Financial Accounting and Corporate Reporting (Study Text) 156 | P a g e

Chapter learning objectives

Upon completion of this chapter you will be able to:

Explain the principles of IAS 2 with regard to the valuation of inventory

Apply the principles of IAS 2 with regard to the valuation of inventory

Financial Accounting and Corporate Reporting (Study Text) 157 | P a g e

1. Accounting for inventory under IAS 2

1.1 Definitions
Inventories are assets:
(a) Held for sale in the ordinary course of business;
(b) In the process of production for sale; or

(c) In the form of materials or supplies to be consumed in the

production process or in the rendering of services

Cost is the cost of bringing items of inventory to their present location and condition
(including cost of purchase and costs of conversion).

Cost of purchase comprises:

purchase price including import duties, transport and handling costs
any other directly attributable costs, less trade discounts, rebates and
subsidies.

Example 1

Sajid Ltd. imported raw material for use in production of goods with following details

Invoice value 1,000

Custom duty 150
Central excise duty (C.E.D) 50
Non-adjustable income tax 225
Refundable sales tax 180
Carriage 40
Commission paid to agent for clearance of raw materials 100

Required:
Calculate the cost of purchase of inventories.

Financial Accounting and Corporate Reporting (Study Text) 158 | P a g e

 Solution
Rs.
Invoice value 1,000
Custom duty 150
C.E.D. 50
Non-adjustable income tax 225
Carriage 40
Commission to agent 100
Cost of purchase 1,565

Cost of conversion comprises:

These include:
Direct labour
Fixed and variable production overheads.

Fixed & variable production overheads

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.

Allocation of fixed & variable production overhead

(a) The allocation of fixed production overheads to the costs of inventories is
based on the 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 circumstance, taking into account the loss of
capacity resulting from planned maintenance;
(b) The actual level of production may be used if it approximates normal capacity;
(c) The amount of fixed overhead allocated to each unit of inventory is not
increased as a consequence of low production or idle plant;
(d) 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; and
(e) Variable production overheads are allocated to each unit of production on the
basis of the actual use of the production facilities.

Financial Accounting and Corporate Reporting (Study Text) 159 | P a g e

 Example 2
Rs.
Direct material 1,000,000
Direct labour 500,000
Overheads-Variable 500,000
Overhead-Fixed 250,000
Normal production per annum 1,500,000 units
During 2004 the actual production of Sibtain Company was 1,200,000 units.
Required:
Calculate cost of ending inventory of 200,000 units.

Solution
Rs.
1,000,000
Material X 200,000 166,667
1,200,000
500,000
Labour X 200,000 83,333
1,200,000
500,000
Variable overheads X 200,000 83,333
1,200,000

250,000
Fixed Overheads X 200,000 33,333
1,500,000

Cost of closing stock 366,666

Example of costs excluded from the cost of inventories and recognized as expenses
in the period in which they are incurred are:

(a) abnormal amounts of wasted materials, labour or other production costs;

(b) storage costs, unless those costs are necessary in the production process
before a further production stage;
(c) administrative overheads that do not contribute to bringing inventories to their
present location and condition, and selling costs

NRV 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.

Example 3
Madina (Private) Ltd. has stock of shoes. The cost of the stock of shoes is Rs.
15,000. The company has also a work in process of that stock. The estimated cost to

Financial Accounting and Corporate Reporting (Study Text) 160 | P a g e

 complete this work-in-process stock is Rs. 5,000. Up till now Rs. 10,000 have been
spent on this work in process stock.
The company pays 2% commission on sales to its distributors. The estimated selling
price of finished goods and work in process (when this will be converted to finished
goods) is Rs. 35,000.

