Inventory & COS Text

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Merchandise

Perpetual method

1/1/X1, XYZ had 1,000 units of merchandise 123, acquired at a weighted average cost of 10 per unit, on hand. 1/2/X1, it sold 2 units for 20 each in cash.

Dr/Cr

1/2/X1 | 2.1.X1
Cash		40
	Revenue: Merchandise		40
Cost of merchandise sold		20
	Inventory: Merchandise: 123		20

 

Same facts except, XYZ accounts for individual sales separately. 1/1/Y1, it purchased 1,000 units of merchandise UPC 123456 for 10.50 per unit.

Although IAS 2.25 requires | ASC 330-10-30-11 suggests that companies use average cost, FIFO or (US GAAP only) LIFO for inventory of this character, XYZ decided to use a specific identification method instead.

IAS 2.25: 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.

IAS 2.23: 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.

ASC 330-10-30-11: ... if the materials purchased in various lots are identical and interchangeable, the use of identified cost of the various lots may not produce the most useful financial statements. This fact has resulted in the general acceptance of several assumptions with respect to the flow of cost factors such as FIFO, average, and LIFO to provide practical bases for the measurement of periodic income.

In making this judgment, XYZ considered that, since its internal accounting was based on the specific identification of individual inventory items, making the adjustments necessary to achieving average cost/FIFO/LIFO reporting would bring it additional cost.

XYZ also considered that using a specific identification method would not lead to a material difference compared with average cost/FIFO/LIFO.

XYZ also considered that the specific identification of costs achieves the objective of inventory accounting as well as, if not better than, average cost/FIFO/LIFO.

ASC 330-10-10-1: A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.

While IAS 2 does not specifically refer to "matching", it nonetheless suggests that matching is a worthwhile objective.

IAS 2.34: When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised (a.k.a. matched).

CF 4.50: Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events; for example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods.

On the basis of these considerations, XYZ concluded cost of making the adjustments necessary to fulfilling the letter of IFRS/US GAAP would outweigh the benefits, so decided on a method that achieves the comparable results, but is more cost effective.

1/1/X1 | 1.1.X1
Inventory: Merchandise: UPC 123456		10,500
	Cash		10,500

 

1/2/X1 | 2.1.X1
Cash		40
	Revenue: Merchandise		40.
Cost of merchandise sold		21
	Inventory: Merchandise: UPC 123456		21

Periodic method

1/1/X1, XYZ had 250 units of merchandise #123 (acquired in X0 for 10 each) in stock. 1/5/X1, it acquired 500 units of merchandise #234 for 25 each. 1/15/X1, it acquired 700 units of merchandise #123 for 10 each. 1/30/X1, it acquired 1,000 units of merchandise #456 for 30 each.

Dr/Cr

1/5/X1 | 5.1.X1
Inventory: Purchases: Merchandise: 234		12,500
	Accounts payable		12,500

 

Purchases is a temporary account that must to be closed at the end of each period.

Permanent (balance sheet) accounts are not closed at the end of the period and so their balance is taken to the balance sheet. In contrast, temporary accounts are closed at the end of each period and no balance to be taken to the balance sheet remains.

Since IFRS and US GAAP do not provide any guidance on the accounts to be used in the bookkeeping process, companies are free to set up any number of temporary accounts.

Its purpose is to match revenue and expenses.

IAS 2.34 states: When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised. ...

While less explicit, ASC 330-10-10-1 states: A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.

Since this guidance does not allow inventory to be expensed as acquired, when a periodic inventory method is used, a temporary Purchases account needs to be set up.

1/15/X1 | 15.1.X1
Inventory: Purchases: Merchandise: 123		7,000
	Accounts payable		7,000

 

1/30/X1 | 30.1.X1
Inventory: Purchases: Merchandise: 456		30,000
	Accounts payable		30,000

 

1/2/X1, it sold 2 units of #123 for 20. 1/7/X1, it sold one unit of #234 for 50 and three of #123 for 20.

1/2/X1 | 2.1.X1
Cash		40
	Revenue: Merchandise		40

 

1/7/X1 | 7.1.X1
Cash		110
	Revenue: Merchandise		110

 

During January, records showed that 800 units of #123, 300 of #234 and zero of #456 had been sold.

