06 Revenue and Inventories.pdf

Revenue and Inventories
Financial Accounting and Reporting
CA Professional Level
Presented by
Sabbir Ahmed FCA
Managing Partner
Ahmed Sheikh Roy & Co.
Chartered Accountants

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1. Introduction
2. IFRS 15 Revenue from Contracts with Customers
3. IAS 2 Inventories
Contents

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Introduction
1

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Introduction
Financial statements are prepared on the underlying assumption of the accrual basis of
accounting, whereby effects of transactions are recognised when they occur and not
when the cash associated with them is received or paid.
But this raises questions about when a transaction 'occurs':
• Is it when the buyer takes possession of the goods, in circumstances where the
contract for sale contains clauses that seek to ensure that ownership does not pass
to the customer until the seller has been paid in full?
• Is it when services are provided, in circumstances where the seller undertakes to
come back to do additional work without charge if needed, eg remedial work carried
out by a building contractor?
• When does the profit arise on a contract for the provision of services to a customer
over time, such as under a maintenance contract of two years' duration? Only at the
start, only in the middle, only at the end, or over the period of two years?
Background
issues

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Introduction
In addition there are issues about which costs to include in the carrying amount for
inventories, in the statement of financial position:
• Should the amount include only those variable costs that are incurred in the
manufacture? After all, fixed costs are incurred regardless of volume of activity and
perhaps should be recognised in profit or loss as incurred.
• Or should the amounts include fixed costs? And if so, which? Should general
administration costs be included?
Background
issues

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Introduction
Finally there is the issue of how to identify the cost of goods which must be removed
from the carrying amount of inventories when they are sold:
• Should it be the cost of the goods manufactured longest ago?
• Should it be the cost of those manufactured most recently?
• Or should some sort of average cost be used?
The timing of the recognition of revenue is critical to the timing of profits, while the
amount of year-end inventories has a CU for CU effect on the profits earned in the
period. So the way these are calculated is vital to any real understanding of the financial
performance in the period.
Background
issues

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Introduction
Revenue is often the largest single item in the financial statements. US studies have
shown that over half of all financial statement frauds and requirements for
restatements of previously published financial information involved revenue
manipulation.
The most blatant recent example was the Satayam Computer Services fraud in 2010, in
which false invoices were used to record fictitious revenue amounting to $1.5bn.
Revenue recognition fraud also featured in the Enron and Worldcom cases.
The directors of Enron inflated the value of ‘agency’ services by reporting the entire
value of each of its trades as revenue, rather than just the agency commission on the
sale. Other energy companies then adopted this ‘model’ in a bid to keep up with
Enron’s results.
Context

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IFRS 15 Revenue
from Contracts with
Customers
2

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IFRS 15 Revenue from Contracts with Customers
The objective of IFRS 15 is to establish the principles that an entity shall apply to report
useful information to users of financial statements about the nature, amount, timing,
and uncertainty of revenue and cash flows arising from a contract with a customer.
IFRS 15 applies to:
• All contracts with customers, except for those that are within the scope of other
IFRSs. Examples of contracts that are outside the scope of IFRS 15 include, but are
not limited to, leases (IAS 17), insurance contracts (IFRS 4), Financial Instruments
(IFRS 9). It is possible that a contract with a customer may be partially within the
scope of IFRS 15 and partially within the scope of another standard.
• The recognition of interest and dividend income is not within the scope of IFRS 15.
However, certain elements of the new model will be applied to transfers of assets
that are not an output of an entity’s ordinary activities (such as the sale of property,
plant and equipment, real estate or intangible assets).
Objective and
scope

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Income is defined in the IASB’s Conceptual Framework as 'increases in economic
benefits in the form of inflows or enhancements of assets or decreases of liabilities
that result in increases in equity.' Revenue is simply income arising in the ordinary
course of an entity's activities and it may be called different names such as:
• Sales
• Turnover
• Royalties
• Fees
• Licensing
• Warranties
Revenue

