Chapter 8: Recognition as an Expense

The Standard eliminates the reference to the matching principle.

The Standard describes the circumstances that would trigger a reversal of a write-down of inventories recognized in a prior period.

When inventories are sold, the carrying amount of those inventories shall be recognized as an expense in the period in which the related revenue is recognized. The amount of any write-down of inventories to net realizable value and all losses of inventories shall be recognized as an expense in the period the write-down or loss occurs. The amount of any reversal of any write-down of inventories, arising from an increase in net realizable value, shall be recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs.

Some inventories may be allocated to other asset accounts, for example, inventory used as a component of self-constructed property, plant, or equipment. Inventories allocated to another asset in this way are recognized as an expense during the useful life of that asset.

The number of inventories recognized as an expense in the period will generally be:

• the carrying amount of inventories sold in the period; and
• the amount of any write-down of inventories to net realisable value and all losses of inventories in the period; less
• the amount of any reversal in the period of any write-down of inventories, arising from an increase in net realisable value.

If inventories are used by the entity rather than being sold, their cost may be capitalized as part of the cost of another asset (e.g., property, plant, and equipment). Their cost is then recognized as an expense through the depreciation of that asset.

Variability in a payable

How do IAS 2 and IFRS 9 apply where all variability in a payable arises from a market price?

Entity A purchases commodity X on 31 January 20X1. Commodity X is delivered and control is transferred at that date. Entity A classifies purchased commodity X as inventory. The purchase price is based on the spot commodity price on 30 April 20X1 and the consideration is payable on that date. There is no other variability associated with the consideration.

How does entity A apply IAS 2 and IFRS 9 where all variability in the payable arises from a market price?

Solution: Commodity X should be recognized as inventory on delivery at 31 January 20X1, based on the forward commodity price for 30 April 20X1 at 31 January 20X1.

The variability in the payable associated with the commodity price gives rise to an embedded derivative that is not closely related to the host financial instrument. IFRS 9 requires embedded derivatives to be separated and accounted for as derivatives if they meet the stated criteria. The embedded derivative should therefore be separated from the short-term host payable unless the payable is designated at fair value through profit or loss in its entirety.

IFRS is not clear on the appropriate accounting for variable payments relating to the purchase of inventory. Therefore, entity A has an accounting policy choice for subsequent changes in the fair value of the embedded derivative. The cost of inventory could be adjusted to reflect subsequent changes in the fair value of the embedded derivative by IAS 2 on the basis that such changes are part of the purchase and other costs incurred in bringing the inventory to its present location and condition.

Alternatively, these changes could be charged to profit or loss by IFRS 9 on the basis that the cost of inventory is determined at the time of delivery and the bifurcated embedded derivative should be accounted for separately as if it was a freestanding instrument. The chosen policy should be consistently applied. Entity A should ensure that the inventory is measured at a lower cost and net realizable value, regardless of which policy is chosen.

How do IAS 2 and IFRS 9 apply where all variability in a payable arises from physical attributes (for example, the quantity of contained metals in concentrate)?

Entity B purchases commodity Y on 31 January 20X1. The commodity Y is delivered in concentrate form and the quality of the concentrate (and thus the final quantity of component commodities) will not be known until further processing and assessment by the purchaser at the delivery point. Goods are delivered and control is transferred on 31 January 20X1.

Entity B classifies the concentrate as inventory. The purchase price is payable on 30 April 20X1. The contract contains a schedule of per-unit fixed pper-unitne for each commodity type. The consideration is derived from these fixed prices, based on the final physical attributes (that is, the quantity of contained metals) of the concentrate determined after further processing and assessment. No adjustments are made for changes in market prices.

How does entity B apply IAS 2 and IFRS 9 when all variability in a payable arises from physical attributes (for example, the quantity of contained metals in concentrate)?

Solution: The concentrate inventory should be recognized on delivery on 31 January 20X1, measured using the commodity prices in the contract and provisional grade and volume of component commodities. Once the final grade and volume of component commodities are known the purchase price of the concentrate should be recalculated.

