¿How is the inventory impairment recognized?

Inventory impairment is the value loss of an asset due to the following factors:

An increase in market competition.

When occurs an increase in the competition in the market; this increase causes an increase in the supply and demand of goods and services and, therefore, a reduction in the selling prices of a company’s products.

Consequently, the net realizable value of inventory is less than the carrying amount of the entity, and this way, the company must recognize an impairment loss.

Another element that triggers an impairment loss occurs when there is a factor that increases the product’s cost, and these increases are not reflected in the sale price.

It will also be necessary to recognize an impairment loss when inventories become obsolete.

Or finally, the market regulations could cause a decrease in the sale price of products.

In this way, after analyzing these elements, an entity, At the end of the reporting period, must assess whether its inventories are impaired.

In other words, if the carrying amount is greater than the net realizable value.

If inventories are impaired, the entity should reduce the asset’s cost to match it to the net realizable value.

That is, the company must recognize this decrease in profit or loss.

The inventory impairment recognition requires two elements, which we will explain below:

Inventories cost

Net realizable value.

Inventories cost

The following items must be included in the inventory cost.

(+) Purchase price:

(+) import duties:

(+) Non-recoverable taxes

(+)Transport:

(+) Directly attributable costs:

(-) Discounts

(-) Rebates:

Net realizable Value

The net realizable value is the estimated sales price less the costs to complete the sale.

The costs to complete the sale are all those costs necessary to be able to sell the product.

That is, if an entity considers that if it does not incur a certain cost, the sale will not take place, this means that it is a necessary cost to complete the sale.

For example, a pharmaceutical company buys 600,000 worth of goods and has a 50% profit margin; in other words, the selling price equals 900,000 and incurs selling expenses of 150,000.

Net realizable value = Estimated selling price – estimated costs to complete the sale.

Net realizable value = 900,000 – 150,000 = 750,000

If an entity finds that the inventory cost calculated with the items that we previously saw is higher than the net realizable value, a company must recognize an impairment loss in the financial statements due to the difference between both concepts.

Inventory impairment calculation

The inventories’ impairment to recognize, it’s necessary to use the formula shown below:

Inventory impairment = carrying amount – net realizable value.

If the net realizable value is less than the carrying amount, inventories must be reduced by the difference generated.

Let’s look at the following example:

A company has three business lines :

Petroleum:
Coal:
Gas:

The financial information of the company at the end of the reporting period is shown below:

Impairment inventory1

The carrying amount of the entity’s products are follows:

Petroleum: 1,050,000

Coal: 950.00

Gas: 1, 100,000

The impairment calculation is follows:

Impairment inventory

As you can see, the only product that shows impairment is the GAS product; for this reason, the entity must reduce its inventory by 202,000 against profit and loss.

At this point, I want to make an essential clarification:

Paragraph 29 of IAS 2 sets out in general terms that the reduction until reaching the net realizable value is calculated for each item of inventories. 

However, it may be appropriate to group similar or related items in some circumstances.

This is the case of inventory elements related to the same business line with similar purposes or are produced and sold in the same geographic area and can’t, for practical reasons, be asses separately from other items of the same line.

Therefore, concerning the proposed example, if, according to management’s judgment, the entity cant analyze the products separately, the company would conclude that it should not recognize an impairment loss, as shown in the following graph:

Impairment inventory3

The inventory analyzed as a whole shows that the carrying amount of the sum of all the products is less than the net realizable value, therefore, it is not necessary to reduce it.

Perishable products Impairment​

Companies with perishable products generally must have very rigorous logistics in terms of inventory management.

Usually, when all the goods aren’t sold, the remaining inventories will likely present a total loss, and therefore the company must derecognize these assets and recognize an impairment loss in the income statement.

For example, a company dedicated to selling fish has an inventory of 50,000 units of product ready to sell at $ 8 per unit.

However, due to low demand, the company only manages to sell 35,000 units.

The entity considers it unlikely to can sell the other units as they are perishable products; therefore, there is the possibility of derecognizing the remaining inventory.

The other possibility that the company has is to sell the inventory at a price significantly lower than its list price; this price reduction will undoubtedly affect the net realizable value and this way, the entity must also recognize an impairment loss.

Inventories impairment in producing companies​

Many people might think that the inventory impairment calculation only is applied to finished products, but this is not so.

Paragraph 32 of IAS 2 states that raw materials generally don’t show impairment.

However, the paragraph also clarifies that if the finished inventory of a company is above its net realizable value, it is necessary to recognize an impairment loss.

Now, what happens if the inventory is still in production at the end of the reporting period?

In this case, the entity’s management the entity must estimate the costs necessary to complete production.

Once this process has been carried out, it must determine if there is impairment; this calculation is made with the following formula. 

Inventory impairment = Estimated selling price – costs to complete production – costs to complete sale vs. carrying amount

As you can see, when we talk about the manufacturing inventory,   another element is introduced into the calculation of the net realizable value; this element is the cost to complete the production.

Let’s look at the following example:

An entity manufactures medicines; its production process begins in April of year 1 and ends in February of year 2.

 The financial information at the end of the reporting period is shown below:

 Raw material: 50,000

Labour direct: 70,000

Indirect costs: 30,000

 Production costs: 150,000

The entity estimates that it will need to incur 80,000 to complete its production in February of year 2; it also considers that the estimated sale price will be 240,000, and the estimated costs to complete the sale will be 25,000.

 Impairment: Estimated selling price – production costs – costs to complete the sale – costs to complete production.

 (+) Estimated sale price: 240,000

(-) Production costs: 150,000

(-) Costs to complete the sale: 25,000

(-) costs to complete production: 80,000

Impairment: -15,000

Impairment reversal

At the end of the reporting period, an entity must assess whether the events that led to the recognition of impairment have been reversed.

For example, an entity dedicated to medicines sales in year 1 has inventory in stock for 500,000 units.

The unit selling price is $8, the selling cost is $4, and the estimated costs to complete the sale are $ 600,000.

When checking whether the inventory is impaired, it is set out that the carrying amount of the inventory is 2,000,000, and the net realizable value is equivalent to 3,400,000 (500,000X8 – 600,000), ie, there is no impairment.

However, due to a regulation of prices by the jurisdiction where the entity operates, it was necessary to lower the product’s sale price to $5.

This means that the new net realizable value is 1,900,000 (500,000X5 – 600,000)

Thus, the impairment for year 1 is 100,000.

This impairment should be reflected as a lower inventory value against profit and loss.

If, for example, for year 2, the restriction is removed and prices return to $8 per unit, the entity must reverse the impaired calculated previously.

It is important to say that inventories must be increased due to the reversal of impairment only in the amount that was reduced as a result of previously recognized impairment, that is, in 100,000.