Here’s a tentative agenda decision recently issued for comment by the IFRIC:

• The Committee received a request about the costs an entity includes as the ‘estimated costs necessary to make the sale’ when determining the net realizable value of inventories. In particular, the request asked whether an entity includes all costs necessary to make the sale or only those that are incremental to the sale.
• Paragraph 6 of IAS 2 defines net realizable value as ‘the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale’. Paragraphs 28–33 of IAS 2 include further requirements about how an entity estimates the net realizable value of inventories. Those paragraphs do not identify which specific costs are ‘necessary to make the sale’ of inventories. However, paragraph 28 of IAS 2 describes the objective of writing inventories down to their net realizable value—that objective is to avoid inventories being carried ‘in excess of amounts expected to be realized from their sale’.
• The Committee observed that, when determining the net realizable value of inventories, IAS 2 requires an entity to estimate the costs necessary to make the sale. This requirement does not allow an entity to limit such costs to only those that are incremental, thereby potentially excluding costs the entity must incur to sell its inventories but that are not incremental to a particular sale. Including only incremental costs could fail to achieve the objective set out in paragraph 28 of IAS 2.
• The Committee concluded that, when determining the net realizable value of inventories, an entity estimates the costs necessary to make the sale in the ordinary course of business. An entity uses its judgement to determine which costs are necessary to make the sale considering its specific facts and circumstances, including the nature of the inventories.
• The Committee concluded that the principles and requirements in IFRS Standards provide an adequate basis for an entity to determine whether the estimated costs necessary to make the sale are limited to incremental costs when determining the net realizable value of inventories. Consequently, the Committee [decided] not to add a standard-setting project to the work plan.

That all sounds pretty straightforward, but it’s still interesting to look at the underlying agenda paper. The request apparently came from the European Securities and Markets Authority (ESMA), reflecting differences observed in practice. The submission focused on the example of “costs necessary to undertake special promotional campaigns that are necessary to sell the entire inventory (or the oldest portions thereof) and other costs that are ordinarily needed to sell inventories,” setting out a possible interpretation that “other costs than direct ones may serve other purposes than only the sale of the inventory and therefore shall not be included when calculating the net realizable value. Net realizable value is generally written down to net realizable value item by item and this may not be possible for such promotional expenses.” ESMA commented that “the lack of clarity of the wording of IAS 2 leads to divergent practices, including within the European jurisdictions. In particular, ESMA is concerned that different outcomes can emerge depending on whether a more conservative or narrower notion of the ‘necessary’ costs to make the sale is adopted.”

The agenda paper addressed that issue, apparently to IFRIC’s satisfaction, by noting: “by reflecting all costs necessary to sell its inventories—instead of only those that are incremental—the entity is simply estimating the net amount it is able to realize from sale of the inventory in its ordinary course of business. Whether a cost also contributes to the sale of other inventory items does not make it unnecessary for the sale of a particular inventory item. If a cost contributes to selling other inventories as well as the inventories for which net realizable value is being determined, then the entity would allocate a portion of the total cost to the inventories in question.” So that’s probably the end of that.

It’s an interesting issue though, if only because IAS 2 (issued twenty years ago!) doesn’t attract the spotlight too often. It’s not too unusual to come across financial statements in which inventory is one of the largest balance sheet items, and yet for which the accompanying accounting policy and other disclosure are very sparse compared to far less important items which happen to be covered by the more prescriptive later standards. Presumably, ESMA hasn’t in any way identified a “new” problem here – it’s more likely that inventory valuation is a sufficiently shadowy process that a long-standing area of divergent practice took twenty years to come to its attention. Perhaps the IFRIC agenda decision, if finalized in something like its current form, will prompt more detailed disclosure of such areas of significant judgment relating to inventory valuation. I wouldn’t count on it though…

The opinions expressed are solely those of the author