Inventories, Property, Intangibles and Asset Impairment

Introduction and context

Assets used in production, held for sale, or developed for future economic benefit are central to financial reporting. Their accounting affects reported profit, asset values, liquidity, solvency, tax planning, and assessments of management performance. Inventory errors affect cost of sales and gross profit; inappropriate capitalization inflates assets and profit; excessive impairment charges may indicate declining asset quality or delayed recognition of economic problems.

This chapter applies the principal requirements of International Financial Reporting Standards (IFRS), especially IAS 2 Inventories, IAS 16 Property, Plant and Equipment, IAS 23 Borrowing Costs, IAS 36 Impairment of Assets, IAS 38 Intangible Assets, IAS 40 Investment Property, and IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. Local legislation or another reporting framework may differ, so professional accountants must identify the applicable requirements before preparing financial statements.

Learning objectives

By the end of this chapter, students should be able to:

1. Measure inventory and explain the lower-of-cost-and-net-realizable-value rule.
2. Classify, recognize, measure, depreciate, revalue, and dispose of property, plant and equipment.
3. Explain investment property and distinguish it from owner-occupied property.
4. Account for borrowing costs that qualify for capitalization.
5. Distinguish research from development and account for intangible assets.
6. Calculate depreciation and amortization under appropriate methods.
7. Identify impairment indicators, calculate impairment losses, and account for cash-generating units.
8. Analyze how accounting choices affect profitability, asset quality, and performance ratios.

1. Inventories

Nature and classification

Inventories are assets held for sale in the ordinary course of business, in the process of production for such sale, or in the form of materials and supplies to be consumed in production or rendering services. Typical examples include merchandise, raw materials, work in progress, finished goods, and consumable production supplies.

Inventory is normally a current asset because it is expected to be sold or consumed during the normal operating cycle. The operating cycle can exceed twelve months in industries such as construction, shipbuilding, and wine production; classification follows the operating cycle rather than an arbitrary twelve-month rule.

Initial cost

Inventory cost includes purchase costs, conversion costs, and other costs incurred in bringing inventory to its present location and condition. Purchase cost includes the purchase price, import duties, and non-recoverable taxes, less trade discounts and rebates. Conversion cost includes direct labour and a systematic allocation of production overhead.

Fixed production overhead is allocated based on normal production capacity. Unallocated overhead caused by abnormal idle capacity is expensed rather than added to inventory. Abnormal waste, storage costs not necessary for production, administrative overhead unrelated to bringing inventory to its present condition, and selling costs are generally expensed.

For jointly produced products, common costs are allocated rationally and consistently, often using relative sales value at the split-off point. By-products may be measured at net realizable value, with that amount deducted from the cost of the main product where appropriate.

Cost formulas

Specific identification is used for items that are not ordinarily interchangeable or for goods produced and segregated for specific projects. For ordinarily interchangeable items, IAS 2 permits first-in, first-out (FIFO) or weighted-average cost. Last-in, first-out (LIFO) is not permitted under IFRS.

The weighted-average unit cost is:

The formula applies when units are interchangeable and costs are pooled. Cost and units must be measured on a consistent basis. Under a periodic system, the average is calculated for the period; under a perpetual system, a moving average may be recalculated after each purchase.

Net realizable value

Inventory is measured at the lower of cost and net realizable value (NRV). NRV is:

Estimated selling price is based on evidence available at the reporting date. NRV is not the same as fair value: NRV is entity-specific and reflects completion and selling costs, whereas fair value is a market-participant measurement.

If NRV falls below cost, the inventory is written down and the loss is recognized in profit or loss. The assessment is normally item by item, although grouping similar or related items may be appropriate. A previous write-down is reversed when NRV increases, but only up to the amount of the original write-down.

Worked example: inventory measurement

A retailer has 1,000 units costing $18 each. At year-end, 120 units are damaged. Damaged units can be sold for $12 each after selling costs of $2 per unit. The remaining 880 units can be sold for $25 each with selling costs of $1 per unit.

