Accounting for Inventories 

Standards

Accounting for Inventories

An AcSB exposure draft provides guidance on inventory reporting.

FROM: JAN-FEB 2007 ISSUE | BY STEPHEN SPECTOR

In June 2006, the Accounting Standards Board (AcSB) issued an exposure draft to replace current Section 3030, Inventories, in light of the fact that international and U.S. generally accepted accounting principles (GAAP) provide more extensive guidance than Canadian GAAP. The International Accounting Standards Board (IASB) had issued revised guidance in December 2003 (International Financial Reporting Standard IAS 2, Inventories), and the U.S. Financial Accounting Standards Board (FASB) had issued Statement of Financial Accounting Standards No. 151, ( Inventory Costs — an amendment of ARB No. 43, Chapter 4), in November 2004, to eliminate one of the existing differences from IAS 2 by clarifying that abnormal amounts of idle capacity and spoilage costs should be excluded from the cost of inventory and expenses.

The revised section, 3031, is expected to provide more explicit guidance regarding the manner in which inventories are accounted for. It is also the first section to reflect the AcSB’s strategic goal of adopting IASB standards for publicly accountable enterprises. With the exception of material addressing not-for-profit entities (which neither the IASB nor the FASB deal with), Section 3031 will be fully converged with IAS 2 and FASB 151 with the following three exceptions:

• The use of the LIFO method of cost determination will no longer be acceptable in Canada but is permitted under U.S. GAAP.
• U.S. GAAP requires inventories to be carried at the lower of cost and market where the definition of market is not the same as “net realizable value.”
• The requirement to reverse previous write-downs when the value of inventories subsequently increases is prohibited in U.S. GAAP.

The proposals will apply to all inventories of all entities, including not-for-profit organizations, except:

• Work in progress arising under construction contracts, including directly related service contracts;
• Financial instruments; and
• Contributions not recognized by not-for-profit organizations in accordance with paragraph 4410.16.

In addition, there will be a scope exemption from the measurement — but not the disclosure — requirements for agricultural inventories up to and including the point of harvest. The measurement exemption also applies to 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 in accordance with well-established practices, and to commodity broker-traders who measure their inventories at fair value less costs to sell.

The proposals represent a significant improvement to Canadian GAAP. The AcSB believes that many entities will encounter significant changes in accounting and reporting for inventories, including the following:

• Measurement of inventories — The proposals require measurement at the lower of cost and net realizable value for inventories within their scope, except for certain specified inventories. Currently, entities are not required to measure their inventories at the lower of cost and net realizable value, although most use a lower of cost and market approach. The proposals include the retail method as an acceptable technique for measuring the cost of inventories if the results approximate cost. However, the technique described could result in a significant change to current practice for entities using such a method.
• Determination of cost — The proposals provide more extensive guidance on the determination of cost, including the allocation of overheads. Use of the LIFO basis of cost determination will no longer be permitted. Determination of cost could change as a result of the guidance in the proposals.
• Reversal of impairment write-downs — The proposals require recognition of a reversal of a previous write-down of inventories arising from an increase in net realizable value. Canadian GAAP does not provide for this.
• Disclosure — The proposals require more extensive disclosure than currently required or generally provided to help users understand the significance and effect of inventories on financial statements.

Specifically, Section 3031 will require:

• Measurement of inventories at the lower of cost and net realizable value — rather than the ambiguous term “market.”
• Allocation of fixed production overhead based on normal capacity levels, with unallocated overhead expensed as incurred.
• The cost of inventories of items that are not ordinarily interchangeable, and goods or services produced and segregated for specific projects, is to be assigned by identification of their individual costs.
• Consistent use (by type of inventory) of either FIFO or weighted average cost formula to measure the cost of other inventories. LIFO will be proscribed.
• Reversal of previous write-downs to net realizable value when there is a subsequent increase in the value of inventories.
• Disclosure of accounting policies, carrying amounts, amounts recognized as an expense, write-downs, and amount of any reversal of any write-downs recognized as a reduction in expenses.

The convergence of Canadian GAAP with International Financial Reporting Standards will occur over a transitional period currently expected to be about five years. Introducing the Canadian equivalent of IAS 2 at this time provides the opportunity for publicly accountable enterprises to ensure conformity with this international standard now, rather than at the end of the transitional period. There will be no transitional provisions, so Section 1506 will apply.

For non-publicly accountable enterprises, there are no differential reporting options specified in the exposure draft. Therefore, the provisions will apply equally to all entities. However, the AcSB is undertaking a comprehensive examination of the needs of the users of these enterprises’ financial statements. Once this examination is complete, the AcSB will determine and implement an appropriate financial reporting model to meet these needs, which may affect the applicability of Section 3031 to non-publicly accountable enterprises, or the timing of its application to these enterprises.

The AcSB expects to issue a final standard in the first quarter of 2007 that will be effective for interim and annual financial statements for fiscal years beginning on or after July 1, 2007, with earlier application encouraged.

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Stephen Spector, MA, FCGA, owns Spector and Associates and teaches Financial and Managerial Accounting at Simon Fraser University. He also serves on CGA-BC’s board of governors. E-mail shspector@shaw.ca.