 

#	Units acquired	Units sold	Unit price	Purchases	Sales	Inventory
	A	B	C	D = A x C	E = B x C	F = B + E
123	700	(800)	10	7,000	(8,000)	(1,000)
234	500	(300)	20	12,500	(7,500)	5,000
456	1,000	0	30	30,000	0	30,000
					(15,500)	34,000

1/31/X1 | 31.1.X1
Cost of merchandise sold		15,500
Inventory: Merchandise: 234		5,000
Inventory: Merchandise: 456		30,000
	Inventory: Purchases: Merchandise: 123		7,000
	Inventory: Purchases: Merchandise: 234		12,500
	Inventory: Purchases: Merchandise: 456		30,000
	Inventory: Merchandise: 123		1,000

 

 

XYZ's policy is to make these adjustments at the end of each month.

A different periodicity, for example each quarter, would also be acceptable.

Same facts except, XYZ recognized purchases directly to cost of sales.

1/2/X1 | 2.1.X1
Cash		40
	Revenue: Merchandise		40

 

1/5/X1 | 5.1.X1
Cost of merchandise sold		12,500
	Accounts payable		12,500

 

1/7/X1 | 7.1.X1
Cash		110
	Revenue: Merchandise		110

 

1/15/X1 | 15.1.X1
Cost of merchandise sold		7,000
	Accounts payable		7,000

 

1/30/X1 | 30.1.X1
Cost of merchandise sold		30,000
	Accounts payable		30,000

 

At the end of the period, it adjusted cost of sales (caveat).

 

#	Beginning	Purchases	Ending	Cost of Sales	Change
	A	B	C	D = A + B + C	E = B - D
123	2,500	7,000	(1,500)	8,000	(1,000)
234	0	12,500	(5,000)	7,500	5,000
456	0	30,000	(30,000)	0	30,000
	2,500	49,500	(36,500)	15,500	34,000

This procedure is not consistent with the explicit guidance provided by either IFRS or US GAAP.

Nevertheless, if adequate adjustments are made, the result would not be inconsistent with the intent of the guidance.

An more detailed discussion is provided in the next section: Nature of expense, function of expense.

1/31/X1 | 31.1.X1
Inventory: Merchandise: 234		5,000
Inventory: Merchandise: 456		30,000
	Cost of merchandise sold		34,000
	Inventory: Merchandise: 123		1,000

Retail method

XYZ is a retailer. 12/31/X0, its merchandise inventory stood at 240,000. During X1, it made purchases of 3,000,000 and sales of 4,500,000. 12/31/X1, its merchandise on hand, measured at retail price, was 480,000. To determine inventory cost, it applied retail method using its standard retail mark-up of 50%.

IAS 2.21: Techniques for the measurement of the cost of inventories, such as the standard cost method or the retail method, may be used for convenience if the results approximate cost. ...

ASC 330-10-30-13: In some situations, a reversed mark-up procedure of inventory pricing, such as the retail inventory method, may be both practical and appropriate. ...

Its inventory on 12/31/X0 had been 240,000.

Dr/Cr

1/1/X1 - 31.12.X1 | 1.1.X1 - 31.12.X1
Cash, Bank cards, etc.		4,300,000
	Cash, Payables		4,300,000
Inventory: Merchandise: Purchases		3,000,000
	Cash, Payables		3,000,000

 

12/31/X1 | 31.12.X1
Cost of merchandise sold		2,920,000
Inventory: Merchandise		320,000
	Inventory: Merchandise: Purchases		3,000,000

 

2,920,000 = 240,000 + 3,000,000 - 320,000

320,000 = 480,000 ÷ (1+50%)

In more detail:

XYZ's stock on hand at at 12/31/X1:

Item #	Units in stock	Unit price	Merchandise at retail	Adjusted to cost
	A	B	C = A x B	D = C ÷ (1 + 50%)
Merch.1	538	80.35	43,230	28,820
Merch.2	269	285.70	76,854	51,236
Merch.3	65	665.00	43,225	28,816
Merch.4	262	329.66	86,370	57,580
Merch.5	91	529.08	48,146	32,097
Merch.6	97	738.88	71,672	47,781
Merch.7	168	285.70	47,998	31,999
Merch.8	184	339.71	62,506	41,671
			480,000	320,000

 

