110 PAS 2 PAS 2 Inventories Learning Objectives 1. Define inventories. 2. Measure inventories and apply the cost formulas. 3. State the accounting for inventory write-down and the reversal thereof. Introduction @RAS"prescribes the accounting treatment for inventories. PAS 2 recognizes that aeprifiarylissue in the accounting for inventories is the determination of cost to be recognized as asset and carried _forwarduntil, itis expensed. Accordingly, PAS 2 provides _§uidance in the determination of cost of inventories, including the _use of cost formulas, and their subsequent measurement and _-despenitionas expense. PAS 2 applies to all inventories except for the following: » Assets accounted for under other standards a. Financial instruments (PAS 32 and PFRS 9); and b. Biological assets and agricultural pee at the point of harvest (PAS 41). > Assets @oPmeasured under the lower of cost or net realizable value (NRV) under PAS 2 a. Inventories of producers of agricultural, forest, and mineral products measured at net realizable value ir accordance with well-established practices in those industries. b. Inventories of commodity broker-traders measured at fair value less costs to sell.Inventories 111 Inventories Inventories are as assets: a, Held for sale in the ordinary course of business (finished goods); b, Inthe process of production for such sale (work in process); or c. In the form of materials or supplies to be consumed in the production Process or in the rendering of services (raw materials and manufacturing supplies). (PAS 2.6) Examples of inventories: a. Merchandise purchased by a trading entity and held for resale. b. Land and other property held for sale in the ordinary course of business. c. Finished goods, goods undergoing production, and raw materials and supplies awaiting use in the production process by a manufacturing entity. Ordinary course of business refers to the necessary, normal or usual business activities of an entity. Measurement ~ Inventories are measured at the lower of cost and net realizable value. Cost The cost of inventories comprises the following: a. Purchase cost — this includes the purchase price (net of trade discounts and other rebates), import duties, non-refundable or non-recoverable purchase taxes, and transport, handling and other costs directly attributable to the acquisition of the inventory. Conversion costs - these refer to the costs necessary in converting raw materials into finished goods. Conversion costs include the costs of direct labor and production overhead. Other costs necessary in bringing the inventories to their Present location and condition.2 PAS 2 The following are excluded from the cost of inventories and are expensed in the period in which they are incurred: a. Abnormal amounts of wasted materials, labor or other production costs; b. Storage costs, unless those costs are necessary in the production process before a further production stage (e.g., the storage costs of partly finished goods may be capitalized as cost of inventory, but the storage. costs of completed goods are expensed); c. Administrative overheads that do not contribute to bringing inventories to their present location and condition; and d. Selling costs (e.g., freight out and advertisement costs). (PAS 2.16) When a purchase transaction effectively contains a financing element, such as when payment of the purchase price is deferred, the difference between the purchase price for normal credit terms and the amount paid is recognized as interest expense over the period of the financing. Illustration: Entity A acquires inventories and incurs the following costs: Purchase price, gross of trade discount 100,000 Trade discount 20,000 Non-refundable purchase tax, not included in the purchase price above 5,000 Freight-in (Transportation costs) 15,000 Commission to broker 2,000 Advertisement costs 10,000 Requirement: How much is the cost of the inventories purchased? Solution: Purchase price, gross of trade discount 100,000 Trade discount (20,000) Non-refundable purchase tax 5,000Inventories 113 Freight-in (Transportation costs) 15,000 Commission to broker 2,000 Total cost of inventories 102,000 The advertisement costs are selling costs. These are expensed in the period in which they are incurred. Cost Formulas The cost formulas deal with the computation of cost of inventories that are charged as expense when the related revenue is recognized (i.e., ‘cost of sales’ or ‘cost of goods sold’) as well as the cost of unsold inventories at the end of the period that are recognized as asset (i.e., ‘ending inventory’). PAS 2 provides the following cost formulas: 1. Specific identification — this shall be used for inventories that are not ordinarily interchangeable (ie, those that are individually unique) and those that are segregated for specific projects. Under this