Blind Freddy – Common errors when accounting for inventories – AASB 102 – Part 2

Last month’s ‘Blind Freddy’ article highlighted six common errors where items are often incorrectly classified as inventory when they should be classified as something else on the balance sheet.

This month we explore other common errors made when valuing inventories, including errors made when other Accounting Standards drive measurement of inventories.

Blind Freddy error 1 – Ignoring the impact of applying AASB 3 Business Combinations to measuring inventories

The acquirer in a business combination is required to recognise and measure all identifiable assets at fair value on acquisition date.

In order to comply with the measurement requirements in AASB 102 for its standalone financial statements and management reporting, the acquiree’s own inventory system records each inventory item at ‘cost’, determined using a FIFO, weighted average or standard costing valuation method.

However, post-acquisition, items of inventory acquired at acquisition date, and still on hand at reporting date, are to be measured at acquisition date (business combination date) ‘fair value’.

We need to consider AASB 13 Fair Value Measurement principles when determining what this acquisition date (business combination date) ‘fair value’ should be. ’Fair value’ is not the amount an end user would pay for the finished product. Rather, it is an ‘exit price’, i.e. the price that would be received from selling an asset in its current condition. This means that we deduct appropriate amounts for costs to complete the inventory, selling effort, and a reasonable profit margin.

The table below provides a general guide on how to measure inventory at fair value.

Many entities ‘forget’ this AASB 3 requirement, resulting in a common Blind Freddy error, whereby fair value adjustments for such inventory are ignored.

Blind Freddy error 2 – Failing to capitalise interest costs on qualifying assets as inventories

AASB 123 Borrowing Costs does not give a choice of capitalising borrowing costs. All borrowing costs incurred on a qualifying asset must be capitalised, including where the qualifying asset is classified as inventory.

While the standard does not define what is meant by a ‘substantial period’, it is generally accepted that an asset taking more than 12 months to be ready for its intended use or sale would be a qualifying asset. This means that inventories with long production cycles could be considered qualifying assets, e.g. properties, wine, or certain types of machinery held for sale.

Failing to capitalise borrowing costs into the cost of inventories within the scope of AASB 123 means that interest costs will be expensed immediately, resulting in both profits and inventories being understated in the financial statements.

Blind Freddy error 3 – Inappropriately capitalising borrowing costs to inventories

While many entities fall into the trap of not capitalising borrowing costs as part of the cost of inventories in Blind Freddy error 2 above, others go overboard and capitalise interest costs when:

• The inventory is not being developed, or
• Development of the inventory is complete.

For more details, refer to our detailed ‘Blind Freddy’ article Common errors in applying AASB 123 Borrowing Costs.

Blind Freddy error 4 – Recording imported inventories at the hedge rate rather than the spot rate

Many entities mistakenly assume that if they have entered into foreign currency contracts to fix the AUD price of imported inventories, this ‘hedge rate’ can be used to determine the cost of purchases. AASB 139 Financial Instruments: Recognition and Measurement (AASB 9 Financial Instruments post 1 January 2018) only permits the hedge rate to be used where hedge accounting applies (i.e. the entity has met the requirements in AASB 139 or AASB 9 to apply hedge accounting). Otherwise, AASB 121 The Effects of Changes in Foreign Exchange Rates requires these inventories to be recorded at spot rate.

Where hedge accounting is not applied, a common ‘Blind Freddy’ error is to subsume any movements in derivatives in the cost of inventories, rather than recognising these as a period expense.

Blind Freddy error 5 – Capitalising foreign exchange movements on trade payables for inventory purchases into the cost of inventories

AASB 121 requires outstanding foreign currency trade payables (monetary items) to be measured at reporting date at spot rate. This results in a gain or loss being recognised in profit or loss.

Another common error occurs when entities capitalise this foreign currency gain or loss into the cost of inventories. AASB 121, paragraph 28 specifically requires such amounts to be expensed immediately.

Blind Freddy error 6 – Translating inventories purchased in foreign currencies to spot rate at reporting date

As noted in Blind Freddy 5 above, foreign currency monetary items are retranslated to spot rate at the reporting date. However, non-monetary items, including inventories, are not retranslated, but instead remain at historical cost

A common Blind Freddy error occurs when inventories purchased in a foreign currency, e.g. USD, but still on hand at year end are retranslated to spot rate. AASB 121, paragraph 16 is explicit that inventories are non-monetary items, and therefore should remain at historical cost.

Next month

Next month, the last in our series of ‘Blind Freddy’ errors when applying AASB 102 will focus on typical errors arising when applying the valuation requirements of AASB 102.