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authorities), and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase (IAS 2.11).

Contractual rebates and discounts are anticipated if it is probable that they have been earned or will take effect. Discretionary (i.e. not contractual) rebates and discounts are not anticipated. This is not covered explicitly in IAS 2, but can be applied by analogy from IAS 34 (IAS 34.B23). Consider the example below.


Example: Accrued contractual volume rebates

On 1 January 20X1 Entity A, a retailer, enters into a 2-year contract with a supplier of product X. Under the agreement, Entity A purchases product X for $100 per item. The agreement provides that Entity A will receive a $5 rebate for each purchased item (applied retrospectively to all purchases) if it purchases at least 10,000 products over the 2-year contract term. During year 20X1, Entity A purchased 9,000 products, of which 8,500 were already sold to customers. At 31 December 20X1 Entity A assesses that it is probable that it will earn the rebate as the sale of product X accelerated during the second half of the 20X1. The rebate is contractual, therefore Entity A accrues it in its financial statements for the year 20X1.

Entries made by Entity A are as follows:

1/ Entity A purchased 9,000 products for $100 per item, of which 8,500 were sold.

DRCR
Cash$900,000
Inventory$50,000
Cost of goods sold$850,000

2/ Entity A accrues the contractual rebate of $5 per product

DRCR
Receivable$45,000
Inventory$2,500
Cost of goods sold$42,500

Example: discretionary volume rebates

On 1 January 20X1 Entity A, a retailer, enters into a 2-year contract with a supplier of product X. Under the agreement, Entity A purchases product X for $100 per item. Supplier of X has a practice of granting volume rebates for entities with high volumes of purchases. However, these rebates are not contractual and are fully at the discretion of the supplier of X. During year 20X1, Entity A purchased 9,000 products. At 31 December 20X1 Entity A assesses that it is probable that it will be granted a rebate after the 2-year contract period. As the rebate is not contractual, Entity A does not accrue it in its financial statements for the year 20X1. If the amount is material, Entity A discloses it as a contingent asset.

The costs of conversion include (IAS 2.12):

  • costs strictly correlated with the units of production (e.g. direct materials used),
  • systematic allocation of variable production overheads,
  • systematic allocation of fixed production overheads.

Variable production overheads are indirect costs of production that vary with the volume of production. Examples of variable production overheads are indirect materials or 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). However, abnormal amounts of wasted materials or other inefficiencies are expensed in P/L as incurred (IAS 2.16(a)).

Fixed production overheads are indirect costs of production that remain relatively constant regardless of the volume of production. Examples of fixed production overheads are depreciation and maintenance of factory buildings and equipment used in the production process or the cost of factory management and administration.

Fixed production overheads are allocated to each unit of production based on the normal capacity of the production facilities. In practice, the actual level of production is used most often as normal capacity. But actual level of production needs to be adjusted for any idle periods (e.g. due to lack of purchase orders) or unexpected repairs. Such an adjustment results in relevant fixed production overheads recognised immediately in P/L, not in the cost of inventories (IAS 2.13).

Note that allocating production overheads is required by IAS 2, i.e. entity cannot decide to exclude them from the cost of inventory.

IAS 2 allows costs other than purchase or conversion cost to be included in the carrying amount of inventories, but they must be incurred in bringing the inventories to their present location and condition (IAS 2.15). Examples of such costs are non-production overheads or costs of design for specific customers.

However, paragraph IAS 2.16 provides a specific list of costs that are excluded from the cost of inventories:

  1. abnormal amounts of wasted materials, labour or other production costs;
  2. storage costs, unless those costs are necessary in the production process before a further production stage;
  3. administrative overheads that do not contribute to bringing inventories to their present location and condition; and
  4. selling costs.

IAS 23 provides criteria for recognising borrowing costs in the cost of inventories.

Storage costs are excluded from the cost of inventories ‘unless those costs are necessary in the production process before a further production stage’. Therefore, storing finished goods in a warehouse does not increase their cost. It is the same with storing materials or work in progress due to timing mismatch (e.g. storing bricks before they are moved to construction site).

Examples of inventories where the storage is necessary in the production process include maturing alcoholic drinks (e.g. wine) or certain types of food products (e.g. cheese).

Transportation costs can be allocated to the cost of inventories provided they are incurred ‘in bringing the inventories to their present location and condition’. At the same time, they cannot be selling costs as these are specifically disallowed from the cost of inventories (IAS 2.16(d)). The distinction can be tough to make and different scenarios are possible when sensibly explained. For example, transporting materials and work-in-progress to production facility can be included in the cost of finished goods. It is also accepted that the cost of transporting finished goods from the production facility or entity’s main warehouses to retail points is also added to the cost of inventory as these costs are incurred ‘in bringing the inventories to their present location’ necessary to make the sale. On the other hand, transporting inventory between retail points to match the local demand, or transporting them from retail points to customer premises, is more likely to fall under selling activities and therefore should be expensed in P/L as incurred.

Paragraph IAS 2.15 states that it is appropriate to include non-production overheads in the cost of inventories provided that these costs ‘are incurred in bringing the inventories to their present location and condition’. This opens the doors to a very wide array of non-production overheads to be allocated to the cost of inventory, as it may be argued that nearly every department within an entity has an input in bringing the inventories to their present location and condition. Every entity needs therefore to establish its own policy based on sensible criteria and taking into account materiality considerations.

When inventories are purchased on credit that differs from the normal credit terms (e.g. credit term is significantly longer when compared to industry average), the cost of inventories is recognised based on the purchase price for normal credit terms. The difference between normal credit terms and actual payments are recognised as interest expense over the period of financing (IAS 2.18). IAS 2 is not very elaborate here, so it may be useful to look into IFRS 15 criteria for determining whether a contract contains significant financing component.

Inventories can also be scoped out of IAS 23.

See other pages relating to IAS 2:

IAS 2: Scope, Definitions and Disclosure
IAS 2: Cost of Inventories
IAS 2: Cost Formulas (FIFO, LIFO and Weighted Average Cost)
IAS 2: Net Realisable Value (NRV)

© 2018-2020 Marek Muc

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