12/31/X1 | 31.12.X1
Cost of merchandise sold		2,920,000
Inventory: Merchandise: Merch. 1		28,820
Inventory: Merchandise: Merch. 2		51,236
Inventory: Merchandise: Merch. 3		28,816
Inventory: Merchandise: Merch. 4		57,580
Inventory: Merchandise: Merch. 5		32,097
Inventory: Merchandise: Merch. 6		47,781
Inventory: Merchandise: Merch. 7		31,999
Inventory: Merchandise: Merch. 8		41,671
	Inventory: Merchandise Merch. 1		24,052
	Inventory: Merchandise Merch. 2		12,425
	Inventory: Merchandise Merch. 3		27,053
	Inventory: Merchandise Merch. 4		57,287
	Inventory: Merchandise Merch. 5		27,040
	Inventory: Merchandise Merch. 6		29,303
	Inventory: Merchandise Merch. 7		25,000
	Inventory: Merchandise Merch. 8		37,840
	Inventory: Merchandise: Purchases		3,000,000

 

	At 12/31/X0
Item #	Units	Purch. Price	Sales price	Stock value
	A	B	C = A x B	D=C÷(1+50%)
Merch. 1	450	80.17	36,078	24,052
Merch. 2	68	274.07	18,637	12,425
Merch. 3	61	665.23	40,579	27,053
Merch. 4	259	331.78	85,931	57,287
Merch. 5	78	520.00	40,560	27,040
Merch. 6	59	745.00	43,955	29,303
Merch. 7	150	250.00	37,500	25,000
Merch. 8	172	330.00	56,760	37,840
			360,000	240,000

For illustration purposes, only a single, annual adjustment is shown.

Production

Full absorption costing

Full absorption costing (a.k.a. absorption costing or full costing) captures all of the costs that go into manufacturing a product (or providing a service).

These costs are subclassified as direct and indirect (a.k.a. overhead).

Direct costs are be further subclassified as direct material and direct wages while overhead as fixed (rent, depreciation, amortization, insurance, etc.) and variable (supervisor salaries, production supplies, utilities, quality control, repairs and maintenance, etc.)

Fixed does not necessarily mean linear.

For example, depreciation calculated using a diminishing balance method is still considered fixed. The difference between fixed and variable is that the latter correlates with production levels while the former does not.

Some overhead costs are, by their nature, always variable. For example the coke used to smelt iron or electricity used to power production machines.

Other overhead costs, for example supervisor salaries or maintenance, can be either fixed or variable (or a combination) depending on how they are determined.

For example, some companies compensate supervisors with fixed salary, at others a wage, while still others pay out bonuses when extra work calls for extra hours. Similarly, production managers can also receive bonuses during times of extra high production.

Costs like waste removal are also generally fixed, but can be subject to surcharges when extra heavy production leads to extra waste.

Maintenance of production buildings tends to be fixed, while maintenance of production machinery variable.

The proper allocation of overheads thus requires both judgment and an accounting system sufficiently flexible to cope with the variations.

While neither IFRS nor US GAAP use the term “full absorption costing” both require its use.

IAS 2.10: 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.

IAS 2.12: ... [costs of conversion] include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. 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, equipment and right-of-use assets used in the production process, and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour.

While its guidance is not nearly as detailed, US GAAP's requirements are the same.

ASC 330-10-30-1: The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. It is understood to mean acquisition and production cost, and its determination involves many considerations.

The following examples illustrate several ways to achieve full absorption costing in manufacturing. Other methods, such as project accounting, are shown in the next section (see: Receivables and revenue).

Nature of expense, function of expense

As noted in the COA release notes (see: Basic Universal COA), using a general ledger including both nature of expense and function of expense classifications makes practical sense.

In this simplified example, XYZ recognizes expenses (by nature) as they occur.

While the general appraoch is simple to illustrate, applying it in practice requires an accounting system that can keep track of both accounts and account attributes.

In addition to the four delimitations used in the expanded COAs (see: Expanded Universal COA), this example uses a comma to designate the nature of the expense and a colon to designate a specific recognized item.

The expanded COAs use a hyphen to designate current / non-current, a forward slash to designate an adjusting account, a semi-colon to designate a financial asset or liability sub-classification and an asterisk to designate a clearing or special account.

Matching expense to revenue is a key IFRS and US GAAP concept, which this example goes against.

While it is true that neither the IFRS nor US GAAP conceptual frameworks specifically define a "matching principle", the concept of matching expense to revenue is the basis for accrual accounting and reflected in numerous standards.

For example, IAS 2.34 states: When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised. ...

