Valuation Methods of Inventories: Advantages Disadvantages

Valuation Methods of Inventories: Advantages Disadvantages The subject of this paper is the valuation of inventories. We have looked at the rules of the International Financial Reporting Standards (IFRS) and Dutch rules. The Dutch rules can be dividend in Title 9 of Book 2 of the Dutch Burgerlijk Wetboek (BW) which is a part of the Dutch law and the recommendations made by the Raad voor de Jaarverslaggeving (RJ) which are giving a interpretation of the Dutch law, but which are not a part of the Dutch law. The research question of this paper is: Which valuation methods of inventories are allowed or not and what are their advantages and disadvantages? Before we are starting with this question we tell you about the general lay out of the different rules and standards in chapter 2. In chapter 3 we will explain the methods based on the historic cost price. This chapter tells you about costs of purchase, costs of conversion and methods to assign costs. We will explain the differences between fifo, lifo and hifo. Chapter 4 deals with fixed transfer price. Chapter 5 describes the fair value (or actual value). Chapter 6 describes one interpretation of fair value, namely the replacement value. Chapter 7 describes net realizable value and the difference with fair value. Chapter 8 will tell you in short about the selling price. At the end of this paper in chapter 9 we will give our opinion about which methods should be used. General laws and standards The use of IFRS is for the consolidated statements of listed companies. All other companies in the Netherlands can opt for the application of IFRS or Dutch Law in Title 9 of Book 2 of the BW and the rules which were made by the RJ.  [1]   IAS 2 (IFRS) IAS 2 sets out how to deal with inventories. Paragraph 6 defines inventories as follows: Inventories are assets: held for sale in the ordinary course of business; in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services.  [2]   IAS 2 is not applicable for all kinds of inventories. Work in progress arising from construction contracts, including directly related service contracts, financial instruments and biological assets related to agricultural activity and agricultural produce at the point of harvest has their own IAS. IAS 2 paragraph 9 prescribes that inventories must be measured at the lower of the cost and net realizable value. This leads to a requirement for impairment test. Paragraph 10 prescribes that the costs of inventories shall contain all costs of purchasing, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Paragraph 6 prescribes that the net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Book 2, Title 9 of the Burgerlijk Wetboek (Civil Law of the Netherlands) The Dutch Law defines in article 2:369 BW about the next four types of inventories: Commodities and consumable supplies; Work in progress; Finished goods and goods for trading; Prepayments on inventories.  [3]   Article 2:384 lid 1 BW allowed the purchase price, the manufacturing price and the actual value to use for valuation of the inventories. Article 2:384 lid 7 BW gives an own regime for financial instruments, other investments and agricultural inventories. In the Besluit Actuele waarde the rules of Book 2 title 9 are further explained.  [4]   Raad voor de Jaarverslaggeving The Raad voor de Jaarverslaggeving (RJ) gives the following definition of inventories: Assets which are  held for sale in the ordinary course of business;  in the process of production for such sale; or  in the form of materials or supplies to be consumed in the production process or in the rendering of services. The RJ prescribes in rule 220.301 RJ that inventories must be valuated based on the cost-price or the lower market value or actual value. 220.201 RJ defines when an inventory item has to be recognized. The inventories are only assets if it is probable that the future economic benefits in according to the assets will be for the company and the costs of the assets can be solid measured. Comparing the rules The definition of inventories is the same in IAS 2 and the rules of the RJ. Book 2 BW is applicable on every type of inventory. IAS 2 is not applicable for every type of inventory. Excluded inventories have their own IAS. Actual value is allowed in the Dutch rules, but not under IAS 2. There are not any differences between the Dutch BW and the RJ about valuation techniques. This is logical, because the RJ has to deal with the Dutch BW. Historic cost price Although there is much criticism about his system, this one of the most used method of valuation of inventories. When you think of historical cost, you immediately think about costs of purchase. But that are not the only costs. Think of transport costs, administrative costs, taxes and other cost. Factories even have cost to complete the products. We call these costs of conversion. Costs of purchase Costs of purchase are not only the price paid for the product. There are more costs that you have to pay. For example import duties, administration cost and shipping cost. Value added tax can be recoverable by the entity from the taxing authorities  [5]  . These taxes are therefore no costs and cannot be added to the inventory. All other costs that are directly related to the product can be added to the inventory (according to IFRS). It is important that also revenues from discounts are deducted from the total costs of purchase. We shall make an example. Let assume there is a company in the Netherlands. They want to buy oranges in Africa. The