1 INTRODUCTION DEFINITIONS VALUATION INVENTORY ALLOWANCE (NET REALIZABLE VALUE) REPORTING INTERNAL INVENTORY...

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1 RAPALA INVENTORY VALUATION PRINCIPLES AND INTERNAL INVENTORY 1 INTRODUCTION DEFINITIONS INVENTORIES STOCK COVERAGE OBSOLETE INVENTORY NET REALIZABLE VALUE VALUATION COST OF INVENTORIES Cost of purchase Cost of conversion Other costs and costs to be excluded SPARE PARTS DISPLAYS AND STANDS COST FORMULAS INVENTORY ALLOWANCE (NET REALIZABLE VALUE) GUIDANCE AND PROCESS TO ALLOWANCE DETERMINATION CALCULATION OF NET REALIZABLE VALUE (NRV) RESERVE Situations in which to consider allowance Grouping similar items Fluctuating prices Binding sales or service contracts Using of estimates Materials and supplies REVERSAL OF THE RESERVE EXAMPLE ON CALCULATION OF NET REALIZABLE VALUE (NRV) RECOGNITION AS AN EXPENSE REPORTING INTERNAL INVENTORY /16

2 1. INTRODUCTION This document presents principles for inventory valuation including all necessary inventory definitions, IFRS valuation principles, instructions on recognizing an allowance for obsolete inventory items and instructions on internal inventories. Inventories are valued at the lower of cost or net realizable value. The costs are determined based on actual costs or FIFO method. The net realizable value is calculated based on the estimated selling prices of the finished goods. The cost of inventories includes all costs of purchase and cost of conversion. Cost of conversion also includes a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. When net realizable value is below the cost of inventories, an allowance for net realizable value should be booked to bring the book value of inventories to net realizable value. Every Rapala unit should have a systematic process to analyze inventory item by item for need of allowance minimum quarterly. 2. DEFINITIONS 2.1 Inventories Inventories are assets 1. held for sale in the ordinary course of business, 2. in the process of production for such sale, or 3. to be consumed in the production process or in rendering of services. Inventories covers 1. goods purchased and held for sale, 2. finished goods produced, or 3. work in progress being produced and include material and supplies awaiting use in the production process. Note: Supplies may be directly expensed if amounts are immaterial. Supplies are immaterial if the amount of supplies in relation to inventory value is small and if the fluctuation of supplies expensed is low. 2/16

3 2.2 Stock coverage Stock coverage compares the existing inventory (pieces or COGS) to anticipated sales (based on forecasted consumption if available and otherwise historical consumption). It is the number of days, months or years of supply of inventory held. 2.3 Obsolete inventory Obsolete inventory is inventory that is no longer sellable through normal sales. Possibly due to too much inventory on hand, discontinued or out of demand. 2.4 Net realizable value Net realizable value is: 1. the estimated selling price in the ordinary course of business less 2. the estimated cost of completion and 3. the estimated costs necessary to make the sale. For example: Estimated selling price +100 Estimated cost of completion -20 Estimated costs necessary to make the sale -10 Net realizable value =70 When net realizable value is below the cost of inventories, an allowance for net realizable value should be booked to bring the book value of inventories to net realizable value. 3/16

4 3. VALUATION Inventories shall be measured at the lower of cost and net realizable value. The cost of inventories shall comprise all costs of purchase, cost of conversion and other costs incurred in bringing the inventories to their present location and condition. The cost of inventories of items that are not ordinarily interchangeable or goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs. Other cost of inventories shall be assigned by using the FIFO or weighted average cost formula. LIFO is not allowed by IFRS. Net realizable value 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. When net realizable value is below cost of inventories, a net realizable value reserve should be booked to bring the book value to net realizable value. For instructions on allowance to net realizable value see chapter 4 Inventory allowance. 3.1 Cost of inventories The cost of inventories should comprise 1. all costs of purchase, 2. costs of conversion and 3. other costs incurred in bringing the inventories to their present location and condition Cost of purchase Costs of purchase of inventories comprise 1. the purchase price, 2. import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authorities) 3. transport, handling and 4. other costs directly attributable to the acquisition of finished goods, materials and services. Note: Trade discounts, rebates and other similar items are deducted in determining the costs of purchase. 4/16