While less explicit as to the exact timing of expense recognition, ASC 330-10-10-1 states: A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.

Comparable guidance is provided by IFRS 15 | ASC 340:

IFRS 15.91 | ASC 340-40-25-1 states: An entity shall recognise as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs.

IFRS 15.91 states: If the costs incurred in fulfilling a contract with a customer are not within the scope of another Standard (for example, IAS 2 Inventories, IAS 16 Property, Plant and Equipment or IAS 38 Intangible Assets), an entity shall recognise an asset from the costs incurred to fulfil a contract ...

ASC 340-40-25-5 states: An entity shall recognize an asset from the costs incurred to fulfill a contract ...

Recognizing expenses before the associated revenue, contradicts this guidance even when it is necessary.

While expensing inventoriable costs as they occur is not consistent with the guidance cited above, it is necessary if a nature of expense profit and loss statement is to be presented under IFRS (US GAAP does not allow nature of expense income statement to be presented).

IAS 1.IG6 Part I: Illustrative presentation of financial statements ...

XYZ Group Statement of profit or loss and other comprehensive income (by nature) For the year ended 31 December 20X7
	20X7	20X6
Revenue	390,000	355,000
Other income	20,667	11,300
Changes in inventories of finished goods and work in progress	(115,100)	(107,900)
Work performed by the entity and capitalised	16,000	15,000
Raw material and consumables used	(96,000)	(92,000)
Employee benefits expense	(45,000)	(43,000)
Depreciation and amortisation expense	(19,000)	(17,000)
Impairment of property, plant and equipment	(4,000)	–
Other expenses	(6,000)	(5,500)
Finance costs	(15,000)	(18,000)
Share of profit of associates	35,100	30,100
Profit before tax	161,667	128,000
Income tax expense	(40,417)	(32,000)
Profit for the year from continuing operations	121,250	96,000
Loss for the year from discontinued operations	–	(30,500)
PROFIT FOR THE YEAR	121,250	65,500
–	–	–

Nevertheless, provided adequate adjustments are made, the accounting procedure illustrated in this example would not contradict the overall aim of either IFRS or US GAAP guidance.

As noted above, this procedure is implicit in IFRS's nature of expense income statement.

Also as noted above, US GAAP merely states that "a major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues." It does not address the specific accounting procedure which must be used achieve this objective.

This implies, as long as care is taken to fulfill IFRS's and US GAAP's overall reporting objectives, expensing all costs as they arise and then making adjustments that will lead to them being reported in the same period as the associated revenue would be an acceptable policy, especially in jurisdictions where it would be more cost effective.

The procedure where inventory costs (particularly employee benefits, depreciation and other production overhead) are charged directly to expenses is common under many national GAAPs.

Under these GAAPs, increases or decreases to inventory are then taken to the profit and loss statement and presented as a "change in inventory".

Not only, as noted above, is this procedure is implicit in IFRS's allowing of a nature of expense income statement, it also reduces the number of differences between IFRS/US GAAP and national GAAP at those companies (subsidiaries) which must, in additional to IFRS/US GAAP for financial reporting purposes, also apply national GAAP for statutory and/or taxation purposes.

Besides simplifying accounting, this procedure is also a shortcut, which should help companies avoid having to recognize many transactions twice: once per IFRS/US GAAP and then again per national GAAP.

During the period (i.e. each month), XYZ expenses production costs (it does not rent any production assets).

It buys material for cash and on credit. It accrues wages at month end and pays them after month end. It recognizes depreciation each month. It also recognizes utilities (electricity and natural gas) each month.

Natural gas is pre-paid on a quarterly basis and actual usage is billed at the end of the period. At the end of each month, XYZ estimates its gas usage to determine the monthly expense.

Electricity is also paid on a quarterly basis but the supplier bills actual usage. At the end of each month, XYZ estimates its electricity usage to determine the monthly expense.

This example uses a rent expense account for the amortization of, or rent payments associated with, ROU assets.

A "right of use" asset may or may not be recognized depending on the characteristics of the ROU.

Please go to the Leasing page for illustrations of this issue.