Required:
Calculate NRV.
Solution
Rs.
Sales price
35,000
Less: Estimated cost of completion (5,000)
Estimated cost necessary to make sales (Rs. 35,000 x 2%) (700)
(5,700)
NRV 29,300

2 Measurement of inventories

2.1 Inventories shall be measured at the lower of cost and net realisable value.
Example 4
Bonus Ltd. measures its inventories at lower of cost and NRV. The cost of inventories
held by Bonus Ltd. is Rs. 35,000. The estimated selling price of inventories is Rs.
30,000. The company pays Rs. 5% commission on sales to manager. You are
required to calculate the value at which inventories should appear in balance sheet.
Solution
Cost = Rs. 35,000
Sales price = Rs. 30,000
Commission = Rs. 30,000 x 5%
= Rs. 1,500
NRV = Rs. 30,000 Rs. 1,500
= Rs. 28,500
Inventories are measured at lower of cost and NRV so value of inventory is Rs.
28,500 that should appear in Balance sheet.

3 Inventory Valuation Method

3.1 Where items of inventory are not ordinarily interchangeable, IAS 2 requires the actual
unit cost valuation method to be used. Such items should be shown at their actual
individual costs.

Financial Accounting and Corporate Reporting (Study Text) 161 | P a g e

 Where items are ordinarily interchangeable, the entity must choose between two cost
formulae: the FIFO method and the AVCO method.

The same method of arriving at cost should be used for all inventories having similar
nature and use to the entity. For inventories with a different nature or use, different
cost methods may be justified.

FIFO
The FIFO formula assumes that the items of inventory that were purchased or
produced first are sold first, and consequently the items remaining in the inventory at
the end of the period are those most recently purchased or produced.

Weighted Average
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.

Example 5
Delta Manufacturing Company is engaged in the production of different items that are
not ordinarily interchangeable. During the month, the company produced the following
units:
Product A 2,000 units
Product B 3,000 units
The sales for the month are:
Product A 1,800 units
Product B 2,700 units
Cost of producing the each unit of:
Product A Rs. 300
Product B Rs. 200
Required:
Calculate the value of inventory.
Solution
Rs.
Product A (200 x 300) 60,000
Product B (300x200) 60,000
Value of Inventory 120,000

Financial Accounting and Corporate Reporting (Study Text) 162 | P a g e

 Example 6
Indus Oil & Expellers Ltd. carries valuation of supplies at the end of each month. For
the month of February following information is available from the records of the
company.
Stock on February 28, 1998 130,000 liters
Purchase 10 February, 1998150,000 liters @ Rs. 10.65
Purchase 17 February, 1998100,000 liters @ Rs. 10.50
Purchase 28 February, 1998100,000 liters @ Rs. 10.60
Sales during the month 345,000 liters
Stock on January 31, 1998 125,000 liters @ Rs. 9.75

Required:
Calculate value of inventory using FIFO.
Solution
Rs.
100,000 litres @ Rs. 10.60 1,060,000
30,000 liters @ Rs. 10.50 315,000
Value of inventory 1,375,000

Example 7
Shah Petroleum Services engaged in supply of petroleum products. For the month of
September following information available:
Stock on 31 August, 2005 25,000 liters @ Rs. 37.01
Purchase 05 September, 2005 100,000 liters @ Rs. 37.35
Purchase 15 September, 2005 100,000 liters @ Rs. 37.15
Purchase 25 September, 2005 100,000 liters @ Rs. 37.05
Stock on 30 September 30,000 liters

Required:
Calculate the value of inventory using monthly weighted average method.
Solution
Date Units (Liters) Rate (Rs.) Price (Rs.)
Sep 01 25,000 37.01 925,250
Sep 05 100,000 37.35 3,735,000
Sep 15 100,000 37.15 3,715,000
Sep 25 100,000 37.05 3,705,000
325,000 12,080,250
12,080,250
Weighted average rate = = Rs. 37.17
325,000
Cost of inventory = 30,000 x 37.17 = Rs. 1,115,100

Financial Accounting and Corporate Reporting (Study Text) 163 | P a g e

 Example 8
Accurate Limited is engaged in the production of sports goods. Raw material is
acquired by the company is shipments. The unit price is measured after the arrival of
each shipment to charge to production on the basis of weighted average. Following
data is available for the month of January:
Stock on January 1 30,000 Units @ Rs. 10.50
Purchases 10 January 60,000 Units @ Rs. 11.00
Purchases 20 January 40,000 Units @ Rs. 13.00
Sales 25 January 110,000 Units
Stock on January 31 20,000 Units

Required:
Calculate value of inventory and cost of goods sold.

