Chapter 3: Measurement of cost

IAS 2 specifically allows the use of the standard cost method or the retail method, provided that the chosen method gives a result that approximates to cost. Standard costs should take into account normal levels of materials and supplies, labor, efficiency, and capacity utilization. They must be regularly reviewed and revised where necessary. The retail method is often used in the retail industry for measuring inventories with high volumes of rapidly changing items with similar margins. It may be unnecessarily time-consuming to determine the cost of the period-end inventory on a conventional basis.

Consequently, the most practical method of determining period-end inventory may be to record inventory on hand at selling prices, and then convert it to cost by adjusting for a normal margin. Judgment is applied in the retail method in determining the margin to be removed from the selling price of inventory to convert it back to cost. The percentage has to take into account circumstances in which inventories have been marked down to below the original selling price.

Adjustments have to be made to eliminate the effect of these markdowns to prevent any item of inventory from being valued at less than both its cost and its net realizable value. In practice, however, entities that use the retail method apply a gross profit margin computed on an average basis appropriate for departments and/or ranges, rather than applying specific mark-up percentages. This practice is acknowledged by IAS 2, which states that ‘an average percentage for each retail department is often used’.

Costs of conversion

Costs of conversion include direct costs such as direct labor and materials, as well as an allocation of fixed and variable production overheads. It must be remembered that the inclusion of overheads is not optional. Overheads may comprise indirect labor and materials or other indirect costs of production. For the most part, there are few problems over the inclusion of direct costs in inventories, although difficulties may arise over the inclusion of certain types of overheads and the allocation of overheads into the inventory valuation.

Overhead costs must be apportioned using a ‘systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods.

Overheads should be allocated to the cost of inventory consistently from year to year, and should not be omitted in anticipation of a net realizable value problem.

Variable production overheads are indirect costs that vary directly, or nearly directly, with the volume of production such as indirect material and indirect labor.

Variable production overheads are allocated to each unit of production based on the actual use of the production facilities.

Fixed production overheads are indirect costs that remain relatively constant regardless of the volume of production, such as building and equipment maintenance depreciation, and factory management expenses. IFRS 16 which is mandatory for accounting periods beginning on or after 1 January 2019 amends IAS 2 to add ‘depreciation of right-of-use assets used in the production process’ as an example of fixed production overheads.

The allocation of fixed production overheads is based on the normal capacity of the facilities. Normal capacity is defined as

‘the production expected to be achieved on average over several periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance’.

While actual capacity may be used if it approximates normal capacity, increased overheads may not be allocated to production as a result of low output or idle capacity. In these cases, the unallocated overheads must be expensed.

Similarly, in periods of abnormally high production, the fixed overhead absorption must be reduced, as otherwise inventories would be recorded at an amount over cost.

In computing the costs to be allocated via the overhead recovery rate, costs such as distribution and selling must be excluded, together with the cost of storing raw materials and work in progress, unless storage costs must be incurred before further processing, which may occasionally be the case.

Although not specifically referred to in IAS 2, when the revaluation model in IAS 16 is applied, depreciation of property, plant, and equipment is based on the revalued amount, less the residual value of the asset and it is the revalued depreciation that, in our view, should be utilized in inventory valuation. IAS 2 mentions the treatment to be adopted when a production process results in the simultaneous production of more than one product, for example, a main product and a by-product. If the costs of converting each product are not separately identifiable, they should be allocated between the products on a rational and consistent basis.

For example, this might be the relative sales value of each of the products either at the stage in the production process when the products become separately identifiable, or after production. If the value of the by-product is immaterial, it may be measured at net realizable value and this value is deducted from the cost of the main product. 

Core inventories and spare parts – IAS 2 or IAS 16 It is our view that an item of inventory that is not held for sale or consumed in a production process should be accounted for as an item of property, plant and equipment (PP&E) under IAS 16 – Property, Plant and Equipment – if it is necessary to the operation of a facility during more than one operating cycle and its cost cannot be recouped through sale (or it is significantly impaired after it has been used to operate the asset or obtain benefit from the asset). This applies even if the part of inventory that is deemed to be an item of PP&E cannot physically be separated from other inventory. By contrast, spare parts are classified as inventory unless they meet the definition of PP&E.