Account The accounts and account numbers used in this example correspond to the accounts and account numbers used in the universal COA which can be downloaded here.		Account #	Debit	Credit
Raw material		5.1.1.2	20,000
Employee benefits		5.1.2	40,000
Depreciation		5.1.4.2	30,000
Utilities		5.1.1.3.4	10,000
	Cash	1.1.1.1.2		5,000
	Accounts payable	2.1.1.1		15,000
	Accrued wages and salaries	2.2.1.1.1		26,000
	Accrued social security tax	2.2.1.1.4.1		8,000
	Accrued health insurance	2.2.1.1.4.2		4,000
	Accrued workers compensation insurance	2.2.1.1.4.4		2,000
	Accumulated depreciation	1.5.(1)		30,000
	Prepaid natural gas	1.4.1.9.1.2.2		6,000
	Accrued electricity	2.2.1.2.1.2.1		4,000

 

This example only includes "short-term employee benefits" which IAS 19.9 defines to include: wages, salaries and social security contributions; paid annual leave and paid sick leave; profit-sharing and bonuses; and non-monetary benefits (such as medical care, housing, cars and free or subsidised goods or services) for current employees.

In some jurisdictions, in addition to social security contributions, healthcare and other similar contributions are also mandated by law.

Although US GAAP (ASC 710-10-30) does not include any guidance on "short-term employee benefits", the accounting would be the same.

However, "There are a number of significant differences between US GAAP and IFRS in the area of accounting for pension and other postretirement and postemployment benefits."

A discussion of these issues is provided here link: PwC.

It also expenses SG&A costs (XYZ only rents SG&A facilities).

Account		Account #	Debit	Credit
Employee benefits		5.1.2	80,000
Rent		5.1.4.1	10,000
Depreciation		5.1.4.2	9,000
Utilities		5.1.1.3.4	1,000
	Cash, Accruals, Accumulated depreciation, etc.	Various numbers		100,000

 

In practice, separate accounts (i.e. Electricity 5.1.1.3.4.1.2.1, Natural Gas 5.1.1.3.4.1.2.2, Water And Sewage 5.1.1.3.4.2, Waste Removal 5.1.1.3.4.3, etc.) would be used for the various utilities.

Since the credits are illustrated in the previous example, they are not shown again.

When XYZ manufacturers a product.

Account		Account #	Debit	Credit
WIP: Product 123, Direct material		1.3.3:123, 5.2.1.1.2.1	80
WIP: Product 123, Direct labor		1.3.3:123, 5.2.1.1.2.2	170
WIP): Product 123, Fixed overhead (depreciation)		1.3.3:123, 5.2.1.2.2.1.1	140
WIP: Product 123, Variable overhead (utilities)		1.3.3:123, 5.2.1.1.2.3.6.2	10
	Raw material	5.1.1.2		80
	Employee benefits	5.1.2		170
	Depreciation	5.1.4.2		140
	Utilities	5.1.1.3.4		10

 

The colon delimits the specific item. In this case, a product model.

The comma delimits the expense classified by its function.

When XYZ finishes a product

Account		Account #	Debit	Credit
Finished goods: Product 123		1.3.4:123	400
	Work in process: Product 123	1.3.3:123		400

 

For illustration, this entry is simplified. The information carried over to finished goods would include:

Finished goods: Product 123, Direct material		1.3.4:123, 5.2.1.1.2.1	80
Finished goods: Product 123, Direct labor		1.3.4:123, 5.2.1.1.2.2	170
Finished goods: Product 123, Depreciation		1.3.4:123, 5.2.1.2.2.1.1	140
Finished goods: Product 123, Utilities		1.3.4:123, 5.2.1.1.2.3.6.2	10

When XYZ sells a product:

Account		Account #	Debit	Credit
Trade accounts receivable		1.2.1.1	800
Cost of sales (cost of products sold)		5.2.1.1.2	400
	Finished goods: Product 123	1.3.4:123		800
	Revenue (products)	4.1.1.2		400

 

For illustration, this entry is simplified. The information carried over to the cost of sales schedule would include:

Cost of sales (direct material)		5.2.1.1.2.1	80
Cost of sales (direct wages)		5.2.1.1.2.2	170
Cost of sales (fixed overhead, depreciation)		5.2.1.2.2.1.1	140
Cost of sales (variable overhead, utilities)		5.2.1.1.2.3.6.2	10

During the period, XYZ sold goods that had cost a total of 95,000 to produce (raw material 19,000, employee benefits 38,000, depreciation 28,500 and utilities 9,500).

At the end of the period, it recognized the change in inventory.

