IAS 2: Inventories
What is Inventories
• IAS2 defines inventories as "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".
• The standard also prescribes a well-known rule for the valuation of
inventories. This rule is that "inventories shall be measured at the lower of
cost and net realisable value".
• The remainder of IAS2 provides guidance on the determination of the cost
and net realizable value of inventories and makes certain disclosure
requirements.
Cost of inventories
• IAS2 states that the cost of inventories "shall comprise all costs of purchase,
costs of conversion and other costs incurred in bringing the inventories to
their present location and condition“
• Costs of purchase consist of the purchase price of inventories, including
import duties and other taxes (if these are irrecoverable), transport and
handling costs and any other costs directly attributable to the acquisition of
the goods concerned. Trade discounts are deducted when calculating costs of
purchase.
• Costs of conversion are relevant mainly to manufacturing businesses and
consist of direct costs of production (such as direct labour) together with a
systematic allocation of fixed and variable overheads incurred in converting
materials into finished goods.
Cost of inventories
• The allocation of fixed production costs to units of production should be based upon the
normal capacity of the production facilities.
If production is abnormally high, the amount of fixed production overheads allocated to
each item of production should be decreased so as to ensure that the cost of inventories
is not overstated.
• Certain costs are explicitly excluded from the cost of inventories. The main items are:
the costs of abnormal wastage of materials, labour or other production costs
storage costs, unless these costs are necessary in the production process before a
further production stage
administrative overheads which do not contribute to bringing inventories to their
present location or condition
selling costs.
Cost of inventories
• Techniques such as standard costing and the retail method may be used
to determine the cost of inventories, so long as they provide a
reasonable approximation to cost.
(Standard costs are computed in accordance with normal prices and
usage of materials, labour etc. and normal levels of efficiency. Standard
costs should be reviewed regularly and revised if necessary.
The retail method is often used in the retail industry for measuring
inventories which consist of large numbers of rapidly changing items
with similar profit margins. This method determines the cost of
inventories by reducing their sales value by the appropriate percentage
profit margin.
Cost formulas
• IAS2 requires that the cost of inventory items should be ascertained
"by using specific identification of their individual costs". In other
words, each item of inventory should be considered separately and its
cost should be individually established.
• However, it is not always possible to distinguish one inventory item
from another. For instance, a business may have an inventory of
identical machine parts which have been bought on different dates
and at different prices
Cost formulas
• First-in, first-out (FIFO). The FIFO formula assumes that inventory items
which are purchased or produced first are sold or used first, so that the items
remaining at the end of an accounting period are those most recently
purchased or produced.
• Weighted average cost (AVCO). Use of the AVCO formula generally involves
computing a new weighted average cost per item after each acquisition takes
place. The cost of the items remaining at the end of each accounting period
is then calculated by using the most recently-computed weighted average
cost per item.
• Last-in, first-out (LIFO). This cost formula assumes that the newest inventory
items are sold or used first, so that the items remaining at the end of an
accounting period are the oldest.
Why LIFO is not allowed by IAS 2
• IAS2 objects to the LIFO formula for a number of reasons:
(a) LIFO is generally not a reliable representation of actual inventory flows.
(b) The use of LIFO is often tax-driven, since it matches sales revenue
against the cost of the newest items acquired. In times of rising prices, this
will result in lower reported profits and so a lower tax expense (as long as
the tax authorities will accept LIFO for tax purposes). However, the IASB
takes the view that tax considerations do not provide an adequate
conceptual basis for the selection of an accounting treatment.
(c) The use of LIFO results in inventories being shown in the financial
statements at values which bear little relation to recent cost levels.
Example
Net realisable value
• IAS2 requires that inventories should be measured at the lower of cost and net realisable value. Net
realisable value (NRV) is defined as
"... estimated selling price in the ordinary course of business less the estimated costs of completion
and the estimated costs necessary to make the sale".
• The effect of measuring inventories at the lower of cost and NRV is that any loss expected on the sale
of items at less than cost is accounted for immediately rather than when the items are sold. Note
that:
(a) The costs and NRVs of inventories are normally compared item by item. But IAS2 accepts that it may
sometimes be appropriate to group items together that cannot be evaluated separately and to
compare the total cost of the group with its total NRV.
