Permanent differences affect the current accounting period’s effective income tax rate (the ratio of the reported income tax expense to pretax income), but do not have any impact on

future income taxes. Temporary differences, on the other hand, affect the income taxes that

Chapter 15 Income Taxes (IAS 12) 181

will be paid in future years because they represent a deferral of taxable income from the cur-rent to subsequent accounting periods (or an acceleration of taxable income from the future into the current accounting period).

6. The $2,300 difference between pretax income and taxable income is attributable in part to the $100 of tax-free interest income that will never be taxed, but is included in the Statement of Comprehensive Income. This is a permanent difference because this income is perma-nently excluded from taxation; the amount of tax on it that has to be paid now or in the future is zero.

7. The $2,200 difference between the $5,200 accelerated consumption depreciation and the

$3,000 straight-line depreciation is a timing (temporary) difference because the taxes that are saved in the current year are only deferred to the future when the timing differences reverse.

Over the life of the equipment, the total depreciation expense will be the same for income tax and book purposes. The $2,200 is a reflection of the difference in the amount of the total cost of the equipment that is allocated to this period by the two methods of accounting for depre-ciation. The Statement of Comprehensive Income has a lower depreciation cost than the tax filing, which results in higher reported income. These differences will reverse over time when the straight-line depreciation rises above the double-declining balance depreciation.

Tax-Free FIGURE 15.3 Income Difference before Taxes—Engine Works

183

Inventories ^{(IAS 2)}

CHAPTER 16

16.1 OBJECTIVE

Inventory comprises the goods held for sale and the cost associated with the production thereof. It is often the heart of entities and defines their business and industry. IAS 2’s objec-tive is to prescribe the accounting treatment of inventories, including the calculation of the cost of inventory, the type of inventory method adopted, the allocation of cost to assets and expenses, and valuation aspects associated with any write-downs to net realizable value.

16.2 SCOPE OF THE STANDARD

This standard deals with all inventories of assets that are:

■ held for sale in the ordinary course of business;

■ in the process of production for sale;

■ in the form of materials or supplies to be consumed in the production process; and

■ used in the rendering of services.

In the case of a service provider, inventories include the costs of the service for which the related revenue has not yet been recognized (for example, the work in progress of auditors, architects, and lawyers).

IAS 2 does not apply to the measurement of inventories held by producers of agricultural and forest products, agricultural produce after harvest, or minerals and mineral products to the extent that they are measured at net realizable value in accordance with well-established practices in those industries. Living plants, animals, and harvested agricultural produce derived from those plants and animals are also excluded (see IAS 41, chapter 12).

Although IAS 2 excludes construction contracts (IAS 11) and financial instruments (IAS 39), the principles in IAS 2 are still applied when deciding how to implement certain features of the excluded standards (see example 16.5).

IAS 2 does not apply to commodity broker-traders who acquire inventories principally for the purpose of selling in the near future and generating a profit from fluctuations in the price or to earn a broker-trader’s margin. Broker-traders typically measure commodities at fair

184 Chapter 16 Inventories (IAS 2)

value less cost to sell, with changes in fair value recognized in profit or loss in the period of change. It is not clear whether the intention of the standard is that commodity broker-traders have the option to apply fair value or IAS 2 or whether the fair value measurement is com-pulsory. The interpretation developed in practice, based in the wording in the standard, is that broker-traders have the option to choose fair value or IAS 2.

16.3 KEY CONCEPTS

16.3.1 Inventories should be measured at the lower of cost and net realizable value.

16.3.2 Cost of inventories comprises all the costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

16.3.3 The net realizable value (NRV) is the estimated selling price less the estimated costs of completion and costs necessary to make the sale.

16.3.4 When inventories are sold, the carrying amount of those inventories should be recog-nized as an expense in the period in which the related revenue is recogrecog-nized (see chapter 23).

16.3.5 The amount of any write-down of inventories to NRV and all losses of inventories should be recognized as an expense in the period of the write-down or loss.

16.4 ACCOUNTING TREATMENT Measurement Techniques

16.4.1 The cost of inventories that are not ordinarily interchangeable and those produced and segregated for specific projects are assigned by specific identification of their individual costs.

16.4.2 The cost of inventories, other than those dealt with in paragraph 16.4.1, should be assigned by using either of the following cost formulas:

■ weighted average cost; or

■ first in, first out (FIFO).

16.4.3 The following techniques can be used to measure the cost of inventories if the results approximate cost:

■ Standard cost:

– Normal levels of materials, labor, and actual capacity should be taken into account.

– The standard cost should be reviewed regularly to ensure that it approximates actual costs.