Cost of damaged units = 120 × $18 = $2,160.

NRV of damaged units = 120 × ($12 − $2) = $1,200.

Write-down = $2,160 − $1,200 = $960.

The remaining units have NRV of 880 × ($25 − $1) = $21,120, exceeding cost of $15,840. Therefore, total closing inventory is $1,200 + $15,840 = $17,040, and the $960 write-down is recognized as an expense.

Inventory analysis

Analysts should examine inventory turnover, days inventory outstanding, ageing, provisions, obsolete stock, and the relationship between inventory growth and revenue growth. A useful measure is:

Average inventory is commonly calculated as (opening inventory + closing inventory) ÷ 2. The measure is meaningful only when the period, valuation basis, seasonality, and industry are considered. A falling turnover may indicate weak demand or obsolete goods, but it may also reflect deliberate stock-building before a planned expansion.

2. Property, plant and equipment

Recognition and classification

Property, plant and equipment (PPE) are tangible items held for production or supply of goods or services, rental to others, or administrative purposes, and expected to be used during more than one period. An item is recognized when it is probable that future economic benefits will flow to the entity and its cost can be measured reliably.

Examples include land, buildings, machinery, vehicles, office equipment, and major components of aircraft or industrial plant. Spare parts and servicing equipment are PPE when they meet the definition; otherwise they are inventory.

Initial measurement

PPE is initially measured at cost. Cost includes purchase price, directly attributable costs of bringing the asset to the location and condition necessary for operation, and the present estimate of dismantling, removal, and site-restoration obligations when the recognition criteria are met. Directly attributable costs may include site preparation, delivery, installation, testing, and professional fees. Start-up losses, general administration, training, and abnormal waste are normally expensed.

If payment is deferred beyond normal credit terms, the difference between the cash price equivalent and total payment is recognized as interest over the credit period unless capitalized under IAS 23. Exchange of assets is measured at fair value unless the exchange lacks commercial substance or neither fair value is reliably measurable.

Component accounting

Significant parts of an asset with different useful lives or consumption patterns are depreciated separately. For example, an aircraft body, engines, and major overhaul component may require separate depreciation. The objective is to match depreciation with the pattern in which economic benefits are consumed, not to preserve a single arbitrary rate.

Subsequent measurement models

After recognition, an entity chooses either the cost model or the revaluation model for an entire class of PPE and applies the policy consistently.

Under the cost model:

Under the revaluation model, an asset is carried at fair value at the revaluation date less subsequent depreciation and impairment. Revaluations must be sufficiently regular that carrying amount does not differ materially from fair value. An increase is generally recognized in other comprehensive income and accumulated in revaluation surplus, except to the extent that it reverses a previous decrease recognized in profit or loss. A decrease is generally recognized in profit or loss, except to the extent of an existing surplus for that asset.

Revaluation changes depreciation and may affect future profit. A transfer from revaluation surplus to retained earnings for the additional depreciation may be made, but it is not recognized in profit or loss.

Depreciation

Depreciation allocates the depreciable amount systematically over useful life. The depreciable amount is:

Straight-line depreciation is:

This method assumes that benefits are consumed evenly. Other methods, such as diminishing balance or units of production, may be appropriate when they better reflect consumption. A revenue-based depreciation method is generally inappropriate because revenue is influenced by factors unrelated to consumption of the asset.

Depreciation begins when the asset is available for use, not necessarily when it first generates revenue. It ceases when the asset is derecognized or classified as held for sale, whichever occurs earlier. Land normally has an indefinite useful life and is not depreciated, although improvements to land generally are.

Useful life, residual value, and depreciation method are reviewed at least annually. Changes are changes in accounting estimates and are applied prospectively. A fully depreciated asset remains recognized if it is still in use, unless derecognition criteria are met.

