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Accounting Manual for Departments
Inventories
Inventories
2015 Page 2
Chapter Content
1 Overview ....................................................................................................................................... 3
2 Key Learning Objectives ............................................................................................................... 3
3 Scope ............................................................................................................................................ 4
4 Identification .................................................................................................................................. 4
5 Recording and Measurement of Inventory.................................................................................... 5
5.1 Recording of inventory ........................................................................................................ 5
5.2 Initial measurement ............................................................................................................ 7
5.2.1 Costs of purchase .................................................................................................... 7
5.2.2 Costs of conversion .................................................................................................. 8
5.2.3 Other costs ............................................................................................................... 8
5.2.4 Cost of inventories of a service provider .................................................................. 8
5.2.5 Cost formulas ........................................................................................................... 8
5.3 Subsequent measurement ............................................................................................... 10
5.3.1 Cost vs. net realisable value .................................................................................. 10
5.3.2 Cost vs. current replacement cost .......................................................................... 11
6 Recommended Controls ............................................................................................................. 12
7 Summary of Key Principles ......................................................................................................... 13
7.1 Scope ................................................................................................................................ 13
7.2 Definition and identification ............................................................................................... 13
7.3 Recording and measurement ........................................................................................... 13
7.4 Disclosure ......................................................................................................................... 14
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1 Overview
The purpose of this Chapter is to provide guidance on how to identify and account for inventories.
The Office of the Accountant-General has compiled a Modified Cash Standard (MCS) and this manual serves as an application guide to the MCS which should be used by departments in the preparation of their financial statements.
Any reference to a “Chapter” in this document refers to the relevant chapter in the MCS and / or the corresponding chapter of the Accounting Manual.
Explanation of images used in the manual:
2 Key Learning Objectives
Understanding what is inventory
Understanding how to account for inventory and what needs to be disclosed
Definition
Take note
Management process and decision making
Example
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3 Scope
The Chapter on Inventories in the MCS, and consequently this guide does not apply to:
The accounting requirements in respect of the primary financial information (i.e. the expenditure relating to the acquisition of inventory etc.). This is dealt with in the Chapter on Expenditure.
Financial instruments. This is dealt with in the Chapter on General Departmental Assets and Liabilities.
Biological assets related to agricultural activity and agricultural produce at the point of harvest. This is dealt with in the Chapter on Capital Assets
Work-in-progress of services to be provided through a non-exchange transaction directly in return from the recipients.
Heritage assets. This is dealt with in the Chapter on Capital Assets.
Consumables. This is dealt with in the Chapter on Expenditure.
This chapter only applies to those goods that are essential for satisfying the service delivery obligation of a department. Accordingly the following items are excluded from the scope of this chapter:
items that are considered to be consumables; and
stationery and printing.
Consumable items are accounted for as consumables in accordance with Chapter on Expenditure.
The recording of inventory (Rand value of balance and number of items on hand at year end), which is currently disclosed in an annexure to the financial statements, will be recorded as secondary financial information from 1 April 2016.
4 Identification
As indicated earlier, inventories are those goods purchased / produced and held specifically for executing the service delivery mandate of the department.
Inventories can include finished goods produced, or work-in-progress being produced, by the department. Inventories also include materials and supplies awaiting use in the production process
Irrespective of an item being inventory or consumable it is important that is managed and controlled. Departmental policies and procedures should address this.
Inventories are assets:
in the form of materials or supplies to be consumed in the production process;
in the form of materials or supplies to be consumed or distributed in the rendering of services;
held for sale or distribution in the ordinary course of operations; or
in the process of production for sale or distribution.
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and goods purchased or produced by a department, which are held for distribution to other parties through a non-exchange transaction or for sale to other parties; for example, educational books purchased by a department of education for distribution to schools.
Examples of inventory in the public sector:
learning and teaching support materials - Department of Education (DoE);
certain items bought for distribution, e.g. school furniture bought by a department of education to be distributed to schools;;
certain library materials;
medicine, e.g. medicine purchased by a department of health to be distributed/sold to a patient ;
strategic stockpiles;
uniforms and protective clothing bought for the use of department staff, e.g. police uniforms; and
work-in-progress related to inventories.
