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Lucubrate Magazine, Issue 31, July 6th, 2018
It is normal to have raw materials, finished-good work-in-process, and finished goods (future cost of sales) inventories. However there are costs, termed conversion costs that are incurred to move the process to a finished good state. Other inventory categories also exist.
- Accounting Series – article No: 12
- Accounting Theory – Advanced Part 2
By Peter Welch, Georgia, CEO GlobalCfo.LLC.
At this point, readers should refer back to Lucubrate Magazine No: 27 and study the PwC Statement of Financial Position format along with the lines and references (IAS 1).
Choice Creates Comparison
And, when it comes to the Income Statement IAS 1 basically gives two options, by nature such as raw materials and by function (the more traditional approach) by for example, cost of sales, distribution costs etc. The functional approach presents line items that are far more clearly understood and readily contributes to analytics and ratio analysis. However, it remains a choice. One notable criticism however is that such a choice creates comparison issues between say two very similar entities with one using by nature and the other by function. Note by using the by nature approach there is no gross profit line, a critical measure. Of course regardless of which methodology profit before tax must be identical.
Inventory Accounting
Now let’s start addressing IAS 2, inventory accounting. First a clarification, inventory, a balance sheet item, is generally normal in all manufacturing operations in which an entity takes raw materials, adds direct labor and direct materials, and creates finished goods at cost.
Courtesy of IFRSbox
When the entity sells those finished goods it creates revenue which is initially offset by “cost of sales” (finished goods at cost) resulting in gross profit before expenses. However, a very, important concept here is called matching. If the entity sells 500 products, resulting in revenue, then only the cost of sales (finished goods at cost) for 500 products can be deducted. There could however be thousands of products remaining on the balance sheet in inventory at cost waiting to be sold. It is also possible that if the entity over-produced relative to the economic demand expected then it is a requirement to consider writing down or writing off inventory to the profit and loss (lower of cost or net realizable value or NRV). Remember the concept of an asset that to exist on the balance sheet there must be derived future economic value existing. Inventory that may never be sold violates the future economic value concept. As a statement representing this (great-than > or less-then <) often used in mathematics within formulae. Thus, if NRV< (less than) cost = Write-down (income statement). In other words there is no expected future economic value. As you record (journal-entries) to transfer finished good to cost-of-good sold (CGS) you would, as an example:
Dr CGS (income statement) 100,000
Cr Inventory, Finished Goods (Balance Sheet) 100,000
Recording CGS transferred to Income Statement, Quarter-end 30/6/x1
If write-downs are required, or if write-downs are reversed, an Inventory Allowance account is Cr/Dr and income statement is the off-set. In accounting, as we shall see, allowances, e.g., provision for bad debts, are commonly used to maintain ‘faithful representation’. Clearly without allowances, the balance sheet values would be either over or under stated.
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My 10 Years old Computer
Inventory can arise in businesses that clearly are not manufacturers such as auto dealerships that depending on the purpose for which the cars were acquired is IAS 16 (Property Plant and Equipment) or resale, IAS 2. Remember that by definition all assets must be associated with future economic value, therefore cars acquired for administrative purposes depending upon the ‘business use’ certainly can qualify as an asset. Future economic value umbrellas all assets as we know. Applying business tax laws any depreciation charged against taxes will disallow personal use. Therefore, having inventory doesn’t automatically mean manufacturing. Also, inventory, per se, can exist in any business that bulk-purchases and expects to draw down the inventory over 2-3 years or more. Laptops that have never been used can remain brand-new for a few years with only technological obsolescence being an issue. Personally I have laptops that are still functional well over 10-years. And having laptops with old-systems can still come in useful. In some countries, senior University professors still have never experienced MS Office. A 10-years old laptop could serve as a training tool!
Going back to manufacturers again, it is normal to have raw materials, finished-good work-in-process, and finished goods (future cost of sales) inventories. However there are costs, termed conversion costs that are incurred to move the process to a finished good state. Other inventory categories also exist.
Conversion Costs
When it comes to conversion costs, IAS 2, provides the criteria, the accepted methodology, that must be applied in order to justify increasing ‘debiting’ the inventory cost.
Courtesy of IFRSbox
But note that these concepts are not financial accounting but rather fall directly under the disciplines of management accounting, i.e. fixed and variable costs. It is relevant to understand that conversion costs is a complex area as to what is allowed to be capitalized or charged against earnings. From a financial reporting standpoint, conversion costs, reflected in the line item of inventory on the balance sheet, can be viewed more as a back-office function. The balance sheet ‘inventory’ value of finished good is after applying management accounting concepts such as allocating overheads. Effectively, what costs by definition justify capitalization versus a requirement to charge to the income statement? By applying a formulae the decision becomes objective and not an arbitrary management decision for manipulating net income.
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High Net Income
Remember management is often times seeking to increase the value of total assets that results in a higher reported net income as well as violating the concept of faithful representation. There have been numerous examples where balance sheets have been inflated. Such non-fiduciary behavior is usually associated with hiding financial difficulties or self-motivation to achieve net income targets which trigger remuneration or profit sharing incentives.
IAS 2 Inventory, will be continued next week.
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Acknowledgments:
Thanks 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.
(Photo: Ella Pix)
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