An IFRS nature of expense profit and loss statements includes an Increase (decrease) in inventories of finished goods and work in progress line item.

IFRS allows entities to present either nature of expense or function of expense P&Ls.

IAS 1.105: The choice between the function of expense method and the nature of expense method depends on historical and industry factors and the nature of the entity. ... this Standard requires management to select the presentation that is reliable and more relevant...

When a company presents a function of expense P&L because it is more reliable and more relevant, it should also present additional nature of expense information in the footnotes.

IAS 1.104: An entity classifying expenses by function shall disclose additional information on the nature of expenses, including depreciation and amortisation expense and employee benefits expense.

US GAAP does not allow entities to present nature of expense income statements.

IAS 1.IG6 Part I: Illustrative presentation of financial statements ...

XYZ Group Statement of profit or loss and other comprehensive income (by nature) For the year ended 31 December 20X7
	20X7	20X6
Revenue	390,000	355,000
Other income	20,667	11,300
Changes in inventories of finished goods and work in progress	(115,100)	(107,900)
Work performed by the entity and capitalised	16,000	15,000
Raw material and consumables used	(96,000)	(92,000)
Employee benefits expense	(45,000)	(43,000)
Depreciation and amortisation expense	(19,000)	(17,000)
Impairment of property, plant and equipment	(4,000)	–
Other expenses	(6,000)	(5,500)
Finance costs	(15,000)	(18,000)
Share of profit of associates	35,100	30,100
Profit before tax	161,667	128,000
Income tax expense	(40,417)	(32,000)
Profit for the year from continuing operations	121,250	96,000
Loss for the year from discontinued operations	–	(30,500)
PROFIT FOR THE YEAR	121,250	65,500
–	–	–

This item reflects the procedure used when preparing this P&L, which involves expensing costs prior to recognizing revenue as outlined above.

Note: the same general procedure is used for self-manufactured assets and presented in the Other work performed by entity and capitalized line item.

Since US GAAP does not allow nature of expense income statements to be presented, these would be adjustment made at the G/L level only, and would never be reported in a US GAAP financial statement.

Account		Account #	Debit	Credit
Increase (decrease) in inventories of finished goods and WIP		5.1.5	5,000
	Raw Material	5.1.1.2		1,000
	Employee Benefits	5.1.2		2,000
	Depreciation	5.1.4.1.2		1,500
	Depreciation	5.1.4.1.2		500

 

As US GAAP does not allow entities to present nature of expense income statements, this item is never taken to a US GAAP income statement.

Then, it took the change to the balance sheet.

Account		Account #	Debit	Credit
Raw Material		1.3.2	1,000
Work in process		1.3.3	3,500
Finished goods: Product 123		1.3.4:123	500
	Increase (decrease) in inventories of finished goods and WIP	5.1.5		5,000

 

For illustration, this entry is simplified. The information carried over to inventory would include:

Raw Material (direct material)		1.3.2, 5.1.1.2	50
Work in process (direct wages)		1.3.3, 5.1.2	150
Work in process (depreciation)		1.3.3, 5.1.4.1.2	200

 

In the next period, its raw material and WIP accounts would have the above opening balances.

Finally, XYZ recognized its SG&A expenses by function.

Account		Account #	Debit	Credit
Sales payroll		5.2.2.1.1.1, 5.1.2	35,000
Rent of sales equipment and facilities		5.2.2.1.1.2.1, 5.1.4.1	5,000
Depreciation of sales equipment and facilities		5.2.2.1.1.2.2, 5.1.4.2	4,000
Utilities (retail outlets)		5.2.2.1.1.3.4, 5.1.1.3.4	600
General and administrative payroll		5.2.2.2.1, 5.1.2	45,000
Rent of office equipment and facilities		5.2.2.2.6.1, 5.1.4.1	6,000
Depreciation of office equipment and facilities		5.2.2.2.6.2 , 5.1.4.2	4,000
Utilities (offices)		5.2.2.2.5.7, 5.1.1.3.4	400
	Employee benefits	5.1.2		80,000
	Rent	5.1.4.1		11,000
	Depreciation	5.1.4.2		8,000
	Utilities	5.1.1.3.4		1,000

 

Although less precise, the same general result can be achieved using function of expense accounts only.

Unlike in the previous example, rather recognize production by nature, XYZ charges them directly to cost of sales.

As noted above, this procedure is implicitly allowed by IFRS.