formula, specific costs are attributed to identified items of inventory. Accordingly, cost of sales represents the actual costs of the specific items sold while ending inventory represents the actual costs of the specific items on hand. For example, if an inventory with a serial number of “ABC-123” costing ?10,948.67 is sold, the amount charged to cost of sales is also P 10,948.67. If that inventory remains unsold, the amount included in ending inventory is also P10,948.67. In this regard, records should be maintained that enables the entity to identify the cost and movement of each specific inventory. Specific identification, however, is not appropriate when inventories consist of large number of items that are ordinarily interchangeable. In such cases, the entity shall choose between formulas 2 and 3 below.114 PAS2 . 2. First-In, First-Out (FIFO) - Under this formula, it is assumed that inventories that were purchased or produced first are sold first, and therefore unsold inventories at the end of the period are those most recently purchased or produced. Accordingly, cost of sales represents costs from earlier purchases, while the cost of ending inventory represents costs from the most recent purchases. 3. Weighted Average — Under this formula, cost of sales and ending inventory are determined based on the weighted average cost of beginning inventory and all inventories purchased or produced during the period. The average may be calculated on a periodic basis, or as each additional purchase is made, depending upon the circumstances of the entity. The cost formulas refer to “cost flow assumptions,” meaning they pertain to the flow of costs (i.e, from inventory to cost of sales) and not necessarily to the actual physical flow of inventories. Thus, the FIFO or Weighted Average can be used regardless of which item of inventory is physically sold first. Same cost formula shall be used for all inventories with similar nature and use. Different cost formulas may be used for inventories with different nature or use. However, a difference in geographical location of inventories, by itself, is not sufficient to justify the use of different cost formulas. (PAS 2.26) PAS 2 does not permit the use of a last-in, first out (LIFO) cost formula. Net realizable value (NRV) Net realizable value is “the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.” (PAS 2.6) NRV is. different from fair value. “Net realizable value refers to the net amount that an entity expects to realize from the sale of inventory in the ordinary course of business. Fair value reflects the price at which an orderly transaction to sell the sameInventories 115 inventory in the principal (or most advantageous) market for that inventory would take place between market participants at the measurement date. The former is an entity-specific value; the latter is not. Net realizable value for inventories may not equal fair value less costs to sell.” (PAS 2.7) Measuring inventories at the lower of cost and NRV is in line with the basic accounting concept that an asset shall not be carried at an amount that exceeds its recoverable amount. The cost of an inventory may exceed its recoverable amount if, for example, the inventory is damaged, becomes obsolete, prices have declined, or the estimated costs to complete or to sell the inventory have increased. In these circumstances, the cost of the inventory is written-down to NRV. The amount of write-down is recognized as expense. If the NRV subsequently increases, the previous write- down is reversed. However, the amount of reversal shall not exceed the original write-down. This is so that so that the new carrying amount is the lower of the cost and the revised NRV. Write-downs of inventories are usually carried out on an item by item basis, although in some circumstances, it may be appropriate to group similar items. It is not appropriate to write down inventories on the basis of their classification (e.g., finished goods or all inventories of an operating segment). Raw materials inventory is not written down below cost if the finished goods in which they will be incorporated are expected to be sold at or above cost. If, however, this is not the case, the raw matefials are written down to their NRV. The best evidence. of NRV for raw materials is replacement cost. Illusiration: Information on Entity A’s inventories is as follows: ProductA = Product B Cost 100,000 200,000 Estimated selling price 140,000 220,000 Estimated costs to sell 20,000 30,000PAS2 116 Le Requirement: Compute for the valuation of Products A and B in Entity A’s statement of financial position. Solution: Product A___ Product B Cost $ 100,000 200,000 Estimated selling price 140,000 220,000 Estimated costs to sell (20,000) (30,000) Net realizable value 120,000 190,000 Lower ~ 100,000 190,000 Amount of write-down a 10,000 Analysis: > Product A need not be written-down because its cost is lower than its NRV. > Product B shall be written-down by ®10,000 because its cost exceeds its NRV (200,000 cost less 190,000 NRV). > The total inventory to be shown in the statement of financial position is ®290,000 (100,000 for Product A + 190,000 for Product B). > The #10,000 write-down is recognized as expense in profit or loss. Recognition as an expense The carrying amount of an inventory that is sold is charged as expense (i.