Common errors when accounting for inventories – NZ IAS 2 – Part 3

Last month’s common errors article highlighted six common errors where the valuation of inventories is driven by the requirements of NZ IFRSs other than NZ IAS 2 Inventories. This month we focus on typical errors arising when applying the valuation requirements contained in NZ IAS 2.

Common error 1 – Trade discounts and rebates on inventories on hand at reporting date

Inventories are required to be measured in the statement of financial position at the lower of ‘cost’ and ‘net realisable value’. ‘Cost’ comprises the aggregate of:

Purchase costs (e.g. for raw materials and finished goods)
Conversion costs, and
Other costs incurred to bring the inventories to their present location and condition.

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.

NZ IAS 2, paragraph 10

The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authorities), and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase.

NZ IAS 2, paragraph 11

A common error occurs where the full effect of these trade discounts and rebates are deducted off ‘cost of sales’, thereby increasing profits, without reducing the cost of inventories still on hand at reporting date.

Example 1

At 30 June 2016, ABC Limited had 100 widgets on hand at a cost of $1 each.

During the year it purchased 500 widgets at $1 each and received a volume rebate from the supplier of $50 on 30 June 2017.

ABC Limited had 200 widgets on hand at 30 June 2017.

	A	B	C
	No rebate	Common error - $50 rebate credited to COGS only	Correct treatment - $50 rebate credited to COGS and reduce cost of inventories at 30 June 2017
	$	$	$
Opening inventories – 1 July 2016 (100 widgets @ $1 each)	100	100	100
Purchase 500 widgets @ $1 each	500	450 ($500-$50)	450 ($500-$50)
Closing inventories – 30 June 2017 (200 widgets @ $1 each)	(200)	(200)	(180)¹ ($200+[$50 X 200/500])
Cost of sales	400	350	370

¹ - Sold 300/500 units – 200/500 on hand at 30 June 2017

In this example, by incorrectly deducting the full $50 volume rebate only off the cost of purchases, with no allocation to inventories on hand at 30 June 2017, results in an understatement of cost of sales, and therefore an overstatement of profit of $20 ($370-$350).

Common error 1

Not reducing the cost of inventories still on hand at year end for the effect of trade discounts and rebates received.

Common error 2 – Trade discounts and rebates received after year end

Following on from common error 1 discussed above, had the rebate only been confirmed after year end, a similar allocation to that recorded in Example 1 would be processed if the final rebate was known prior to finalising the financial statements.

However, in some cases the rebate may not be known until after the financial statements are completed, particularly where the rebate period does not coincide with the financial year. Where such rebates are ‘probable’ they should be recognised.

Volume rebates or discounts and other contractual changes in the prices of raw materials, labour, or other purchased goods and services are anticipated in interim periods, by both the payer and the recipient, if it is probable that they have been earned or will take effect. Thus, contractual rebates and discounts are anticipated but discretionary rebates and discounts are not anticipated because the resulting asset or liability would not satisfy the conditions in the Framework that an asset must be a resource controlled by the entity as a result of a past event and that a liability must be a present obligation whose settlement is expected to result in an outflow of resources.

NZ IAS 34, paragraph B23

A common error ignores rebates until they have been received in cash or are known.

Example 2

At 1 January 2017, ABC Limited had 100 widgets on hand at a cost of $1 each.

During the year it purchased 500 widgets at $1 each (200 in first half and 300 in second half) and has 200 widgets on hand at 31 December June 2017.

ABC Limited has an agreement with its Supplier that it will receive a 10% rebate on purchase price paid if it purchases 600 widgets for the 12 months ended 30 June 2018.

Based on ABC Limited purchasing 300 widgets in the six months to 31 December 2017, absent of any seasonal factors, it can be assumed that it is probable that ABC Limited will receive the 10% volume rebate on the 300 widgets purchased between 1 July 2017 and 31 December 2017, i.e. $30 (10% X 300 widgets X $1 each).

	A	B	C
	No rebate	Common error - $30 rebate credited to COGS only	Correct treatment - $30 rebate credited to COGS and reduce cost of inventories at 31 December 2017
	$	$	$
Opening inventories – 1 July 2016 (100 widgets @ $1 each)	100	100	100
Purchase 500 widgets @ $1 each	500	470 ($500-$30)	470 ($500-$30)
Closing inventories – 30 June 2017 (200 widgets @ $1 each)	(200)	(200)	(180)¹ ($200-[$30 X 200/300])
Cost of sales	400	370	390

¹ - 200 widgets out of 300 purchased during second half of year on hand at 31 December 2017

In this example, cost of sales is overstated, and profit understated, by $10 if the effect of the rebate is ignored on the 100 widgets sold during the period subject to the probable 10% rebate.