What is the classification of assets acquired for sale at the end of their lease term – example Entity X, a lessor, leases assets ordinarily under three-year agreements. At the end of the lease term, the lessee has the option either to return or to acquire the asset. Some of the leases contain an extension option, which allows the lessee an additional three months to return or to acquire the asset. The extension option must be exercised prior to the end of the main lease term. Entity X enters into ‘residual value guarantee‘ contracts with Entity A, a third party. Under these contracts, Entity A will purchase the assets from Entity X at the end of each lease term at a predetermined price. Entity A receives a fee in return for providing the residual value guarantee. When an extension option is exercised by the lessee, ownership of the asset is transferred to Entity A at the end of the main lease term for the predetermined price. During the extension period, Entity X passes the rental income to Entity A. At the end of the extension period, Entity A sells the asset either in the market or to the lessee. Rental income received by Entity A during the extension period is considered incidental to Entity A’s principal activities, which are the provision of residual value guarantee contracts and selling the assets acquired. In order to determine how to recognise the assets in the period from acquisition at the end of the main lease term to the date of sale (whether in the market or to the lessee), Entity A must establish how the assets are used in the business, i.e., whether they represent inventories or property, plant and equipment. In the circumstances described, Entity A acquires the assets at the end of the main lease term to profit from selling them in the market. The assets are classified as inventories because they are assets “held for sale in the ordinary course of business“. The assets acquired do not represent property, plant and equipment, in accordance with IAS 16, because they are not held primarily for rental by Entity A to others and are not expected to be used during more than one period.

Classification and measurement of pipeline fill – example Company A operates a pipeline to transport crude oil. Company A does not produce or distribute crude oil; it merely provides the use of its pipeline to the buyer and seller in a contract for a usage fee. The seller and buyer independently negotiate the sales price, and either the buyer or the seller pays a fee to Company A for transporting the oil purchased/sold through its pipeline. The pipeline needs to be full of oil at all times to be operational. Therefore, during initial construction of the pipeline, Company A purchases oil to fill the pipeline. Once the pipeline is operational, Company A charges a fixed fee for its transportation services and, in effect, swaps crude oil pushed into the pipeline by a seller for crude oil of the same grade and quality delivered to the customer at the exit point of the pipeline. Company A bears the risk of loss due to theft or line loss in excess of the maximums allowed under the contract. Such losses are rare and normally arise as the result of a pipeline spill that is covered by insurance. The pipeline fill meets the definition of an asset and should be recognised at cost when acquired. The pipeline fill does not meet the definition of property, plant and equipment under IAS 16. Rather, it should be classified as inventories in accordance with IAS 2 because it is held “in the form of materials or supplies to be consumed in the production process or in the rendering of services“. Because an accounting transaction does not take place at the time of each swap of crude oil, no step-up in the value of inventories is recognised. The pipeline fill is measured at the lower of cost and net realisable value throughout the term of the pipeline’s operations in accordance with IAS 2.

Classification of cryptocurrencies (digital currencies) As discussed, cryptocurrencies held for sale in the ordinary course of business should be classified as inventories in the scope of IAS 2. If the entity is acting as a commodity broker-trader in respect of the cryptocurrency in question, it is permitted to measure its holdings at fair value less costs to sell through profit or loss in accordance with IAS 2 due to the similarities between cryptocurrencies and more traditional commodities. The IFRS Interpretations Committee noted the following disclosure requirements in the context of holding cryptocurrencies. An entity should provide the disclosures required by IAS 2 for cryptocurrencies held for sale in the ordinary course of business. If an entity measures holdings of cryptocurrencies at fair value, the disclosures specified in IFRS 13 should be provided. An entity should disclose judgements that its management has made regarding its accounting for holdings of cryptocurrencies if those judgements are among those that had the most significant effect on the amounts recognised in the financial statements, in accordance with IAS 1. An entity should disclose details of any material non-adjusting events, including information about the nature of the event and an estimate of its financial effect (or a statement that such an estimate cannot be made), in accordance with IAS 10. For example, an entity holding cryptocurrencies would consider whether changes in the fair value of those holdings after the reporting period are of such significance that non-disclosure could influence the economic decisions that users of financial statements make on the basis of the financial statements.

