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Inventories and Provisions
Inventories are current assets, representing goods held for sale or used in production. Provisions are liabilities of uncertain timing or amount, recognized when a present obligation arises from past events, and settlement is probable and can be reliably estimated.
Inventories
Inventories are defined as assets that are:
- held for sale in the ordinary course of business (finished goods, merchandise)
- in the process of production for such sale (unfinished goods)
- to be consumed in the production/service process (raw materials, production supplies)
Just like with tangible assets, inventories are recognized when:
- it is probable that future economic benefits will flow to the entity
- the cost of the inventories can be measured reliably
Initial Measurement
Inventories are measured at cost. Individual inventory (specific items) are measured just like other tangible assets, i.e., at purchase cost or production cost.
For items that are ordinarily interchangeable, cost formulas can be applied to determine the cost of inventory at sale:
- Weighted Average: Items are valued at the weighted average cost of similar items at the beginning of the period, and the purchase/production cost during the period.
- FIFO (first in first out): Items sold are assumed to be those that were purchased/produced first. Thus, ending inventory consists of the most recently purchased/produced items.
- LIFO (last in first out): Not allowed under IFRS, only German GAAP. Items sold are assumed to be those that were purchased/produced most recently. Thus, ending inventory consists of the oldest items.
Subsequent Measurement
Inventories are subsequently measured at the minimum of cost, or net realizable value (NRV).
Net Realizable Value (NRV)
NRV is 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.
For materials / supply, replacement costs are used as an estimate for NRV, if the finished goods are expected to be sold at/above cost. In German GAAP, replacement costs are typically used for materials.
Each item is valued individually, except when items are similar and can be grouped. Write-downs are recognized as an expense in the period they occur. The NRV is assessed in each subsequent period, and if the reason for the previous write-down no longer exists, the write-down is reversed (up to the original write-down cost). However, the reversal cannot exceed the original cost.
Provisions
Contrary to liabilities, provisions are liabilities of uncertain timing or amount and part of equity or non-current liabilities on the balance sheet. They are recognized when:
- a present obligation (legal or constructive) arises from past events
- it is probable that an outflow of resources will be required to settle the obligation
- the amount can be reliably estimated
If one of these criteria is not met, no provision is recognized. Instead, the obligation is disclosed as a contingent liability in the notes to the financial statements, or ignored if the possibility of an outflow is remote.
Under German GAAP, provisions are recognized for uncertain liabilities, impending losses from pending transactions, and for restructuring.
Contingent Liability
Besides liabilities and provisions, contingent liabilities are the third type of obligations. They are either:
- A possible obligation: arises from past events, but its existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the entity’s control
- A present obligation that is not recognized because either an outflow of resources is not probable, or the amount cannot be reliably estimated.
A contingent liability is not recognized in the financial statements, but disclosed in the notes, including an estimate of its financial effect, an indication of the uncertainties to timing and amount, and the possibility of reimbursement.
Measurement
Provisions are measured at the best estimate of the expenditure required to settle the present obligation at the balance sheet date. This is typically the amount that an entity would rationally pay to settle the obligation or to transfer it to a third party. There are two basic methods:
- Most Likely Amount: Used for one-off events (e.g. a court case). The estimated amount with the highest probability is used.
- Probability Weighted Expected Value: When there is a large range of possible outcomes, or there are many similar events (e.g. warranties). The expected value is calculated by weighting each possible outcome by its probability.
The value is discounted to current value and remeasured at each fiscal year.
When a provision is used (i.e., the obligation is settled), the expense is recognized in the income statement. If is settled for more than the provision, the additional cost is recognized as an expense (as provision under the corresponding expense). If it is settled for less, the difference is recognized as income (reversal of provision).
Provision Accrual occurs when an existing provision is reevaluated at a higher value, leading to an expense. If the revision leads to a lower value, it is called Provision Reversal leads to income.
Impact on Earnings Management
Because provisions are measured by estimates, there is no wrong or right. Management can use this influence earnings by increasing or decreasing (provision) expenses in a given period.
Earnings management is further discussed in Accounting Policy.
Disclosure
Changes to provisions must be disclosed in the notes, including:
- carrying amount at the beginning and end of the period
- additional provisions made during the period
- amounts used during the period
- unused amounts reversed during the period
- the increase during the period due to the passage of time (interest)
For each class of provision, the amount recognized and a brief description of the nature of the obligation must be disclosed, along with an indication of the uncertainties about the amount or timing of the outflow, and any expected reimbursements.