Trading stock valuation
09 May 2016
Posted by: Author: PwC South Africa
Author: PwC South Africa
During SARS audit inquiries, companies are frequently questioned about how they have valued trading stock. These inquiries highlight a subtle difference in approach between the commercial world and SARS. In a world where accounting practice is well documented and universally applied, one may question why such a difference should persist.
In terms of International Financial Reporting Standards (IFRS) (International Accounting Standard 2 or IAS 2), inventory is required to be disclosed at the lower of cost or net realisable value.
In terms of the Income Tax Act, section 22(1), trading stock (other than financial instruments) must be accounted for at the cost price less such amount as the Commissioner may think just and reasonable as representing the amount by which the value of such trading stock has been diminished by reason of damage, deterioration, change of fashion, decrease in market value, or any other reason satisfactory to the Commissioner.
In both instances, a two-step approach is required:
1. Establish the cost of the trading stock.
2. Determine whether the value has diminished (i.e. whether the value of the inventory or trading stock is lower than the cost).
Establishing the cost
As regards establishing the cost, IAS 2 and the Income Tax Act are aligned, with the exception of foreign currency hedging arrangements.
IAS 2 specifies that costs will include the cost of acquiring the trading stock and such further costs as may be incurred in getting that stock into the condition and position it is in as at the accounting date.
Section 22(3)(a)(i) provides that the cost price of trading stock shall include the acquisition price of the stock plus such further costs incurred in terms of IFRS (in the case of a company) as may be incurred in getting that stock into the condition and position it is in as at the end of the year of assessment
Diminution in value
IAS 2 and section 22(1)(a) both recognise that there may be factors that cause the value of the inventory to be less than its cost price (diminution in value). The language that they use is very different, however.
In the case of IAS 2, the concept of net realisable value is established in a particular context. One must look at the company concerned and its inventory, and identify the net cash flow that is expected to accrue to the company as a result of disposing of that inventory in the normal course of business.
IAS 2 contains the following definition:
Net realisable value is the estimated selling pricein the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
The basis of recording stock at the lower of cost or net realisable value is justified in paragraph 28, where it is stated:
The practice of writing inventories down below cost to net realisable value is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use.
In effect, the commercial world has identified that one cannot ascribe a value to an asset that is greater than the net cash flow it is expected to generate for the business. This recognises that it is not only the selling price that establishes value; costs related to securing the sale will also affect the value of the inventory.
The following example supports the conceptual soundness of the proposition.
X imports a product. The cost of the product is 100. X can sell the product for 150 if X delivers the product to the customer and warrants the product free of defects for 12 months. To deliver the product, X must incur transport and insurance costs of 20.
In addition, the experience of X over the past five years has shown that expenditure on remediating warranty claims averages 10% of the sales turnover of the prior year.
Applying IAS 2, the net realisable value would be 115, that is, 150 from proceeds on sale in the ordinary course of business, less the estimated costs of delivery and of meeting anticipated obligations under the warranty.
X would therefore reflect the inventory at cost in the financial accounts.
If there were to be an adverse currency fluctuation and the cost of the imported product increased to 120, and X could not command a higher price for the product in the market, the net realisable value of the items imported at the higher rate of exchange would be lower than the cost and X would reflect the inventory at 115.
When considering what a purchaser would pay for the product, the same principles apply, but in reverse.
The customer (Y) will pay 150 for a product delivered with a 12-month warranty. What would Y be prepared to pay if the product had to be collected from X’s factory? Logic suggests Y would seek a discount equal to the cost of transporting the product and insuring it in transit. Assume further that X is not prepared to give a warranty against defects. In such a case, it would be logical to assume that Y would demand a further discount to address the risk of encountering repair costs within that period. On the assumption that X’s estimates are reasonable and verifiable by reference to trading experience, the price finally agreed is likely to approximate 115.
This illustrates that net realisable value is a concept that has a sound logical foundation and that its adoption for the purpose of IFRS may be universally accepted as sound. It takes account of the context, and estimates the fair market value, of particular inventory items between a willing seller and a willing buyer who both have full knowledge of the circumstances. It establishes what a person would pay for that inventory if it were to be sold subject to the same conditions.
Income Tax Act
Section 22(1)(a) specifies reasons for diminution in value. These are:
"… damage, deterioration, change of fashion, decrease in market value or for any other reason satisfactory to the Commissioner”.
Section 22(1)(a) and IFRS are, in general, not inconsistent in relation to the stated reasons for diminution in value. IAS 2, at paragraph 28, begins with the following statement:
"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 have declined.”
These different words convey the same conceptual appreciation – damage, deterioration, change of fashion, and decrease in market value are reasons for which the value may be diminished, as is stated in section 22(1)(a).
IAS 2, paragraph 28 sets out further reasons that the commercial world accepts for recognising a diminution in value:
"The cost 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.”
In other words, the reasons acceptable to the commercial world are ‘codified’ in IAS 2: the net return and, by implication, the value of the inventory may be diminished by the fact that there are costs that must be incurred in getting the inventory to the point of saleability and closing the sale at a particular price.
Section 22(1)(a) goes a different route. It avoids using the universally acceptable commercial practice and instead gives the Commissioner discretion to approve which factors may reasonably contribute to a diminution in value.
The essence of an amendment to section 22(1)(a) is that the phrase "any other reason satisfactory to the Commissioner” is to be replaced by "any other reason listed in a public notice issued by the Commissioner”.
The partial reliance on IFRS as the basis for establishing cost, and partial rejection of the IFRS principles as the basis for determining whether the inventory has a realisable value that is lower than cost, smacks of running with the hares and hunting with the hounds.
It may be conceded that section 22(1)(a) was conceived before there were international accounting standards, and the determination of the value of inventory was not universally settled. This in itself does not justify a reluctance to move with the times and align tax practice with internationally accepted accounting principles.
Is there worse to come?
An amendment to section 22(1)(a) was enacted in the Taxation Laws Amendment Act, 2015. The amendment will come into effect from a date determined by the Minister of Finance by notice in the Gazette.
The essence of the amendment is that the phrase "any other reason satisfactory to the Commissioner” is to be replaced by "any other reason listed in a public notice issued by the Commissioner”.
This must be regarded as a step backwards. If section 22(1)(a) required amendment, it would have been expected that SARS would have sought to align the valuation of inventory by reference to the amount determined under IFRS. It would have been simple to state that the amount to be taken into account in respect of trading stock held and not disposed of at the end of the year of assessment shall be the net realisable value thereof, as determined under IFRS.
Such a move would have been consistent with the fact that IFRS is already an element of the Income Tax Act, not only in section 22. The term is defined in section 1 and is used in sections 23L, 24JB, 25BB, 28 and 29A. Reference to and reliance on IFRS on a wider basis would suggest that National Treasury considers the principles of IFRS, in relation to the matters addressed in the relevant sections, to be reasonable.
Treasury’s reluctance to move with the times means trading stock valuation will continue to be an issue for taxpayers who report their financial results under IFRS.
Companies must value their trading stock for the purpose of annual disclosure in the manner prescribed in IAS 2.
In preparing their returns of income, these companies should exercise caution in evaluating the extent to which any diminution in the value of trading stock below cost (applying IAS 2) may be acceptable based on the criteria given in section 22(1) of the Income Tax Act. Anticipated cash flows identified under IAS 2 which may affect the anticipated return on realising the trading stock may be rejected by SARS as not being ‘just and reasonable’.
This article first appeared on pwc.co.za.