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IFRS 15 has defined the key terms as follows:
Contract: An agreement between two or more parties that creates enforceable rights
and obligations.
Customer: A party that has contracted with an entity to obtain goods or services that
are an output of the entity’s ordinary activities in exchange for consideration.
Income: Increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in an increase in
equity, other than those relating to contributions from equity participants.
Definitions

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IFRS 15 has defined the key terms as follows:
Performance obligation: A promise in a contract with a customer to transfer to the
customer either:
• a good or service (or a bundle of goods or services) that is distinct; or
• a series of distinct goods or services that are substantially the same and that have
the same pattern of transfer to the customer.
Revenue: Income arising in the course of an entity’s ordinary activities.
Transaction price: The amount of consideration to which an entity expects to be
entitled in exchange for transferring promised goods or services to a customer,
excluding amounts collected on behalf of third parties.
Definitions

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An entity will recognise revenue to depict the transfer
of promised goods or services to customers in an
amount that reflects the consideration to which the
entity expects to be entitled in exchange for those
goods or services.
The core
principle of IFRS
15

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The five-step
model
framework

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This core principle is delivered in a five-step model framework:
• Identify the contract(s) with a customer
• Identify the performance obligations in the contract
• Determine the transaction price
• Allocate the transaction price to the performance obligations in the contract
• Recognise revenue when (or as) the entity satisfies a performance obligation.
Application of this guidance will depend on the facts and circumstances present in a
contract with a customer and will require the exercise of judgment.
The five-step
model
framework

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Step 1: Identify the contract with the customer
A contract with a customer will be within the scope of IFRS 15 if all the following
conditions are met:
• the contract has been approved by the parties to the contract;
• each party’s rights in relation to the goods or services to be transferred can be
identified;
• the payment terms for the goods or services to be transferred can be identified;
• the contract has commercial substance; and
• it is probable that the consideration to which the entity is entitled to in exchange for
the goods or services will be collected.
Recognition

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Can the customer benefit from the good or service, whether
on its own, or with other readily available resources?
Does the entity provide a significant service of integrating the
goods or services?
Do one or more of the goods or services significantly modify
or customise, or are significantly modified or customised by,
the other goods or services?
Are the goods or services highly interdependent or highly
interrelated?
Good or service is
'DISTINCT’: Separate
performance
obligation
The good or service is
‘NOT DISTINCT’:
Combine the good or
services until a bundle
of goods /services
that is distinct can be
identified
YES
YES
NO
NO
NO

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Example
Entity XYZ has contractually agreed to build a fence at the home of a customer. From an
operational perspective, there are likely three stages to the contract:
1. Purchase the timber, nails, concrete and other required building supplies
2. Deliver the required building supplies to the customer’s home, and
3. Build the fence.
Recognition

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Example
However, from the perspective of the customer, a completed fence has been promised.
In addition:
1. Entity XYZ performs a significant amount of work to integrate the goods (building
materials) and services (building of the fence) provided under the contract,
2. The goods (building materials) and services (building of the fence) are highly
interrelated, and
3. The service (building of the fence) provided by Entity XYZ significantly modifies the
goods (building materials) promised in the contract.
Given the above there is only one performance obligation in the contract and that is the
provision of a completed fence.
Recognition

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Step 2: Identify the performance obligations in the contract
At the inception of the contract, the entity should assess the goods or services that
have been promised to the customer, and identify as a performance obligation:
• a good or service (or bundle of goods or services) that is distinct; or
• a series of distinct goods or services that are substantially the same and that have
the same pattern of transfer to the customer.
A series of distinct goods or services is transferred to the customer in the same pattern
if both of the following criteria are met:
• each distinct good or service in the series that the entity promises to transfer
consecutively to the customer would be a performance obligation that is satisfied
over time (see below); and
• a single method of measuring progress would be used to measure the entity’s
progress towards complete satisfaction of the performance obligation to transfer
each distinct good or service in the series to the customer.
Recognition