5 Recording and Measurement of Inventory
5.1 Recording of inventory
For the purposes of recording inventory, a department should maintain an inventory register that will enable it to comply with the disclosure that needs to be made in the financial statements - refer to the Section on Disclosure which sets out the disclosure required.
Inventories should be recorded as part of the secondary financial information if, and only if:
it is probable that future economic benefits or service potential associated with the item will flow to the department; and
the cost or fair value of the item can be measured reliably.
A department should record inventory on the day when the risk and rewards of ownership of the inventory have been transferred to the department. This will normally be the date on which the inventory is delivered. However there are exceptions, for example when inventory is shipped free on board (FOB), in which case the risk and rewards are transferred to the buyer when the goods are loaded onto the ship, resulting in the buyer recognising inventory on the FOB date.
Service potential is the capacity of an inventory item, individually or in a group with other inventory items, to contribute directly or indirectly to achieving the objectives of the department. These objectives may include delivering a service to the public without receiving any economic return. Therefore inventory items that are used to deliver goods and services in accordance with a department‟s mandate, but do not directly generate net cash inflows are often described as embodying „service potential‟.
Example: Economic benefits
Hospitals sell medicine to patients at Rx per unit. Future economic benefits exist as it is probable that the hospital will receive payment for the medicine provided to the patient.
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Example: Service potential
A department distributes school furniture to schools as part of their service delivery mandate. In this case there is no direct economic benefit to the department distributing the furniture, but there is a service potential value (carrying out their mandate) that can be associated with the furniture.
Guidance on completion of inventory note in the financial statements
Opening balance
The opening balance is represented by the inventory closing balance as at the previous financial year. This balance should agree to the closing balance disclosed in the annexure to the financial statements of the previous financial year.
Adjustments to opening balance
This represents adjustments to prior year inventory as a result of prior period errors that are only identified in the current year. The following can give rise to adjustments:
Surpluses and shortages: A record of all inventory surpluses or shortages must be kept. The surpluses or shortages will represent the difference between recorded inventory amounts and actual inventory levels.
Reclassification as capital or minor assets: All inventories previously classified as inventory and reclassified as capital or minor assets need to be accounted for and transferred from the inventory register to the major or minor asset register.
Reclassification as inventory: All inventory previously classified as capital or minor assets and reclassified as inventory need to be accounted for and transferred from the asset register to the inventory register.
Reclassification as consumables: All items previously classified as inventory and reclassified as consumables under the new classification categories in the Standard Chart of Accounts (SCOA) need to be accounted for and transferred from the inventory register to the consumables register.
Additions / Purchases – Cash
All additions for the year should be reflected. The cash additions must be reconciled to the amounts reflected in goods and services in the statement of financial performance.
Additions – Non-cash
The fair value of inventory received in-kind or donated from sources outside government during the financial year is disclosed on this item. This also includes inventory is transferred from another government department for no value. There should be adequate and appropriate substantiating records to support the transfer. The recipient department should take on the inventory at the same value in the transferor’s books.
Disposals
All approved disposals of inventory, should be recorded here. These amounts will represent obsolete, lost or damaged inventory which is unable to be issued into production or for distribution.
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5.2 Initial measurement
Inventories are initially measured at cost, e.g. costs of purchase.
Where inventories are acquired through a non-exchange transaction, their cost must be measured at their fair value as at the date of acquisition.
5.2.1 Costs of purchase
The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequently recoverable by the department from the taxing authorities), and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and supplies. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase.
Issues
All inventory issued to cost centres or external stores for production, distribution or consumption must be recorded.
Adjustments
This represents correction of errors that occurred in the current financial year that relate to inventory. This also represents the difference between the initial recognition amount (eg cost for inventory purchased) and weighted average.
Closing balance
In an accrual environment this amount is shown as a current asset in the statement of financial position. The closing balance of inventory for the current financial year will be the opening balance for the following financial year. A stocktake at year end or close to year end will assist with verifying the accuracy of inventory amounts reported in the annexure.