oranges normally costs 2 euro per kg, but the company gets a discount (because they buy a large quantity). They cost now à ¢Ã¢â‚¬Å¡Ã‚ ¬1,50 per kg. The company buys 500kg. Value added tax is à ¢Ã¢â‚¬Å¡Ã‚ ¬0,50 per kg (based on the discounted price). To ship the oranges to the Netherlands there are costs: à ¢Ã¢â‚¬Å¡Ã‚ ¬100. The company also needs to pay import duties: à ¢Ã¢â‚¬Å¡Ã‚ ¬50,-. The costs of purchase can be determined as followed: Price: 500kg x à ¢Ã¢â‚¬Å¡Ã‚ ¬2,- = 1,000 Discount (500kg x à ¢Ã¢â‚¬Å¡Ã‚ ¬0,50) = (250) VAT (500kg x à ¢Ã¢â‚¬Å¡Ã‚ ¬0,50) = (250) Shipping cost = 100 Import Duties = 50 Cost of purchase = 650 Note that you really pay à ¢Ã¢â‚¬Å¡Ã‚ ¬900,- in total. But 250 will be returned to you by the tax authorities. Costs of conversion Costs of conversion are the costs that occur when a manufacturing entity makes products out of raw materials. You do not only have the raw materials. Think of the machines in the factory and employees. These are examples of direct costs. But they are not the only costs. There are many costs that cannot be directly linked to a product: administration, electricity, depreciation of machinery and so on. But which costs should you assign to the product (and inventory). This is a topic that is very much discussed in management accounting. There are basically 4 types of methods to allocate costs to the products. Throughput costing, direct costing, absorption costing and activity based costing. Throughput costing Throughput costing traces the least amount of cost to the inventory. Throughput costing only assigns only the direct costs. These direct costs are based on unit-level. This is an advantage because otherwise managers would have an incentive to overproduce  [6]  . Managers do that because you are able to lower the average cost per unit when you produce more. We shall give an example: A company produces 10.000 products. 5000 products will be sold. Fixed costs are $ 50.000 and variable costs are $ 1 per unit. Selling price = 15 We assume that there is no beginning inventory. We can see that in this example the profit is much higher under absorption costing. In this example is the production higher than the actual sales. Note that if the production is equal to the sales, there would be no difference. If the production is lower than the sales, you need to have a beginning inventory and profit under absorption costing is lower. This is because you take a part of the last years fixed cost and takes that this year. So it looks like throughput costing is a good system because you cant steer the profit, but it violates the matching principle. That is why this method is not allowed for external reporting purposes. Direct (or variable) costing In this system all variable manufacturing costs are allocated to the inventory. All other costs flow into the expense of the current period. The variable manufacturing costs include direct material, direct labor and variable overhead. Variable overhead can be for example the electricity needed to operate machines. Absorption costing In absorption costing all of the manufacturing cost (fixed and variable) capitalized in the inventory. As we mentioned earlier, this means that the cost will not be an expense until the product is sold. The only costs that are taken at cost when incurred are selling and administrative costs. This is the system that is mostly used for external reporting. This is because it is aligned with the matching principle. Today, this system is now increasingly used also for internal reporting. But as mentioned earlier, this system has a great disadvantage that it might encourage a manager to overproduce. Activity based costing Activity based costing is invented to improve traditional costing systems. The system provides more accurate product costs. You have to first assign costs to activities and then to goods and services based on how much each good or service uses the activity. You can say that activities consume resources and products consume activities You can determine the cost of goods and service in four steps: Step 1: Search for activities that are related to the companys products. You need to make a list of activities and classify them as unit-level, batch level, product level, customer level or facility level. There are varies ways to do this: You can use the top-down approach. The organization use specials ABC teams of people at the middle-management or above. Advantage of this method is that generating the activity dictionary is quick and inexpensive.  [7]   You can also use the interview or participative approach. In this method you interview operating employees. So you have to rely on their knowledge. And last but not least you can use the recycling method. In this method you have to reuse documentation of processes used for other purposes. Step 2: Estimate the costs of the activities that you identified in step 1. Step 3: Calculate a rate for each of the activities that you indentified in step 1. For example machine cost is caused by hours it is used. So you need to calculate a rate per machine hour used. Step 4: Assign the activity cost to the product. For instance: measure how much hours you used and calculate total cost assigned to the product. Do this for all of the activities. As you can see it is a very time-consuming and therefore expensive method. But you get the advantage of detailed information. Therefore a company needs to evaluate whether the extra information has a higher value than the costs. As you can see, fixed costs are included in this system to. The system treats