The cost of inventory should be adjusted by applying the recalculated purchase price by IAS 2 if the inventory continues to be held. If the inventory has been sold, the adjustment should be charged to profit or loss. A payable is recognized on delivery which is within the scope of IFRS 9. There is no embedded derivative to be separated at delivery. This is because the underlying is a non-financial variable specific to a party to the contract (being the physical attributes of the commodity delivered).

How do IAS 2 and IFRS 9 apply where variability in a payable arises from both market price and physical attributes and the two kinds of variability are not readily separable?

Entity C purchases concentrate C on 31 January 20X1. Goods are delivered and control is transferred at that date. Entity C classifies the concentrate as inventory. The quality of the concentrate (and thus the final quantity of component commodities) will not be known until further processing and assessment by the purchaser at the delivery point. The consideration is payable on 30 April 20X1, based on the spot commodity price per unit at that date. The price is also subject to adjustment for the final physical attributes (that is, the quantity of contained metals) of the concentrate determined after further processing and assessment.

How does entity C apply IAS 2 and IFRS 9 where variability arises from both market price and physical attributes and the two kinds of variability are not readily separable?

Solution: The concentrate inventory should be recognized on delivery on 31 January 20X1, based on the forward commodity price for 30 April 20X1 at 31 January 20X1 and the provisional grade and volume of component commodities. The purchase price of the concentrate should be recalculated once the final grade and volume of component commodities are known.

The two elements of variability in the payable would be considered on a combined basis. The variability in the payable associated with the commodity price gives rise to an embedded derivative that is not closely related to the host financial instrument. IFRS 9 requires embedded derivatives to be separated and accounted for as derivatives if they meet the stated criteria. The embedded derivative should therefore be separated from the short-term host payable and accounted for by IFRS 9 unless the payable is designated at fair value through profit or loss in its entirety.

IFRS is not clear on the appropriate accounting for variable payments relating to the purchase of inventory. Therefore, entity C has an accounting policy choice for changes in the fair value of the embedded derivative. The cost of inventory could be adjusted to reflect changes in the fair value of the embedded derivative by IAS 2 on the basis that such changes are part of the purchase and other costs incurred in bringing the inventory to its present location and condition.

Alternatively, these changes could be charged to profit or loss by IFRS 9 on the basis that the cost of inventory is determined at the time of delivery and the bifurcated embedded derivative should be accounted for separately as if it was a freestanding instrument. This chosen policy should be consistently applied. Entity C should ensure that the inventory is measured at a lower cost and net realizable value, regardless of which policy is chosen.

What factors should be considered in determining the ‘normal capacity’?

IAS 2 does not specify in detail the factors to be considered in determining the ‘normal capacity’. We consider that the governing factor is that the cost of unused capacity should be written off in the current year, where such cost does not constitute a part of ‘normal’ capacity and where the company does not have a fully operating facility. In determining what constitutes ‘normal’, the following factors might be considered:

The volume of production that the production facilities are intended, by their designers and by management, to produce under the working conditions (for example, single or double shift) prevailing during the year. The budgeted level of activity for the year under review and the ensuing years. The level of activity achieved both in the year under review and in previous years.

Although temporary changes in the load of activity can be ignored, persistent variation from the range of normal activity should lead to revision of the previous normal level of activity.

Reservation of title

In some jurisdictions, it is quite common for companies that sell goods to other companies to have reservations about title clauses included in their contracts. This enables the selling company to retain legal ownership of those goods until the purchaser has paid for them. The main effect of selling goods with reservation of title is that the position of the unpaid seller could be improved if the purchaser becomes insolvent. However, whether an effective reservation of title exists depends on the construction of the particular contract.

Under IFRS 15, the sale of goods is recognized when the purchaser has obtained control of the product. The passage of title is one of five indicators that the customer has obtained control.