Our company is currently facing audit adjustment issues related to inventory valuation. Due to multiple factors, including Bill of Materials (BOM) changes, supplier price increases, and foreign exchange rate fluctuations—of which exchange rate fluctuations are the primary cause, as approximately 60% of our raw materials are imported from Europe and Japan—the company conducts frequent monthly inventory revaluations. However, in the most recent audit, the auditors did not accept the foreign currency revaluation adjustments made at the end of the fiscal year, nor did they accept the revaluation adjustments made over the past three months. We would appreciate relevant guidance.

Background and Core Controversy of the Issue

Under International Accounting Standard 2 - Inventories (IAS 2), inventories should be measured at the lower of cost and net realizable value. Cost includes purchase costs, conversion costs, and other costs incurred in bringing the inventories to their present location and condition. Changes in the cost of imported raw materials due to foreign exchange rate fluctuations are generally part of purchase costs, but the timing of measurement and frequency of adjustments must strictly comply with the requirements of the standard.

Your company conducts monthly inventory revaluations, primarily driven by the following factors:

  • BOM changes: Changes in product structure may lead to adjustments in raw material consumption quantities or standard costs.
  • Supplier price increases: Higher purchase prices affect the actual cost of inventories.
  • Foreign exchange rate fluctuations: Due to the high proportion of imports (60% from Europe and Japan), exchange rate movements have a significant impact on inventory costs.

The auditors' rejection of the year-end foreign currency revaluation and the revaluation adjustments over the past three months may be based on the following reasons: IAS 2 does not permit periodic revaluation of inventories due to exchange rate fluctuations, unless such adjustments align with cost measurement principles (e.g., actual cost changes arising from translating foreign currency payables into the functional currency). If the revaluation is based solely on expected exchange rate movements or transactions that have not actually occurred, it may not comply with the standard's requirements.

Key Principles of Inventory Measurement under IAS 2

According to paragraphs 9 to 11 of IAS 2, inventory costs should be determined using full absorption costing, including all direct and indirect purchase and conversion costs. For purchases denominated in foreign currencies, the cost should be translated into the functional currency at the spot exchange rate on the transaction date. If there are prepayments or payables, subsequent exchange rate movements are generally not included in inventory costs but should be treated as exchange differences (in accordance with IAS 21 - The Effects of Changes in Foreign Exchange Rates). Therefore, the auditors may believe that your company's direct inclusion of exchange rate revaluations in inventory value blurs the boundary between inventory measurement and foreign currency translation.

Furthermore, IAS 2 requires inventories to be measured at the lower of cost and net realizable value. Net realizable value should be estimated based on reliable evidence, not through frequent revaluation. If the monthly revaluations are not based on actual cost changes but on market exchange rate forecasts, they may be deemed inappropriate.

Practical Recommendations and Next Steps

In response to the audit adjustments, it is recommended that your company take the following steps:

  1. Re-examine the composition of inventory costs, distinguishing between actual purchase costs and exchange differences. For recognized payables, exchange differences should be recognized in profit or loss for the period, rather than adjusting the carrying amount of inventories.
  2. Review whether the revaluation adjustments over the past three months and at year-end were based on actual transactions or contractual agreements. If adjustments were made solely due to exchange rate fluctuations, consider reversing the relevant entries.
  3. Communicate with the auditors to clarify the specific basis for their rejection and obtain written opinions. If necessary, consult professional accounting advisors.
  4. If there are BOM changes or supplier price increases, provide sufficient evidence (e.g., updated standard cost sheets, purchase contracts) to support the reasonableness of the cost adjustments.

Please note that this response provides general guidance based solely on the information you have provided and does not constitute formal accounting advice. Specific treatment should be based on a detailed analysis of your company's actual circumstances and applicable standards.