COS in intirim statements
15 August 2010
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8 Comments
I ran into a situation where a company takes a physical inventory (serially manufactured products) annually. In its interim statements, it would like to omit the change in inventory from its cost of sales calculation (since including it would require a physical inventory in the interim). Assuming it publishes condensed interim statements, would this be acceptable? Or should it estimate the change? If so, any suggestions as to how?
(sorry if this was posted twice, the firs time I got a server timeout).
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Since you refer to making an estimate of the change in inventory, you infer that leaving the inventory change at zero is not a reasonable estimate. So it looks to me like something needs to be done. Here are two options I have used in the past to get out of the full physical at interim:
1- Look at what manufacturing, purchasing and production planning are doing. If the company has any significant volume or complexity, there is a very good chance that you should be able to get some pretty reliable data on quantities. You will still need to perform analysis to validate that the production costs are not changing or to get an estimate of how much they are. Then with the quantities, some sensible groupings as to average costs and the analysis supporting the current costs, you should be able to make a reasonable estimate of the interim inventory value.
2- If plan 1 isn’t working-(which I have seen both in cases where the mfg units wasn’t available or where there were too many variables to make a good estimate on the cost), I have sometimes been able to do a partial physical and/or costing. This only works if you are lucky enough to have some concentration of value on a few components and finished items. That said, even in large and diverse looking inventories, I have found the 80/20 rule to be in play, so look belfore you quit. If I use this approach, I calculate the ending interim inventory on the sample and extrapolate the change.
Lastly, the ideal is to get to the point where there is an inventory system is reialble enough to used in the interim accounts. To get to that you need a cycle count program (in addition obviously to a perpetual inventory system), the manufacturing team may whine at first, but once its in place if you cycle based on value, it really isn’t much work on an on-going basis and the mfg team benefits from the improved accuracy level as well. The key to having an effective cycle count program is that the variances must be investigated, not just booked.
Good luck!
Most companies only take a physical inventory annually. But most French companies keep an inventory control system outside of the plan comptable général so that they have some idea during the year how much stock they have! Not to do so is sheer folly.
There is absolutely no excuse for avoiding a proper cost of goods sold calculation, just because you haven’t taken a physical inventory. IAS34 requires the interim financial statements to be taken every bit as seriously as the annuals. So if they don’t have an inventory control system, tell them they must get one fast!
Although Appendix B to IAS 34 is not considered part of the standard, paragraph B25 (in part) provides the following guidance (which was my initial gut reaction):
To save cost and time, entities often use estimates to measure inventories at interim dates to a greater extent than at the
end of annual reporting periods.
Paragraphs B26-28 provide additional guidance on inventories in interims.
In my view, there’s no requirement to do a physical inventory and the company should still estimate the change in inventories, otherwise inventory carrying amount is definitely misstated.
Patricia Walters
As rightly pointed out by Patricia, there is no requirement to do a physical inventory (Provided auditors are comfortable from a true and fair view). However, the relaxation does not mean that change in inventory can be omitted.
You can cite B25 of IAS 34 to do away with physical count. However, the change in inventory cannot be omitted unless it is immaterial.
I didn’t say they didn’t have an inventory control system. I said they did not want to run around counting product every quarter.
As to the second (useful) reply.
Thanks for that gut reaction. Mine was similar. But it’s nice to get some confirmation (sometimes one looses sight of the forest for the trees), though the client won’t be happy.
BTW, I like to tell clients “while appendices are not a formal part of IFRS, this does not mean they can be ignored. Their ‘below the line’ status merely allows one to exercise a greater degree of professional judgment in applying their guidance.” Otherwise, they think they can ignore them if they happen to be disadvantageous.
So, now the question is one of methodology. Let me briefly describe the situation:
The company manufactures both for the retail and trade market. To keep production economical, they keep production volume of the former fairly constant.
The problem is, retail sales are seasonal. That means their inventory fluctuates a great deal throughout the period. Fortunately (given that their product is as close to a commodity as a manufactured product gets), their margins are pretty high, the product has an unlimited shelf life, technological obsolesce is not an issue, which means that write-downs to NRV are rare.