■ Retail method:

– Sales value should be reduced by gross margin to calculate cost.

– Average percentage should be used for each homogeneous group of items.

– Marked-down prices should be taken into consideration.

Cost and NRV

16.4.4 Cost of inventories consists of:

■ purchase costs, such as the purchase price, import charges, non-recoverable taxes, and other directly attributable transport and handling costs;

Chapter 16 Inventories (IAS 2) 185

■ costs of conversion;

– direct labor; and

– production overheads, including variable overheads and fixed overheads allocated at normal production capacity; and

■ other costs, such as design and borrowing costs.

16.4.5 Cost of inventories excludes:

■ abnormal amounts of wasted materials, labor, and overheads;

■ storage costs, unless they are necessary prior to a further production process;

■ administrative overheads; and

■ selling costs.

16.4.6 NRV is the estimated selling price less the estimated costs of completion and costs necessary to make the sale. These estimates are based on the most reliable evidence at the time the estimates are made. The purpose for which the inventory is held should be taken into account at the time of the estimate. Inventories are usually written down to NRV based on the following principles:

■ Items are treated on an item-by-item basis.

■ Similar items are normally grouped together.

■ Each service is treated as a separate item.

16.5 PRESENTATION AND DISCLOSURE

The financial statements should disclose the following:

■ accounting policies adopted in measuring inventories, including the cost formulas used;

■ total carrying amount of inventories and amount per category;

■ the amount of inventories recognized as an expense during the period, that is, cost of sales;

■ amount of inventories carried at fair value less costs to sell;

■ amount of any write-downs and reversals of any write-downs;

■ circumstances or events that led to the reversal of a write-down; and

■ inventories pledged as security for liabilities.

16.6 FINANCIAL ANALYSIS AND INTERPRETATION

16.6.1 The accounting method used to value inventories should be selected based on the order in which products are sold, relative to when they are put into inventory. Therefore, whenever possible, the costs of inventories are assigned by specific identification of their individual costs. In many cases, however, it is necessary to use a cost formula—for example, first-in, first-out (FIFO)—that represents fairly the inventory flows. IAS 2 does not allow the use of last-in, first-out (LIFO) because it does not faithfully represent inventory flows. The IASB has noted that the use of LIFO is often tax driven and concluded that tax considerations do not provide a conceptual basis for selecting an accounting treatment. The IASB does not permit the use of an inferior accounting treatment purely because of tax considerations.

16.6.2 Analysts and managers often use ratio analysis to assess company performance and condition.

186 Chapter 16 Inventories (IAS 2)

The valuation of inventories can influence performance and cash flow through the events or manipulations in the presentation of data shown in table 16.1.

16.6.3 Although LIFO is no longer allowed in IFRS financial statements, some jurisdic-tions continue to allow the use of LIFO. When comparing entities in the same industry, inventories should be adjusted to FIFO to ensure comparability. (In a similar manner, ana-lysts should adjust the statements of non-IFRS entities prior to comparing them with IFRS entities.)

16.6.4 FIFO inventory balances constitute a closer reflection of economic value because FIFO inventory is valued at the most recent purchase prices. Table 16.2 summarizes the effects of using FIFO and LIFO on some of the elements in financial statements.

16.7 COMMENTARY

16.7.1 The calculation of the cost of inventory involves complex cost allocation and cost tracking systems and can vary significantly between entities. IAS 2 addresses these cost ac-counting principles only at a very high level and the costing of inventory is therefore effected more by cost accounting methodologies in general use, as opposed to strict theoretical prescriptions.

16.7.2 Inconsistency exists in the treatment of rebates and discounts that can be deducted from the cost of inventories. The IFRIC notes that IAS 2 requires only rebates and discounts received as a reduction in the purchase price to be deducted from the cost of the inventories (for example, cash discounts and volume rebates). Rebates that specifically refund the selling expenses should not be deducted from the costs of inventories.

Valuation element or manipulation Effect on company Beginning inventory overstated by $5,000 Profit will be understated by $5,000 Ending inventory understated by $2,000 Profit will be understated by $2,000 Inventory accounting method effect on cash

flows

Taxes will be affected by the choice of accounting method

Early recognition of revenue on a sale Understatement of inventory Overstatement of receivables Overstatement of profit TABLE 16.1 Impact of Inventory Valuation on Financial Analysis

Financial statement variable LIFO FIFO

Cost of goods sold (COGS) Higher—more recent prices are used Lower

Income Lower—COGS is higher Higher

Cash fl ow Higher—taxes are lower Lower

Working capital Lower—current assets are lower Higher

TABLE 16.2 The Impact of LIFO vs. FIFO on Financial Statement Variables