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A good or service is distinct if both of the following criteria are met:
• the customer can benefit from the goods or services on its own or in conjunction
with other readily available resources; and
• the entity’s promise to transfer the goods or services to the customer is separately
identifiable from other promises in the contract.
Factors for consideration as to whether a promise to transfer goods or services to the
customer is not separately identifiable include, but are not limited to:
• the entity does provide a significant service of integrating the goods or services with
other goods or services promised in the contract;
• the goods or services significantly modify or customise other goods or services
promised in the contract;
• the goods or services are highly interrelated or highly interdependent.
Recognition

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Some examples of identify the performance obligations:
1. Goods and services are not distinct: Say, a School, for the purpose of extending the
school building, enters into a contract with a contractor. The contract states that the
contractor would be responsible for the overall management, including maintenance of
the site, construction of the building, and other site work, and also includes the various
goods and services that would be provided.
All the promised goods and services are capable of being distinct as other entities can
also provide the same. However, the goods and services are not distinct in the context
of the contract, as the entity provides significant services in integrating to all the
promises to deliver a newly constructed wing, that the school had contracted for. Since
both the above criteria are not being met, the contract contains one single performance
obligation, that is, to construct the entire new extension as per the promise!
Recognition

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2. Distinct goods and services: An IT company enters into a contract to deliver the
following to a customer: a software license, installation services, subsequent software
updates, and online technical support services for a period of three years.
Let us analyze the promises other than that of the software license: Other entities
working within the same industry also routinely provide installation services which does
not significantly modify the software originally provided. Therefore, the customer can
benefit from the service on its own by adding other readily obtained resources, i.e. the
software license.
The software license is a separately delivered item and can function without the
frequent updates or the technical support. Thus, the customer can benefit from the
license on its own. The updates and technical support are also separately available as
the entity sells the products separately.
Recognition

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The contract thus has four performance obligations:
1. Software license
2. Installation services
3. Software updates
4. Technical support
Revenue will be recognized as and when each one of the obligations is fulfilled by the
entity.
Recognition

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3. Customization services: Considering the same facts in the above example of IT
company, consider that the software requires significant customization as per the
customer’s requirements. In this situation, since the customer cannot obtain the special
customizations from another entity, the customer cannot obtain the benefit of the
software license from readily obtained resources. The software license and custom
installation services are thus clubbed into one performance obligation. Hence, here the
contract has three performance obligations:
1. Software license and custom installation
2. Software updates
3. Technical support
Revenue will be recognized as and when each obligation is satisfied by then entity.
Specifically, in this example the consideration related to the software license itself could
not be recognized until the customization services are completed.
Recognition

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Step 3: Determine the transaction price
The transaction price is the amount to which an entity expects to be entitled in
exchange for the transfer of goods and services. When making this determination, an
entity will consider past customary business practices.
Where a contract contains elements of variable consideration, the entity will estimate
the amount of variable consideration to which it will be entitled under the contract.
[IFRS 15:50] Variable consideration can arise, for example, as a result of discounts,
rebates, refunds, credits, price concessions, incentives, performance bonuses,
penalties or other similar items. Variable consideration is also present if an entity’s right
to consideration is contingent on the occurrence of a future event.
Measurement

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Step 4: Allocate the transaction price to the performance obligations in the contracts
Where a contract has multiple performance obligations, an entity will allocate the
transaction price to the performance obligations in the contract by reference to their
relative standalone selling prices. If a standalone selling price is not directly observable,
the entity will need to estimate it. IFRS 15 suggests various methods that might be used,
including:
• Adjusted market assessment approach
• Expected cost plus a margin approach
• Residual approach (only permissible in limited circumstances).
Measurement

