Common errors when accounting for inventories – NZ IAS 2 – Part 1
After a short recess, we continue our successful ”common errors” series, this month highlighting some common errors when accounting for inventories in an entity’s financial statements.
NZ IAS 2 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 NZ IAS 2 are not particularly complex, there are nevertheless a number of areas where preparers make common error mistakes, and these fall into the following two main categories:
- Accounting for items as inventories under NZ IAS 2 when the item is not inventory, and
- Valuing inventory incorrectly.
This article summarises some of the typical common error 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.
Common error 1 – Accounting for items as inventory which are not within the scope of NZ IAS 2
NZ IAS 2 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:
Accounted for under other standards
NZ IAS 32 Financial Instruments: Presentation
NZ IFRS 9 Financial Instruments/NZ IAS 39 Financial Instruments: Recognition and Measurement
Biological assets related to agricultural activity and produce up to point of harvest
NZ IAS 41 Agriculture
While the above assets meet the definition of ‘inventories’ in NZ IAS 2 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 NZ IAS 32, NZ IFRS 9/NZ IAS 39 and NZ IAS 41.
Common error 1
Accounting for financial instruments, biological assets and agricultural produce prior to harvest under NZ IAS 2 at the lower of cost and net realisable value.
Common 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).
Property, plant and equipment are tangible items that:
- Are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes, and
- Are expected to be used during more than one period.
NZ IAS 16, paragraph 6 definition
These long-dated spares and components do not meet the definition of ‘inventories’ under NZ IAS 2 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 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.
Common error 2
Accounting for long-dated spares and components as inventories in the statement of financial position.
Common 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 NZ IAS 2.
Investment property is property (land or a building—or part of a building—or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:
- Use in the production or supply of goods or services or for administrative purposes, or
- Sale in the ordinary course of business.
NZ IAS 40, paragraph 5 definition
The following are examples of items that are not investment property and are therefore outside the scope of this Standard:
- Property intended for sale in the ordinary course of business or in the process of construction or development for such sale (see NZ IAS 2 Inventories), for example, property acquired exclusively with a view to subsequent disposal in the near future or for development and resale…
Extract of NZ IAS 40, paragraph 9
However, property companies often make common 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/statement of financial position.
Common error 3
Accounting for properties as inventories when there is no active development or construction.
Common error 4 – Accounting for investment property as inventory under NZ IAS 2 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 error occurs if this land is accounted for as inventory.
The following are examples of investment property:
- Land held for a currently undetermined future use. (If an entity has not determined that it will use the land as owner-occupied property or for short-term sale in the ordinary course of business, the land is regarded as held for capital appreciation.)
Extract of NZ IAS 40, paragraph 8
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.
Common error 4
Accounting for properties as inventories when there is an undetermined future use.
Common 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.
In some cases, expenditure is incurred to provide future economic benefits to an entity, but no intangible asset or other asset is acquired or created that can be recognised. In the case of the supply of goods, the entity recognises such expenditure as an expense when it has a right to access those goods. …. Other examples of expenditure that is recognised as an expense when it is incurred include: …
- Expenditure on advertising and promotional activities (including mail order catalogues) …
Extract of NZ IAS 38, paragraph 68
An entity has a right to access goods when it owns them. Similarly, it has a right to access goods when they have been constructed by a supplier in accordance with the terms of a supply contract and the entity could demand delivery of them in return for payment. Services are received when they are performed by a supplier in accordance with a contract to deliver them to the entity and not when the entity uses them to deliver another service, for example, to deliver an advertisement to customers.
NZ IAS 38, paragraph 69A
Accounting for these advertising assets as inventories is therefore another common error because NZ IAS 38 specifically prohibits these assets from being capitalised on the balance sheet/statement of financial position.
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.
Common error 5
Accounting for advertising brochures and other assets acquired for distribution for marketing purposes incorrectly capitalised as inventories.
Common 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.
NZ IAS 38, paragraph 69 (refer common 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. NZ IAS 38, paragraph 69A (refer common error 5 above) clarifies the point at which an entity has a right to access goods, which is when an entity owns the goods.
Common error 6
Accounting for assets to be used in the research process incorrectly as inventories.
For more on the above, please contact your local BDO representative.