7.2 Initial Recognition and Measurement
An obvious question that arises when considering inventory is, what costs should be included? In answering this question, IFRS has provided some general guidance: the cost of inventories shall include all costs of purchase, costs of conversion, and “other costs incurred in bringing the inventories to their present location and condition” (International Accounting Standards, n.d., 2.10).
Costs of Purchase
Purchase costs include not only the direct purchase price of the goods but also the costs to transport the goods to the company’s premises and any nonrecoverable taxes or import duties paid on the purchase. As well, any discounts or rebates earned on the purchase should be deducted from the cost of the inventory.
One issue that often needs to be considered when determining inventory costs at the end of an accounting period is the matter of goods in transit. Goods may be shipped by a seller before the end of an accounting period but are not received until after the end of the purchaser’s accounting period. The question of who owns the goods while they are in transit obviously needs to be addressed. More specifically, three issues arise from this question:
- Who pays for the shipping costs?
- Who is responsible for the loss if goods are damaged in transit?
- When should the transfer of ownership be recorded in the accounting records?
To answer these questions, the legal term free on board (FOB) needs to be understood. When goods are shipped by a seller, the invoice will usually indicate that the goods are shipped either FOB shipping or FOB destination. If the goods are FOB shipping, the purchaser is assuming legal title as soon as the goods leave the seller’s warehouse. This means the purchaser is responsible for shipping costs as well as for any damage that occurs in transit. As well, the purchaser should record these goods in his or her inventory accounts as soon as they are shipped, even if they don’t arrive until after the end of the accounting period.
If the goods are FOB destination, the purchaser is not assuming ownership of the goods until they are received. This means that the seller would be responsible for shipping costs and any damage that occurs in transit. As well, the purchaser should not include these goods in his or her inventory until they are actually received. Likewise, the seller would still include the goods in his or her inventory until they are actually delivered to the purchaser. Accountants and auditors pay close attention to the FOB terms of purchases and sales near the fiscal period end, as these terms can affect the accurate recording of the inventory amount on the balance sheet.
Also note that it is very important to distinguish the purchaser and the seller and FOB shipping or destination could be different for either.
Costs of Conversion
Another more complex issue arises in the determination of the cost of manufactured inventories. As noted above, IAS 2-10 requires the inclusion of costs to convert inventories into their current form. For a manufacturing company, this means that inventories will include raw materials, work in progress, and finished goods. For raw materials, the cost is fairly easy to determine. However, for work in progress and finished goods, the determination of which costs to include becomes more complicated.
Although labour and variable overhead costs, such as utilities consumed by operating factory machines, are fairly easy to associate directly with the production of a product, the treatment of other fixed overhead costs is not as clear. It can be argued that costs such as factory rent should not be included in the inventory cost because this cost will not vary with the level of production. However, it can also be argued that without the payment of rent, the production process could not occur.
For management accounting purposes, a variety of methods are used to account for overhead costs. For financial accounting purposes, however, it is clear that all conversion costs need to be included in inventory. Thus, the financial accountant will need to determine the best way to allocate fixed overhead costs. In normal circumstances, the fixed overhead costs are simply allocated to each unit of inventory produced in an accounting period. However, if production levels are significantly higher or lower than normal levels, then the accountant needs to apply some judgment to the situation. If fixed overhead costs are applied to very low levels of production, the result would be inventory that is carried at a value that may be higher than its realizable value. For this reason, fixed overhead costs should be allocated to low production volumes using the rate calculated on normal production levels, with unallocated overhead being expensed in the period. This is done to avoid reporting misleadingly high inventory levels.
On the other hand, if abnormally high production occurs, the fixed overhead costs are allocated using the actual production level. This would result in lower per-unit costs for the inventory produced. This situation could result in higher profits, as presumably some of the excess production would be held in inventory at the end of the year. A manager may be tempted to increase production strictly for the purpose of increasing current earnings. Although this does not violate any accounting standard, the accountant should be careful in this situation, as there may be a risk of obsolete inventory as a result of the overproduction, or there may be other forms of income-maximizing earnings management occurring.
Other Costs
IAS 2–15 indicates that other costs can be included in inventory only to the extent “they are incurred in bringing the inventories to their present location and condition.” The standard provides examples such as certain non-production overhead costs or product-design costs for specific customers. Clearly, the accountant would need to exercise judgment in allocating these kinds of costs to inventory. The standard also clearly defines some costs that should not be included in inventories but rather expensed in the current period. These costs include the following:
- Abnormal amounts of wasted materials, labour, or other production costs
- Storage costs, unless those costs are necessary in the production process before a further production stage
- Administrative overheads that do not contribute to bringing inventories to their present location and condition
- Selling costs
As well, IAS 23–Borrowing Costs describes some limited and specific circumstances when interest costs can be included in inventory. IAS 2-19 also discusses inventory of a service provider. An example of this would be a professional services firm, such as an accounting practice. These types of firms will often track work in progress on their balance sheets. These accounts should include only direct costs (which would primarily consist of direct and supervisory labour) and attributable overheads. These costs should not include the costs of any administrative or sales personnel or other non-attributable overheads, nor should they include any mark-ups on costs that might be included in standard charge rates for customers.
Recall from the revenue chapter inventory on consignment. The consignor includes inventory on consignment, NOT the consignee.