all costs as variable. ABC is not used for external inventory valuation, but for decision-making purposes. This is because selling and administrative costs are also included. Activity based costs are therefore also not charged to the inventory accounts. Thats why most of the companies that use the ABC method have an IT-system. This system is separate from the companies accounting system used for external reporting. Normally the process of identifying is done once per year, or when changes are made in the production process. Main difference with other costing systems is that other costing systems the manufacturing costs are allocated to products on the basis of production volume related measurement such as direct labor hours. ABC uses both production volume and non-production volume related bases. In ABC an attempt is made to assign all costs to products including engineering, marketing, distribution and administrative costs  [8]  . Methods to assigning costs Historical cost price is only a valuation at first recognition. For subsequent measurement you have different methods for assigning costs to inventory on sale. Fifo We begin with fifo. Fifo means first in first out. According to this method you assume that items that were first purchased are first sold. This is not literally. This method makes more sense in businesses where actually the first purchased products are first sold. This is the case in for example a supermarket. In this method the remaining inventory comes near to replace value. Because the inventory is valued for the price that you have paid last time. If this was not a long time ago, this last price is the replace value. When products decrease in prices (deflation), fifo gives a lower income. This can be an advantage when you have to pay tax. But when there is inflation, fifo gives a higher income. LiFo Lifo means last in first out. It is basically the same as fifo, but in this method you assume that the last purchase goods are first sold. When goods do not have an expiry date this is a method that makes sense. For example think of a warehouse full with steel. You grab the first one you can reach. Steel will not decrease in value over time. It is a lot more work to grab the last one. In that way you actually first sell the product that you bought last. When you use lifo, the cost of goods sold comes near replace value. This is because you use the newest purchase cost. But the inventory is valued according to the oldest products purchased. When there is inflation, lifo gives a lower income. This gives an advantage when for example you have to pay tax. Collective LiFo (periodic LiFo) In collective LiFo, the amount of inventory is determined periodically by conducting a physical count and multiplying the number of units by a cost per unit to value the inventory on hand  [10]  . This makes a difference with normal LiFo. This difference can be best explained with an example: A company buys on 1/1 500products à ¡ $1,50 Buys 1/4 200products à ¡ $1,60 Sells 1/5 600products Buys 1/7 300products à ¡ $1,40 Sells 1/9 200products LiFo: When the company sells on 1/5 the purchase cost of that 600products are: 200 x 1,60 + 400 x 1,50 = $920,- There are 100products left in the inventory with the worth of $1,50 each= $150,- When the company sells on 1/9 the purchase cost of that 200 products are: 200 x 1,40 = 280. Total costs of purchase for the period = 280 + 920 = $1200 The worth of the inventory on the end of the period = 100 x 1,40 + 100 x 1,50 = $290 Collective Lifo: This time we do not look at when the company sells, but only at the end of the period. At the end of the period there are 800 products total sold (800+200). The purchase cost of that product can be calculated as follows: 300 x 1,40 + 200 x 1,60 + 300 x 1,50 = 1190 The worth of the remaining inventory = 200 x 1,50 = $300 As you can see this makes a difference of $10. In this example it is not that much. But think of a company that buys and sells every day. In that case the difference can get much bigger. Collective Lifo is a good example of a periodic method. Lifo is a perpetual method. As you saw in the perpetual method the inventory are updated each time a transaction involving inventory takes place. In the periodic method the amount of inventory is determined by conducting a physical count  [11]  . Unfortunately despite the advantages, this method can only be used for homogeneous products. The perpetual method is a much more time consuming method. Therefore the cost is higher. But this method has advantages. You can get anytime you want information about the cost of purchase and the value of the remaining inventory. Therefore management can make better decisions. Because of the better control that you have, you will immediately see differences in stock. These differences can come from multiple reasons, for example they can be stolen or spoiled. Management can examine why there is a difference and can take action. Hifo Hifo means highest in first out. In this method you assume that the goods with the highest value will be sold first. In this case the company records the highest cost of goods sold as possible. Therefore, this method decreases your income. This is an advantage for companies, because they have to pay less tax or have less attention from for example environment associations or government. For example shell will not make too much profit. Otherwise government would raise taxes because it is polluting for the environment to produce oil. The cost for having this attention is called political cost. You need to minimize