The Accounting standards for inventory is 10 pages in both Accounting Standards for Private Enterprises (ASPE) and International Financial Reporting Standards (IFRS).  If we compare this to the number of pages for financial instruments, 60 pages in ASPE, and 130 pages in IFRS, it is easy to assume that inventory costing is simple.

Less Words Mean More Judgment

Inventory accounting standards are written based on principles versus with financial instruments using rules.  Rules based accounting is explicit and requires more words to tell people how to apply them.  The difference between the two sections is like black and white versus shades of gray. 

The principles based inventory accounting standards gives companies options (considered accounting policy choices) on how it records its inventory.

Different Options and Different Results!

If different options exist it means that, depending on what choices you make, you can have different values for your inventory at the end of the year.  For example, what costs make up your production overhead?  How do you assign direct and indirect costs? if you produce more than one product, what is your overhead allocation between your different product lines?

These decisions will impact your financial statements and the decisions people make from those statements.

A Detailed Example

A company mass-produces two different products for sale and one of the products is a raw material of the other.  The production costs for the raw material are not separately identifiable which means ASPE requires the company to assign costs using the weighted average cost method (assigning costs evenly over all of the goods produced).  While the company has to use the weighted average method, it still has some options when designing its inventory cost formula.

We have seen circumstances where a small change in the cost formula, assigning certain costs one step earlier in the production process, resulted in about a 15% swing in the yearend inventory.  The change was about a $1.5 million increase on $9 million of inventory.  This swing could impact the company in a number of different ways.

Financing

If the company has a working capital facility capped at 75% of good accounts receivable and 75% inventory (common terms in manufacturing) the company would receive an additional (75% * $1.5 million) $1.13 million in financing.

Corporate Taxes

By increasing the value of yearend inventory, expenses are moved from the income statement to the balance sheet which increases net income by $1.5 million increasing corporate income taxes by $292,500 based on the 2016 BC and Federal tax rates for a company not eligible for the small business deduction (26%).

Sale of a Business

If the company is up for sale and inventory is a part of post-closing purchase price adjustments, the seller may receive an additional $1.5 million, although in practice, the purchase price of inventory would be subject to negotiation.

Other Areas

How costs are assigned impacts more than outside users of the financial statements, it also impacts decisions made by management and operational staff.  If you pay a bonus on net income or gross margin, a $1.5 million increase in net income would also increase management's bonus.  How your inventory is costed provides both positive and negative incentives. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.