04 May 2020
Coronavirus is certainly going to disrupt manufacturing and supply for many businesses. This, in turn, will have an effect on the valuation of inventories under FRS 102.
What does FRS 102 say?
FRS 102 (Section 13) states that inventories must be held at the lower of cost and net realisable value.
The cost of inventories includes the cost of purchase, conversion, and any other costs incurred to bring the inventory to its present location and condition. FRS 102 states that fixed production overheads are allocated to the costs of conversion on the basis of the normal capacity of the production facilities, and variable costs are allocated to each unit on the basis of actual production usage.
The standard also specifies that abnormal amounts of wasted materials and labour, storage costs and selling costs are not included as part of the cost of inventories.
Practical impact and interpretation for preparers
Entities may have inventories rendered obsolete due to Coronavirus, for example if the business has had to close or reduce operations, particularly if stock is perishable, or if the inventory is stored in a location which is not accessible due to the pandemic. Obsolete inventory is required to be written down to its net realisable value, which could currently be significantly lower than cost.
- Inventories should be measured at the lower of cost and net realisable value. If selling prices fall and/or cost to complete and sell increase, inventory may need to be written down.
- Entities that export their products overseas and sell in foreign currencies may be particularly impacted. Exchange rate volatility may result in a reduction in selling prices if businesses do not pass on the cost of this onto customers, meaning that net realisable value is lower than cost.
- Employee absence due to illness or isolation and the implementation of social distancing measures in the manufacturing sector may mean that production capacity is significantly reduced. The standard requires that the allocation of fixed production overheads is based on normal capacity, and so reduced production capacity may limit this. Any abnormal costs should be expensed as incurred. If a standard costing system is not used, an exercise will need to be undertaken to identify these abnormal costs.
- Entities with reporting dates before the coronavirus outbreak will need to consider the interaction between accounting for inventory with the requirements of Section 32 Post Balance Sheet Events.
- Entities should assess whether any of their inventory is likely to be obsolete or sold for a reduced price as a result of the pandemic and impair inventory down to net realisable value where required.
- Expected production capacity over the period of the pandemic should be estimated and compared to normal production capacity. If an entity expects this to reduce significantly, excess overheads which are normally allocated as costs of conversion should be expensed to the profit or loss account in the period in which they are incurred.
- Entities should ensure they track any wasted materials and labour, storage costs and selling costs as a result of coronavirus and expense these to the income statement, rather than including as part of the cost of inventory.