Inventory Valuation

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Summary[edit]

PAGE STATUS is ALPHA - I am still working on this.

This page looks specifically at Inventory Valuation and how this is recorded in the Purchase Process of Adempiere.

In compiling the information in this page, the following references have been used:

  • IAS2 - Inventories (International Financial Reporting Standard)
  • HMRC BIM33132 - Stock: valuation: International Accounting Standard (IAS) 2 Inventories (UK
  • HMRC 700 VAT Guide s7.3.2b - VAT on Discounts

Some of these sources, specifically the VAT information is UK specific and hence may vary from country to country.

Purchase Transaction[edit]

This section considers the purchase cycle of inventory and discusses the system accounting consequences in relation to applicable accounting standards.

IAS2 - Inventories[edit]

International Financial Reporting Standards (IFRS) and International Accounting Standards (IAS) provide a framework for the basis of preparation and presentation of accounts. These standards have been adopted in over 80 countries (details) and are applicable predominantly to external report users (Financial Accounting).

Specifically, IAS2 - Inventories is applicable to inventories, their recognition, valuation and de-recognition.

Inventories are assets (future economic benefit) held for sale in the ordinary course of business in the process of product for sale or in the form of materials or supplies to be consumed in production or rendering services. (IAS2.6)

Industry Exclusions[edit]

IAS2 does not apply to the following specific industries:

  • work in progress arising under construction contracts, including directly related service contracts (see IAS 11 Construction Contracts) IAS2(a)
  • financial instruments (see IAS32/IAS39) IAS2(b)
  • biological assets related to agricultural activity and agricultural products at the point of harvest (see IAS 41 Agriculture) IAS2(c)
  • producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realisable value in accordance with well-established practices in those industries. IAS3(a)
  • commodity broker-traders who measure their inventories at fair value less costs to sell. IAS3(b)

Determining the cost of the Inventory Asset[edit]

In addition, it is important to understand what is included in the cost of the inventory asset:

  • purchase price
  • import duties & taxes to the extent that they are not recoverable (i.e. excludes Value Added Taxes)
  • transport
  • handling
  • other costs directly attributable to the acquisition of finished goods, materials or services
  • but deducting any trade discounts or rebates

The General Rule[edit]

If the cost of an item is:

  • not normally interchangeable, or
  • the goods or services are produced and segregated for specific projects,

then the item shall be recognised using the specific identification of their individual costs.


The Details[edit]

However, in the example we look at further, we consider where a business trades in widgets which are traded in large quantities and are not normally interchangeable. In this case, the rule is that the business applies the first-in, first-out (FIFO) or weighted average cost formula using the same formula for all inventories having a similar nature. It is not sufficient to use different methods in different geographical locations by itself even if each of the locations are subject to different tax rules.

FIFO is specifically excluded for tax purposes in some countries, so we will focus compliance for IFRS on the weighted average cost (WAC) method. Under the WAC method the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the entity.

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. This is the point to CR Inventory Asset and DR the COGS.

Perishable Goods and Expense Recognition by period closing[edit]

  • Notes- this is a special case where specific costs are tracked for the duration of product life cycle - eg. weekly

Example 1[edit]

I will use the following example proposed by Colin Rooney in this thread http://sourceforge.net/forum/forum.php?thread_id=1738341&forum_id=611161 to discuss the inventory and VAT consequences.

In summary, we purchase 1000 units of widgets @ $1.00 per widget at X0. We then buy another 1000 units of widgets at $3.00 per widget at some date prior to the X1 balance date. At some time during X0 - we shall say X0.n we sold 1000 widgets at $2 per widget.

I am assuming that we are in the UK selling to another UK business and widgets are not electronic services.

Raising the Purchase Order[edit]

There is no accounting consequence - only a legal consequence of placing the order.

Receiving the Widgets[edit]

A receipt of inventory is recorded as a "Material Receipt".

DR Product Asset (Current Asset)             1000
CR Not Invoiced Receipts (Current Liability)        1000 
   Receipt of 1000 widgets at $1 each

Adempiere bases the cost price on various figures depending on the costing method attached to the accounting schema. e.g. Average Invoice, Average PO, FIFO, Last Invoice, Last PO Price, LIFO or Standard Costing.

IAS2.21 specifccally allows the use of Standard Cost or the Retail Method to approximate cost as long as standard costs take in to account the normal level of materials and supplies, labour, efficiency and capacity utilisation and these are regularly reviewed.

