Underlying Rationale and Relation with IASBs Framework - Essay Example

IAS2 – Inventories Table of Contents History and Objective of IAS2 IAS2 was effective on January 1995. This was later revised by the IASB in 2003. This standard relates to the accounting treatment of inventories. It guides in the determination of the inventory cost and the subsequent recognition of an expense that includes write-down to the net realizable value. It also guides on the cost formulas which are used in assigning costs to the inventories (Belk College of Business, n.d.). Underlying rationale and relation with IASB’s framework Under this standard the inventories are measured at cost or net realizable value whichever is lower. The net realizable value refers to the selling price that is estimated to be received during the course of activities after deducting for any estimated costs relating to completion and other such costs that are incurred to make the sale. The main objective of IASB for IAS2 was to reduce the alternatives in the measurement of inventories. The revised IAS2 does not allow the consideration of the exchange differences, arising from the purchase of inventories that are invoiced in the overseas currency, to be treated as a part of inventories purchase cost (Malaysian Accounting Standards Board, n.d.). Measurement, presentation and disclosure As per IAS2 the inventories are measured at cost or realizable value whichever is lower, based on every item. The inventory costs is the sum total of the purchase cost like cost price, import duties, handling as well as transportation costs; after the adjustments of rebates and trade discounts, conversion costs and other costs that are incurred for transporting the inventories to the current location and form. But this excludes the storage costs, costs relating to abnormal wastage; and selling and administration. Inventories costs can be approximated using the standard cost method or retail inventory method. The cost of inventories relating to items that are usually interchangeable and also goods or services that are produced and set aside for other projects can be assigned costs on the basis of specific identification. The inventories are valued using the first-in-first-out (FIFO) method or the weighted average method. In FIFO the items in the inventory are measured on the basis of recent purchase. Net realizable value is the amount that the business expects to receive from the inventory sale in the due course of the business. In the Balance Sheet an entity reports the lower of the net realizable value and cost as an asset. This is shown below- Source: (CPA Australia Ltd., 2008). After the sale of inventories, the carrying amount of the related inventories is recognized as expenditure in the statement of income in the time period when the revenue from it is recognized. In the event of a fall in the net realizable value below the inventories costs the write-down is shown in the income statement of the relevant period in which it occurs. A rise in the net realizable value is shown as a reduction in the inventories amount that was shown as an expense in the time period of the reversal. Disclosure- The disclosures include the following- The accounting policies that are adopted in the measurement of the inventories and this also include the cost formula that is used. Total carrying value of the inventories is classified as appropriate to the business entity. The carrying value of the inventories is recorded at fair value minus costs relating to sale. The amount of inventories that are consumed during the accounting period, disclosing any write-downs to the net realizable value separately. Reversal of any write-down amount and the events or circumstances that led to it. The carrying inventories amount that is pledged as a security for loans or any other liability. Application and Scope The IAS2 rules and procedures are applicable to all inventories except the following- Work-in-progress that arises in the case of construction contracts. Financial instruments Biological assets that are a part of agricultural activities and produce at the time of harvest. The principles relating to IAS2 does not apply to inventories that are held by producers of forest and agricultural products, agricultural produce held after the harvest, minerals as well as mineral products to the point that they are valued at net realizable value as per the established practices prevailing in those industries. This will also not apply to broker-traders of commodity who measure the amount of inventories at fair value minus costs related to sale (CPA Australia Ltd., 2008). Comparison with US GAAP There are three main differences in inventory valuation between International Accounting Standard 2(IAS 2) and US GAAP. Firstly the last-in-first-out (LIFO) method of inventory valuation is not permitted under