Quantity
Where weighted average is used to value inventory, the quantity is required to reconcile the actual units counted to the units as per the inventory system.
For the purposes of preparing the inventory reconciliations and disclosure, the LOGIS team has prepared a presentation on the reports available for the reconciliation and reporting requirements for inventory. This document can be found on either the LOGIS website (http://logis.pwv.gov.za/logisweb/) or on the OAG website.
Example: Inventory acquired through a non-exchange transaction
An international aid agency donates medical supplies to a department in the aftermath of a natural disaster. Under such circumstances, the cost of the inventory is its fair value as at the date it is acquired.
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5.2.2 Costs of conversion
The costs of converting work-in-progress inventories into finished goods inventories are incurred primarily in a manufacturing environment. The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour.
For example, the allocation of costs, both fixed and variable, incurred in the development of undeveloped land held for sale into residential or commercial landholdings, could include costs relating to landscaping, drainage, pipe laying for utility connection, etc.
5.2.3 Other costs
Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include non-production overheads or the costs of designing products for specific customers in the cost of inventories.
5.2.4 Cost of inventories of a service provider
To the extent that service providers have inventories they measure them at the costs of their production. These costs consist primarily of the labour and other costs of personnel directly engaged in providing the service, including supervisory personnel, and attributable overheads. The costs of labour not engaged in providing the service are not included. Labour and other costs relating to general administrative personnel are not included in the cost of inventory.
5.2.5 Cost formulas
The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects must be assigned by using specific identification of their individual costs.
Specific identification of costs means that specific costs are attributed to identified items of inventory. This is the appropriate treatment for items that are segregated for a specific project. However, specific identification of costs is inappropriate when there are large numbers of items of inventory that are ordinarily interchangeable. In such circumstances, the method of selecting those items that remain in inventories could be used to obtain predetermined effects on the surplus or deficit for the period.
The cost of inventories which are not costed specifically as per above, must be assigned by weighted average cost formula.
Applying the weighted average formula
On 1 April 20x1 Department A buys 1,000 units of product X at R2.00 per unit. On 1 December 20x1 Department A buys another 500 units of product X at R2.50 per unit. At 31 March 20x2, 600 units were on hand, thus 900 units were sold during the year.
The weighted average cost per unit is:
[R2 000 (1 000 x R2.00) + R1 250 (500 x R2.50)] / 1 500 = R2.17
The value of inventory on hand (closing balance) at year end will therefore be:
R2.17 x 600 = R1 300
Weighted average cost per unit is calculated by dividing inventory purchased by the sum of opening inventory plus purchases minus inventory sold.
Note that internal movements do not affect the weighted average cost.
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For this example it was assumed that the weighted average cost per unit is calculated periodically, i.e. on a monthly basis (note that the weighted average cost can be calculated after each purchase or periodically, e.g. weekly, monthly, yearly, etc, consequently, depending on how it is done, it could result in different costs per unit).
To illustrate the concept above, assume that Department A calculates the weighted average cost per unit after every purchase.
The following inventory transactions took place during the month of October 20x1:
Date Movement Units Cost / sale price per unit (R)
01 October Opening balance 200 20
02 October Sales (120) 40
05 October Purchases 300 24
15 October Sales (200) 48
20 October Purchases 150 30
25 October Sales (150) 50
31 October Closing balance 180 ?
The calculation of the weighted average cost per unit will be done as follows:
Date Movement Units Cost per unit (R)
01 October Opening balance 200 20
02 October Sales (120) 20
80 20
05 October Purchases 300 24
380 23.16 [(80x20) + (300x24)] / 380
15 October Sales (200) 23.16
180 23.16
20 October Purchases 150 30
330 26.27 [(180x23.16) + (150x30)] / 330
25 October Sales (150) 26.27
31 October Closing balance 180 26.27
The value of inventory on hand at month end will therefore be:
R26.27 x 180 = R4,729
If we take the same example, but calculate the weighted average on a yearly basis (as in our first example), the outcome will be as follows:
Units Cost price per unit (R) Total cost price (R)
Opening balance 200 20 4 000
Purchases 300 24 7 200
Purchases 150 30 4 500
Total 650 15 700
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The weighted average cost per unit is:
15 700 / 650 = R24.15
The value of inventory on hand (closing balance) at year end will therefore be:
R24.15 x 180 = R4 347
As can be seen from the previous calculations, the weighted average cost per unit and ultimately the value of inventory on hand will differ depending on the basis used to calculate the cost per unit.