Disposal

An asset is derecognized on disposal or when no future economic benefits are expected. The gain or loss is:

The gain or loss is normally recognized in profit or loss and is not classified as revenue. Any related revaluation surplus may be transferred directly to retained earnings, subject to the reporting framework and entity policy.

Worked example: depreciation and disposal

Equipment costs $120,000, has a residual value of $12,000, and a useful life of six years. Straight-line annual depreciation is:

($120,000 − $12,000) ÷ 6 = $18,000.

After four complete years, carrying amount is $120,000 − (4 × $18,000) = $48,000. If it is sold for $52,000, the gain is $52,000 − $48,000 = $4,000. If sold for $43,000, the loss is $43,000 − $48,000 = $5,000.

3. Investment property

Investment property is land or a building, or part of a building, held to earn rentals, for capital appreciation, or both. It is not property held for sale in the ordinary course of business and is not owner-occupied property used in production, supply, or administration.

A property rented to an external tenant is generally investment property. A building occupied by the reporting entity is PPE. Property held for future undetermined use may qualify as investment property when held for capital appreciation. Property under construction for future use as investment property is also within IAS 40.

An entity chooses a fair-value model or cost model for investment property. Under the fair-value model, changes in fair value are recognized in profit or loss and the property is not depreciated. Under the cost model, the property is depreciated and tested for impairment under IAS 36, while fair value is generally disclosed. Transfers occur only when there is a change in use supported by evidence, such as commencement of owner-occupation or development for sale.

4. Borrowing costs

Borrowing costs include interest calculated using the effective interest method, certain finance charges, and some exchange differences regarded as an adjustment to interest cost. IAS 23 requires capitalization of borrowing costs directly attributable to acquiring, constructing, or producing a qualifying asset. A qualifying asset takes a substantial period to get ready for intended use or sale.

Capitalization begins when all three conditions exist: expenditure is being incurred, borrowing costs are being incurred, and activities necessary to prepare the asset are in progress. Capitalization is suspended during extended periods in which active development is interrupted. It ceases when substantially all activities necessary to prepare the asset are complete.

For a specific borrowing, the capitalized amount is actual borrowing cost less income from temporary investment of unused funds. For general borrowings, a weighted-average capitalization rate is applied to qualifying expenditures. Capitalization cannot exceed borrowing costs incurred during the period.

5. Intangible assets

An intangible asset is an identifiable non-monetary asset without physical substance. Identifiability exists when the asset is separable or arises from contractual or other legal rights. Examples include patents, licences, copyrights, software, and customer-related contractual rights. Internally generated brands, mastheads, publishing titles, customer lists, and goodwill are not recognized as intangible assets under IAS 38.

Recognition requires probable future economic benefits and reliable measurement of cost. Separately acquired intangible assets usually satisfy these conditions because the price paid provides evidence of expected benefits and measurable cost. In a business combination, identifiable acquired intangibles are recognized at fair value even if the acquiree had not recognized them previously.

Research and development

Research expenditure is expensed as incurred because the entity cannot yet demonstrate a technically feasible project capable of generating probable benefits. Development expenditure is capitalized only from the date the entity demonstrates all required conditions, including technical feasibility, intention and ability to complete and use or sell the asset, probable future benefits, adequate resources, and reliable measurement of costs.

Costs incurred before the recognition conditions are met cannot subsequently be reinstated as an asset. Capitalized development costs are amortized when the asset is available for use and tested for impairment when indicators exist, and at least annually if the asset is not yet available for use.

Subsequent measurement and amortization

Intangibles with finite useful lives are carried using a cost or permitted revaluation model and amortized over their useful lives. The residual value is normally zero unless a third party is committed to purchase the asset or an active market is expected to exist at the end of its life.

Intangibles with indefinite useful lives are not amortized but are tested for impairment annually and whenever an indicator exists. “Indefinite” does not mean infinite; it means there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows.

