The Death of LIFO Accounting ?

IAS 2 Inventories does not permit the use of the last-in, first-out (LIFO) formula to measure the cost of inventories of a company. This regulation has left the first-in, first-out (FIFO) and the weighted-average methods as the only two acceptable costing methods under IFRS.

In connection with the prohibition of LIFO formula, CFO.com on July 15, 2010 published an article titled “Sucking the LIFO Out of Inventory”. Written by Marie Leone, Senior Editor of CFO.com, this article described why companies still prefer LIFO method to measure the cost of inventories.

Here is the quotation from the article,

LIFO allows companies to calculate the cost of goods sold based on the price of the most recently purchased (“last-in”) inventory, rather than inventory that was purchased more cheaply in the past and has been sitting on the shelf. That boosts the cost of goods sold, which lowers profits – and, thus, taxable income. LIFO is particularly important to companies that have slow-moving inventory. Read further

The LIFO method has long been acceptable in the US for tax purposes, and, within the condition of rising prices, LIFO costing method resulted in lower reportable income and therefore in lower taxes.

Read also : Method of Inventory Costing under IAS 2

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)

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)

IAS 2 Inventories, How and When to Determine the Ownership of Goods

Inventory can only be an asset of the reporting entity if it is an economic resource of the entity at the date of the statement of financial position.

In general, an enterprise should record purchases and sales of inventory when legal title passes. Although strict adherence to this rule may not appear to be important in daily transactions, a proper inventory cut off at the end of an accounting period is crucial for the correct determination of periodic results of operations. Thus, for accounting purposes, to obtain an accurate measurement of inventory quantity and corresponding monetary representation of inventory and cost of goods sold in the financial statements, it is necessary to determine when title has passed.

The most common error made in this regard is to assume that title is synonymous with possession of goods on hand. This may be incorrect in two ways: (1) the goods on hand may not be owned, and (2) goods that are not on hand may be owned.

There are four matters that may cause confusion about proper ownership: (1) goods in transit, (2) consignment sales, (3) product financing arrangements, and (4) sales made with the buyer having generous or unusual right of return.

Good in transit. At year end, any goods in transit from seller to buyer may properly be includable in one, and only one, of those parties’ inventories, based on the terms and conditions of the sale.

Under traditional legal and accounting interpretation, goods are included in the inventory of the firm financially responsible for transportation costs. This responsibility may be indicated by shipping terms such as FOB, which is used in overland shipping contracts, and by FAS, CIF, C&F and ex-ship, which are used in maritime contracts.

The term FOB stands for “free on board”. If goods are shipped FOB destination, transportation costs are paid by the seller and title does not pass until the carrier delivers the goods to the buyer; thus these goods are part of the seller’s inventory while in transit.

If goods are shipped FOB shipping point, transportation costs are paid by the buyer and title passes when the carrier takes possession; thus these goods are part of the buyer’s inventory while in transit.

The terms FOB destination and FOB shipping point often indicate a specific location at which title to the goods is transferred, such as FOB Milan. This means that the seller retains title and risk of loss until the goods are delivered to a common carrier in Milan who will act as an agent for the buyer.

A seller who ships FAS (free alongside) must bear all expense and risk involved in delivering the goods to the dock next to (alongside) the vessel on which they are to be shipped. The buyers bears the cost of loading and of shipment; thus title passes when the carrier takes possession of the goods.

In a CIF (cost, insurance and freight) contract the buyer agrees to pay in a lump sum the cost of the goods, insurance costs, and freight charges.

In a C&F contract, the buyer promises to pay a lump sum that includes the cost of the goods and all freight charges.

In either case, the seller must deliver the goods to the carrier and pay the costs of loading; thus both title and risk of loss pass to the buyer upon delivery of the goods to the carrier.

A seller who delivers goods ex-ship bears all expense and risk until the goods are unloaded, at which time both title and risk of loss pass to the buyer.

Consignment sales. There are specifically defined situations where the party holding the goods is doing so as an agent for the true owner.

In consignments, the consignor (seller) ships goods to the consignee (buyer), which acts as the agent of the consignor in trying to sell the goods.

In some consignments, the consignee receives a commission; in other arrangements, the consignee “purchases” the goods simultaneously with the sale of goods to the final customer.

Goods out on consignment are properly included in the inventory of the consignor and excluded from the inventory of the consignee.

Disclosure may be required of the consignee, however, since common financial analytical inferences, such as days’ sales in inventory or inventory turnover, may appear distorted unless the financial statement users are informed. However, IFRS does not explicitly address this (to be continued).

Source of this article : WILEY - IFRS 2008 Interpretation and Application of IFRS

Revised IAS 2 Inventories, the history and the main changes

The History

IAS 2 Inventories was issued by the International Accounting Standards Committee (IASC) in December 1993. It replaced IAS 2 Valuation and Presentation of Inventories in the Context of the Historical Cost System (originally issued in October 1975).

The Standing Interpretations Committee developed SIC-1 Consistency-Different Cost Formulas for Inventories, which was issued in December 1997.

Limited amendments to IAS 2 were made in 1999 and 2000.

In December 2003, the IASB issued a revised IAS 2, which also replaced SIC-1.

The Main Changes of Revised IAS 2

The main changes from the previous version of IAS 2 are described below.

Objective and scope

The objective and scope paragraphs of IAS 2 were amended by removing the words ‘held under the historical cost system’, to clarify that the Standard applies to all inventories that are not specifically excluded from its scope.

Scope clarification

The Standard clarifies that some types of inventories are outside its scope while certain other types of inventories are exempted only from the measurement requirements in the Standard.

Paragraph 3 establishes a clear distinction between those inventories that are entirely outside the scope of the Standard (described in paragraph 2) and those inventories that are outside the scope of the measurement requirements but within the scope of the other requirements in the Standard.

Scope exemptions

The Standard does not apply to the measurement of inventories of producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realizable value in accordance with well-established industry practices.

The previous version of IAS 2 was amended to replace the words ‘mineral ores’ with ‘minerals and mineral products’ to clarify that the scope exemption is not limited to the early stage of extraction of mineral ores.

The Standard does not apply also to the measurement of inventories of commodity broker-traders to the extent that they are measured at fair value less costs to sell.

Cost of Inventories

IAS 2 does not permit exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency to be included in the costs of purchase of inventories.

This change from the previous version of IAS 2 resulted from the elimination of the allowed alternative treatment of capitalizing certain exchange differences in IAS 21 The Effects of Changes in Foreign Exchange Rates.

That alternative had already been largely restricted in its application by SIC-11 Foreign Exchange - Capitalization of Losses from Severe Currency Devaluation. SIC-11 has been superseded as a result of the revision of IAS 21 in 2003.

Paragraph 18 was inserted to clarify that when inventories are purchased with deferred settlement terms, the difference between the purchase price for normal credit terms and the amount paid is recognized as interest expense over the period of financing.

Cost formulas

The Standard incorporates the requirements of SIC-1 Consistency-Different Cost Formulas for Inventories that an entity use the same cost formula for all inventories having a similar nature and use to the entity. SIC-1 is superseded.

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

Recognition as an expense

The Standard eliminates the reference to the matching principle.

The Standard also described the circumstances that would trigger a reversal of a write-down of inventories recognized in a prior period.

Disclosure

The Standard requires disclosure of the carrying amount of inventories carried at fair value less costs to sell.

The Standard also requires disclosure of the amount of any write-down of inventories recognized as an expense in the period and eliminates the requirement to disclose the amount of inventories carried at net realizable value.