Regulating Inventory

Regulating Inventory – An Examination of AASB 102 “Inventories” Inventories are in essence what organisations hold with an intention to sell, however directly or indirectly. For most businesses, this is how their profits are made, and it is reasonable to assume that these items account for much of an organisation’s activities. Such a big influence on indicators of financial performance and position warrants an equally large need for regulation to ensure that users of the financial statements are given a clear picture of the state the organisation is in. The Australian Accounting Standards Board (AASB) is responsible for developing the standards that govern the way reporting entities disclose their accounting figures.

Despite much international debate, the regulation of inventories has changed over the years, and problems that appear in even the current regulations make it likely that more changes are to come. The standards governing inventories are contained in AASB 102 “Inventories. Paragraph 6 of this standard defines inventories as assets held for sale in the ordinary course of business, in the process of production for such sales, or held in the form of materials or supplies to be consumed in the production process or rendering of services (2009). In order to give more conservative figures for the value of inventories held, they are to be valued at the “lower of cost and net realisable value” under paragraph 9, net realisable value being defined in paragraph 7 as the net amount expected to be realised from the sale of the inventory in the ordinary course of business. The “cost” of inventories is defined as “all costs of purchase and conversion, and other costs incurred in bringing the inventories to their present location and condition,” in paragraph 10. Paragraphs 11-15 define the three elements of this cost. The “cost of purchase” includes in addition to the purchase price, any costs incurred in the acquisition of the finished goods less any discounts or rebates. Conversion costs” includes costs incurred in the production of the finished goods, such as direct labour. In compliance with paragraph 6 of AASB 102, paragraph 12 states that fixed production and manufacturing overheads, such as factory depreciation or rent, must also be allocated to the cost of inventories as they are incurred as conversion costs to the same extent as direct labour and other variable costs (Deegan, 2010, pp. 227). This is done using the “absorption costing” method, the method required by AASB 102, although “standard costs,” that is predetermined product costs based on prior planning, can be used where they can be attained realistically and reviewed regularly. In order to provide consistent cost figures, paragraph 13 prescribes that costs be allocated based on “normal capacity,” the production expected to be achieved based on the average production of past periods, and taking into account diminished production levels resulting from planned maintenance. However actual production levels may be used if they approximate normal capacity.

Additionally AASB 102 allows different methods of measuring cost for service providers, agricultural produce harvested from biological assets, and retailers. Paragraph 19 requires that service providers include labour, other costs of personnel directly engaged in providing the service, and attributable overheads. In administering the measurement of agricultural inventories, paragraph 20 makes reference to another standard AASB 141, which requires that the cost harvested inventories be measured at their fair value less the costs to sell at the point of harvest.

The retail method is set out in paragraph 22, and requires the cost of inventory to be determined by reducing the sales value of the inventory by an average gross margin (i. e mark-up) percentage for each relevant department, taking into account any mark-ups or mark-downs applied. |Cost ($) |Cost relating to | | | |inventory | |Rent – administration building |20 000 | | |Rent – factory building |25 000 |25 000 | |Office stationery |500 |- | |Salaries – administrative staff |30 000 |- | |Salaries – factory staff |20 000 |20 000 | |Raw materials |5 000 |5 000 | |Freight n of raw material |1 000 |1 000 | |Freight out to customers |1 000 |- | |Depreciation – plant |1 500 |1 500 | |Depreciation – office furniture |1 000 |- | |Late payment expense on raw materials |500 |- | |Total |105 500 |52 500 | |Table 1. 0 – Example of costs | An example of a set of costs can be found in Table 1. 0. In this example, AASB 102 requires that the purchase and freight of raw materials be included as costs of purchase as they are directly attributable to the acquisition of finished goods. The rent and depreciation of the factory and salaries of factory staff are to be included in the cost of inventories as costs of conversion as they are incurred in the process of converting the materials into finished goods. Under paragraph 16, the salaries of administrative staff, rent of the administration building, and depreciation of office furniture are not included as they are not incurred in bringing the inventories to their present location. Freight out to customers does not take place in the process of acquiring finished goods or converting materials and so is not included, and although the late payment expense seems to be incurred in the process of acquisition or conversion, it is more a consequence of the mismanagement of accounts payable (Deegan, 2010 pp. 227), and therefore not included in the cost of inventories. After the application of paragraph 10 of AASB 102, the total cost of inventories is $52 500. If for example the normal capacity for production were 10 000 units, the cost per unit of inventory would be $52 500 ? 10 000, or $5. 25. The net realisable value of the inventory will be equal to the selling price, for example $15 per unit, less the estimated cost of completion and cost necessary to make the sale (say, $5. 30 per unit), which is $9. 70 per unit. In accordance with paragraph 9, the lower of the two values is the one that should be used for reporting, which is the cost of $5. 25 per unit. To negate the impracticality of valuing each individual item of inventory, AASB 102 allows assumptions to be made regarding the cost-flow of inventories and valuation of ending inventory. Aside from the “specific identification” method, where cost is assigned to each individual item, paragraph 25 sets out that the cost of inventories may also be assigned by the “weighted average” and “first-in-first-out (FIFO)” methods.

The International Accounting Standard IAS 2 allowed another method known as “last-in-first-out (LIFO),” but the standard was amended in 2004 to prohibit it due to it being used to obtain lower tax obligations. Paragraph 25 states that an entity should use the same cost method for all inventories similar in nature and purpose. The weighted-average approach adds the period’s cost of goods to the opening inventory cost and divides the result by the total number of inventories acquired. Ending inventory is valued using this average price. The FIFO method assumes that the first goods purchased are the first goods to be sold. Under this method, the ending balance is valued based on the costs of more recent purchases.