Common error 2

Not accounting for anticipated rebates where it is probable that purchase volumes will be achieved.

Common error 3 – Inappropriate capitalisation of fixed production overheads

Manufacturing entities are required to capitalise conversion costs into the cost of inventories. Conversion costs include:

Direct labour
Fixed production overheads, and
Variable production overheads, i.e. indirect costs that vary with production volumes, e.g. indirect materials and labour.

Fixed production overheads are 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.

Extract of NZ IAS 2, paragraph 12

The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. The actual level of production may be used if it approximates normal capacity. The amount of fixed overhead allocated to each unit of production is not increased as a consequence of low production or idle plant. Unallocated overheads are recognised as an expense in the period in which they are incurred. In periods of abnormally high production, the amount of fixed overhead allocated to each unit of production is decreased so that inventories are not measured above cost.

Extract of NZ IAS 2, paragraph 13

When production levels are below normal capacity, the amount of fixed production overheads not allocated to units of production is to be expensed in profit or loss to reflect production inefficiencies or idle plant.

Many entities mistakenly allocate fixed production overheads based on the actual level of production rather than normal capacity, resulting in inflated values for inventories. Similarly, in periods of ‘super production’, they incorrectly allocate fixed production overheads based on normal capacity, which means that inventory is recorded at inflated values because too much overhead has been absorbed.

Common error 3

Incorrectly capitalising fixed production overheads to the cost of inventory.

Common error 4 – Inappropriate capitalisation of non-production overheads

Common error 3 above discussed instances where fixed and variable production overheads could be capitalised into the cost of inventories. A common error occurs where non-production overheads are capitalised when they do not relate to bringing the inventories to their present location and condition.

NZ IAS 2, paragraph 16(c) requires that such non-production overheads be expensed.

Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include non-production overheads or the costs of designing products for specific customers in the cost of inventories.

NZ IAS 2, paragraph 15

Examples of costs excluded from the cost of inventories and recognised as expenses in the period in which they are incurred are:

…

(d) …

Extract of NZ IAS 2, paragraph 16

Common error 4

Incorrectly capitalising non-production overheads into the cost of inventory.

Common error 5 – Inappropriate capitalisation of selling costs

Selling costs are not incurred to bring inventory to its present location and condition ready for sale. NZ IAS 2, paragraph 16(d) therefore expressly prohibits these costs from being capitalised as part of inventory. Delivery costs to ship goods to customers are to be expensed when incurred.

Common error 5

Incorrectly capitalising selling costs into of inventory.

Common error 6 – Harvested agricultural produce

At their point of harvest from biological assets (i.e. when they become inventory), agricultural produce is measured at fair value less costs to sell. This is their ‘cost’ under NZ IAS 2 going forward.

Common errors include either not valuing harvested produce at fair value at date of harvest and using cost instead, or omitting material selling costs.

Common error 6

Incorrectly valuing agricultural produce at date of harvest.

Common error 7 – Failing to use the specific identification method to allocate the cost of inventories

A common error occurs where an entity sells a low volume of very high value inventories that are not ordinarily interchangeable, or engages in specific projects, and fails to use the specific identification method to allocate inventory costs.

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.

NZ IAS 2, paragraph 23

Common error 7

Using FIFO or weighted average cost formulas where the specific identification method is more appropriate.

Common error 8 – LIFO is not an acceptable cost formula

While perhaps no longer so common, some entities may incorrectly apply a LIFO cost formula to determine cost of sales rather than FIFO or weighted average.

The cost of inventories, other than those dealt with in paragraph 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.

NZ IAS 2, paragraph 23

Common error 8

Using a LIFO cost formula.

Common error 9 – Omitting the ‘net’ in net realisable value (NRV)

NZ IAS 2 requires inventories to be recognised in the statement of financial position at the lower of cost and net realisable value. Common errors 1 to 8 focus on determining the appropriate ‘cost’. However, many entities also make common errors when determining ‘net realisable value’, including forgetting to deduct selling costs.

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

NZ IAS 2, paragraph 9

Net realisable 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.

Definition of ‘net realisable value’ in NZ IAS 22

Common error 9

Not deducting material selling costs from net realisable value.

Other net realisable value common errors

Other common NRV errors occur where entities:

Fail to adjust the NRV of raw materials and work-in-progress where the selling price for the related finished good has declined below cost
Fail to factor in conversion costs for raw materials and work-in-progress, and
Fail to reverse inventory write-downs.

For more on the above, please contact your local BDO representative.