Solution
30,000 x 10.5 60,000 x 11.0 40,000 x 13.0
Weighted Average per unit =
30,000 60,000 40,000
= Rs. 11.5
Value of stock on January 31 = 20,000 x 11.5
= Rs. 230,000
Cost of sales for January = Opening stock + Purchases- Closing stock
= 110,000 x 11.5
= Rs. 1,265,000

4 Net realizable value

4.1 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.

Inventories are usually written down to net realizable value on an item by item basis.
In some circumstances, however, it may be appropriate to group similar or related
items e.g. items of inventory relating to same product line that have similar purposes
or end uses and cannot be practically evaluated separately from other items in that
product line.

Financial Accounting and Corporate Reporting (Study Text) 164 | P a g e

 Example 9
Steadtler Limited owns the following products with details
Items Units Cost per unit (Rs.) NRV per unit (Rs.)
Josh 400 5,000 6,000
Jazba 400 4,500 4,000
Easy 200 400 410
Max 300 600 500
Calculate the value of inventory on items by item basis:

Solution
Items Units Cost per unit NRV per unit Valuation Lower of
(Rs.) (Rs.) Cost& NRV
Rs. (Total)
Josh 400 5,000 6,000 (400 x 5,000) 2,000,000
Jazba 400 4,500 4,000 (400 x 4,000) 1,600,000
Easy 200 400 410 (200 x 400) 80,000
Max 300 600 500 (300 x 500) 150,000
Value of Inventory 3,830,000

Example 10
Bata Pakistan Limited is engaged in the manufacturing of shoes. The following is the
details of units held by one of its retail outlet
Items Units Cost per unit (Rs.) NRV per unit (Rs.)
P 450 900 100 80
F 160 200 400 410
L 120 300 600 500
Q 200 100 300 400
Calculate the value of inventory to be recognized in the books on aggregate basis.

Solution
Items # Units Cost per unit Total Cost NRV per unit Total NRV
Rs. Rs. Rs. Rs.
P 450 900 100 90,000 80 72,000
F 160 200 400 80,000 410 82,000
L 120 300 600 180,000 500 150,000
Q 200 100 300 30,000 400 40,000
380,000 344,000
As NRV of the entire inventory is lower so value of inventory should be measured at
NRV which is Rs. 344,000

Financial Accounting and Corporate Reporting (Study Text) 165 | P a g e

 Example 11
Stream Limited is engaged in the production of fountain pens. At the year end, the
company owns the following inventory.
Items # Units Cost per unit (Rs.) NRV per unit (Rs.)
K 300i 300 100 80
K 500i 200 5000 6000
K 700i 100 4500 4000
J 200i 400 300 400
C 100 400 400 410
C 110 900 600 500
C 200 1000 50 55
N 500 50 100 95
N 600 200 50 40

Required:
You are required to calculate the amount of inventory by aggregate by category
basis.

Solution
Items # Units Cost NRV Total Total Lower of
per unit per unit cost NRV cost & NRV
Rs. Rs. Rs Rs. Rs.
K 300i 300 100 80 30,000 24,000
K500i 200 5,000 6,000 1,000,000 1,200,000
K700i 100 4,500 4,000 450,000 400,000
1,480,000 1,624,000 1,480,000
J 200i 400 300 400 120,000 160,000 120,000
C100 400 400 410 160,000 164,000
C110 900 600 500 540,000 450,000
C200 1,000 50 55 50,000 55,000
750,000 669,000 669,000
N500 50 100 95 5,000 4,750
N600 200 50 40 10,000 8,000
15,000 12,750 12,750
Value of Inventory 2,281,750

Financial Accounting and Corporate Reporting (Study Text) 166 | P a g e

 Example 12
Value the following items of inventory.
(a) Materials costing Rs 12,000 bought for processing and assembly for a
profitable special order. Since buying these items, the cost price has fallen to
Rs 10,000.