The process of initially expensing conversion costs then subsequently capitalizing them by adjusting net income is implicit in IFRS's nature of expense profit and loss statement.

IAS 1.IG6 Part I: Illustrative presentation of financial statements ...

XYZ Group Statement of profit or loss and other comprehensive income (by nature) For the year ended 31 December 20X7
	20X7	20X6
Revenue	390,000	355,000
Other income	20,667	11,300
Changes in inventories of finished goods and work in progress	(115,100)	(107,900)
Work performed by the entity and capitalised	16,000	15,000
Raw material and consumables used	(96,000)	(92,000)
Employee benefits expense	(45,000)	(43,000)
Depreciation and amortisation expense	(19,000)	(17,000)
Impairment of property, plant and equipment	(4,000)	–
Other expenses	(6,000)	(5,500)
Finance costs	(15,000)	(18,000)
Share of profit of associates	35,100	30,100
Profit before tax	161,667	128,000
Income tax expense	(40,417)	(32,000)
Profit for the year from continuing operations	121,250	96,000
Loss for the year from discontinued operations	–	(30,500)
PROFIT FOR THE YEAR	121,250	65,500
–	–	–

 

To get around the logical inconsistence of allowing a profit and loss statement format that contradicts the guidance provided in paragraph 34, IAS 2.39 states: "Some entities adopt a format for profit or loss that results in amounts being disclosed other than the cost of inventories recognised as an expense during the period. Under this format, an entity presents an analysis of expenses using a classification based on the nature of expenses. In this case, the entity discloses the costs recognised as an expense for raw materials and consumables, labour costs and other costs together with the amount of the net change in inventories for the period.

IAS 2.34 When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised.

Nevertheless, IFRS and US GAAP guidance does require these costs to be first capitalized and expensed only after (when) the inventory is sold.

IAS 2.34 states: When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised. ...

While less explicit as to the exact timing of expense recognition, ASC 330-10-10-1 states: A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.

Comparable guidance is provided by IFRS 15 | ASC 606:

IFRS 15.91 | ASC 340-40-25-1: An entity shall recognise as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs.

IFRS 15.91: If the costs incurred in fulfilling a contract with a customer are not within the scope of another Standard (for example, IAS 2 Inventories, IAS 16 Property, Plant and Equipment or IAS 38 Intangible Assets), an entity shall recognise an asset from the costs incurred to fulfil a contract ...

ASC 340-40-25-5 An entity shall recognize an asset from the costs incurred to fulfill a contract ...

However, if care is taken to make the proper adjustments, this procedure would not be an error.

Fortunately, while IFRS and US GAAP do provide what seems like procedural guidance, in the end, both focus on reporting not accounting.

This implies, provided the proper adjustments (backing out the costs prematurely recognized as expenses) are made, the result would be inconsistent with gist of the guidance even if not its letter.

Expensing production costs as they are incurred is common practice under many national GAAPs.

The procedure where inventory costs (particularly employee benefits, depreciation and other production overhead) are charged directly to expenses is common under many national GAAPs.

Under these GAAPs, increases or decreases to inventory are then taken to the profit and loss statement where they are generally presented as "changes in inventory", an adjustment to expenses.

This procedure is (implicitly) allowed by IFRS.

The process of initially expensing conversion costs then subsequently capitalizing increases in inventory by recognizing income, rather than reducing the expenses, is implicit in IFRS's nature of expense profit and loss statement where changes in inventory line item can have either a debit or a credit balance.

IAS 1.IG6 Part I: Illustrative presentation of financial statements ...

XYZ Group Statement of profit or loss and other comprehensive income (by nature) For the year ended 31 December 20X7
	20X7	20X6
Revenue	390,000	355,000
Other income	20,667	11,300
Changes in inventories of finished goods and work in progress	(115,100)	(107,900)
Work performed by the entity and capitalised	16,000	15,000
Raw material and consumables used	(96,000)	(92,000)
Employee benefits expense	(45,000)	(43,000)
Depreciation and amortisation expense	(19,000)	(17,000)
Impairment of property, plant and equipment	(4,000)	–
Other expenses	(6,000)	(5,500)
Finance costs	(15,000)	(18,000)
Share of profit of associates	35,100	30,100
Profit before tax	161,667	128,000
Income tax expense	(40,417)	(32,000)
Profit for the year from continuing operations	121,250	96,000
Loss for the year from discontinued operations	–	(30,500)
PROFIT FOR THE YEAR	121,250	65,500
–	–	–

 

To get around the logical inconsistence of allowing a profit and loss statement format that contradicts the guidance provided in paragraph 34, IAS 2.39 states: "Some entities adopt a format for profit or loss that results in amounts being disclosed other than the cost of inventories recognised as an expense during the period. Under this format, an entity presents an analysis of expenses using a classification based on the nature of expenses. In this case, the entity discloses the costs recognised as an expense for raw materials and consumables, labour costs and other costs together with the amount of the net change in inventories for the period.