Bitcoin and other crypto-currencies In recent years, numerous crypto-currencies (e.g., Bitcoin) and crypto-tokens have been launched. Crypto-assets each have their own terms and conditions, and the purpose for holding them differs between holders. As a result, the holders of a crypto-asset will need to evaluate their own facts and circumstances in determining which IFRS recognition and measurement requirements should be applied. Many crypto-assets would meet the relatively wide definition of an intangible asset. An intangible asset is defined by IAS 38 as an identifiable non-monetary asset without physical substance. However not all intangible assets are within the scope of IAS 38 as the standard is clear that it does not apply to items that are in the scope of another standard. For example, IAS 38 excludes from its scope intangible assets held by an entity for sale in the ordinary course of business, which are within scope of IAS 2 and financial assets as defined in IAS 32 – Financial Instruments: Presentation. Although this is often assumed, IAS 2 does not require inventory to be tangible. IAS 2 defines inventory as assets: (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. Crypto-assets could be held for sale in the ordinary course of business, for example, by a commodity broker-trader. Whether crypto-assets are held for sale in the ordinary course of business would depend on the specific facts and circumstances of the holder. In practice, crypto-assets are generally not used in the production of inventory and, thus, would not be considered materials and supplies to be consumed in the production process. However, in limited circumstances, a crypto-asset could be held for consumption in the rendering of a service. For example, a crypto-asset, not readily convertible to cash, that only entitles the holder to a specific service (e.g., server capacity) could be considered inventory if the holder uses the underlying service to deliver its own services in the ordinary course of its business. IAS 2 does not apply to financial instruments. Thus, where a crypto-asset meets the definition of a financial instrument, it should be accounted for under IFRS 9 – Financial Instruments – rather than as inventory under IAS 2.

Measurement of crypto-assets in the scope of IAS 2

Crypto-assets each have their terms and conditions and, as a result, the holders of a crypto-asset will need to evaluate these terms and conditions to determine which IFRS recognition and measurement requirements should be applied. In some cases, crypto assets may meet the definition of inventory. Generally, IAS 2 requires inventory to be measured at the lower of cost and net realizable value.

However, commodity broker-traders have the choice to measure their inventories, if these are considered to be commodities, at fair value less costs to sell.

Crypto-assets: Cost or lower net realizable value

The costs of purchased crypto-asset inventories would typically comprise the purchase price, irrecoverable taxes, and other costs directly attributable to the acquisition of the inventory (e.g., blockchain processing fees). The cost of inventory excludes anticipated selling costs as well as storage expenses (e.g., costs of holding a wallet or other crypto-account). The cost of crypto-assets recorded as inventory may not be recoverable if those crypto-assets have become wholly or partially obsolete (decline in interest or application) or if their selling prices have declined.

Similarly, the cost of crypto-asset inventory may not be fully recoverable if the estimated costs to sell them have increased. An entity holding crypto-asset inventory will need to estimate the net realizable value at each reporting period. For crypto-assets quoted on a crypto-asset exchange, the net realizable value would typically comprise the current quoted price less the estimated selling costs.

These selling costs can fluctuate significantly depending on the current demand for processing on the particular blockchain. Where the net realizable value is below cost, the inventory should be written down to its net realizable value with the write-down recorded in profit or loss.

A previous write-down of inventory is reversed when circumstances have improved, but the reversal is limited to the amount previously written down so that the carrying amount never exceeds the original cost.

Crypto-assets: Fair value less costs to sell

As noted above, commodity broker-traders may measure their commodity inventories at fair value less costs to sell.

Broker traders buy or sell commodities for others or on their account. When these commodities are principally acquired to sell shortly and generate a profit from fluctuations in price or broker-traders’ margin, they can be classified as commodity inventory at fair value and less costs to sell. While there is no definition of a commodity under IFRS, crypto-assets that are fungible and immediately marketable at quoted prices could potentially be considered commodities if they were held by broker traders. However, judgment should be exercised in determining whether a particular crypto-asset can be regarded as a commodity.

The quoted prices of crypto-assets may vary considerably between exchanges. A broker-trader measuring crypto-assets at fair value less costs to sell will need to determine the principal (or most advantageous) market for those assets, and whether they could enter into a transaction for the crypto-asset at the price in that market at the measurement date. The determination of the principal (or most advantageous) market. When a broker-trader measures its inventory at fair value fewer costs to sell, any changes in the recognized amount should be included in profit or loss for the period.