Ademepiere does not support the Retail Method as at 18-07-2007.

A discussion of costing methodologies including the Retail Method is documented elsewhere.

The purpose of the 'cost price' used in the calculation is to determine the difference between the "recognised cost" and the "price invoiced".

Comment - If balance date fell at this point in time, we would need to look to the purchase contract to see who had the title to the goods. In most contracts, title doesn't pass until the goods are paid for and hence we may not be entitled to the future economic benefit of these goods. In a pure technical sense, perhaps the goods should be put in to a special account that recognises that the title to the goods have not passed to the purchaser.

Receipt of the Purchase Invoice[edit]

DR Inventory Clearing (COGS)            1000
DR Tax Due (Current Liability)           175        
CR Accounts Payable (Current Liability)         1175 

The accounts payable is correct as we now have received the goods and hence have an obligation to pay the supplier. This is currently offset by the "Not Invoiced Receipts" account.

Discounts related to Early Payment[edit]

The Tax recognises the Input Credit we are entitled to tax base amount. Under UK VAT law, if a payment or an unconditional discount was offered on the goods then the tax base would be the amount including the discount. So for example, in the case above, if a 2% discount was offered for early settlement then the tax base amount is 980 and the VAT amount should be 171.50.

The second part of the journal would be:

DR Accounts Payable (Current Liability)    4.50
CR Tax Due  (Current Liability)                    4.50

Under normal circumstances this would be combined in the calculation of the journal above.

We can only know the credit terms when we receive the invoice from the supplier. Before that point, even with a supply contract, we may not be entitled to the early payment discount. Furthermore, even if we do not pay within the early period to get the discount, the VAT calculation still stands. I would be interested in updating this section on variations to this practice in our EU countries.

In the UK, the converse is also true, so if you offer a discount for early payment when you invoice your customer, you should calculate VAT only on the discounted amount. This needs to be worked in to the tax calculation on orderline, invoiceline and over the entire invoice. i.e. where tax is calculated on the line basis it must be modified for any discounts provided in payment terms.

In relation to the cost of inventory, IAS 2 (para 11) states that "Trade discounts, rebates and other similar items are deducted in determining the costs of purchase." i.e. The discount reduces the cost of the inventory. However, items such as bank fees relating to online payment of supplier invoices (for inventory) are not capitalised in to the cost of inventory because it relates to the method of making the payment rather than the purchase of the goods.

Price change between when the goods were ordered and when the are invoiced[edit]

If there was a price change between the purchase order price and when the invoice is received then this creates an Invoice Price Variance (IPV)

What if the material receipt happens without a purchase order?[edit]

In the previous example we assumed that the purchase price came from the purchase order. In some scenarios it is possible that a purchase order has not been raised and we merely want to receipt goods in to stock (ready for an invoice at some point in the future).

This dependency from the purchase order is why a "cost" from the system is used to book the material receipt values rather than the purchase order price.

The variance between the "cost" and the supplier invoice is later recorded as the IPV.

What if the material receipt is not linked to the purchase order?[edit]

Comment: The "Inventory Clearing" is currently in the P&L, the first transaction in the process being a DR which means that we are charging our P&L the cost of the goods - even if they are not sold. If balance date were to fall before the matching process we would have a net effect DR 1000 COGS (Inventory Clearing) and CR Liabilities (Not Invoiced Receipts) 1000 in the accounts. I believe that we should make this account somewhere in the Current Liabilities space to correct this.

Matching the Purchase Invoice[edit]

DR Not Invoiced Receipts (Current Liability) 1000 
CR Inventory Clearing (COGS) 1000 

At this point, we have the following balances:

DR Product Asset 1000 (OK) 
CR Accounts Payable 1000 (OK) 

The issue as illustrated above is how does Adempiere accumulate cost (and adjust for it when the invoice price changes from say the PO price)

I think in an IFRS world, it might be difficult to justify costing methods Average PO, Last PO, LIFO (based only on their name) and I'd like to have a closer inspection of Last Invoice, Average Invoice, FIFO, and standard cost.

Paying the purchase invoice[edit]

Notes:

  • If the business was another VAT registered business in the EU then no VAT should be charged.

Payment Application Module[edit]

Notes:

  • For perishable goods which have short life cycle, you can receive them as open items in a lot, sell them by lot number, and pay them by lot in the payment application using Purchase Order Receipts.

Notes[edit]

  • BIM33132 mentions that IAS2 allows use of the FIFO method and this is not allowed for tax purposes