The amounts reported as ‘inventories’ and ‘cost of goods sold’ are two significant items that can appear on a company’s financial statements, especially manufacturing and merchandising companies. Some costs are included in the asset ‘inventories’, while others are recognized as expenses on the income statement in the period in which they are incurred.
The inclusion of costs in inventory defers their recognition as an expense on the income statement until the inventory is sold. Additionally, a company which includes costs in inventory that should rightfully be expensed will overstate the profitability reported on its income statement, as well as create an overstated inventory value on the balance sheet.
Costs Included in Inventories
Both US GAAP and IFRS stipulate that the costs that are to be included in inventories are “all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.”
Costs of purchase include the purchase price, import and tax-related duties, transport costs, insurance during transport, handling costs, and other costs that are directly attributable to the acquisition of finished goods, materials, and services. The costs of purchase, as well as the price paid, are reduced by trade discounts, rebates, and similar items.
Costs of conversion include all costs that are directly related to the units produced, for example, direct labor costs, and fixed and variable overhead costs.
Costs Recognized as Expenses
Under both IFRS and US GAAP, the costs that are excluded from inventory include: abnormal costs that are incurred as a result of material waste, labor or other production conversion inputs, storage costs (unless required as part of the production process), and all administrative overhead and selling costs.
These excluded costs are treated as expenses and recognized on the income statement during the period in which they are incurred.
Which of the following costs should a company recognize as expenses?
A. Raw materials, overhead, and direct labor costs
B. Handling costs, transport, and administrative costs
C. Abnormal waste, storage, and selling costs
The correct answer is C.
Abnormal waste, storage, and selling costs are all usually recognized as expenses. Choice A provides costs that are usually included in inventories, while choice B gives a combination of costs that are included in inventories (handling costs and transport costs) and some that are usually expensed (administrative costs).
Reading 27 LOS 27a:
Distinguish between costs included in inventories and costs recognised as expenses in the period in which they are incurred