Blind Freddy – Common errors when accounting for inventories – AASB 102 – Part 1

After a short recess, we continue our successful ‘Blind Freddy’ series, this month highlighting some common ‘Blind Freddy’ errors when accounting for inventories in an entity’s financial statements.

AASB 102 Inventories is the accounting standard which sets out key principles for recognising and measuring inventories. While inventories is not usually a material item for entities whose business model is primarily for the provision of services, it is often a significant item in the financial statements for manufacturers, wholesalers and retailers. Although the requirements of AASB 102 are not particularly complex, there are nevertheless a number of areas where preparers make common ‘Blind Freddy’ mistakes, and these fall into the following two main categories:

• Accounting for items as inventories under AASB 102 when the item is not inventory, and
• Valuing inventory incorrectly.

This article summarises some of the typical ‘Blind Freddy’ mistakes we encounter when an entity incorrectly accounts for items as inventories when they are not inventories. Next month we will continue our series with common errors when valuing inventories.

Blind Freddy error 1 – Accounting for items as inventory which are not within the scope of AASB 102

AASB 102 applies to the accounting for ‘inventories’ which are defined to include 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.

However, the following items are not inventories, and are excluded from the scope of AASB 102:

While the above assets meet the definition of ‘inventories’ in AASB 102 because they are held for trading, a common error is to measure these items at the lower of cost or net realisable value under this standard, instead of following the specific measurement requirements included in AASB 132, AASB 9/139 and AASB 141.

Blind Freddy error 2 – Accounting for PPE items as inventory

The definition of ‘inventories’ basically includes raw materials to be used in the production process, work-in-progress for manufactured items, and finished goods.

Entities in some industries such as mining or heavy production may hold significant stocks of spare parts for machinery and equipment, to be used over a period of more than 12 months. Similarly, some may hold stocks of components essential for their property, plant and equipment (PPE) to work (such as oil in a pipeline).

These long-dated spares and components do not meet the definition of ‘inventories’ under AASB 102 because:

• They are not held for sale in the ordinary course of business
• They are not assets in the process of production for such sale (i.e. they are not WIP, but are merely used as replacement parts of components in PPE), and
• They are not materials or supplies to be consumed in the production process (i.e. raw materials).

Instead, these items are PPE because they are used in the manufacturing/mining process and are expected to be used during more than one period.

A common ‘Blind Freddy’ error is to treat these as inventories and classify as current assets in the statement of financial position. This results in an understatement of depreciation charge in the income statement because these spares/components will be recognised as expenses only when put to use, which could be several years after the current reporting period.

Blind Freddy error 3 – Accounting for investment property as inventory when there is no active construction or development

‘Investment property’ is property held to earn rentals, or for capital appreciation, or both. If an entity intends to sell a property in the ordinary course of business, or is in the process of construction or development for such sale, it is not investment property, but is instead accounted for as inventory under AASB 102.

However, property companies often make common ‘Blind Freddy’ errors by incorrectly classifying properties as inventories, when in fact, a property is not being actively developed. This results in inflated current assets on the balance sheet.

Blind Freddy error 4 – Accounting for investment property as inventory under AASB 102 when the entity has not decided what to do with the property

Where property companies hold land and have not yet decided whether to sell or develop it, another common ‘Blind Freddy’ error occurs if this land is accounted for as inventory.

This is because such land meets the definition of investment property, being held for capital appreciation, and not inventories, again resulting in current assets that are too high.

Blind Freddy error 5 – Accounting for advertising brochures and other advertising assets as inventories

Despite the prevalence of social media advertising, many industries still spend significant amounts on mail order catalogues and advertising brochures, and keep a tally of these via an inventory system. As such, these are often accounted for as inventories because they are logged within the entity’s inventory system.

Accounting for these advertising assets as inventories is therefore another common ‘Blind Freddy’ error because AASB 138 specifically prohibits these assets from being capitalised on the balance sheet.

This principle can also be extended to high value assets such as fridges, watches and air conditioners distributed by pharmaceutical companies to doctors as part of their brand promotion (fridges and air conditioners being used to keep drugs at the correct temperature in the doctor’s surgery). Because they are acquired with the intent that they will be used for marketing purposes, the IFRS Interpretations Committee, who considered this issue at its June 2017 meeting, are proposing to draft an agenda decision to the effect that the costs of these assets should be expensed.

Blind Freddy error 6 – Capitalising assets used in the research process as inventory

Many people also mistakenly capitalise consumables as inventory where those consumables will be used in an activity that will not result in a recognised asset. An example of this is where a pharmaceutical company purchases stocks of chemicals to be used during the research process.

AASB 138, paragraph 69 (refer Blind Freddy error 5 above) requires, in the case of the supply of goods that will be used for an activity where no intangible or other asset can be recognised, that an expense is recognised when an entity has a right to access the goods. AASB 138, paragraph 69A (refer Blind Freddy error 5 above) clarifies the point at which an entity has a right to access goods, which is when an entity owns the goods.