A broker-trader holder of a crypto-asset will need to estimate the costs to sell the crypto-asset at each reporting date, taking into consideration the transaction cost on the relevant blockchain and other fees required to convert the crypto-asset into cash. These fees could fluctuate significantly from period to period depending on the current demand for processing on the relevant blockchain.

Classification of a property leased out for a short period before the sale Entity A purchases and develops residential properties solely for the purpose of a sale in its ordinary course of business. The properties are classified as inventory until sold, generally shortly after the completion of the development. However, in some cases, shortly prior to the sale, Entity A leases out the property (or a portion thereof) on a temporary basis for specific reasons (e.g., to optimise net cash flows until a buyer is found, or to enhance the value of the property by incorporating tenants). In these cases, the lease agreements are not entered into with the objective of generating rental earnings or capital appreciation in the long term and rental earnings before the sale are not significant compared to the sale price of the property. Although inception of an operating lease is cited as an example of evidence of a change in use in IAS 40, it does not automatically trigger a reclassification from inventory to investment property. In order for the property to be reclassified, it must also meet the definition of the investment property (i.e., management intention for holding the property must also have changed so that it is now to earn rentals or for capital appreciation or both). In this scenario, the period of the lease prior to the sale is limited and the rental earnings are not significant compared to the expected sale price which indicates that Entity A’s intention, strategy and business model for a sale in the ordinary course of its business has not changed. Accordingly, Entity A is not permitted to reclassify the property from inventory to investment property in accordance with IAS 40 and the property should remain classified as inventory.

Classification of purchased inventory with CO2e emission offsets attached An airline has an obligation to offset a portion of the CO2e its aircraft emit during the current period. It chooses to reduce its emissions by buying and using a blend of standard aircraft fuel and a biofuel made from used cooking oil. The price of this blended fuel is significantly higher than standard fuel because the biofuel component is more expensive to produce. However, the blended fuel has carbon offsets attached to it, which the airline receives when it buys the blended fuel from its supplier. The airline is able to either use those carbon offsets towards its obligation to offset its CO2e emissions or sell them to another entity. The airline should recognise separately the fuel inventory and the carbon offsets acquired. If the airline intends to sell the carbon offsets in the ordinary course of business, it should account for them as inventory. Otherwise, the carbon offsets are accounted for as an intangible asset. To determine the cost of the blended fuel and the carbon offsets on initial recognition, the airline should apply the requirements in IFRS 3 which stipulate that when a group of assets that do not constitute a business are acquired, the cost is allocated to the individual identifiable assets on the basis of their relative fair values at the date of purchase. Supplies purchased during the research phase of a project (e.g., in the pharmaceutical industry) will not meet the definition of inventories prior to a decision to proceed with commercial production. Nevertheless, such supplies may qualify for recognition as an asset.

Scope exemptions

Producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products

The Standard does not apply to the measurement of inventories of producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realizable value by well-established industry practices. The previous version of IAS 2 was amended to replace the words ‘mineral ores’ with ‘minerals and mineral products to clarify that the scope exemption is not limited to the early stage of extraction of mineral ores.

Inventories of commodity broker-traders

The Standard does not apply to the measurement of inventories of commodity broker-traders to the extent that they are measured at fair value less costs to sell.

Consistency

The Standard incorporates the requirements of SIC-1 Consistency—Different Cost Formulas for Inventories that an entity uses the same cost formula for all inventories having a similar nature and use to the entity. SIC-1 is superseded.

Prohibition of LIFO as a cost formula

The Standard does not permit the use of the last-in, first-out (LIFO) formula to measure the cost of inventories.

IAS 2 applies to all inventories, except:

• financial instruments; and
• biological assets related to agricultural activity and agricultural produce at the point of harvest.

IAS 2 does not apply to the measurement of inventories held by:

• producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at the net realizable value by well-established practices in those industries; or
• commodity broker-traders who measure their inventories at fair value less costs to sell.

Although inventories held by the types of entities referred to in IAS 2 are excluded from the measurement requirements of IAS 2, the Standard requires that when such inventories are measured at net realizable value/fair value fewer costs to sell, changes in those values are to be recognized in profit or loss in the period of change. IAS 2 The other requirements of IAS 2 (e.g., regarding presentation and disclosure) apply in the normal way to such inventories.

