The appearance and the spread of Corona Virus at the beginning of year 2020 has disrupted both social and economic infrastructure of the whole world. This has led to various measures to manage the virus and its attendant economic impact on various businesses. The pandemic has also introduced some measure of uncertainty in the way and manner certain information in the financial statements are presented to enable users make informed decisions. The global accounting bodies are not leaving any stone unturned in order to ensure true and fair reporting. To that end, some updates have been made by the standard setters to the existing accounting standard to reduce the level of uncertainty or at least clear some doubts for both the users and the preparers of financial statements. One of such areas, that need close attention is the treatment of manufacturing costs in the financial statements in the year of the pandemic. Manufacturing, wholesale/retail companies are the worst hit by the impact of Covid-19 on the measurement of their inventories- raw materials, work in progress and finished goods. Entities with yearend that falls within 2020 are the immediate target of this article.
COST OF INVENTORIES
Inventories are required to be measured at the lower of cost and net realizable value. (IAS2:9). Two concepts that should be clarified here are “cost” and “net realisable value”. Our attention in this article is focused on what constitutes cost because understanding of cost and its nature is critical to the application of net realisable value.
The cost of inventories ordinarily comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. (IAS 2:10)
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 entity from the taxing authorities), and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase. IAS2:11
COSTS OF CONVERSION
When inventories are purchased, they need to be converted or changed to finished goods. The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. The costs also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production. Examples are depreciation and maintenance of factory buildings, equipment and right-of-use assets used in the production process, and the cost of factory
management and administration. 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. (IAS2:12)
THE CRUX OF THE MATTER
The crux of the matter lies in the manner in which fixed costs are allocated to production. The IAS 2 describes how this is done. The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the
production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. Even where the allocation of cost is based on actual level of production, such level should approximate the normal capacity.
IMPACT OF COVID-19 ON THE APPLICATION OF NORMAL CAPACITY
Although the standard describes what is normal capacity, it fails to define how this is to be determined or explain what constitutes “normal circumstances”. Therefore, if normal capacity is to be determined based on the “normal circumstances”, the outbreak of COVID-19 must be carefully considered in arriving at the accurate cost of conversion that will ensure true and fair presentation in the financial statements under such normal circumstances.
The presence of Covid-19 should therefore be construed as an abnormal circumstance. Consequently, all the time/period lost due to Covid-19 should be adjusted for in the calculation of normal capacity that is eventually used for the absorption of fixed overhead to production. This is especially so considering the position of the standard that entities should take into account only the loss of capacity resulting from planned maintenance-not from abnormality resulting from events such as Covid-19.
What if planned maintenance was carried out during the Covid-19 period? The most ideal thing to do would be to separate the period covered by the planned maintenance/shut down from that of idleness resulting from COVID-19 and expense any related cost appropriately.
Having determined the capacity lost due to Covid-19, all the associated costs too are treated as abnormal cost and should be adjusted for. Examples of such costs are employee costs, loss of inventories, quality deterioration and additional costs incurred as a result close-down. Companies operating in the fast moving consumer goods are still in the clutter ensuing from loss of inventories and increase in transportation costs.
WHY BE CAUTIOUS AT THIS TIME?
In the event that accurate capacity is not determined, the amount of fixed overhead allocated to each unit of production may be needlessly increased as a result of low production or idle plant brought about by Covid-19. The point is: You should expense the costs arising as a consequence of low production or idle plant.
What about those entities that had a sudden increase in their production level as a result of the pandemic? Good examples are manufacturers of face mask, noodles, certain essential drugs, hand sanitizers, amongst others. In periods of abnormally high production, the amount of fixed overhead allocated to each unit of production is decreased so that inventories are not measured above cost. That will only be possible if all abnormal costs are adjusted for or removed and expensed. The point: You must reduce the amount of fixed overheads capitalised to each unit of production during periods of abnormally high production. Otherwise, the cost reported in the financial statements in respect of inventories may be overstated.
CONCERNS FOR INTERNAL AND EXTERNAL REPORTING
Auditors need to give a closer look at the costing template of their manufacturing companies at this time. This is because many of them may not revisit the costing template during this period. Some may under or over absorb manufacturing overhead.
More responsibility is also placed on the auditors in the area of Inventory Costing Module on the various accounting package available. Most of them are set up to ensure proper allocation of direct and overhead costs based on Bill of Materials and standard costs. There is no doubt that the system is not able to distinguish a Covid-19 period from the other “normal” period.
Both internal and external auditors are especially interested in the control around changes in overhead rates. Are the rates reviewed regularly? Are updates done to reflect the changes warranted by Covid-19 pandemic? Further work may be deemed necessary for the auditors to investigate significant variances. How are the variances taken care of in the costing of inventory and in the overall total cost of production at year end? For entities that lack control in the area of periodic analysis of absorption rates, this period is especially the right time to determine how significant the risk of misstatement in inventory costing /cost of production might affect the financial statements.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice.
For further information, please contact the following to discuss these matters in the context of your particular circumstances.
Olugbemiga A. Akibayo
Partner and Head, Assurance and IFRS Advisory
T: +234 0806 707 9994
E: [email protected]
Olutayo A. Adesina
Manager, Assurance and IFRS Advisory
T: +234 8032138511
E: [email protected]
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