5 3.1.2 Cost of conversion Direct costs Costs of conversion include costs directly related to the units of production such as direct labor. For Rapala Group reporting purposes cost of conversion is mainly for inventory valuation in manufacturing units and processes (converting materials/goods into finished goods). In calculating cost of conversion the main priority is to apply actual costs and actual production. However, if they are not applicable the alternative is to apply standard costing to approximate to actual costs. Standard costs take into account normal levels of materials and supplies, labor, efficiency and capacity utilization. They are regularly reviewed and, if necessary, revised in the light of current conditions. Allocation of fixed and variable productions overheads Cost of conversion also includes 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, such as depreciation and maintenance of factory buildings and equipment, 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 labor. Variable production overheads are allocated to each unit of production on the basis of the actual use of the production facilities. The variable production overhead unit cost is calculated by dividing actual variable production overheads by actual production. The allocation of fixed production overheads to the costs of conversion is based on 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. The actual level of production may be used if it approximates normal capacity. The practice of allocation of fixed production overheads is the following: 1. Determine normal capacity as described above. 2. Determine amount of indirect cost related to fixed overheads 5/16

6 3. Calculate multiplier for unit cost. This multiplier is used for allocation of fixed overheads to actual inventory. Costs are based on actual costs. Significant changes in planned unit costs must be included. The amount of fixed overhead allocated to each unit of production is not increased as a consequence of low production or idle plant, i.e. if actual production is lower than during normal capacity the earlier determined unit costs are applied when allocating fixed overheads to inventory (costs are not increased in inventory). Unallocated overheads are recognized as an expense in the period in which they are incurred. 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 costs, i.e. if actual production is higher than during normal capacity the earlier determined unit costs are adjusted by dividing used indirect costs with higher production level. (Assuming that inventories are increased unit cost has to be decreased in order not to over valuate inventory.) Allocation principles based on normal capacity are determined on yearly basis if production capacity is expected to stay on current level. However, the effect of abnormally high production should be measured on monthly basis. Abnormally high production may occur for example in case an earlier planned maintenance stop is delayed or if additional shifts are introduced Other costs and costs to be excluded 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. Costs excluded from the cost of inventories are recognized as expenses in the period in which they are incurred. Examples of costs to be excluded are: Abnormal amounts of wasted materials, labor, or other production costs Storage costs, unless those costs are necessary in the production process prior to a further production stage Finished goods storage costs should be excluded from the inventory value. Those are identified as selling expenses. 6/16

7 Administrative overheads that do not contribute to bringing inventories to their present location and condition Selling and marketing expenses R&D costs (normal quality control and development costs directly relating to the production are allocated to the cost of inventory). If the inventory purchase effectively contains a financing element (purchase on deferred settlement terms), that element, for example a difference between the purchase price for normal credit terms and the amount paid, is recognized as interest expense over the period of the financing. 3.2 Spare parts Spare parts to finished goods (e.g. rods, reels) should be reported as purchases during the period, supplies and other. Only material (i.e. significant) spare parts (in relation to finished good value) should be booked to inventory. 3.3 Displays and stands According to IFRS expenditure on advertising and promotional activities should be recognized as an expense. Therefore, primarily stands/displays should be recognized as expense (e.g. always recognized as cost when stand/display is made of cardboard). However, if a stand/display is seen as very enduring and having a long term use it may be capitalized. In these cases, expected useful life for depreciation should not exceed 3 year. Please consult Group Finance if you are not sure about endurance of displays/stands. 3.4 Cost formulas The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by using specific identification of their individual costs (= actual costs). Specific identification of cost 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, regardless of whether they have been bought or produced. However, specific identification of costs is inappropriate when there are large numbers of items of inventory that are ordinarily interchangeable. In such 7/16

8 circumstances, the method of selecting those items that remain in inventories could be used to obtain predetermined effects on profit or loss. The FIFO formula assumes that the items in inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. Under the weighted average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the entity. 4. INVENTORY ALLOWANCE (NET REALIZABLE VALUE) Assets should not be carried in excess of amounts expected to be realized from their sale or use and inventories should be written down to net realizable value (NRV). Any write-downs of inventories booked as expenses (NRV) during the accounting period must be reported separately in a specified account (account Change in inventory, net realizable value). NRV is only calculated on the products that are planned to be sold to the customers. If inventories are totally damaged and cannot be sold at all, they have to be scrapped according to normal scrapping procedures. 4.1 Guidance and Process to allowance determination Rapala has no Group level rules for recognizing allowance for inventory items. Allowance is based on judgment and market knowledge of unit management. No general rule for the Group can be easily adopted, because the obsolete items vary between locations, markets, type of products etc. Every Rapala unit should have a systematic process to analyze inventory itemby-item for need of allowance minimum quarterly. Analysis and process is audited yearly. Examples of processes item by item: Inventory aging Inventory coverage (based on forecasted consumption if available) Classification to active and discontinued products 8/16