The straight-line amortization formula is:

The method and useful life are reviewed annually. A change in expected consumption pattern or useful life is accounted for prospectively as a change in estimate.

6. Impairment of assets

Core principle

IAS 36 prevents assets from being carried above their recoverable amount. Recoverable amount is the higher of fair value less costs of disposal and value in use.

Value in use is the present value of future cash flows expected from continuing use and ultimate disposal, using pre-tax cash flows and a pre-tax discount rate consistent with the risks reflected in those cash flows. Forecasts should be reasonable, supportable, and based on approved budgets, normally covering no more than five years unless a longer period is justified. Cash flows should exclude financing activities and income tax if a pre-tax model is used.

An impairment loss arises when carrying amount exceeds recoverable amount:

The loss is recognized in profit or loss unless the asset is carried under a revaluation model, in which case it is treated as a revaluation decrease to the extent of any related surplus.

Indicators and testing

External indicators include significant declines in market value, adverse technological or legal changes, increased market interest rates, and market capitalization below net assets. Internal indicators include obsolescence, physical damage, poor performance, restructuring, or plans to discontinue an asset.

Assets not yet available for use, intangible assets with indefinite lives, and goodwill must be tested annually even without an impairment indicator. Other assets are tested when indicators exist.

Cash-generating units

When an asset does not generate largely independent cash inflows, it is tested within the smallest cash-generating unit (CGU) that does. Goodwill acquired in a business combination is allocated to CGUs or groups of CGUs expected to benefit from synergies. An impairment loss for a CGU is allocated first to goodwill and then pro rata to other assets, subject to the rule that no asset is reduced below the highest of its fair value less costs of disposal, value in use, and zero.

Impairment losses other than goodwill are reversed when estimates change, but the revised carrying amount cannot exceed the amount that would have been determined, net of depreciation or amortization, had no impairment been recognized. Goodwill impairment is never reversed under IAS 36.

Worked example: impairment

A machine has a carrying amount of $90,000. Its fair value less costs of disposal is $72,000, and its value in use is $78,000. Recoverable amount is the higher figure, $78,000. The impairment loss is therefore $90,000 − $78,000 = $12,000. The machine is subsequently carried at $78,000, subject to future depreciation based on its revised carrying amount and remaining useful life.

7. Integrated case: Northstar Manufacturing Ltd.

Background

Northstar Manufacturing Ltd. produces specialist refrigeration equipment. At 31 December, management is preparing financial statements and has identified four issues: slow-moving inventory, a major production line, a new software project, and a factory building partly rented to another entity.

Problem and analysis

Inventory costing $300,000 has an estimated selling price of $285,000 and selling costs of $10,000. NRV is $275,000, so a $25,000 write-down is required.

The production line cost $1,000,000, has a residual value of $100,000, and an eight-year useful life. After three years of straight-line depreciation, its carrying amount is $662,500: annual depreciation is ($1,000,000 − $100,000) ÷ 8 = $112,500, and accumulated depreciation is $337,500. Engineers identify technological obsolescence. Fair value less costs of disposal is $590,000 and value in use is $620,000. Recoverable amount is $620,000, producing an impairment loss of $42,500.

Northstar spent $180,000 researching a new cooling algorithm and $260,000 developing software after technical feasibility, funding, and commercial viability were demonstrated. The $180,000 research cost is expensed. The $260,000 qualifying development cost is capitalized and amortized from the date the software is available for use.

The factory building is partly occupied by Northstar and partly leased to an unrelated tenant. The portions are accounted for separately if they could be sold or leased separately. The owner-occupied portion is PPE; the independently rented portion is investment property. If separation is not possible, the whole property is investment property only when the owner-occupied portion is insignificant.

Outcome

The adjustments reduce current profit through the inventory write-down, research expense, and impairment loss. They increase recognized assets through qualifying development expenditure, but future amortization will reduce profit. Correct classification of the building improves comparability and ensures that the selected measurement model is applied appropriately.