5.3 Subsequent measurement
This section only applies to inventory recorded in the financial statements as secondary financial information.
Inventories are subsequently measured at the lower of cost and net realisable value, except where the following paragraph applies.
Inventories are measured at the lower of cost and current replacement cost where they are held for:
distribution through a non-exchange transaction; or
consumption in the production process of goods to be distributed at no charge or for a nominal charge.
5.3.1 Cost vs. net realisable value
The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices declined due to market conditions, or the estimated costs incurred to complete has increased.
The practice to write down inventories to net realisable value is consistent with the view that assets should not be reflected in excess of the future economic benefits or service potential expected to be realised from their sale, exchange, distribution or use. Inventories that are held for distribution at a market price are measured at the lower of cost and net realisable value upon subsequent measurement.
Example: Inventory write-down to net realisable value
Department Z’s reporting date is 31 March 20x3. During the previous financial year, 20x2, Department Z, imported diesel from Iraq at R5 per litre which is sold at R7.5 per litre.
During 20x3, scientists and geologists discovered oil fields in Malawi. As from 20x3 diesel can be imported at R2 per litre from Malawi. This results in an announcement from the South African government that diesel can only be sold at a maximum of R4.5 per litre.
At the reporting date, Department Z still holds 5 000 litres of diesel imported from Iraq during 20x2 (assume that in 20x3 and 20x2 no other changes took place).
The net realisable value of diesel on hand at 31 March 20x3 is R4.5 per litre. The inventory carrying amount before any write-down at reporting date is R25 000 (5 000 x
Net realisable value is the estimated selling price in the ordinary course of operations less the estimated costs of completion and the estimated costs necessary to make the sale, exchange or distribution.
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R5).
Inventory must then be written down to its net realisable value of R22 500 (5 000 x R4.5). The difference of R2 500 is recorded as part of the movement in inventory.
The following illustrates the disclosure that will be made in the financial statements of Department Z:
Extract from Notes to the financial statements
Quantity 20x3 Quantity 20x2
Inventory R R
Opening balance 5 000 25 000 - -
Adjustment to opening balance - (2 500) - -
Add: Additions / Purchases - Cash - - 5 000 25 000
Add: Additions - Non-cash - - - -
(Less): Disposals - - - -
(Less): Issues - - - -
Add / (Less): Adjustments - - - -
Closing balance 5 000 22 500 5 000 25 000
5.3.2 Cost vs. current replacement cost
In certain situations, a department may hold inventories with future economic benefits or service potential that are not directly related to their ability to generate net cash inflows, i.e. inventories are distributed at no charge or for nominal value.
Therefore, where market rates are not applicable for distribution of inventories, they are measured at the lower of cost and current replacement cost upon subsequent measurement.
Example: Current replacement cost of inventory that will be discharged at no cost
Department B purchased 200 units of inventory X with a cost of R65 per unit, to be distributed to various departments and the public at no cost. At year end there were 20 units on hand and the cost to acquire inventory X is now R60 per unit.
As inventory is distributed it will be removed from the inventory records and shown as “issues” in the financial statements. The remaining units on hand should be written down to their replacement cost of R60 per unit. Therefor an amount of R100 (20 units x R5) will be shown as part of the movement in inventory.
The following illustrates the disclosure that will be made in the financial statements of Department B:
Current replacement cost is the cost the department would incur to acquire the inventory on the reporting date.
Therefore, it is the value that the department would need to pay to replace the inventory should the need arise.
