In addition to the IFRIC Tentative Agenda Decision: Preparation of financial statements when an entity is no longer a going concern, IFRIC on 12 February 2021 also issued another tentative agenda decision – Costs necessary to sell inventories. This tentative agenda decision is open for public comments until 14 April 2021.
What are the accounting requirements on inventories?
Before we dive deep into the issue submitted and IFRIC tentative agenda decision, let’s have a quick look at the requirements of the accounting standard on inventories. Alternatively, you can also have a quick read on the summary of accounting requirements for inventories in our Accounting 101 series – Accounting for non-financial assets.
The accounting for inventories is generally governed under IAS 2 Inventories. Inventories are defined as 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 are recognised initially at the cost of acquiring/producing/purchasing them. These costs comprise the cost of purchase, costs of conversion and other costs to the extent that they are incurred in bringing the inventories to their present location and condition.
Subsequent to its initial recognition, inventories are carried or measured at the lower of cost and net realisable value. Net realisable value is defined as 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.
When the costs are higher than the net realisable value, the value of inventories is written down below its costs to reflect that the inventories should not be carried more than the amounts expected to be realised from their sale or use. Inventories may be written down for example, when inventories are damaged or obsolete or when the inventory selling prices have declined.
The amount that has been written down may also be reversed subsequently if the circumstances that previously caused the inventories to be written down no longer exist. This assessment of net realisable value is performed in each subsequent period.
Costs necessary to sell inventories: What is the issue submitted?
From the discussion above, we can appreciate that the assessment of net realisable value has a direct consequence on the amount written down for inventories. The standard, however, does not provide any guidance or explanation to determine what costs should be considered by an entity to sell the inventories.
In the absence of guidance in IAS 2, a submitter had written to IFRIC to seek guidance on what costs that an entity should include as part of the estimated costs necessary to make the sale when determining the net realisable value of inventories. The submitter had observed the following two practices in the market:
- View 1 – an entity includes all costs needed to make the sale
- View 2 – an entity includes only ‘incremental costs’ required by the particular conditions of the inventories to make the sale.
Proponents of View 1 argued that IAS 2 does not limit the costs that need to be estimated to sell the inventories to only incremental costs. Accordingly, all costs should be included so long it is needed for the entity to make the sale. Proponents of View 2 on the other hand quoted the difficulty of allocating other costs to each item of inventory if considering all costs. Accordingly, only incremental costs are included. As such, under View 1, entities would deduct more costs to derive the net realisable value as compared to View 2. This leads to a lesser amount written down under View 2 as compared to View 1.
IFRIC tentative agenda decision
When IFRIC discussed the issues above in its February 2021 meeting, IFRIC had tentatively decided that an entity should include all costs needed to make the sale of inventories, instead of limiting it to only ‘incremental costs’. This is consistent with the requirements of IAS 2 for an entity to estimate the costs necessary to make the sale. IFRIC also concluded that an entity should use its judgment to determine which costs are necessary to make the sale considering its specific facts and circumstances, including the nature of the inventories.
The above decisions, if finalised without any changes, are expected to change the accounting policy of certain entities with regard to the determination of the net realisable value. The tentative agenda decision may also lead certain entities to record a bigger number of inventories written down. A retrospective adjustment may also need to be made if the entity’s current practice is not consistent with the tentative agenda decision. You can refer to the IFRIC Update February 2021 for this tentative agenda decision. We will update you by updating this article once the decisions have been finalised or should there be any changes to the tentative decisions. Till then. Stay tuned!