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Adjusted market assessment approach
The adjusted market assessment approach involves the entity evaluating the market in
which it sells goods or services, and estimating the price that a customer in that market
would be willing to pay for those goods or services. This might also include referring to
prices from the entity’s competitors for similar goods or services, and adjusting those
prices as necessary to reflect the entity’s costs and margins.
Measurement

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Expected cost plus a margin approach
Using the expected cost plus margin approach, the entity estimates the costs of
satisfying the performance obligation, and then adds an appropriate margin.
Residual approach
The residual approach involves the entity:
• Estimating the stand-alone selling price by reference to the total transaction price,
and then deducting
• The sum of the observable stand-alone selling prices of other goods or services
promised in the contract.
Measurement

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Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation
Revenue is recognised as control is passed, either over time or at a point in time.
Control of an asset is defined as the ability to direct the use of and obtain substantially
all of the remaining benefits from the asset. This includes the ability to prevent others
from directing the use of and obtaining the benefits from the asset. The benefits related
to the asset are the potential cash flows that may be obtained directly or indirectly.
These include, but are not limited to:
• using the asset to produce goods or provide services;
• using the asset to enhance the value of other assets;
• using the asset to settle liabilities or to reduce expenses;
• selling or exchanging the asset;
• pledging the asset to secure a loan; and
• holding the asset.
Measurement

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An entity recognises revenue over time if one of the following criteria is met:
• the customer simultaneously receives and consumes all of the benefits provided by
the entity as the entity performs;
• the entity’s performance creates or enhances an asset that the customer controls as
the asset is created; or
• the entity’s performance does not create an asset with an alternative use to the
entity and the entity has an enforceable right to payment for performance
completed to date.
Measurement

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If an entity does not satisfy its performance obligation over time, it satisfies it at a point
in time. Revenue will therefore be recognised when control is passed at a certain point
in time. Factors that may indicate the point in time at which control passes include, but
are not limited to:
• the entity has a present right to payment for the asset;
• the customer has legal title to the asset;
• the entity has transferred physical possession of the asset;
• the customer has the significant risks and rewards related to the ownership of the
asset; and
• the customer has accepted the asset.
When a transaction takes place, the amount of revenue is usually decided by the
agreement of the buyer and the seller. The revenue, however, should be measured at
the fair value of the consideration received or receivable.
Measurement

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Worked example: Sale of goods
Morgan Motors Ltd sells a car for CU1,500,000 with one year's credit. There is a three-
year manufacturer’s warranty on the vehicle.
Revenue will be recognised at the time of sale, but:
• The CU1,500,000 receivable will be split between interest earned and the cash sale
price.
• The cash sale price will be recognised in the period the sale is made.
• The interest income will be recognised over the period of credit.
• The production and selling costs of the car will be set against the cash sale price. At
the same time a charge to profit or loss will be made to set up a warranty provision
for the expected costs of carrying out the expected amount of warranty work over
the three-year warranty period.
• Costs incurred on the warranty work over the three years will be charged to the
provision, with any over-provision being written back (and any under-provision being
charged) to the profit or loss.
Measurement

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Interactive question 1: Publishing revenue [Difficulty level: Easy]
A magazine publisher launched a new monthly magazine on 1 January 20X7. During
January it received CU48,000 in annual subscriptions in advance. It has despatched four
issues by the year end 31 March 20X7.
What revenue should be recognised for the year ended 31 March 20X7?
Answer to Interactive question 1
Magazine revenue CU16,000
Explanation
Revenue for the magazines should be recognised in the periods in which they are
despatched, assuming the items are of similar value in each period. Thus the revenue to
be recognised in the year ended 31 March 20X7 is CU48,000 x 4/12 = CU16,000.
Measurement

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Interactive question 2: Advance sales [Difficulty level: Intermediate]
A DIY store is about to sell a new type of drill. Customer demand is high and the store
has taken advance orders for the drill. The selling price of the drill will be CU5,000 and
so far two hundred customers have paid an initial 10% deposit on the selling price of the
drill. No drills are yet held in inventory.
What amount should be recognised as revenue?
Answer to Interactive question 2
Revenue CUnil
Explanation
Revenue should be recognised when the drills are delivered to the customer. Until then
no revenue should be recognised and the deposits should be carried forward as
deferred income.
Measurement