(b) Materials held for use in production are not written down below cost so long as the products in
which they will be incorporated are expected to be sold at cost or above.
If an inventory item was written down to NRV in the previous period and is still on hand at the end of
the current period, its NRV should now be re-assessed and it should be measured at the lower of cost
and the revised NRV figure
Net realisable value
• If an inventory item was written down to NRV in the previous period
and is still on hand at the end of the current period, its NRV should
now be re-assessed and it should be measured at the lower of cost
and the revised NRV figure
• Net realisable value Formula
NRV = expected selling price - costs expected to be incurred to make
the sale
Net realisable value
Inventory write-downs and
write-offs
• The expected saleable value of an item could (for various reasons) fall
below its original cost. If so, it should be shown in the financial
statements at its net realisable value (NRV).
• When this happens, the cost of the item is said to be written down to
its NRV.
• If the item is completely worthless (i.e. if its NRV is zero) then the cost
of the item is said to be written off completely.
Inventory write-downs and
write-offs
Standard cost and the Retail
method.
• Standard costing is typically used by manufacturers. Under the
standard cost method, the business decides at the start of the year
what the normal, typical cost of making an item is expected to be. All
units of that item will be valued at this standard cost throughout the
year.
• If the cost actually incurred in making units of that item during the
year deviates from the standard cost, then the difference is recorded
as a ‘variance’ in the income statement. For example, if units end up
costing a little bit more than expected, then the total of all the
differences (the ‘variance’) will be an extra cost in the income
statement.
Standard cost and the Retail
method.
• The retail method is only used by retail businesses, i.e. those that sell directly
to the public. Such businesses typically keep their inventory records showing
each item at its expected selling price.
• Under the retail method, the valuation of inventory in the financial statements
will be based on the expected selling price of items minus the normal profit
margin that the business expects to achieve on them.
• ‘Margin’ and ‘Mark-up’ percentages:
The margin percentage (also known as the gross profit or gross margin
percentage) is the profit per unit calculated as a percentage of the selling price.
The mark-up percentage is the profit per unit calculated as a percentage of the
cost price.
‘Margin’ and ‘Mark-up’ percentages
• For example, suppose you are told that the expected selling price of an
item is £140.
If you are told that the margin percentage is 25%, then the profit per
unit would be £140 * 25% = £35. The cost price of this item is therefore
£105 (£140 selling price − £35 profit).
If you were told that the mark-up percentage is 25%, then this means
that the selling price represents 125% of the cost price. The profit per
unit would therefore be £140 * 25>125 = £28, so the cost price of this
item must be £112 (£140 selling price - £28 profit). (You can check that
this is correct by calculating: £112 cost price * 11 + 0.252 = £140.)
‘Stocktaking’: counting inventory at
the year end
• There is normally no account in the nominal ledger that tracks all the
increases and decreases in inventory over the course of the year. To establish
the quantity of inventory held by a business as at the end of the financial year,
it is therefore often necessary to physically count it. This is commonly known
as stocktaking.
• Many businesses will actually monitor their inventory movements during the
year using some sort of inventory management software. But even these
businesses will still need to carry out some physical counting to gain
confidence that their computerised records are accurate.
• Given that closing inventory is such an important figure in the financial
statements, carrying out these physical checks will be particularly important
at the end of the year.
Inventory held on a ‘sale or return’
basis
• Sometimes a business (typically a manufacturer or a wholesaler) will send
its goods to another business (usually a retailer) on a ‘sale or return’ basis.
• For example, suppose Business A sends some of its goods to Business B
under a sale or return arrangement. This means that the goods remain the
property of Business A until Business B either manages to sell them or (for
some other reason) decides to purchase them outright.
• At the end of the financial year, any of these goods held by Business B on a
sale or return basis must be included in the closing inventory of Business A
and excluded from the inventory of Business B. They will be valued in the
normal way, at the lower of their cost and their net realisable value.