Learning points

The case demonstrates that asset accounting is not merely a capitalization exercise. It requires classification, evidence, estimates, periodic reassessment, and disciplined separation of costs that create controlled future benefits from costs that merely support current operations.

8. Analysis, governance, and professional practice

Asset accounting involves substantial judgment. Management may have incentives to capitalize borderline expenditure, extend useful lives, increase residual values, delay impairment, or use optimistic cash-flow forecasts. These actions can overstate assets and profit while understating risk.

Effective governance includes documented capitalization policies, component registers, physical inspections, independent valuation where appropriate, review of ageing reports, impairment models supported by budgets, sensitivity analysis, and approval controls over development projects. Auditors should challenge assumptions about useful lives, residual values, forecast growth, discount rates, and the distinction between research and development.

Technology can improve control through enterprise asset registers, barcode or RFID tracking, automated depreciation, satellite or sensor evidence of asset condition, and analytical procedures that identify unusual capitalization or inventory movements. Artificial intelligence may assist in anomaly detection and forecasting, but it does not replace management’s responsibility for estimates or the accountant’s responsibility to understand data quality, model bias, and explainability.

Contemporary reporting increasingly emphasizes climate-related risks, supply-chain disruption, technological obsolescence, and stranded assets. These matters may affect useful lives, impairment indicators, NRV, restoration obligations, and forecast cash flows. Disclosures should explain significant judgments, estimation uncertainty, measurement models, movements in carrying amounts, impairment assumptions, and sensitivity where material.

Chapter Summary

Inventories are measured initially at cost and subsequently at the lower of cost and NRV. FIFO and weighted-average cost are permitted for interchangeable items under IFRS, while LIFO is prohibited. PPE is recognized when future benefits are probable and cost is reliably measurable, initially measured at cost, and subsequently accounted for using either the cost or revaluation model. Significant components are depreciated separately, and depreciation begins when an asset is available for use.

Investment property is property held for rental or capital appreciation and is distinguished from owner-occupied property. Borrowing costs directly attributable to qualifying assets are capitalized during active preparation. Intangible assets must be identifiable, controlled, and expected to produce benefits; research is expensed, while qualifying development expenditure is capitalized. Finite-life intangibles are amortized, whereas indefinite-life intangibles are tested annually for impairment.

Impairment accounting compares carrying amount with recoverable amount, the higher of fair value less costs of disposal and value in use. CGUs are used when independent cash inflows cannot be identified. Goodwill impairment is allocated first to goodwill and cannot be reversed. Sound asset reporting depends on evidence, consistent policies, careful estimates, effective governance, and transparent disclosure.

Key Terms

Inventory: Asset held for sale, in production for sale, or to be consumed in production.

Net realizable value: Estimated selling price less completion and selling costs.

Property, plant and equipment: Tangible long-term assets used in operations or administration.

Component accounting: Depreciating significant parts of an asset separately.

Carrying amount: Amount at which an asset is recognized after accumulated depreciation, amortization, and impairment.

Residual value: Estimated amount obtainable from disposal at the end of useful life, less disposal costs.

Depreciable amount: Cost or revalued amount less residual value.

Revaluation model: Subsequent measurement of PPE at fair value less subsequent depreciation and impairment.

Investment property: Property held for rental income or capital appreciation.

Qualifying asset: Asset requiring a substantial period to become ready for use or sale.

Borrowing costs: Interest and related costs of obtaining finance.

Intangible asset: Identifiable non-monetary asset without physical substance.

Research: Investigation undertaken to obtain new scientific or technical knowledge.

Development: Application of research findings to a plan or design for producing a new or improved product or process.

Amortization: Systematic allocation of the depreciable amount of a finite-life intangible asset.

Impairment: Condition in which carrying amount exceeds recoverable amount.

Recoverable amount: Higher of fair value less costs of disposal and value in use.