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In some sectors of the retail industry it is common practice to provide interest-free
credit to customers in order to encourage sales of, for example, furniture and new cars.
Where an extended period of credit is offered, the revenue receivable has two separate
elements:
• The fair value of the goods on the date of sale, for example the cash selling price
• Financing income
In order to separate these two elements the future receipts are discounted to present
value at an imputed interest rate, identified as either:
• The prevailing rate for lending to a customer with a credit rating similar to that of the
customer or
• The rate of interest which discounts the receivable back to the current cash selling
price.
Deferred
consideration

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The effect on the timing of the revenue recognition is that:
• The fair value of the goods is recognised on delivery of the goods.
• The finance element is recognised over the period that the financing is provided.
Deferred
consideration

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Worked example: Deferred consideration
A car retailer sells its new cars by requiring a 20% deposit followed by no further
payments until the full balance is due after two years. The price of the cars is calculated
using a 10% per annum finance charge.
On 1 January 20X7 a car was sold to a customer for CU20,000.
How should the revenue be recognised in the year ended 31 December 20X7 and what
should the carrying amount of the customer receivable be on that date?
Deferred
consideration

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Solution
Revenue to be recognised
Workings
1. The deposit is CU4,000 (CU20,000 x 20%), so the amount receivable in two years is
CU16,000.
2. This is discounted at 10% for two years to CU13,223 (CU16,000 x 1/1.102).
Deferred
consideration
CU
Sale of goods (CU4,000 + CU13,223 (W)) 17,223
Financing income (CU13,223 (W) ´ 10%) 1,322
Carrying amount of receivable (CU13,223 (W) ´ 1.10) 14,545

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One marketing tool frequently used is to bundle together into one transaction both
goods and services. For example a car dealer may sell new cars with one year’s free
servicing and insurance.
In such cases:
• The components of the package which could be sold separately should be identified
and
• Each should be measured and recognised as if sold separately.
IFRS 15 state how each component should be measured and the principles require that
each component should be:
• Measured at its fair value.
• Recognised as revenue only when it meets the recognition criteria.
If the total of the fair values exceeds the overall price of the contract, an appropriate
approach would be to apply the same discount percentage to each separate component.
Goods and
services
provided in one
contract

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Worked example: Goods and services
A car dealer sells a new car, together with 50 litres of fuel per month for a year and one
year’s servicing, for CU27,000. The fair values of these components are: car CU28,000,
fuel CU1,200 and servicing CU800.
How should the CU27,000 be recognised as revenue?
Goods and
services
provided in one
contract

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Solution
The total fair value of the package is CU30,000 (28,000 + 1,200 + 800) but is being sold for
CU27,000, a discount of CU3,000 or 10%.
The discounted fair value of the car should be recognised as revenue upon delivery:
CU28,000 x 90% = CU25,200
The discounted fair value of the fuel should be recognised as revenue on a straight line
basis over the next 12 months: CU1,200 x 90% = CU1,080
The discounted fair value of the servicing should be recognised as revenue at the earlier
of when the servicing is provided and the end of the year: CU800 x 90% = CU720
Goods and
services
provided in one
contract

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Only incremental costs of obtaining a contract that are incremental and expected to be
recovered can be recognised as an asset.
A contract asset is recognised under IFRS 15 if, and only if, the costs:
• Are specifically identifiable and directly relate to the contract (e.g. direct labour,
materials, overhead allocations, explicitly on-charged costs, other unavoidable costs
(e.g. subcontractors))
• Create (or enhance) resources of the entity that will be used to satisfy performance
obligation(s) in the future, and
• Are expected to be recovered.
Contract costs