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Extract from Notes to the financial statements
Quantity 20x3 Quantity 20x2
Inventory R R
Opening balance - - - -
Adjustments to opening balance - - - -
Add: Additions / Purchases - Cash 200 13 000 - -
Add: Additions - Non-cash - - - -
(Less): Disposals - - - -
(Less): Issues (180) (11 700) - -
Add / (Less): Adjustments - (100) - -
Closing balance 20 1 200* - -
* Test to make sure closing balance is accurately valued:
At year end there were 20 units on hand and the current replacement cost at which the inventory should be measured is R60 per unit, therefore 20 units x R60 = R1 200.
Inventory is therefore accurately valued as year-end.
6 Recommended Controls
The following are examples of controls or procedures a department can implement to assist in inventory management:
appoint or designate an inventory manager;
have an inventory management policy;
implement controls over the safeguarding of inventory;
ensure there is maintenance of records over inventory movement;
keep an overall inventory register for the department as well as individual registers for each separate location;
perform inventory counts periodically to ensure that actual inventory agrees with theoretical inventory records and to ensure inventory is still in the condition as intended by management (i.e. not obsolete); and
annual review of inventory management policy.
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7 Summary of Key Principles
7.1 Scope
Includes: Excludes
inventories held for sale or distribution in the ordinary course of operation or rendering of services;
material or supplies to be consumed in the production process; and
inventories to be consumed in the ordinary course of operations.
work-in-progress from construction contracts or services to be provided through a non-exchange transaction;
financial instruments;
biological assets at the point of harvest;
heritage assets; and
consumables.
Inventories are those goods purchased / produced and held specifically for executing the service delivery mandate of the department.
7.2 Definition and identification
To classify an item as inventory, management should consider the definition, nature, timing and materiality of the item.
Inventory types:
Items held for sale or distribution in the ordinary course of business
E.g. school furniture, library materials
Items in the production process for sale or distribution
E.g. work-in-progress
Materials and supplies consumed in production process
E.g. raw materials and consumable spare parts
Materials and supplies consumed or distributed in the rendering of services
E.g. ammunition and security supplies
7.3 Recording and measurement
Inventory is recorded and disclosed as inventory in the financial statements when it meets the recognition criteria:
it is probable that future economic benefits or service potential will flow to the department; and
its cost or fair value can be measured reliably.
Inventory is recognised at cost, except when it is acquired at no cost in which case it is recognised at fair value.
Costs include:
Cost of purchase;
Cost of conversion;
Other cost;
Excludes abnormal spillages, selling expenses, admin overheads, etc.
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After initial recognition, as secondary financial information, inventory is recorded at the lower of cost and net realisable value, or current replacement cost where inventory is held at no or nominal charge.
Net realisable value:
Selling price less cost to sell
Current replacement cost:
Cost department would incur to acquire inventory on reporting date
All inventory items at year-end are reflected using the specific identification of their individual costs or weighted average cost formula.
7.4 Disclosure
Inventory purchased is recognised as expenditure under goods and services in the statement of financial performance.
Inventory is also recorded in the financial statements where more detail is provided, such as inventory quantities, opening balance, movements and closing balance.
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ANNEXURE A: Inventories FAQ’s
Is the chapter on Inventory in agreement with the Inventory Management Framework?
The Inventory Management Framework and Guide were issued in 2009. Although Inventory meets the definition of an asset, inventory was previously expensed as goods and services with no additional disclosure requirements. Similar to the Capital Asset project initiated in the early 2000‟s, there is a need for departments to provide additional disclosure on Inventory to users of financial statements. Following a status assessment by the OAG departments a requirement that inventory be shown in an annexure was added.
The OAG assessed the progress of departments in showing details of inventory on an annual basis and considers the systems‟ capacity before modifying the requirement to show Inventory as a note. Ultimately, as determined by the OAG, the departmental framework will require inventory to be recognised on the statement of financial position.
Following the status assessment, the OAG established that some departments have goods that are essential for satisfying the service delivery obligation of a department thus meeting the definition of inventory. These are “inventory departments” such as Health with medical supplies as its inventory. The term Consumables was broadened to include goods that normally meet the definition of inventory, but are not essential for satisfying the service delivery obligation of a department.
It should be noted that the MCS is the latest accounting framework and supersedes any other accounting framework and guide that are issued for departments. The following table compares key principles, requirements and proposals stated in the Inventory Management Framework and the principles and requirements of the MCS.
