IAS 2 - Inventory

1. IAS 2 - Inventory

2. Executive summary IFRS does not permit the LIFO method of costing inventory, unlike US GAAP. IFRS reports inventory at the lower of cost or net realizable value (LCNRV).  US GAAP reports inventory at the lower of cost or market (LCM), where market is defined as a replacement cost with a floor (NRV less normal profit margin) and a ceiling (NRV). IFRS allows reversals of prior inventory write-downs to be made and recognized in income, unlike US GAAP. Inventory is recognized when risk and rewards pass to entity under both US GAAP and IFRS.

3. Physical goods and costs included in inventory US GAAP IFRS Costs include productions costs, conversion costs and purchase costs. Similar Cost includes freight-in. Similar Interest must generally be capitalized. Similar, although certain conditions must be met.

4. Cost flow assumptions US GAAP • Different cost flow assumptions may be used for inventory with a similar nature and use. • LIFO method is allowed: • The IRS has a conformity rule that requires LIFO to be used for book purposes if it is used for tax purposes. IFRS • The same cost flow assumptions must be used for inventory with a similar nature and use even if inventory is held in different geographic locations and/or by different entities. • LIFO method is not allowed: • This is significant to some companies because of taxation implications. If IFRS is adopted with no changes made in the current standards and the current tax laws, then companies will have to pull the LIFO reserve back into their taxable income over a four-year period.

5. Cost flow assumptions Analysis of companies as of 2009: • Exxon had a reserve of $17.1 billion in 2009 and $10.0 billion in 2008. In 2009, this was 65% of Exxon’s operating income, 89% of its net income and 7% of its assets. • Keystone Consolidated Industries had a reserve balance that was 6 times its operating income and 79.8 times its net income in 2009. *Inventory is the LIFO inventory with the reserve added back. Analysis of companies as of 2009 using Compustat: 6,565 companies in the sample of which 4,564 companies had inventory of which 318 companies had a LIFO reserve.

6. US GAAP Reports at the LCM: Market is defined as replacement cost with a floor (NRV less normal profit margin) and a ceiling (NRV). NRV is defined as the estimated selling price less the estimated costs of completion and sale. Reversals of prior write-downs are not allowed. Lower of cost or market IFRS • Reports at the lower of cost or net realizable value (LCNRV): • NRV is defined as the estimated selling price less the estimated costs of completion and sale. • Since replacement cost would typically be less than NRV, IFRS will generally result in lower write-downs than US GAAP. • Reversals of prior write-downs can be made and recognized in income.

7. US GAAP Write-down can be done using an item-by-item, group-by-group or on a total inventory basis. Lower of cost or market IFRS • Write-downs are typically done on an item-by-item basis: • Group-by-group basis is allowed under certain circumstances. • Since most companies in the US use an item-by-item basis, significant differences are not expected.

8. US GAAP Write-downs must be included as expense: ASC 420-10-S99-3, Exit or Disposal Cost Obligations – Overall – SEC Materials,states that inventory write-downs should be included in cost of goods sold even when related to an exit or restructuring cost. ASC 330-10-50-2, Inventory – Overall – Disclosure, states that if “substantial and unusual losses” result from the LCM rule then the loss amount should not be included in cost of goods sold on the income statement. Lower of cost or market IFRS • Write downs and reversals of write-downs must be included as expense, but a particular expense account is not specified.

9. Example 1 – inventory write-down Part 1:On December 31, 2009, Jets International had an inventory of five different types of airplane parts. Given the current fuel costs, airplane parts are not as valuable as they once were. The chart on the next slide provides the cost basis, net realizable value, replacement cost and net realizable value less normal profit margin as of December 31, 2009. Jets International prepares its inventory valuation comparisons on an item-by-item basis. Inventory write-down example • What is the amount of write-down (if any) required using US GAAP? Please provide the necessary journal entry. • What is the amount of write-down (if any) required using IFRS? Please provide the necessary journal entry.

10. Inventory write-down example Part 1 (continued):

11. Inventory write-down example Example 1: Part 1 solution:

12. Part 1 solution (continued): US GAAP: IFRS: Original cost $ 58,000 Original cost $ 58,000 LCM 50,000 LCNRV 52,000 Write-down $ 8,000 Write-down $ 6,000 US GAAP journal entry: IFRS journal entry: CGS $8,000 Inventory write-down expense $6,000 Inventory $8,000 Inventory valuation allowance $6,000 The amount of inventory write down in this example is $8,000 using US GAAP because the LCM is less than the original cost. The amount is to be recorded in the income statement to CGS and directly to inventory because a future reversal of write-downs is not permitted.Using IFRS, the write-down is $6,000 because the LCNRV is less than the original cost. The write-down is not required to be recorded in a specific income statement account. A valuation allowance is used because future reversals of write-downs are permitted. Inventory write-down example

13. Inventory write-down reversal example Example 1 – write-down reversal Part 2:The airline industry’s business was so terrible during 2010 that Jets International still had the same five parts in its inventory as of December 31, 2010. However, fuel prices have decreased, so the outlook is more optimistic. As of the end of the year, Jets International’s original cost basis, net realizable value, replacement cost and net realizable value less the normal profit are as shown on the next slide. • What is the amount of write-down reversal (if any) required using US GAAP? Please provide the necessary journal entry. • What is the amount of write-down reversal (if any) required using IFRS? Please provide the necessary journal entry.

14. Inventory write-down reversal example Part 2 (continued):

15. Inventory write-down reversal example Example 1: Part 2 solution:

16. Inventory write-down reversal example Part 2 solution (continued): No reversal of a write-down is permitted using US GAAP. IFRS: December 31, 2010 LCNRV $ 56,000 December 31, 2009 LCNRV 52,000 Write-down $ 4,000 Journal entry: Inventory valuation allowance $4,000 Inventory write-down expense $4,000 Since the LCNRV at December 31, 2010 exceeds the LCNRV at December 31, 2009 by $4,000, this amount is recorded as a reversal to the previous write-down.

17. Disclosures US GAAP IFRS Basis upon which amounts are stated (e.g., LCM) and costing method Similar Carrying amounts by classification Similar Inventory financing arrangements Similar

18. US GAAP Requires disclosure of the amount of write-downs recognized as expense. Various required disclosures when a firm uses the LIFO costing method (e.g., the LIFO reserve or replacement cost must be disclosed). Disclosures IFRS • Requires disclosure of both the amount of write-downs recognized as expense and any reversal of write-downs. • No required disclosures related to LIFO method since LIFO is not allowed.