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Costs that are recognised as an expense as incurred
• General and administrative expenses
• Wastage, scrap, and other (unanticipated) costs not incorporated into pricing the
contract
• Costs related to (or can’t be distinguished from) past performance obligations.
Amortisation and impairment of contract assets
• Amortisation is based on a systematic basis consistent with the pattern of transfer of
the goods or services to which the asset relates
• Impairment exists where the contract carrying amount is greater than the remaining
consideration receivable, less directly related costs to be incurred.
Contract costs

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IAS 2 Inventories
3

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IAS 2 Inventories
The objective of IAS 2 Inventories is to prescribe the accounting treatment for
inventories. In particular it provides guidance on the determination of cost and its
subsequent recognition as an expense, including any write-down to net realisable
value.
IAS 2 applies to all inventories except the following:
• Work in progress under construction contracts
• Financial instruments (eg shares, bonds)
• Biological assets
Objective and
scope

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IAS 2 Inventories
Construction contracts and biological assets are outside the scope of the Financial
Accounting and Reporting syllabus.
Certain inventories are exempt from the standard's measurement rules, ie those held
by:
• Producers of agricultural, forest and mineral products
• Commodity-broker traders.
Objective and
scope

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IAS 2 Inventories
Inventories: Assets:
• Held for sale in the ordinary course of business
• In the process of production for such sale; or
• In the form of materials or supplies to be consumed in the production process or in
the rendering of services.
Inventories can include:
• Goods purchased and held for resale
• Finished goods
• Work in progress being produced
• Raw materials awaiting use
Definition

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IAS 2 Inventories
Cost: Comprises all costs of purchase, costs of conversion and other costs incurred in
bringing the inventories to their present location and condition.
Net realisable value: 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.
A write-down of inventories would normally take place on an item-by-item basis, but
similar or related items may be grouped together. This grouping is acceptable for, say,
items in the same product line, but it is not acceptable to write-down inventories based
on a whole classification (eg finished goods) or a whole business.
Measurement of
inventories

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IAS 2 Inventories
The cost of inventories will consist of:
• Cost of purchase
• Costs of conversion
• Other costs incurred in bringing the inventories to their present location and
condition
Costs of purchase
IAS 2 lists the following as comprising the costs of purchase of inventories.
• Purchase price plus
• Import duties and other non-recoverable taxes plus
• Transport, handling and any other costs directly attributable to the acquisition of
finished goods, services and materials less
• Trade discounts, rebates and other similar amounts.
Measurement of
inventories

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IAS 2 Inventories
Costs of conversion
Costs of conversion of inventories consist of two main parts.
• Costs directly related to the units of production, eg direct materials, direct labour
• Fixed and variable production overheads that are incurred in converting materials
into finished goods, allocated on the basis of normal production capacity.
Measurement of
inventories

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IAS 2 Inventories
Fixed production overheads: Those indirect costs of production that remain relatively
constant regardless of the volume of production, such as depreciation and maintenance
of factory buildings and equipment, and the cost of factory management and
administration.
Variable production overheads: Those indirect costs of production that vary directly, or
nearly directly, with the volume of production, such as indirect materials and labour.
Measurement of
inventories

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IAS 2 Inventories
IAS 2 emphasises that fixed production overheads must be allocated to items of
inventory on the basis of the normal capacity of the production facilities. This is an
important point.
• Normal capacity is the expected achievable production based on the average over
several periods/seasons, under normal circumstances.
• The above figure should take account of the capacity lost through planned
maintenance.
• If it approximates to the normal capacity then the actual level of production can be
used.
• The allocation of variable production overheads to each unit is based on the actual
use of production facilities.
Measurement of
inventories

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IAS 2 Inventories
As a result:
• Low production or idle plant will not result in a higher fixed overhead allocation to
each unit.
• Unallocated overheads must be recognised as an expense in the period in which
they were incurred.
• When production is abnormally high, the fixed production overhead allocated to
each unit will be reduced, so avoiding inventories being stated at more than cost.
Measurement of
inventories

