International accounting standards (IAS 2) establish cost, not to exceed net realizable value, as the basis for valuation of inventories. In contrast to the standard for plant assets, there is no option for revaluing inventories to current replacement cost or fair value, presumably due to the far shorter period of time over which such assets are held, thereby limiting the cumulative impact of inflation on reported amounts. Furthermore, the benchmark treatment prescribes the relatively more conservative FIFO or weighted-average cost methods as the means of measuring historical cost of inventories, although the allowed alternative method, LIFO, may result in a somewhat more meaningful measure of earnings in periods of rising prices. These methods are discussed fully later in this chapter.
From the accounting perspective, concern with the ownership of inventories is to assist in the determination of the actual physical quantity of inventory on hand. In general, an enterprise should record purchases and sales of inventory when legal title passes. Although strict adherence to this rule may not be important in daily transactions, a proper inventory cutoff at the end of an accounting period is crucial. 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 create a question as to proper ownership: (1) goods in transit, (2) consignment sales, (3) product financing arrangements, and (4) sales made with the buyer holding the right of return.
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 conditions of the sale. Under traditional legal and accounting interpretation, such 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 buyer 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.
The foregoing is meant only to define normal terms and usage; actual contractual arrangements between a given buyer and a given seller can vary widely. The accounting treatment should in all cases strive to mirror the substance of the legal terms established between the parties.
In consignments, the consignor (seller) ships goods to the consignee (buyer), who 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 the goods to the customer. Goods out on consignment are included in the inventory of the consignor and excluded from the inventory of the consignee.
A product financing arrangement is a transaction in which an entity sells and agrees to repurchase inventory with the repurchase price equal to the original sales price plus the carrying and financing costs. The purpose of this transaction is to allow the seller (sponsor) to arrange financing of its original purchase of the inventory. The substance of the transaction is illustrated by the diagram below.
In the initial transaction the sponsor "sells" inventoriable items to the financing entity in return for the remittance of the sales price and at the same time agrees to repurchase the inventory at a specified price (usually the sales price plus carrying and financing costs) over a specified period of time.
The financing entity procures the funds remitted to the sponsor by borrowing from a bank (or other financial institution) using the newly purchased inventory as collateral.
The financing entity actually remits the funds to the sponsor and the sponsor presumably uses these funds to pay off the debt incurred as a result of the original purchase of the inventoriable debt.
The sponsor then repurchases the inventory for the specified price plus costs from the financing entity at a later time when the funds are available.
In a variant of this transaction, an entity can acquire goods from a manufacturer or dealer, with the contractual understanding that they will be resold to another entity at the same price plus handling, storage, and financing costs.
The purpose of either variation of product financing arrangement is to enable the sponsor to acquire or control inventory without incurring additional reportable debt. Under international accounting standards, transactions of this type are not directly addressed, and thus it would appear that, if a "form over substance" approach is subscribed to, these transactions may successfully result in financing that is not reported in the balance sheet. It would therefore be instructive to look to the standard imposed in the United States by the FASB, which ruled that the substance of this type of transaction is that of a borrowing.
Under the pertinent US standard (SFAS 49, Accounting for Product Financing Arrangements), such transactions are, in substance, no different from those where a sponsor obtains third-party financing to purchase its inventory. As a result, the FASB ruled that when an entity sells inventory with a related arrangement to repurchase it, proper accounting is to record a liability when the funds are received for the initial transfer of the inventory in the amount of the selling price. The sponsor is then to accrue carrying and financing costs in accordance with its normal accounting policies. These accruals are eliminated and the liability satisfied when the sponsor repurchases the inventory. The inventory is not to be taken off the balance sheet of the sponsor and a sale is not to be recorded. Thus, although legal title has passed to the financing entity, for purposes of measuring and valuing inventory, the inventory is considered to be owned by the sponsor. Although the other variation on this financing arrangement with a nominee entity acquiring the goods for the ultimate purchaser is not addressed in SFAS 49, logic suggests that an analogous accounting treatment be prescribed.
A final issue that requires special consideration is the situation that exists when the buyer holds the right of return. Again, while international accounting standards do not address this topic directly, logical guidance is suggested by the US accounting standards. SFAS 48, Revenue Recognition When Right of Return Exists, addresses the propriety of recognizing revenue at the point of sale under these circumstances. Generally speaking, the sale is to be recorded if the future amount of the returns can reasonably be estimated. If the ability to make a reasonable estimate is precluded, the sale is not to be recorded until the returns are unlikely. In this situation, although legal title has passed to the buyer, the seller must continue to include the goods in its measurement and valuation of inventory. Absent a standard to the contrary under international accounting standards, the "substance over form" dictum would seemingly support the guidelines suggested by SFAS 48.
The major objectives of accounting for inventories is the matching of appropriate costs against revenues in order to arrive at the proper determination of periodic income, and accurate representation of inventories on hand as assets of the enterprise as of the balance sheet date. As it happens, these two goals are in conflict and, under any system of accounting in which the financial statements are fully articulated (i.e., where the balance sheet and income statement are linked together mechanically), it will be virtually impossible to achieve both fully.