IAS 2.34 When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised.

A similar procedure is also used to "capitalize" asset accusation costs, in that the costs to self-produce assets are initially recognized as expenses, then subsequently "capitalized" by recognizing work performed by the entity as income.

As US GAAP does not allow companies to publish nature of expense income statements, nor does it acknowledge the physical concept of capital maintenance, neither procedure is acceptable under US GAAP.

In contrast, IFRS and US GAAP guidance requires these costs to be first capitalized (recognized as assets, in this case inventory), and expensed only after (when) the products are sold.

IAS 2.34 states: When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised. ...

While less explicit as to the exact timing of expense recognition, ASC 330-10-10-1 states: A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.

Comparable guidance is provided by IFRS 15 | ASC 606:

IFRS 15.91 | ASC 340-40-25-1: An entity shall recognise as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs.

IFRS 15.91: If the costs incurred in fulfilling a contract with a customer are not within the scope of another Standard (for example, IAS 2 Inventories, IAS 16 Property, Plant and Equipment or IAS 38 Intangible Assets), an entity shall recognise an asset from the costs incurred to fulfil a contract ...

ASC 340-40-25-5 An entity shall recognize an asset from the costs incurred to fulfill a contract ...

Nevertheless, if care is taken to make the proper adjustments, this procedure would not be an error.

Fortunately, while they do provide some procedural guidance, IFRS and US GAAP focus on reporting not accounting.

This implies, as long as the proper adjustments, backing out the costs prematurely recognized as expenses, are made, the result would be consistent with gist of the guidance even if not (as discussed above ) its letter.

The primary aim this shortcut is to avoid having to recognize individual transactions separately once per IFRS/US GAAP and then again per national GAAP.

This shortcut thus obviates the need for a separate IFRS/US GAAP / National GAAP book and not only saves time and effort, but also reduces the potential for mistakes when the same transaction is recognized twice, one per IFRS/US GAAP and then again per national GAAP.

Dr/Cr

During the first quarter XYZ recorded the following transactions and accruals.

Sales

Cash, Receivables		2,000,000
	Revenue		2,000,000

 

Raw material purchases

Cost of goods sold: direct materials		130,000
	Cash, Payables		130,000

 

Vender discount on raw material purchases

Cash, Receivables		10,000
	Cost of goods sold: direct materials		10,000

 

Production supply and consumable purchases

Cost of goods sold: supplies, consumables		20,000
	Cash, Payables		20,000

 

Production worker wages

Cost of goods sold: wages and salaries		250,000
	Cash, Accrued payroll		250,000

 

Supervisor's salaries

Cost of goods sold: wages and salaries		75,000
	Cash, Accrued payroll		75,000

 

Utilities

Cost of goods sold: production overhead		85,000
	Cash, Payables		85,000

 

Accrual for repairs and maintenance

Cost of goods sold: production overhead		80,000
	Repairs and maintenance allowance		80,000

 

Rent

Cost of goods sold: production overhead		170,000
	Cash		170,000

 

Depreciation

Cost of goods sold: production overhead		200,000
	Accumulated Depreciation, amortization		200,000

 

At the end of the quarter, XYZ reviewed its inventory, evaluated the changes and adjusted cost of sales:

Inventory balance at:	1/1/X1	3/31/X1	Change
	A	B	C = A - B
Raw material	100,000	120,000	20,000
Production supplies	20,000	10,000	(10,000)
Work in process	50,000	100,000	50,000
Finished goods	40,000	20,000	(20,000)
	210,000	250,000	40,000

31/3/X1/ 31.3.X1
Inventory: Raw materials		20,000
Inventory: WIP		50,000
	Inventory: Supplies & consumables		10,000
	Inventory: Finished goods		20,000
	Cost of goods sold		40,000