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IAS 2 Inventories
Worked example: Fixed production overheads
A business plans for fixed production overheads of CU50,000 and annual production of
100,000 items in its financial year. So the planned overhead recovery rate is 50p per
item.
A fire at the factory results in production being only 75,000 units, with no saving in
fixed production overheads.
Inventory should still be valued on the basis of 50p per item, leading to a recovery of
CU37,500 of overheads. The CU12,500 balance of overhead cost must be recognised as
an expense in the year.
Measurement of
inventories

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IAS 2 Inventories
Other costs
Any other costs should only be recognised if they are incurred in bringing the
inventories to their present location and condition.
IAS 2 lists types of cost that would not be included in cost of inventories. Instead, they
should be recognised as an expense in the period in which they are incurred.
These include:
• Abnormal amounts of wasted materials, labour or other production costs.
• Storage costs (except costs that are necessary in the production process before a
further production stage).
• Administrative overheads not incurred to bring inventories to their present location
and condition.
• Selling costs.
Measurement of
inventories

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IAS 2 Inventories
Techniques for the measurement of cost
Two techniques are mentioned by the standard, both of which produce results that
approximate to cost, and so both of which may be used for convenience.
a) Standard costs: These are set up to take account of normal levels of raw materials
used, labour time etc. They are reviewed and revised on a regular basis.
b) Retail method: This is often used in the retail industry where there is a large
turnover of inventory items, which nevertheless have similar profit margins. The only
practical method of inventory valuation may be to take the total selling price of
inventories and deduct an overall average profit margin, thus reducing the value to
an approximation of cost. The percentage will take account of reduced price lines.
Sometimes different percentages are applied on a departmental basis.
Measurement of
inventories

sabbir@asr-ca.com
IAS 2 Inventories
Cost formulae
It is possible to attribute specific costs to items that are not interchangeable and to
items produced for specific projects or customers and it is these costs which are used in
arriving at inventory valuations.
But many inventories include items that are interchangeable with each other, in which
case it is not possible to identify a specific cost for a specific item. In these cases, cost
formulae should be used, which make assumptions about which of the items produced
have been sold and which are still held in inventory, and therefore about the cost of
inventory.
Only two cost formulae are allowed under IAS 2:
Measurement of
inventories

sabbir@asr-ca.com
IAS 2 Inventories
Cost formulae
Measurement of
inventories
First-in, first-out (FIFO) Weighted average cost
This assumes a physical flow of items
whereby those produced earliest are
the first to be sold. The items produced
most recently are the ones in inventory,
to be measured at the most recent
production cost.
This formula calculates an average cost
of production (either at the end of each
period or after each new batch has been
produced, depending on the
circumstances of the company) and
measures inventories at that average
cost.

sabbir@asr-ca.com
IAS 2 Inventories
Points to note:
1. The last-in, first-out (LIFO) formula (which makes an assumption about the physical
flows of items that is the opposite of FIFO) is not permitted by IAS 2. The reasoning,
not included in the IAS, is that LIFO is not a reliable representation of the actual flow
of items into and out of inventory.
2. The same cost formula must be used for all inventories having a similar nature. This
limitation on management choice is aimed to ensure that like items are accounted
for in like ways.
Measurement of
inventories

sabbir@asr-ca.com
IAS 2 Inventories
As a general rule assets should not be carried at amounts greater than those to be
realised from their sale or use. This applies to inventory where NRV falls below cost.
There are a number of reasons why this may be the case, including the following:
• An increase in costs or a fall in selling price
• A physical deterioration in the condition of inventory
• Obsolescence of products
• A strategic decision to manufacture and sell products at a loss
• Errors in production or purchasing
Where NRV falls below cost the inventory is written down to its recoverable amount
and the fall in value is charged to profit or loss. The write-down may be of such size,
incidence or nature that it must be disclosed separately.
Net realisable
value