The accounting for inventories is done under either a periodic or a perpetual system. In a periodic inventory system, the inventory quantity is determined periodically by a physical count. The quantity so determined is then priced in accordance with the cost method used. Cost of goods sold is computed by adding beginning inventory and net purchases (or cost of goods manufactured) and subtracting ending inventory.
Alternatively, a perpetual inventory system keeps a running total of the quantity (and possibly the cost) of inventory on hand by recording all sales and purchases as they occur. When inventory is purchased, the inventory account (rather than purchases) is debited. When inventory is sold, the cost of goods sold and reduction of inventory are recorded. Periodic physical counts are necessary only to verify the perpetual records and to satisfy the tax regulations (tax regulations require that a physical inventory be taken, at least annually).
According to IAS 2, the primary basis of accounting for inventories is cost. Cost is defined as the sum of all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. This definition allows for significant interpretation of the costs to be included in inventory.
For raw materials and merchandise inventory that are purchased outright and not intended for further conversion, the identification of cost is relatively straightforward. The cost of these purchased inventories will include all expenditures incurred in bringing the goods to the point of sale and putting them in a salable condition. These costs include the purchase price, transportation costs, insurance, and handling costs. Trade discounts, rebates, and other such items are to be deducted in determining inventory costs; failure to do so would result in carrying inventory at amounts in excess of true historical costs.
The impact of interest costs as they relate to the valuation of inventoriable items (IAS 23) is discussed in Chapter 8. In general, even when the allowed alternative treatment prescribed by IAS 23 is employed, borrowing costs will not be capitalized in connection with inventory acquisitions, since the period required to ready the goods for sale will not be significant. However, where a lengthy production process is required to prepare the goods for sale, the provisions of IAS 23 would be applicable and a portion of borrowing costs would become part of the cost of inventory.
Conversion costs for manufactured goods should include all costs that are directly associated with the units produced, such as labor and overhead. The allocation of overhead costs, however, must be systematic and rational, and in the case of fixed overhead costs (i.e., those which do not vary directly with level of production) the allocation process should be based on normal production levels. In periods of unusually low levels of production, a portion of fixed overhead costs must accordingly be charged directly to operations, and not taken into inventory.
Costs other than material and conversion costs are inventoriable only to the extent they are necessary to bring the goods to their present condition and location. Examples might include certain design costs and other types of preproduction expenditures if intended to benefit specific classes of customers. On the other hand, all research costs and most development costs (per IAS 38, as discussed in Chapter 8) would typically not become part of inventory costs. Also generally excluded from inventory would be such costs as administrative and selling expenses, which must be treated as period costs; the cost of wasted materials, labor, or other production expenditures; and most storage costs. Included in overhead, and thus allocable to inventory, would be such categories as repairs, maintenance, utilities, rent, indirect labor, production supervisory wages, indirect materials and supplies, quality control and inspection, and the cost of small tools not capitalized.
In some production processes, more than one product is produced simultaneously. Typically, if each product has significant value, they are referred to as joint products; if only one has substantial value, the others are known as by-products. Under IAS 2, when the costs of each jointly produced good cannot be clearly determined, a rational allocation among them is required. Generally, such allocation is made by reference to the relative values of the jointly produced goods, as measured by ultimate selling prices. Often, after a period of joint production the goods are split off, separately incurring additional costs before being completed and ready for sale. The allocation of joint costs should take into account the additional individual product costs yet to be incurred after the point at which joint production ceases.
By-products by definition are products that have limited value when measured with reference to the primary good being produced. IAS 2 suggests that by-products be valued at net realizable value, with the costs allocated to by-products thereby being deducted from the cost pool, being otherwise allocated to the sole or several principal products.
For example, products A and B have the same processes performed on them up to the split-off point. The total cost incurred to this point is $80,000. This cost can be assigned to products A and B using their relative sales value at the split-off point. If A could be sold for $60,000 and B for $40,000, the total sales value is $100,000. The cost would be assigned on the basis of each product's relative sales value. Thus, A would be assigned a cost of $48,000 (60,000/100,000 x 80,000) and B a cost of $32,000 (400,000/100,000 x 80,000).
If inventory is exchanged with another entity for similar goods, the earnings process is generally not culminated. Accordingly, the acquired items are recorded at the recorded, or book, value of the items given up.
In some jurisdictions, the categories of costs that are includable in inventory for tax purposes may differ from those that are permitted for financial reporting purposes under international accounting standards. To the extent that differential tax and financial reporting is possible (i.e., that there is no statutory requirement that the taxation rules constrain financial reporting) this situation will result in interperiod tax allocation. This is discussed more fully in Chapter 15.
The method of allocating fixed overhead to both ending inventory and cost of goods sold is commonly known as (full) absorption costing. IAS 2 requires that absorption costing be employed. However, often for managerial decision-making purposes an alternative to absorption costing, variable or direct costing, is utilized. Direct costing requires classifying only direct materials, direct labor, and variable overhead related to production as inventory costs. All fixed costs are accounted for as period costs. The virtue of direct costing is that under this accounting strategy there will be a predictable, linear effect on marginal contribution from each unit of sales revenue, which can be useful in planning and controlling the business operation. However, such a costing method does not result in inventory that includes all costs of production, and therefore this is deemed not to be in accordance with GAAP under international standards. If an entity uses direct costing for internal budgeting or other purposes, adjustments must be made to develop alternative information for financial reporting purposes.