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Key Topics
Requirement
There is a note to the financial statements saying we have chosen to adopt the cost method for valuing assets. Our auditors recommended we move to the fair value method but we have always thought the cost method better met the qualitative characteristics of good financial information. We need some advice on this before making any changes.
Solution
As per IAS -2 the accounting treatment of Inventories not only includes the cost so determined for the inventories but it also includes the cost subsequent to the recognition of any of such expenses or any amount that will be written down to net realizable value (Walton et al, 2003).
As the definition suggest that the cost of inventories includes all the cost of purchase and conversion so these cost has to be taken into accounts while determining the cost value of the inventory (Holthausen & Watts, 2001). But the same needs to be measured at the lower of Cost and net realizable value.
IAS/IFRS further suggests that though the cost of inventories is determined by using FIFO or weightage average formula but the same has to be written down to NRV on an item by item basis, unless the same is more appropriate to any of the related items.
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Inventories can be accountable by three modes; FIFO, LIFO and weighted average method. So, different GAAP rules have different prospective about adopting the methods of inventory accountable modes. Once the same is decided then the policy over inventory valuation is decided. The same can be cost method, market value or Net realizable value. Usually GAAP suggests the lesser of cost or market value is to be taken as the inventory value and should be recorded in the books of accounts. But if someone is adopting the net realizable value as well then they are adopting the policy of FASB, which is also being considered as per the GAAP discipline (Parker & Morris, 2001).
Accounting Methods:
If a company is literally focusing on the "periodic income" then the company should adopt the FIFO or weighted average cost method to the company books of accounts.
Given scenario:
Company is interested to adopt the cost method for valuing assets but the auditors are of the opinion that it should be fair value method. So company needs to understand which should be taken and what relevant changes needs to be adopted.
Action to be taken:
As per GAAP rules, the market price is taken because in case of sale or in case of liquidation the same will be taken. So, if we take the cost value in the books of accounts then it will mislead the actual value of the inventory. In case the company sells the inventory at the higher the amount prevailing in the market then it will overstate the profit in the books of accounts. On a contrary note, the loss will be reflected less if the inventory is recorded at a value than the market value.
If the books of accounts records the market value of the inventory then the actual value of the inventory will be shown and in case of sale or liquidation the same will be reflected actual value. So, in order to reflect the correct profit value on the sale amount the same should be recorded at market value so that the value shown in the books of accounts will not mislead to the stakeholders.
In case the company records the value of inventories at cost then later on the profit/loss should have to re-state and it will mislead to the stakeholders about the valuation of the books of accounts. Further if there any change in the price list of the inventory or plans to estimate more of the value of profit and estimated to increase the value of production then also the company will take lower value of inventory as it has recorded cost value only (IFRS, 2017). So, it will also leads to record the lower profit amount.
But if the company records the value at market value, they just need to pass a journal entry in the books of accounts by crediting the revaluation reserve or the figure that is above the cost value. It will be effectively recorded at debit amount if the same is lower and revalued at lower cost. So in that case it will be revaluation loss to the inventory (Delaney et al, 2003). After doing this accounting treatment, the company will give the reason of such change in the books of accounts as a part of notes to accounts, where they need to give the reason of such change from cost to market value. Though the auditor have suggested to show the value at market value but still the notes to accounts should have fact full reason to record the same.
After the Notes to Accounts the company can record the values at market value and the over/understated value will effect the reverse and surplus account so the same amount needs to be transferred to assets side too and thus the value of current assets will also increase/decrease with the proportionate increase/decrease in the value of inventory.
So, on the conclusion note, it can be recorded that the company have to record the value of inventories at cost or market value which ever is lower. The vary reason for this is to give better presentation as per the GAAP discipline and this will not only benefit the company in case of liquidation or sale of such inventories but also increase the value of assets i.e. financial position of the company (KPMG, 2015). If the same has been recorded at the cost then the value of assets shows the lower value but the same is not so low and thus the stakeholders will identify and determine the value of company at a lower side and the inventory is the active part of current assets so the same should need to be recorded as per the market value.
So, the company has the position where they need to change the accounting policy so for this they need to pass some additional entries in the books of accounts either by debiting or crediting the revaluation reserve and then can increase/decrease the value of inventory at the market value. Necessary notes should be given at the end of financial reports.
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KPMG (2015). "Fair value measurement of inventories", Available from: https://home.kpmg.com/content/dam/kpmg/pdf/2015/12/fair-value-qa-2015.pdf
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IFRS (2017). AS-2, Inventories", Available from : http://www.ifrs.org/issued-standards/list-of-standards/ias-2-inventories/#translations
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Walton, P., Haller, A., & Raffournier, B. (Eds.). (2003). International accounting. Cengage Learning EMEA.
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Holthausen, R. W., & Watts, R. L. (2001). The relevance of the value-relevance literature for financial accounting standard setting. Journal of accounting and economics, 31(1-3), 3-75.
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Parker, R. H., & Morris, R. D. (2001). The influence of US GAAP on the harmony of accounting measurement policies of large companies in the UK and Australia. Abacus, 37(3), 297-328.
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Delaney, P. R., Epstein, B. J., Nach, R., & Budak, S. W. (2003). Wiley GAAP 2004: Interpretation and Application of Generally Accepted Accounting Principles. John Wiley & Sons.
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