IFRS, mainly IAS 2 but this is permitted under US GAAP. Secondly the reversal of write-downs in inventory is allowed in IAS 2 in certain conditions but this is not allowed in GAAP. Thirdly while the GAAP considers lower of cost or market value, IAS 2 considers lower of cost or net realizable value. Due to above differences the amount of inventory in Balance Sheet should be more under IAS 2 provided the asset prices generally increase over the years. The prohibition of LIFO in IAS 2 will make the process of inter-company comparison simpler as there will be no need to adjust the inventory value from another method. Application of LIFO method leads to a mismatch in the sales and costs. Under LIFO the recent costs are shown in the statement of income and the balance sheet values are based on old LIFO values. When there is a decrease in the actual inventory it can lead to LIFO liquidation and result in an extraordinary mismatch in the timing of sales and costs. This will further distort the differences between the two accounting forms. As LIFO is not allowed under IAS 2, this will raise the value of the inventory in the Balance Sheet, provided that the asset prices increase over the years. However during deflation the inventory value will be higher in the Balance Sheet of companies that use US GAAP as compared to the companies using IAS 2. Due to the effect of inventory write-downs under IAS 2 the value of inventory is higher in the Balance Sheet in the case of IAS 2 when a significant decreasing trend in the price of the inventory is reversed. IAS 2 allows the recognition of lower of cost or net realizable value and not the lower of cost or market value rule as followed by GAAP. The market value refers to replacement cost. Net realizable value is the ceiling of replacement cost and its floor is net realizable value minus a normal margin of profit. As the net realizable value forms the ceiling, the value of inventory reported under IAS 2 is more than or equal to the inventory amount under GAAP (Bao & Romeo, n.d.). Example Tesco Plc follows IFRS in presenting its accounting information (London Stock Exchange plc, 2009). In its annual reports for the year 2009 the company has valued its inventories at cost and fair value minus costs of sell using the weighted average method of costing (Tesco Plc, 2009, pp. 74). Discussion IAS2 relates to the accounting treatment of the inventories in the books of account. The inventories consist of the assets that are held for the purpose of sale in the due course of the business. Recently the harmonization of the international reporting standards has gained momentum. There exist important differences in the reporting standards under US GAAP and IFRS mainly IAS 2. The former considers LIFO as well as FIFO in the measurement of inventory whereas the use of LIFO is prohibited under IAS 2. This leads to a rise in the inventory amount in the Balance Sheet under IFRS. Under the FIFO method of inventory valuation the calculations are based on the recent purchase. This means that this method gives preference to the most recent prices prevailing in the market. Under the LIFO method of inventory valuation, the calculations are based on the prices of the inventories that first enter the system. The weighted average method as the name itself suggests considers the weighted average costs of the inventories. A change in the inventory value affects the net income. As per IAS 2 the inventories are reported initially as an asset in the balance sheet and thereafter reported as an expenditure in the statement if income, this includes any write-downs in the net realizable value. Reference Belk College of Business. No Date. SUMMARY OF IAS 2. IAS 2 INVENTORIES. Available at: http://belkcollegeofbusiness.uncc.edu/haburton/IAS%202%20Summary.htm [Accessed on March 17, 2010]. Malaysian Accounting Standards Board. No Date. Working Groups Projects. Events. Available at: http://www.masb.org.my/index.php?option=com_content&view=article&id=61%3Afrs102-pg3&catid=6%3Amasb-exclude-private&Itemid=32 [Accessed on March 17, 2010]. CPA Australia Ltd. 2008. IAS 2 Inventories. INTERNATIONAL FINANCIAL REPORTING STANDARDS. Available at: http://www.cpaaustralia.com.au/cps/rde/xbcr/cpa-site/IAS-2-fact-sheet.pdf [Accessed on March 17, 2010]. Bao, D. Romeo, G. No Date. U.S GAAP versus IAS2. Reporting Inventory: U.S. GAAP vs. IAS2. Available at: http://www.theaccountingjournal.org/J.%20of%2021st%20Century-Inventory.htm [Accessed on March 17, 2010]. Tesco Plc 2009. Inventories. Notes to the Group financial statements. Available at: http://www.investis.com/tesco/pdf/repp2009.pdf [Accessed on March 17, 2010]. London Stock Exchange plc. 2010. Fundamentals. Tesco Plc. Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/exchange-insight/company-fundamentals.html?fourWayKey=XS0414350974ZZGBPCRTR [Accessed on March 17, 2010]. Read More