sabbir@asr-ca.com
IAS 2 Inventories
Points to note:
1. In the case of incomplete items, NRV must take account of costs to complete.
2. In the absence of a contractually agreed selling price, the best estimate must be
made of the likely selling price and then appropriate deductions made from it.
3. Materials to be incorporated into a finished product should only be written down if
that finished product will be sold at below its cost.
4. Net realisable value must be reassessed at the end of each period and compared
again with cost. This may result in the reversal of all or part of the original write-
down.
Net realisable
value

sabbir@asr-ca.com
IAS 2 Inventories
Once an item has been sold, it cannot remain in inventories as it no longer meets the
IASB Conceptual Framework definition of an asset. Its carrying amount is recognised as
an expense in the accounting period in which the item is sold and the related revenue
recognised.
Recognition as
an expense

sabbir@asr-ca.com
IAS 2 Inventories
The financial statements should disclose the following:
• Accounting policies adopted in measuring inventories, including the cost formula
used.
• Total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity (eg merchandise, production supplies, materials, work in
progress, finished goods).
• Carrying amount of inventories carried at fair value less costs to sell.
• The amount of inventories recognised as an expense in the period.
• The amount of any write-down of inventories recognised as an expense in the period.
• The amount of any reversal of any write-down that is recognised as a reduction in the
amount of inventories recognised as an expense in the period.
• Circumstances or events that led to the reversal of a write-down of inventories.
• Carrying amount of inventories pledged as security for liabilities.
Disclosure

sabbir@asr-ca.com
IAS 2 Inventories
The financial statements must also disclose one of two things:
• The cost of inventories recognised as an expense during the period.
• The operating costs, applicable to revenues, recognised as an expense during the
period, classified by their nature.
The choice reflects differences in the way the statement of profit or loss can be
presented (see Chapter 2).
Disclosure

sabbir@asr-ca.com
Consignment sales
Under such arrangements, the buyer of the goods undertakes to sell them on, but on
behalf of the original seller. So the buyer is effectively acting as an agent on behalf of the
original seller. The original seller only recognises his sale when his buyer sells them on to
a third party.
This treatment also applies to sale and return transactions.
Practical
application

sabbir@asr-ca.com
Sale with a Right of Return
In some contracts, an entity transfers control of a product to a customer and also grants
the customer the right to return the product for various reasons (such as dissatisfaction
with the product) and receive any combination of the following:
a) a full or partial refund of any consideration paid;
b) a credit that can be applied against amounts owed, or that will be owed, to the entity;
and
c) another product in exchange.
Practical
application

sabbir@asr-ca.com
Sale with a Right of Return
To account for the transfer of products with a right of return (and for some services that
are provided subject to a refund), an entity shall recognize all of the following:
a) revenue for the transferred products in the amount of consideration to which the
entity expects to be entitled (therefore, revenue would not be recognized for the
products expected to be returned);
b) a refund liability; and
c) an asset (and corresponding adjustment to cost of sales) for its right to recover
products from customers on settling the refund liability.
An entity’s promise to stand ready to accept a returned product during the return period
shall not be accounted for as a performance obligation in addition to the obligation to
provide a refund.
Practical
application

sabbir@asr-ca.com
Repurchase agreements
Where an entity sells a good to a customer and the entity has either a right or an
obligation to repurchase the asset, this will affect the accounting treatment. If the entity
is required to repurchase the good, or has the option to repurchase, the arrangement will
either be accounted for as a financing arrangement or as a lease.
Similarly, if the customer can choose whether to sell the item back to the entity, and at
the outset would have a significant economic incentive to do so, the arrangement will
either be accounted for as a financing arrangement or as a lease.
If the customer can choose whether to sell the item back to the entity, but at the outset
would not have a significant economic incentive to do so, the arrangement should be
accounted for as a sale with right to return.
Practical
application

06 Revenue and Inventories.pdf

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