Cash-generating unit: Smallest identifiable group of assets generating largely independent cash inflows.

Value in use: Present value of future cash flows expected from continuing use and disposal.

Review Questions

Short Answer Questions

1. What costs are included in inventory conversion cost?
2. Why is LIFO not permitted under IFRS?
3. When does depreciation of PPE begin?
4. Distinguish research expenditure from development expenditure.
5. What is the relationship between carrying amount and recoverable amount in impairment testing?

Long Answer Questions

1. Explain the recognition, initial measurement, and subsequent measurement of PPE under IAS 16.
2. Discuss the lower-of-cost-and-NRV rule, including the treatment of later recoveries in NRV.
3. Compare the cost and fair-value models for investment property.
4. Explain the conditions and timing for capitalization of borrowing costs.
5. Describe impairment testing for a CGU containing goodwill and explain why goodwill impairment is not reversed.

Analytical / Application Questions

1. A company capitalizes staff training, advertising, abnormal production waste, and installation costs in the cost of a machine. Identify which costs should be included and explain why.
2. An asset has a carrying amount of $500,000, fair value less costs of disposal of $430,000, and value in use of $470,000. Calculate the impairment loss and explain the accounting entry.
3. A business reports rapidly increasing inventory, declining turnover, and stable sales. Evaluate possible explanations, identify the evidence required, and explain the implications for NRV and asset quality.

Multiple Choice Questions with Answers

Question 1

Which inventory cost formula is permitted under IFRS for ordinarily interchangeable items?

A. Last-in, first-out only

B. FIFO or weighted average

C. Replacement cost only

D. Retail selling price only

Correct Answer: B. FIFO or weighted average

Question 2

Inventory cost is $40,000 and NRV is $36,500. What amount should be reported before considering other adjustments?

A. $3,500

B. $36,500

C. $40,000

D. $76,500

Correct Answer: B. $36,500

Question 3

When should depreciation of a machine normally begin?

A. When the machine is ordered

B. When the supplier is paid

C. When the machine is available for use

D. When the machine first earns revenue

Correct Answer: C. When the machine is available for use

Question 4

Equipment costs $90,000, has a residual value of $10,000, and a useful life of eight years. What is annual straight-line depreciation?

A. $10,000

B. $11,250

C. $12,500

D. $80,000

Correct Answer: A. $10,000

Question 5

Which item is generally classified as investment property?

A. A factory used by the owner

B. Inventory held for ordinary sale

C. Land held for capital appreciation

D. Office equipment used by employees

Correct Answer: C. Land held for capital appreciation

Question 6

Which condition is required before development expenditure can be capitalized?

A. The project must already generate revenue

B. Technical feasibility must be demonstrated

C. All research costs must have been capitalized

D. The asset must have an indefinite useful life

Correct Answer: B. Technical feasibility must be demonstrated

Question 7

Recoverable amount is defined as:

A. The lower of cost and NRV

B. The higher of fair value less costs of disposal and value in use

C. Historical cost less depreciation only

D. Replacement cost plus disposal costs

Correct Answer: B. The higher of fair value less costs of disposal and value in use

Question 8

An asset has a carrying amount of $100,000 and recoverable amount of $82,000. What impairment loss arises?

A. $18,000

B. $82,000

C. $100,000

D. $182,000

Correct Answer: A. $18,000

Question 9

Under IAS 23, capitalization of borrowing costs ceases when:

A. The loan is legally repaid

B. The asset is substantially ready for intended use or sale

C. The first interest payment is made

D. Management approves the project

Correct Answer: B. The asset is substantially ready for intended use or sale

Question 10

Which statement about goodwill impairment under IAS 36 is correct?

A. It is never tested annually

B. It is allocated to relevant CGUs and impairment is not reversed

C. It is amortized over five years in all cases

D. Any impairment is recognized directly in inventory

Correct Answer: B. It is allocated to relevant CGUs and impairment is not reversed