For the avoidance of doubt, note that the requirements of IAS 2 apply in their entirety to:

• property intended for sale in the ordinary course of business or the process of construction or development for such sale (e.g., property acquired exclusively with a view to subsequent disposal shortly or for development and resale); and
• inventories held by producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, when they are not measured at the net realizable value by well-established practices in those industries.

Costs incurred to fulfill contracts with customers

Costs incurred to fulfill a contract with a customer that does not give rise to inventories (or assets within the scope of another Standard – for example, IAS 16 or IAS 38) are accounted for by IFRS 15.

Treatment of Inventories on consignment

In some industries it is common for a manufacturer to supply goods to a distributor ‘on consignment’; the manufacturer retains the substantial risks and rewards of ownership and legal title to the goods until some future predetermined event occurs (e.g., sale to a third-party customer) which triggers the transfer of the legal title to the distributor.

In such circumstances, the distributor (i.e., the buyer) will need to determine when it is appropriate to recognize inventories on consignment as an asset in its statement of financial position. IFRS Standards do not provide any guidance on accounting for consignment arrangements from the point of view of the buyer and, therefore, by IAS 8, the distributor should determine an accounting treatment for inventories on consignment that results in information that is relevant and reliable. Until it is established that the transfer to the distributor is substantive, the goods should be treated as the manufacturer’s inventories and excluded from the distributor’s statement of financial position.

IFRS 15 provides specific guidance on determining whether an arrangement is a consignment arrangement and requires that revenue is not recognized (and, therefore, the inventory is not derecognized) by the manufacturer upon delivery of the goods if the delivered product is held on consignment.

Arrangements where goods are supplied from a manufacturer to a dealer or distributor on a consignment basis are common in certain industries, particularly in the motor vehicle trade. The objective of both parties to a consignment arrangement is to enable the dealer to sell as many units of the product as possible. The dealer is often given some incentive by the manufacturer, through various bonus schemes, to ensure that the volume of items sold is as high as possible. The consignment arrangement serves to achieve this objective and to benefit both parties.

However, under such arrangements, the manufacturer (or a financier) generally retains title to the goods supplied to the dealer until some predetermined event occurs. This might be when the dealer sells the goods or has held them for a set period, or some other event triggers the dealer’s adoption of the goods (that is when he pays for them and acquires title).

However, the date that title transfers tend to be some time after the date that the inventory item is physically transferred to the dealer. The title will generally pass on receipt of cleared funds (but not to the dealer if he has already sold the vehicle). The key issue is to determine the point at which the dealer has, in substance, acquired an asset that should be recognized on its balance sheet (that is, whether it is when legal title passes or at some other time).

In addition to setting out the conditions for when revenue from the sale of goods should be recognized, IFRS 15 deals with revenue recognition from consignment arrangements. It states that a product that has been delivered to another party can be held in a consignment arrangement if that other party has not obtained control of the product.

Accordingly, an entity should not recognize revenue on the delivery of a product to another party if the delivered product is held on consignment. Indicators that an arrangement is a consignment arrangement include, but are not limited to, the following:

1. The product is controlled by the entity until a specified event occurs, such as the sale of the product to a customer of the dealer, or until a specified period expires.
2. The entity can require the return of the product or transfer the product to a third party (such as another dealer).
3. The dealer does not have an unconditional obligation to pay for the product (although it might be required to pay a deposit).

Example – consignment arrangements – retail and consumer industry Manufacturers provide household products to Retailers on a consignment basis. Retailers do not take title to the products until they are scanned at the register and have no obligation to pay the Manufacturer until they are sold to the consumer unless the goods are lost or damaged while in the Retailer’s possession. Any unsold products, excluding those that are lost or damaged, can be returned to the Manufacturer, and the Manufacturer has the discretion to call products back or transfer products to another customer.

The goods should be treated as the Manufacturer’s inventory until control of the products transfers to the Retailer. Control has not transferred if the Manufacturer can require the return or transfer of those products. The inventory should be de-recognized by the Manufacturer when the products are sold to the consumer, or when they are lost or damaged while in the Retailer’s possession.