Net Realizable Value of Inventory Measurement

IAS 2 Inventories, para. 9 states that :

Inventories shall be measured at the lower of cost and net realizable value.

Para. 7 of IAS 2 defines the Net Realizable Value as :

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 amount for which the same inventory could be exchanged between knowledgeable and willing buyers and sellers in the marketplace. The former is an entity-specific value; the later is not. Net realizable value for inventories may not equal fair value less costs to sell.

So, 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.

The utility of an item of inventory is limited to the amount to be realized from its ultimate sale; where the item's recorded cost exceeds this amount, IFRS requires that a loss be recognized for the difference. The logic for this requirement is twofold; first, assets (in particular, current assets such as inventory) should not be reported at amounts that exceed net realizable value; and second, any decline in value in a period should be reported in that period's results of operations in order to achieve proper matching with current period's revenues. Were the inventory to be carried forward at an amount in excess of net realizable value, the loss would be recognized on the ultimate sale in a subsequent period. This would mean that a loss incurred in one period, when the value decline occurred, would have been deferred to a different period, which would clearly be inconsistent with several key accounting concepts, including conservatism.

Revised IAS 2 states that estimates of net realizable value should be applied on an item-by-item basis in most instances, although it makes an exception for those situations where there are groups of related products or similar items that can be properly valued in the aggregate.

Recoveries of previously recognized losses

IAS 2 stipulates that a new assessment of net realizable value should be made in each subsequent period; when the reason for a previous write-down no longer exists (i.e., when net realizable value has improved), it should be reversed. Since the write-down was taken into income, the reversal should also be reflected in profit  or loss. As under prior rules, the amount to be restored to the carrying value will be limited to the amount of the previous impairment recognized.

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

Comparative Information of financial statements based on IAS 1

Except when IFRSs permit or require otherwise, an entity shall disclose comparative information in respect of the previous period for all amounts reported in the current period's financial statements. An entity shall include comparative information for narrative and descriptive information when it is relevant to an understanding of the current period's financial statements (IAS 1 par. 38).

Par. 39 stated that an entity disclosing comparative information shall present, as a minimum, two statements of financial position, two of each of the other statements, and related notes. When an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements or when it reclassifies items in its financial statements, it shall present, as a minimum, three statements of financial position, two of each of the other statements, and related notes. An entity presents statements of financial position as at :

1. the end of the current period,
2. the end of the previous period (which is the same as the beginning of the current period), and
3. the beginning of the earliest comparative period

In some cases, narrative information provided in the financial statements for the previous period(s) continues to be relevant in the current period. For example, an entity discloses in the current period details of a legal dispute whose outcome was uncertain at the end of the immediately preceding reporting period and that is yet to be resolved. Users benefit from information that the uncertainty existed at the end of the immediately preceding reporting period, and about the steps that have been taken during the period to resolve the uncertainty (IAS 1 par. 40).

Further, par. 41 stated that when the entity changes the presentation or classification of items in its financial statements, the entity shall reclassify comparative amounts unless reclassification is impracticable. When the entity reclassifies comparative amounts, the entity shall disclose :

1. the nature of the reclassification;
2. the amount of each item or class of items that is reclassified; and
3. the reason for the reclassification.

When it is impracticable to reclassify comparative amounts, an entity shall disclose :

1. the reason for not reclassifying the amounts, and
2. the nature of the adjustments that would have been made if the amounts had been reclassified.

Enhancing the inter-period comparability of information assists users in making economic decisions, especially by allowing the assessment of trends in financial information for predictive purposes. In some circumstances, it is impracticable to reclassify comparative information for a particular prior period to achieve comparability with the current period. For example, an entity may not have collected data in the prior period(s) in a way that allows reclassification, and it may be impracticable to recreate the information (par. 43).

Later, par. 44 stated that IAS 8 sets out the adjustments to comparative information required when an entity changes an accounting policy or corrects an error (Hrd) ***

(Source : IAS 1 - Presentation of Financial Statements)

Methods of INVENTORY COSTING Under IAS 2 re.Inventories

IAS 2 regarding 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)

How to record the changes in accounting estimates ?

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors par. 32 - 40 rules the treatment of changes in accounting estimates.

As a result of the uncertainties inherent in business activities, many items in financial statements cannot be measured with precision but can only be estimated. Estimation involves judgements based on the latest available, reliable information. For example, estimates may be required of : (a) bad debts, (b) inventory obsolescence, (c) the fair value of financial assets or financial liabilities, (d) the useful lives of, or expected pattern of consumption of the future economic benefits embodied in, depreciable assets, and (e) warranty obligations.

The use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability.

An estimate may need revision if changes occur in the circumstances on which the estimate was based or as a result of new information or more experience. By its nature, the revision of an estimate does not relate to prior periods and is not the correction of an error (par. 34).

A change in the measurement basis applied is a change in an accounting policy, and is not a change in an accounting estimate. When it is difficult to distinguish a change in an accounting policy from a change in an accounting estimate, the change is treated as a change in an accounting estimate (par. 35).

Par. 36 of IAS 8 stated that the effect of a change in an accounting estimate, other than a change to which par. 37 applies, shall be recognized prospectively by including it in profit or loss in :

1. the period of the change, if the change affects that period only; or
2. the period of change and future periods, if the change affects both.

To the extent that a change in an accounting estimate gives rise to changes in assets and liabilities, or relates to an item of equity, it shall be recognized by adjusting the carrying amount of the related asset, liability or equity item in the period of change (par. 37).

Further, par. 38 stated that prospective recognition of the effect of a change in an accounting estimate means that the change is applied to transactions, other events and conditions from the date of the change in estimate. A change in an accounting estimate may effect only the current period's profit or loss, or the profit or loss of both the current period and future periods.

For example, a change in the estimate of the amount of bad debts affects only the current period's profit or loss and therefore is recognized in the current period. However, a change in the estimated useful life of, or the expected pattern of consumption of the future economic benefits embodied in, a depreciable asset affects depreciation expense for the current period and for each future period during the asset's remaining useful life.

In both cases, the effect of the change relating to the current period is recognized as income or expense in the current period. The effect, if any, on future periods is recognized as income or expense in those future periods.

Disclosure

An entity shall disclose the nature and amount of a change in an accounting estimate that has an effect in the current period or is expected to have an effect in future periods, except for the disclosure of the effect on future periods when it is impracticable to estimate that effect (par. 39).

If the amount of the effect in future periods is not disclosed because estimating it is impracticable, an entity shall disclose that fact (par. 40).

Source : IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.