9 Special focus on discontinued Local gaap requirements Special focus on samples Non-sellable goods 4.2 Calculation of Net Realizable Value (NRV) Reserve A procedure to compare the NRV to inventory value has to be created and carried out in each unit having inventories. With this procedure the acquisition cost of inventories and the cost of conversion accrued in the inventory value are compared to the NRV of the inventories. If NRV is less than the book value of the inventories a write down reserve has to be made. Example: Costs to be compared to NRV: Acquisition cost: +50 Cost of conversion: +50 Costs accrued in inventory =100 Calculation of the NRV: Estimated selling price +100 Estimated cost of completion -20 Estimated costs necessary to make the sale-10 Net realizable value =70 Inventory is valued at lower of cost (100) and NRV (70) -> 70. Need for reserve = 30 A new assessment is made of net realizable value in each subsequent period. The procedure to consider the possible write down has to be carried out in each accounting period; i.e. on a monthly basis. When the circumstances that previously caused inventories to be written down below cost no longer exist, the amount of the write down is reversed so that the new carrying amount is the lower of the cost and the revised net realizable value. 9/16

10 4.2.1 Situations in which to consider allowance The cost of inventories may not be recovered if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices have declined. The costs of inventories may also not be recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale have increased. The practice of writing inventories down below cost to NRV is consistent with the view that assets should not be carried in excess of amounts expected to be realized from their sale or use. In the following are listed some situations where allowance (NRV) should specifically be considered: Damaged goods that are planned to be sold at lower price than normal quality goods. Slow moving normal quality items in the inventories causing a possible risk of becoming obsolete. Selling prices have declined compared with the prices that made the order profitable in the first place. Procedure for non-profitable orders (higher cost of inventories than the estimated selling prices) is similar and write down reserve is made in case needed. Estimated cost of completion has been increased so that the cost of purchase and the cost of conversion of inventory and the estimated cost of completion are higher than the estimated selling price and the costs necessary to make the sale. Estimated cost to make the sale has increased so that the estimated selling price is less than the costs incurred and the cost of completion plus estimated costs to make the sale (freights, commissions etc. direct cost attributable to the sale) Grouping similar items Inventories are usually written down to net realizable value on item-by-item basis; however, in some circumstances it may be appropriate to group similar or related items together. Similar or related items are grouped for the write down procedure purposes if item-by-item assessment is not practically applicable. Product groups may be applied to group similar or related items, as estimated selling prices are available by end products. The definition of product group is based on end products where estimated selling prices are available (e.g. product group). Separate product 10/16

11 groups have to be identified to slow moving (normal quality) and obsolescent products. The estimated selling price of a product group is compared with the costs incurred (and cost of completion and estimated costs necessary to make the sale) of that product group and a write down is made in case costs are higher than estimated selling price Fluctuating prices Estimates of net realizable value are based on the most reliable evidence available at the time the estimates are made as to the amount the inventories are expected to realize. These estimates take into consideration fluctuations of price or cost directly relating to events occurring after the end of the period to the extent that such events confirm conditions existing at the end of the period. In case price fluctuation at the end of the period requires NRV reserve and if the price level remains at lower level after the closing the reserve has to be made. In case price fluctuation was temporary there is no need for NRV reserve. If selling price declined even more after the closing, no further write down is needed Binding sales or service contracts The net realizable value of the quantity of inventory held to satisfy binding sales or service contracts is based on the contract price. If the sales contracts are for less than the inventory quantities held, the net realizable value of the excess is based on general selling prices. Allowances may arise from binding sales contracts in excess of inventory quantities held or from binding purchase contracts Using of estimates Estimates of net realizable value are based on the most reliable evidence available at the time the estimates are made as to the amount the inventories are expected to realize. Estimates are determined by using Objective information on the costs of completion as well as On the estimated costs to make the sale. 11/16

12 In case there is no better information available on the future costs of completion the actual cost levels at the time of closing of the books may be applied. The estimated selling prices are based on the already fixed selling prices. Fixed selling prices can be based on order stock. Also, updated sales forecast can be applied in case of short order stock and in case reliable information of future price levels is available. In case this information is not available, a market price at the time of closing of the books has to be applied as a general selling price. Estimates take into consideration fluctuations of price or costs directly relating to events occurring after the end of the period to the extent that such events confirm conditions existing at the end of the period Materials and supplies Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. When determining the net realizable value of inventory the costs have to be compared with the estimated selling price of the finished products (not selling price/replacement costs of the raw materials). However, when a decline in the price of materials indicates that the cost of the finished products will exceed net realizable value, the materials are written down to net realizable value. In such circumstances, the replacement cost of the materials may be the best available measure of their net realizable value. If changes in the market prices affect directly or indirectly the estimated selling price of the finished product the material is going to be used for, the decline in market price has to be taken into account when determining the estimated selling price. It therefore affects the net realizable value. 4.3 Reversal of the Reserve The practical approach to the write down reserve may be that it is reversed wholly in each closing and a new reserve is recorded if needed. The movement of reserve shows the result effect during the accounting period and the amount of the new reserve shows how much inventory value has been reduced by the reserve at the end of the period. The reserve can never be positive; i.e. inventory value cannot exceed the acquisition costs and conversion costs. 12/16

