Learning Unit 4: Inventories International Accounting

Standard 2 (IAS 2)

✓ The objective of this Standard is to prescribe the accounting treatment for

inventories
✓ A primary issue in accounting for inventories is the amount of cost to be recognised
as an asset and carried forward until the related revenues are recognised
✓ This Standard provides guidance on the determination of cost and its subsequent
recognition as an expense, including any write-down to net realisable value
✓ It also provides guidance on the cost formulas that are used to assign costs to
inventories.

Inventories are assets:

a) held for sale in the ordinary course of business;
b) in the process of production for such sale; or
c) in the form of materials or supplies to be consumed in the production process or in
the rendering of services.

Net realisable 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.

Fair value is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement
date.

Net realisable value refers to the net amount that an entity expects to realise from
the sale of inventory in the ordinary course of business.

Fair value reflects the price at which an orderly transaction to sell the same
inventory in the principal (or most advantageous) market for that inventory would
take place between market participants at the measurement date.
 The former is an entity-specific value; the latter is not. Net realisable value for
inventories may not equal fair value less costs to sell.

Inventories encompass

✓ Goods purchased and held for resale including, for example, merchandise
purchased by a retailer and held for resale, or land and other property held for
resale.
✓ Inventories also encompass finished goods produced, or work in progress being
produced, by the entity and include materials and supplies awaiting use in the
production process.

Inventories shall be measured at the lower of

Cost and
Net realisable value.

The cost of inventories shall comprise all costs of

❖ Purchase
The costs of purchase of inventories comprise the:
✓ purchase price,
✓ import duties and other taxes (other than those subsequently recoverable by the
entity from the taxing authorities),
✓ Transport, handling and other costs directly attributable to the acquisition of
finished goods, materials and services.

❖ Costs of conversion

✓ The costs of conversion of inventories include costs directly related to the units of
production, such as direct labour.
 ✓ They also include 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, equipment and right-of-use assets used in the
production process, 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 labour.
✓ The allocation of fixed production overheads to the costs of conversion is based on
the normal capacity/budgeted capacity/planned 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.
✓ Unallocated overheads are recognised 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 cost.
✓ Variable production overheads are allocated to each unit of production on the basis
of the actual use of the production facilities.

❖ Other costs incurred in bringing the inventories to their present location and
condition.
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.

Examples of costs excluded from the cost of inventories and recognised

as expenses in the period in which they are incurred are:
▪ Abnormal amounts of wasted materials, labour or other production costs;
▪ Storage costs, unless those costs are necessary in the production process before a
further production stage;
▪ Administrative overheads that do not contribute to bringing inventories to their
present location and condition; and
▪ Selling costs.
Techniques for the measurement of the cost of inventories, such as the standard cost
method or the retail method, may be used for convenience if the results approximate
cost.
Standard costs take into account normal levels of materials and supplies, labour,
efficiency and capacity utilisation. They are regularly reviewed and, if necessary,
revised in the light of current conditions.

The retail method is often used in the retail industry for measuring inventories of
large numbers of rapidly changing items with similar margins for which it is
impracticable to use other costing methods. The cost of the inventory is determined
by reducing the sales value of the inventory by the appropriate percentage gross
margin. The percentage used takes into consideration inventory that has been
marked down to below its original selling price. An average percentage for each
retail department is often used.

The cost of inventories shall be assigned by using the first-in, first-out (FIFO) or
weighted average cost formula. An entity shall use the same cost formula for all
inventories having a similar nature and use to the entity.
The FIFO formula assumes that the items of 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.

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.
 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.
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.
Inventories are usually written down to net realisable value item by item. In some
circumstances, however, it may be appropriate to group similar or related items.
This may be the case with items of inventory relating to the same product line that
have similar purposes or end uses, are produced and marketed in the same
geographical area, and cannot be practicably evaluated separately from other items
in that product line. It is not appropriate to write inventories down on the basis of a
classification of inventory, for example, finished goods, or all the inventories in a
particular operating segment.
Estimates of net realisable value are based on the most reliable evidence available
at the time the estimates are made, of the amount the inventories are expected to
realise. 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.

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
However, when a decline in the price of materials indicates that the cost of the finished products
exceeds net realisable value, the materials are written down to net realisable value. In such
circumstances, the replacement cost of the materials may be the best available measure of their
net realisable value.

When inventories are sold, the carrying amount of those inventories shall be recognised as an
expense in the period in which the related revenue is recognised.
The amount of any write-down of inventories to net realisable value and all losses of inventories
shall be recognised as an expense in the period the write-down or loss occurs.

The financial statements shall disclose:

The total carrying amount of inventories

The carrying amount of inventories carried at fair value less costs to sell;
The amount of inventories recognised as an expense during the period;
The amount of any write-down of inventories recognised as an expense in the period