Prevent Violating Faithful Representation

Lucubrate Magazine, Issue 32, July 13th, 2018

IAS 2 is structured and formularized to prevent misrepresentative data from violating faithful representation in order to manipulate net income. 


  • Accounting Series – article No: 13
  • Accounting Theory – Advanced Part 3

By Peter Welch, Georgia, CEO GlobalCfo.LLC.


Finally to wrap-up, a very important aspect of inventory accounting under IAS 2 is the selection of which finished products are transferred to cost of goods sold. It may seem intuitively obvious but it is based on the identification by date order as to when a product became part of inventory ready for sale. Unlike the US, IFRS permits ‘weighted-average’ and ‘FIFO’ (First-In, First-Out).

LIFO (Last-in, First-Out) is not allowed under IFRS. Additionally, in certain circumstance, the only specific cost is capitalized that falls outside ‘date criteria’. Also, as referenced, IAS 2, states emphatically that management may not arbitrarily use weighted-average or FIFO to serve net income purposes. In other words, maintain consistent treatment for inventory with similar use and nature.

Courtesy of IFRSbox

 

Depending upon price changes (inflation) the election of FIFO vs Weighted Average could have a marked difference to net income as well as taxes. FIFO assumes that the first items bought/converted are the first items sold. Therefore, at the end of the period, any items in inventory are the items purchased (or produced) most recently. As CGS is a Dr or effectively an expense, the smaller the CGS, the greater is net income and the higher is taxes. Given the function of taxation, the selection of an inventory methodology has a direct effect on macroeconomic variables.

Photo: rawpixel.com

 

These examples demonstrate the effect of selecting either FIFO or Weighted-Average approached. Consider the closing inventory tax differences, (14.500 – 13.500) @ tax rate!

Example: FIFO

You are selling one model of car. You have no inventory at the start of the period. You buy 4 cars during the period.

Due to price rises, the cars cost you: $6000, $6500, $7000, $7500 in the order you purchase them.

You sell 2 cars and use FIFO to value your inventory.

The value of your inventory at the end of the period is $14500 ($7000+$7500). Your cost of sales = $12500 ($6000+$6500).

  I/B DR CR
Cost of sales I 12.500
Inventory B 12.500
Allocation of inventory costs to costs of sales

Acknowledgment: IFRS Workbook 2017 Inventory

 

The weighted-average cost is calculated from the inventory at the start of the period, plus any items bought (or produced) during the period.

Example: weighted average

You are selling one model of car.

You have no inventory at the start of the period.

You buy 4 cars during the period.

Due to price rises, the cars cost you: $6000, $6500, $7000, $7500 in the order you purchase them. Total cost=$27000.

 

You sell 2 cars, and use weighted-average cost to value your inventory.

 

The value of your inventory at the end of the period is $13.500

($27000/2). Your cost of sales = $13.500 ($27000/2). Or, $27000/4=$6750 @ 2 = $13500

I/B DR CR
Cost of sales I 13.500
Inventory B 13.500
Allocation of inventory costs to costs of sales

Acknowledgment: IFRS Workbook 2017 Inventory

Conclusion, IAS 2 is structured and formularized to prevent misrepresentative data from violating faithful representation in order to manipulate net income.

 

The Statement of Cash Flows

Now, let’s turn to The Statement of Cash Flows, IAS 7.  Given the natural disconnect between net income and cash (net income ≠ cash), it behooves to create a reconciliation between opening and closing cash (bank and cash equivalents). Every week, even more frequently perhaps, the financial accountants/treasury should generate a bank reconciliation statement. Remember, the bank is a 3rd party thus providing solid credibility to the financial statements, devoid of any attempts to manipulate/fraudulent management behavior.

As a backdrop to IAS 7, there are still many opportunities to bypass ‘transparency and comparability’ by management. Let it be perceived that there are too many negative comments about management, just read ‘Financial Shenanigans, 3rd Edition (Howard M. Schilit/Jeremy Perler)’ and many others along with the daily press, NY Times, Financial times to understand unfortunately the frequency of occurrences of fraud and corruption. Oh also read the daily FCPA tracker (https://fcpatracker.com/) published by ‘Foreign Corrupt Practices Act’. (The Foreign Corrupt Practices Act of 1977 (FCPA) (15 U.S.C. § 78dd-1, et seq.) is a United States federal law that prohibits bribery of foreign officials and addresses accounting transparency and internal controls requirements under the Securities Exchange Act of 1934.) Contrast to the requirements of the Framework, discussed many times, especially faithful representation and an interesting picture emerge regarding the accounting standards and disclosure requirements and the synergy with the FCPA.

Photo. Fox

The Statement of Cash Flow, IAS 7, as seen above (IFRSbox) is comprised of 3-sections:

6 The following terms are used in this Standard with the meanings specified:

Cash comprises cash on hand and demand deposits.

Cash equivalents are short-term, highly liquid investments that are readily

convertible to known amounts of cash and which are subject to an

insignificant risk of changes in value.

Cash flows are inflows and outflows of cash and cash equivalents.

Operating activities are the principal revenue-producing activities of

the entity and other activities that are not investing or financing activities.

Investing activities are the acquisition and disposal of long-term assets

and other investments not included in cash equivalents.

Financing activities are activities that result in changes in the size and

composition of the contributed equity and borrowings of the entity.”

10 “The statement of cash flows shall report cash flows during the period classified

by operating,

investing and

financing activities.”

Relative to the IASB, and the official standard of IAS 7 – Statement of Cash Flows “Definitions

 

Let’s first discuss ‘Operating’ and the options for disclosure/presentation, the direct vs indirect method.

Courtesy of IFRSbox

 

 

 

Acknowledgments:

IFRS Workbook 2017 Inventory. The set of books provides a book for every standard. Our acknowledgment to Mr. Prof. Robin Joyce.

Thanks also to IFRSbox and Silvia for her valuable contribution as a reference source. Ms. Silvia Mahútová runs the website  www.ifrsbox.com dedicated to helping people understand and learn IFRS in an easy way.  In 2018, her website has over 130 000 visits per month and students come from more than 130 countries around the world.

 

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Peter Welch
Peter Welch

GlobalCfo.LLC is an expert at developing entrepreneurs and building 3-5 year business plans and cash flow projections as a prerequisite for accessing financing sources. GlobalCfo.LLC targets accounting standards compliance and theory, sound infrastructure /process mapping and COSO 2013-17/solid internal controls, ERM, and last but not least documentation /Policy and Procedures and other manuals. Additionally, interim CFO services (or Rent-a-CFO by the hour/day) are offered locally or remotely as well as training at all levels and all functions, not just accounting; e.g., management and leadership skills. Pre/Post-M&A is also offered.

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