13 The acquisition cost and the conversion cost of the inventory are always recorded separately from the reserve. In case a definite loss of the inventory has taken place (damage, scrapping etc.) the original cost of the inventory has to be written down. In case the reserve has earlier been made to provide for the coming loss the reversal of the reserve and the actual loss offset each other and the net result is not affected in the accounting period the actual loss is booked. This applies also to the realization of the estimated lower selling prices. When the sale is realized the actual loss is booked. The reversal of the reserve gives an opposite result effect and a new reserve is regarded related to the remaining inventory. When an item of inventory, which is carried at net realizable value because its selling price has declined, is still on hand in a subsequent period and its selling price has increased the amount of the write down is reversed. 4.4 Example on calculation of net realizable value (NRV) Period 1: First assessment Costs accrued in inventory Acquisition cost Cost of conversion Costs accrued in inventory 50 (DB) 50 (DB) = 100 (DB) NRV Estimated selling price +100 Estimated cost of completion -20 Estimated costs necessary to make the sale-10 NRV = 70 The reserve needed (100-70=30) is recognized for the first time: Reserve to be booked Opening reserve 0 Change in the reserve 30 (DB) Closing reserve in balance sheet 30 (CR) Profit effect (period) Profit effect (cumulative) 30 (DB) 30 (DB) 13/16

14 Period 2: Subsequent assessment, estimated selling price has declined as inventory considered partially obsolete Costs accrued in inventory Acquisition cost Cost of conversion Costs accrued in inventory 50 (DB) 50 (DB) = 100 (DB) NRV Estimated selling price +90 Estimated cost of completion -20 Estimated costs necessary to make the sale -10 NRV =60 Needed reserve (100-60=40) to be booked Opening reserve Change in the reserve: Reversal of the opening reserve New closing reserve Net change in the reserve Closing reserve in balance sheet Profit effect (period) Profit effect (cumulative) 30(DB) 30 (CR) 40 (DB) 10 (DB) 40 (CR) 10(DB) 40 (DB) Period 3: Subsequent assessment: actual sales with slightly higher selling price Costs accrued in inventory Acquisition cost Cost of conversion Costs accrued in inventory 50 (DB) 50 (DB) = 100 (DB) Actual selling price +95 Cost of completion -20 Costs necessary to make the sale -10 NRV = 65 14/16

15 Reversal of reserve from period 2 (100-60=40) Opening reserve Change in the reserve: Reversal of the opening reserve Net change in the reserve Closing reserve in balance sheet 40(DB) 40 (CR) 40 (CR) 0 (CR) Profit effect for the period: NRV 65 (CR) Cost carried in the inventory Reversal of the reserve Profit effect (period) 100 (DB) 40 (CR) 5 (CR) Profit effect cumulatively: NRV Cost carried in the inventory Profit effect (cumulative) 65 (CR) 100 (DB) 35 (DB) 4.5 Recognition as an expense When inventories are sold, the carrying amount of those inventories should be recognized as an expense in the period in which the related revenue is recognized. Usually the revenue is recognized as title to goods passes from the seller to the buyer. Any goods cannot be part of both seller s and buyer s inventories. Usually seller recognizes revenue at the same time or at least in the same period when buyer recognizes the expense. Terms of delivery and dispatching date determine the transition of ownership and thus the right period for revenue and expense recognition of inventories. Delivery terms also dictate the ownership of material in intra-group sales; i.e. whether inventories of the seller or buyer. For example according to sales terms (FOB) the passing of risks occurs when the goods pass the ship's rail at the port of shipment i.e. receiver books goods in transit. The amount of any write down of inventories to net realizable value and all losses of inventories should be recognized as an expense in the period the write down or loss occurs. 15/16

16 The amount of any reversal of any write down of inventories, arising from an increase in net realizable value should be recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs. The amount of any reversal of write down of inventories must never exceed the actual historical cost of inventory. Some inventories may be allocated to other asset accounts, for example, inventory used as a component of self-constructed property, plant or equipment. Inventories allocated to another asset in this way are recognized as an expense during the useful life of that asset. 5. REPORTING INTERNAL INVENTORY Internal inventory includes goods purchased from another Group (Rapala) company. The goods purchased can be group branded or non-group branded the transaction counterparty determines if the purchase should be reported as internal inventory. The value of internal inventory (reported with Internal Inventory sheet) is the purchase price. Import duties, taxes and transport are not included. In Internal Inventory sheet the inventory values should be the amount of internal purchases included in the inventory value, i.e. excluding any external costs although those costs are also capitalized in the total inventory value. 16/16