Inventory Management Framework
Modified Cash Standard Comments
Inventory management is concerned with accounting for and management of assets which are classified as inventory
This chapter only applies to those goods that are essential for satisfying the service delivery obligation of a department
Inventory not essential for satisfying the service delivery obligation of a department was reclassified to Consumables with effect from the 2013/14 financial year (2014/15 for the Western Cape Province). This lessens the additional disclosure requirements for “non-inventory departments”
Assets classified as inventory are current assets which are often held in a warehouse or stockroom and issued to jobs or projects or otherwise utilised as required. Assets held in inventory are generally required to ensure production or service delivery can continue as planned without interruption.
Inventory encompasses those goods purchased / produced and held specifically for executing the service delivery mandate of the department.
The principles stated by both documents are alike.
The phrase “often held in a warehouse or stockroom” does not imply that all items held in the warehouse or storeroom meet the definition of inventory. Only items that meet the definition of inventory should be treated as such.
Inventory management policies should be reviewed annually and adjusted as necessary with a view to continuous improvement in inventory management.
According to the AMD, as an example of controls or procedures a department can implement to assist in inventory management, a department should have an inventory management policy
The requirements stated by both documents are alike.
National and provincial This Chapter becomes effective The OAG assesses the readiness of the
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Inventory Management Framework
Modified Cash Standard Comments
departments are moving towards accrual accounting and will be asked to phase-in certain requirements. The OAG will provide guidance on disclosures each year in the Preparation Guide to the Annual Financial statements.
The proposed road map for national and provincial departments to phase in the GRAP 12 requirements is shows that Inventory may be a disclosure note item in 2011/12 and adopt full accrual requirements in 2012/13.
for annual financial statements covering periods beginning on 1 April 2016
departments to account for inventory in consultation with various stakeholders which include the systems unit. This led to determining the effective date of the MCS’s Inventory Chapter as 1 April 2016 where Inventory will be reported as secondary financial information. Ultimately departments will be required to comply fully with GRAP issued by the Accounting Standards Board, in which case Inventory and all other assets will be recognised on the statement of financial position.
Should a department account for immaterial items that meet the MCS definition of inventory as inventory or as consumables?
The default position is for all items that meet the definition of inventory as defined by the MCS to be accounted for as inventory. In instances where management decides to account for such items as consumables, the department‟s management policy that deals with inventory should specify management reasons for accounting for such items as consumables rather than inventory. Where there is uncertainty in this regard, the OAG should be consulted.
If a department acquires items that meet the definition of inventory once-off, should they account for these as consumables or inventory?
Inventory, similar to 2.12.2 above, the default position is for all items that meet the definition of inventory as defined by the MCS to be accounted for as inventory. In instances where a management decides to account for such items as consumables, the department‟s management policy that deals with inventory should specify management reasons for accounting for such items as consumables rather than inventory. Where there is uncertainty in this regard, the OAG should be consulted.
Should inventory acquired by the department, meant for distribution to beneficiaries, delivered directly to the beneficiary be accounted for as inventory of the department?
Yes. Such inventory should be recorded as a transfer in and transfer out of inventory. The risks and rewards of the inventory remains with the department until it is under the control of the beneficiary. For example, the department still has the responsibility to ensure that the quantity delivered meets the required standards. Also if there is a shortfall, the department should ensure that the shortfall is resolved. The agreement to deliver goods is between the supplier and the department and not with the beneficiary.
How should a department account for “gain or loss” that resulted from using weighted average to value inventory?
The difference between the initial recognition amount of inventory and weighted average should be shown as “adjustments” in the Inventory annexure.
How should items that were inventory and reclassified as consumables be accounted for?
Prior year figures of items previously classified as inventory and reclassified as consumables under the new classification categories in the Standard Chart of Accounts (SCOA) should be restated.
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Guidance on reclassification for Inventory Departments and Non-Inventory Departments is in a document titled Classification Circular 3 – Inventory and Consumables on the SCOA website. A department that reclassified its inventory to consumables should add narrative information in the goods and services note summarizing details of the reclassification.