¢., cost of sales) in the period in which the related revenue is recognized. Likewise, the write-down of inventories to NRV and all losses of inventories are recognized as expense in the period the write-down or loss occurs. “The amount of any reversal of any write-down of inventories, arising from an increase in net realizable value, shall be recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs.” (PAS 2.34) Inventories that are used in the construction of another asset is not expensed but rather capitalized as cost of theInventories 117 constructed asset. For example, some inventories may be used in constructing a building. The cost of those inventories is capitalized as cost of the building and will be included in the depreciation of that building. Disclosures a. Accounting policies adopted in measuring inventories, including the cost formula used; b. Total carrying amount of inventories and the carrying amount in classifications appropriate to the entity; c. Carrying amount of inventories carried at fair value less costs to sell; d. Amount of inventories recognized as an expense during the period; e. Amount of any write-down of inventories recognized as an expense in the period; : f. “Amount of any reversal of write-down that is recognized as a reduction in the amount of inventories recognized as expense in the period; g. Circumstances or events that led to the reversal of a write- down of inventories; and i h. Carrying amount of inventories pledged as security for liabilities. (PAS 2.36)118 PAS2 Summary: Inventories include goods that are held for sale in the ordi course of business, in the process of production for such sale, and in the form of materials and supplies to be consumed in the production. Inventories are measured at the lower of cost and net realizable value (NRV). 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. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase. The following are excluded from the cost of inventory: Abnormal costs, Storage costs, unless necessary, Administrative costs, and Selling costs. The cost formulas permitted under PAS 2 are (a) specific identification, (b) FIFO, and (c) weighted average. Specific identification shall be used for inventories which are not ordinarily interchangeable. Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Inventories are usually written down to NRV on an item by item basis. Raw materials inventory is not written down below cost if the finished goods in which they will be incorporated are expected to be sold at or above cost. Reversals of inventory write-downs shall not exceed the amount of the original write-down.Inventories 119 PROBLEMS PROBLEM 1: TRUE OR FALSE 1. 2. 3. Freight-out is included in the cost of inventories. Trade discounts are deducted from the cost of inventories. Storage costs of part-finished goods. may be included in the cost of inventory, but not storage costs of finished goods. Import duties, freight-in and non-refundable purchase taxes form part of the cost of inventories. Inventory is not written down if its cost does not exceed the net realizable value. For inventories consisting of individually unique items, the appropriate cost formula is the Specific identification. Use the following information for the next two questions: An item inventory has a cost of #20 and a net realizable value of P16. 7. 10. The amount of inventory that is presented in the statement of financial position is #20. The amount of write-down that is presented in the statement of profit or loss is P4._ Raw materials inventory is not written down below cost if the finished goods to which they will be incorporated are expected to be sold at or above cost. Reversals of inventory write-downs may exceed the amount of write-downs previously recognized. PROBLEM 2: MULTIPLE CHOICE 1. Entity A is a manufacturing company. To account for its inventories, Entity A will most certainly apply the specific provisions of a. the Conceptual Framework. c. PAS 2. b. PFRS1. d. PAS 7.PAS 2 120 2. PAS 2 provides guidance on a. determining the cost of inventories recognized as asset. b. determining the cost of inventories recognized as expense when the related revenue is recognized. c. the presentation of financial statements to promote comparability. d. aandb 3. 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