(b) Equipment constructed for a customer for an agreed price of Rs 18,000. This
has recently been completed at a cost of Rs 16,800. It has now been
discovered that, in order to meet certain regulations, conversion with an extra
cost of Rs 4,200 will be required. The customer has accepted partial
responsibility and agreed to meet half the extra cost.

Solution
(a) Value at Rs 12,000. Rs 10,000 is irrelevant. The rule is lower of cost or NRV,
not lower of cost or replacement cost. Since the special order is known to be
profitable, the NRV will be above cost.

(b) Value at NRV, i.e. Rs 15,900, as this is below cost

(NRV = contract price, Rs 18,000
Rs 2,100).

5 Recognition as an expense

5.1 Cost of inventories are recognized as an expense:

(a) When inventories are sold, carrying amount of those inventories shall be
recognized as an expense in the period in which the related revenue is
recognized.
(b) The amount of any write-down of inventories to net realizable value and all
losses of inventories shall be recognized as an expense in the period, the
write-down or loss occurs.
(c) The amount of any reversal of any write-down of inventories, arising from an
increase in net realizable value shall be recognized as a reduction in the
amount of inventories recognized as an expense in the period in which the
reversal occurs.

Financial Accounting and Corporate Reporting (Study Text) 167 | P a g e

 Example 13
SOS Limited is engaged in the production of surgical item. The following data is
available for the month of August.
Opening stock 3,000 unit @ Rs. 100 per unit
Production 30,000 unit @ Rs. 100 per unit
Closing stock 2,000 unit @ Rs. 100 per unit

Required:
Calculate the expenses to be charged to income statement.

Solution
Expense charged to Income Statement.
Rs.
Opening Stock 300,000
Add: Production 3,000,000
3,300,000
Less: Closing Stock 200,000
Cost of goods sold 3,100,000
OR
Unit sold = Opening units + Units produced Closing units
= 3,000 + 30,000 2,000
= 31,000 units
Cost of goods sold = 31,000 x 100
= Rs. 3,100,000

Example 14
Khas Traders has the following data for the month of March:
Opening stock 300 units @ Rs. 100
Purchases 1,000 units @ Rs. 100
Closing stock 200 units
At 31 March, the NRV of the product comes down to Rs. 95. You are required to
calculate the expense that should be recognized.

Solution
Closing stock at NRV (Rs.)
Opening stock 30,000
Purchases 100,000
130,000
Closing stock (19,000)
Cost of goods sold 111,000

Financial Accounting and Corporate Reporting (Study Text) 168 | P a g e

6 Disclosure Requirements

6.1 The main disclosure requirements of IAS 2 are:

accounting policy adopted, including the cost formula used

total carrying amount, classified appropriately
amount of inventories carried at NRV
amount of inventories recognised as an expense during the period
details of any circumstances that have led to the write-down of inventories to
their NRV.

7 Key Points
Inventories are assets:
Held for sale in the ordinary course of business;
In the process of production for sale; or
In the form of materials or supplies to be consumed in the production process
or in the rendering of services.

Net realizable value:

Estimated selling price Estimated cost to complete Estimated cost to sell.

Cost of inventories shall comprise of:

Costs of purchases
Costs of conversion
Other costs

Variable production overheads are allocated on actual capacity whereas fixed

production overheads are allocated over the higher of Normal capacity or Actual
Capacity.

Cost of conversion in case of joint production is allocated on a reasonable and

consistent basis.

In case of by-products, the NRV of by-product is often deducted from the cost of main
product.

Cost of inventories of service providers will be the cost of labour and other costs of
personnel directly involved in providing the services. It also does not include the profit
margin. At the end of period if any service is not yet completed, its cost will be taken
as inventory.