The made to order products are, however, the big problem. Due to fairly high set-up costs, an economical production run is, say, 100,000. The customer may, initially, only order 5,000. As the customer ramps up its own production, orders grow. But, they may order another 15,000 in week 5 or week 20. Then another 25,000 in week 30 or 45. And, this can go on for two to as many as six (sometimes more) years (depending on the customer’s own sales).
Then, to keep things from getting too dull, there is not an exact one to one relationship between inputs and outputs. Sometimes 1000 units of material plus 1000 units of labor yields 1000 units of product. Sometimes 1003, sometimes 996, and so on day-in, day-out. The company says this is due to environmental considerations: grain size and texture, inherent cohesion (whatever that is), ambient humidity, operator fatigue, etc., which cannot be fully controlled (but that is a separate issue).
And, I almost forgot, over half of the product has to be designed to customer spec!
The good news is that customers face extremely high switchover costs (which grow over time) and eventually order from three to as many as twenty production runs of each product. Also, about 40% of product designed for one customer meets spec for other customers (and no significant restrictions on these sales exist).
Thus, though it may take awhile, 90% of the product eventually gets sold (at profit!). The rest? That can be broken back down into “second-stage raw material”. Even with waste, this process only costs about 60% of what it would cost to manufacture “second-stage raw material” out of “first-stage raw material” or to buy “second-stage raw material” on the open market (though, since this material is an industrial commodity, the savings can vary greatly, or even turn negative, depending on market prices).
Thus, it probably comes as no surprise that the company devotes approximately 60% of its floor space to warehousing, spread over eight buildings (fortunately, within walking distance of one another) and that taking a physical count / measure is the exact opposite of fun (and its also really messy. And part of its involves wearing a breather. Blick).
As to methodology. The best thing I can think of is to take direct cost (wages and material) per quarter (based on actual prior year costs) and estimate units in. Then take actual units out (which I can get from shipping documents) and net the two. I would also like to do this for the major inventory groups only: retail sales, large customers (by customer) and small customers (in aggregate).
Does anyone have any better ideas?
Also, in response to the third reply (which came as I was editing the above), I have no idea what their auditor will be comfortable with. The client is just now making the transition to IFRS from a National “GAAP” (which is why this hasn’t already been dealt with). It hasn’t had a real IFRS audit yet.
What I do know is that its old auditors (I will not mention them by name, but if I did I’m sure everyone would know who I’m talking about) were perfectly willing to sign off on anything (they not only signed off on a “mapping” from National GAAP to “IFRS”, but even advised the client in how to apply it).
What will the new auditors do? That is an open question.
I am assuming they will be somewhat more rigorous, given that they are the same firm that audits the company’s most serious potential acquirer (which is the point of the exercise). But, given that the principle partner will still be a local, who knows.
And, I really don’t want to ask. Even if they answered (which they’re not supposed to), I would rather get yes/no to a policy I devised, than invite them to advise me on how to set policy in the first place.
But, obviously, yes would be preferable to no.
To Mvolchek,
Thanks for your thoughtful comments.
I absolutely agree. If I had the data, your third suggestion would be optimal. Unfortunately, I am not in a position to dictate policy to the client. If I were, they’d be using RFID tags (or some comparable technology) and have 100% accurate inventory (in real time).
As it is, their internal controls are rudimentary, planning and purchasing ad hoc, production management seat-of-the-pants and accounting set up to to fulfill the minimum necessary to satisfy local legislation (primarily tax law). Oh, and did I mention that their current audit partner (though fully versed in local “GAAP”) has trouble remembering what the IFRS acronym stands for.
So, pretty much the only reliable data I have is last year’s ending, YTD direct costs (their overhead calculations are a mess) and YTD sales.
Hopefully, if they do manage to sell the company, the new owners will take their accounting a bit more seriously. But, as it is, my job is simply to get them a unqualified IFRS opinion with the information I have (or can wheedle out of a recalcitrant management).
The good thing is, I get to bill by the hour.
Oh, BTW, the example used is a fictitious, composite company. Citing an actual company’s / auditor’s specifics would be a breach of etiquette, err, … confidentiality.
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