that cost. This method can also be Lowest in, First out. It works the same way. Only in this way you maximize your profit. This can be an advantage for managers whose income is dependent of the profit. Average costing method The inventory is based on the average costs of all products. This can be a weighted average; this is the average of a period. The average can also be a moving average. In this case the average is changed every time the company buys new products or when there is a purchase return. This method makes the assumption that all products are homogeneous. Therefore it makes sense to use it in companies that have homogeneous products. The method has the advantage that is very easy to apply. Because it is an average, you eliminate unusually high or low materials prices. This can help for better or stable cost estimates. Fixed transfer price (Dutch: vaste verrekenprijs) When purchase prices changes a lot it is very time consuming to register individual purchase price. It is even more time consuming when a company has a lot of transactions. That is why a fixed transfer price can be used. The fixed transfer price is based on a fixed purchase price plus cost of purchase and cost of inventory. At the beginning of the period, an average purchase price, average purchasing cost and average inventory cost is estimated. Because it is an estimation, there will be differences in the real cost and the estimated cost. The difference must be recorded on a separate account called: price differences at purchase.  [12]   An example: Company Bert sells chairs. The fixed transfer price is $ 200,-. This price consists of: Purchase price $ 160 Purchasing cost 10 Inventory cost 30 $ 200 The company buys 50 chairs for a total price of $ 8200. The following journal entry has to be made: Inventory $ 10000 (50 x $ 200) Price differences $ 200 a/ revenue purchasing department $ 500 a/ revenue inventory department $1500 a/ creditors $8200 Price differences are only based on the difference between expected purchasing price and real purchasing price. Therefore price differences is 8200 (50 x 160) = 200. In this case the difference is an asset, because you actually paid more than the worth in your inventory. But sometimes you evaluate your inventory to high, because actual price is lower. For example: Company Bert buys 50 chairs for total price of $ 7800. Journal entry will be: Inventory $10000 a/ revenue purchasing department $ 500 a/ revenue inventory department $1500 a/ creditors $7800 a/ price differences $ 200 You can see that inventory did not change. Thats why FTP has the major advantage that inventory is easy to valuate. You can immediately calculate how much units you have (Inventory divided by FTP). When you sell your products the sale will be calculated on actual price. The difference will disappear. For example you sell 40 chairs of the 50 chairs you bought. You sold them for $400,- per chair. Journal entry will be: Cash 40 x $ 400,- = $16.000 a/ Sales $16.000 Cost of goods sold (8700/50) x 40 = $ 6960 Price differences = $ 1040 a/ inventory 40 x 200 = $ 8.000 Cost of goods sold is valuated at actual price (in this case). This can also be on average price. The remaining price difference only consists of the 10 remaining chairs in inventory. If they are sold too, the price difference is 0 again. Price differences are a correction on the inventory. When you use average cost price you create a special situation. Because then price differences are not only a correction on the inventory but also on the cost of goods sold. Therefore you have to make a distinction between price differences that go to the balance sheet and that go to profit and loss account, at the end of the period. Fair value (or actual value) Paragraph 6 of IAS 2 gives the following definition of fair value for inventories: Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction. How works the fair value accounting method? Fair value isnt laid in one conception. The basis of fair value is that the value of an asset or liability is the value for what the asset can be traded between well informed, independent parties which want to do the transaction. The best indication of fair value is the quoted price on an active market. But not every asset has a quoted price on an active market. If an active market isnt available, than you can look to the last transaction. This is just a good indication if the economic situation has been the same. At least you can use valuation techniques to determine the valuation. Other fair value conceptions are value in use and replacement value.  [13]   Is the fair value accounting method allowed for inventories? IAS 2 doesnt prescribe fair value as a valuation method. The RJ allows the use of fair value for valuation of inventories in 220.301 RJ. Art. 2:384 lid 1 BW allows the use of fair value.  [14]   IAS 2 gives an explanation of the conception of fair value, because it explains that net realizable value may not equal to fair value minus selling costs. Article 8 of the Besluit Actuele waarde explains that you can use the replacement value for inventories, besides the agricultural inventories. If the gain value is lower than the replacement value, than you have to use the gain value. If it is probable that the inventories will be replaced, than you have to use the gain value. For agricultural inventories which are valuated by actual value, you have to use the realizable value. 220.331 RJ describes if the inventories will be valuated by the actual value and that is probable that the inventories will be replaced, than must the actual value be based on the replacement value or the lower realizable value. 