Thursday, February 5, 2009

Methods of Inventory Costing Under IAS 2

International Accounting Standard (IAS) 2 Inventories states that inventories shall be measured at the lower of cost and net realizable value.

The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

Then, how to assign the cost of inventories ?

Par. 23 to par. 27 of IAS 2 lines out the guidance of valuing the cost of inventories.

The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs (par. 23).

The theoretical basis for valuing inventories and cost of goods sold requires assigning the production and/or acquisition costs to the specific goods to which they relate. For example, the cost of ending inventory for an entity it its first year, during which it produced ten items (e.g., exclusive single family homes), might be the actual production cost of the first, sixth, and eighth unit produced if those are the actual units still  on hand at the date of the statement of financial position. The costs of the other  homes would be included in that year's income statement (the presentation of comprehensive income in two statements) as cost of goods sold. This method of inventory valuation is usually referred to as specific identification.

Specific identification is generally not a practical technique, as the product will generally lose its separate identity as it passes through the production and sales process. Exceptions to this would generally be limited to those situations where there are small inventory quantities, typically having high unit value and a low turnover rate. Under IAS 2, specific identification must be employed to cost inventories that are not ordinarily interchangeable, and goods and services produced and segregated for specific projects. For inventories meeting either of these criteria, the specific identification method is mandatory and alternative methods cannot be used.

The cost of inventories, other than those dealt with in par. 23, shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula. An entity shall use the same cost formula for all inventories having a similar nature and use to the entity. For inventories with a different nature or use, different cost formulas may be justified (par. 25).

The FIFO formula assumes that the items of inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. Under the weighted average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the entity (par. 27).

The FIFO method of inventory valuation assumes that the first goods purchased will be the first goods to be used or sold, regardless of the actual physical flow. This method is thought to parallel most closely the physical flow of the units for most industries having moderate to rapid turnover of goods. The strength of this cost flow assumption lies in the inventory amount reported in the statement of financial position. Because the earliest goods purchased are the first ones removed from the inventory account, the remaining balance is composed of items acquired closer to period end, at more recent costs. This yields results similar to those obtained under current cost accounting in the statement of financial position, and helps in achieving the goal of reporting assets at amounts approximating current values.

The other acceptable method of inventory valuation under revised IAS 2 involves averaging and is commonly referred to as the weighted-average cost method. The cost of goods available for sale (beginning inventory and net purchases) is divided by the units available for sale to obtain a weighted-average unit cost. Ending inventory and cost of goods sold are then priced at this average cost.

The Standard (IAS 2) does not permit the use of the last-in, first-out (LIFO) formula to measure the cost of inventories (par. IN13).

The IASB, as part of its Improvements Project, determined that the goals of achieving convergence among accounting standards and of promoting uniformity across entities reporting under IFRS would be served by eliminating the formerly "allowed alternative" of costing inventories by means of the last-in, first-out (LIFO) method. This has left the first-in, first-out (FIFO) and the weighted-average methods as the only two acceptable costing techniques under IFRS.

(Sources : Wiley IFRS 2008 : Interpretation and Application of International Financial Reporting Standards - Barry J. Epstein, Eva K. Jermakowicz and IAS 2 Inventories)

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