Financial Accounting and Corporate Reporting (Study Text) 169 | P a g e

 Two techniques are being used for measuring the cost of inventories:
1. Standard costing 2. Retail method

Cost formulas:
1. Specific Inventories: Individuals costs 2. Other Inventories: FIFO or
Weighted average

Inventories shall be measured at lower of cost and net realizable value. However
raw-material shall be valued at lower of cost or replacement cost.

If the finished goods are expected to be sold at above cost, then inventories shall not
be written down to NRV even if it is lower than cost.

When inventories are sold they are recognized as an expense, i.e. charged to cost of
goods sold.

Any write down of inventories to NRV shall be recognized in the period of write down.

Amount of any reversal arising from increase in NRV shall be recognized in period in
which reversal occurred.

After reversal, the amount recognized as inventories shall not increase from the cost
that would be, had there been no reduction to NRV.

Financial Accounting and Corporate Reporting (Study Text) 170 | P a g e

 Chapter Summary

Financial Accounting and Corporate Reporting (Study Text) 171 | P a g e

 Self Test Questions

1 The financial accounting records are used to determine the overhead cost, and this is
applied as a percentage based on the direct labour cost. For direct labour cost, you
have agreed that the labour expended for a unit in work in progress is half that of a
completed unit.

The draft accounts show the following materials and direct labor cost in inventory.
Raw material WIP Finished goods
Material 786,740 92,685 125,963
Direct labour 13,082 46,594
The cost incurred in April, as recorded in the financial accounting records were as
follows:
Rs.
Direct labour 68,012
Selling cost 55,430
Depreciation 9,440
Distribution cost 7,560
Factory managers cost 2,560
Other production overheads 34,920
Purchasing and accounting cost relating to production 4,550
Other accounting cost 7,260
Administration overheads 42,760

For calculations assume that all work-in-process and finished goods were produced
in April 20X6 and that the company was operating at a normal level of activity.

Required:
Calculate the value of overheads which should be added to work-in-process and
finished goods in accordance with IAS-2.

2 The material is imported by the ABC Co. from America and there are the following
expenses incurred on manufacturing of goods:

Purchase price of materials used 2,500

Volume rebate 380
Custom duty 500
Sale tax (Refundable) 870
Material handling charges 250
Discount allowed 550

Financial Accounting and Corporate Reporting (Study Text) 172 | P a g e

 Store rent 630
Indirect labour 740
Variable overheads 230
Depreciation 120
Material wasted 600
Commission to agent for selling the products 880

Required:
Calculate the value of inventory.

3 The following information is available from ABC Company, 20X6 accounting records:
Rs.
Purchases 530,000
Purchase discounts 10,000
Beginning inventory 160,000
Ending inventory 215,000
Freight out 40,000

Required:
Calculate cost of goods sold.

Financial Accounting and Corporate Reporting (Study Text) 173 | P a g e

Answers

1 Production overheads are as follows:

Rs.
Depreciation 9,440
2,560
Other production overheads 34,920
Accounting / purchase cost 4,550
51,470
Direct labour = 68,012
51,470
Production overhead rate = x 100
68,012
= 75.687%
Inventory valuation:
Raw material W.I.P. F.G.
Material 786,740 92,685 125,963
Direct labour 13,082 46,594
Production o/h (Estimated/applied) 9,900 35,266
786,740 115,667 207,823

2
Purchase price of materials used 2,500
Volume rebate (380)
Custom duty 500
Material handling charges 250
Store rent 630
Indirect labour 740
Variable overheads 230
Depreciation 120
Value of Inventory 4,590
Note-1:
Note-2: Material wasted is considered as abnormal loss so it will be charged as
expense in profit and loss Account.

Financial Accounting and Corporate Reporting (Study Text) 174 | P a g e

3
Rs.
Beginning inventory 160,000
Purchases 530,000
Purchase discount (10,000)
Closing inventory (215,000)
Cost of goods sold 465,000

Financial Accounting and Corporate Reporting (Study Text) 175 | P a g e