The LIFO method is the opposite of FIFO, where the ending balance is valued based on the costs of earlier purchases (Deegan, 2010 pp. 234). As far as reporting is concerned, if the physical inventories follow the same assumptions the selected cost-flow method uses, no material problems arise. However, problems become more apparent when the cost-flow method is only reflected by accounting figures and not by actual inventory flow. Where prices normally increase over time due to inflation, the LIFO method assumes that more recent purchases, which are more expensive, are sold first. This results in a higher cost of goods sold which equates to a lower profit, and an understatement of ending inventory if the newest physical goods were not the first goods actually sold. This lower profit is one of the reasons LIFO was a popular tool for reducing income tax. LIFO can also distort major ratios such as the current, debt-to-equity, and turnover ratios.

Another limitation of LIFO is that the valuation process cannot be run smoothly throughout the year; In essence, it is a year-end calculation – more information relies on forecasts of future prices instead of the inventory lready on hand (Gibson, 2002), which results in an increased need for adjustments, a higher possibility of errors occurring, and higher costs to oversee the system. Such problems have seen LIFO eventually being prohibited by the International Accounting Standards Board in 2004. |[pic] | |Graph 1. 0 – Profit differences of LIFO & FIFO | The FIFO method reflects the actual inventory-cost-flow of most entities (especially those trading perishable items) and is favoured by the IASB and AASB over the prohibited LIFO. However, even the FIFO method is also far from flawless. With prices usually rising, the assumption that the first goods purchased are the first to be sold results in the reported figure for profit being inflated (as shown in Graph 1. 0), due to the cost of goods sold remaining at a historical level, although the cost to replace that good has risen (Miller, 2004). Although paragraph 32 and 33 of AASB 102 allows adjustments to be made to the values of inventory, these only include write-downs of net realisable value, and the reversal of such write-downs. The Framework of the AASB for the Preparation and Presentation of Financial Statements sets out the objective of financial statements as being to provide understandable, relevant, reliable, and comparable information that is useful to a wide range of users in the course of making economic decisions (AASB, 2004). AASB 102 tries to establish understandability by requiring financial statements to disclose the accounting policies adopted in measuring the inventories including the cost formulas and methods used, as well as the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity, the carrying amount of inventories carried at fair value less costs to sell, the amount of inventories recognised as an expense during the period, and the circumstances, results and reversals of any write-downs carried out under paragraphs 32 and 33 (2009). The characteristics “comparability” and “reliability” are perhaps the most troublesome in terms of standardisation and regulation. As different organisations may have different needs in terms of inventory management, it may be possible that methods other than the specific-identification, weighted-average, and FIFO methods may provide a more comparable view of their performances and positions, however it is clear that regulators face a situation where the risks of easy embezzlement must be weighed against the goal of easy and absolute comparability. The components of comparability and reliability are dealt with in paragraphs 9 to 22, where the methods of inventory measurement are set out, and paragraphs 23 to 33, which set out the methods of inventory valuation. In order to help prevent profit manipulation, the standard precludes LIFO from its list of inventory valuation methods. The issue of reliability is also raised in paragraph 13, which requires that total inventory costs be allocated on the basis of “normal capacity,” which is a average figure of expected production. In a case of low or idle production, unit costs would appear to be higher due to the inclusion of fixed production cost. This is dealt with by allowing the figure for normal capacity to take into account any decreased production due to planned maintenance. In a perfect standardised environment, only one set of methods would be sufficient but for now, the AASB has settled for allowing three methods of inventory valuation, and five techniques for measuring inventories. These provisions encompass a wide array of business types which allows a comfortable degree of comparability in financial data.

However, the freedom given in the valuation and measurement of inventory in order to encourage better comparability comes at the price of the possible problems arising from inconsistencies between accounting practices and physical inventory movement. These inaccuracies can lead to profit and asset balances grossly over or under-stated, giving users a tainted picture of an organisation’s condition. While covering a lot of ground, it is quite clear that the current standards governing inventory reporting have room for improvement.

References – Australian Accounting Standards Board (2009, November 2). AASB 102 Inventories. Retrieved April 30, 2010, from https://www. aasb. com. au/admin/file/content105/c9/AASB102_07-04_COMPjun09_01-09. pdf – Australian Accounting Standards Board (2004, July). Framework for the Preparation and Presentation of Financial Statements. Retrieved April 30, 2010, from https://www. aasb. com. u/admin/file/content105/c9/AASB102_07-04_COMPjun09_01-09. pdf – Deegan, C. (2010). Australian Financial Accounting (6th ed. ). North Ryde, NSW: McGraw Hill – Gibson, S. C. (2002, October). LIFO vs FIFO: a return to the basics. Retrieved May 3, 2010, from https://findarticles. com/p/articles/mi_m0ITW/is_2_85/ai_n14897182/ – Miller, P. B. W. (2004, June 1). It’s time to get rid of LIFO conformity: IASB’s move to ban LIFO deserves a thoughtful response.

Retrieved April 29, 2010, from https://www. allbusiness. com/government/business-regulations/171735-1. html ———————– 1 2 3 4 5 6 7 8 Sub-period No. Sales Price LIFO Profit FIFO Profit Cost

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