220.332 RJ says if the inventories will be valuated by the actual value and it is not probable that the inventories will be replaced, than must the actual value be based on the realizable value. The replacement value and the realizable value will be explained in another part of the paper. What are the advantages and disadvantages of fair value? The general advantages of fair value accounting for inventories are: More transparency Providing more information (about the market prices) Financial reports are less subject to earnings management.  [15]   Disadvantages are: Fair value accounting can be expensive. Implementation and maintenance of a fair value accounting system will cost time and resources. Fair value accounting for inventories is allowed by the RJ and the BW, but not by the IFRS. This can be confusing for some companies. We think that it will be good if the Dutch rules and the IFRS will be the same, because this makes it more clear for the companies if the allowed or not to use fair value accounting for inventories. We dont think that fair value must substitute the other methods, because for some companies is it not easy to measure the fair value. Replacement value There are two variances of the replacement value method: replacement value with a normal inventory and replacement value without a normal inventory. First we will give an example of the replacement value with a normal inventory: base stock value (ijzeren voorraadmethode). After this example we will explain the replacement value without a normal inventory. The function of the replacement value method is inventory valuation. Replacement value with a normal inventory How works replacement value with a normal inventory? An example of replacement value with a normal inventory is the use of a base stock. The base stock is the inventory which the company needs for a continued process of the company. The base stock can exist of a physical inventory and an economic inventory. The economic inventory consists of the physical inventory plus the orders and minus sales which are not delivered. The company has a price risk on the economic inventory.  [16]   The company can valued the base stock by the next three values: The price paid in the past; Or the lower buying price on the balance date; Or the lower net realizable value on the balance date. The base stock is valued by an established price. It is possible that the actual inventory differs from the base stock. There are two types of differences: a manco or a surplus. There is a manco when the actual inventory is lower than the base stock. The difference between the actual inventory and the base stock has the company to buy as soon as possible and must be valuated by the using the replacement value. The replacement value is the price which the company has to give if she buys today the inventory to solve the manco. There is a surplus if the actual inventory is higher than the base stock. The surplus must be valuated by using the minimum valuing rule. The company has to use the lowest of the following values: The last paid price (Fife method); Buying price on balance date; Selling price on balance date. The reason of this rule lies in the prudence principle.  [17]   This system doesnt take into account changes of the value of money. The system is used to determine the profit which can be pay out.  [18]   There is a profit on the selling on e. of 50 (e-/-b) and a profit on the selling on f. of 50 (f-/- 0,5c). The total profit is 100. Is it allowed to use the replacement value with a normal inventory? IFRS doesnt allow the use of the replacement value with a normal inventory. In the Netherlands has the Hoge Raad decided that the base stock method still acceptable is for the calculation of the taxable profit.  [19]   220.204 RJ says that a method which uses the economic inventory cant be a basis for valuation. 220.301 RJ prohibits methods which are using a normal inventory; one of these methods is the base stock method. The reason behind this idea is that the balance has to reflect the physical inventory. What are the disadvantages of this method? A disadvantage of this method is that it is difficult to make a definition of the normal inventory. Another disadvantage is that you have to deal with results of price speculation. The use of a normal inventory method leads to differences between the physical inventory and the normal inventory. This is sometimes confusing.  [20]   Replacement value without normal inventory The second method of using replacement value doesnt know a normal inventory. How works replacement value without normal inventory? Replacement value is the value which you have to give if you want to replace your asset for another asset with the same economic value.  [21]   If the price of the inventory increases you make a revaluation reserve with the same value as the price increasing. An example: Company Y has 1000 pieces as inventory. Every pieces has she has bought for 5 euro. The price increases to 6 euro. The company has to make a revaluation reserve for 1000 euro. (1000 x à ¢Ã¢â‚¬Å¡Ã‚ ¬1)  [22]   If the replacement value of the inventory decreases, than you must the change deduct from the revaluation reserve. If the revaluation reserve isnt big enough, than you must the decrease subtract directly from the profit- and loss account.  [23]   When is it allowed to use the replacement value without normal inventory? IAS 2 doesnt allow the use of the actual value, and implicit the use