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IAS 2 INVENTORIES
What is sauce for the goose may be sauce for the gander but is not necessarily sauce for the
duck or the turkey.
Alice B. Toklas

How can Inventories be this important to attract a whole Standard?

Y ou might start wondering why a whole standard has been dedicated to this seemingly simple
and harmless element of financial statement. The reasons are not far-fetched. It only takes a
broader look as explained on the BlogSpot.

So lets set the ball rolling

OBJECTIVES
To prescribe the accounting treatment of inventories, including the calculation of the cost of
inventory, the type of inventory method adopted, the allocation of cost to assets and expenses,
and valuation aspects associated with any write-downs to net realizable value.

SCOPE

The following items are excluded from the scope of the standard.
i. Work in progress under construction contracts (Already addressed by IAS 11 Construction
Contracts)
ii. Financial instruments i.e. shares, bonds (Already addressed by IAS 32 Financial Instruments:
Presentation & IAS 39 Financial Instruments: Recognition and measurement)
iii. Biological assets (Already addressed by IAS 41 Agriculture)

Wait! Dont get it twisted

Remember that we discussed this in the IAS 1 edition that not all cases of a subject matter is
addressed by a particular standard. Here, IAS 2 doesnt cover the above items. This means we
are not to bother ourselves about treating them here.

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DEFINITIONS

Inventories:
The nature of inventories varies with the type of business. Inventories are:
Assets held for sale. For a retailer, these are items that the business sells its stock-in
trade. For a manufacturer, assets held for sale are usually referred to as finished goods
Assets in the process of production for sale (work-in-progress for a manufacturer)
Assets in the form of materials or supplies to be used in the production process (raw
materials in the case of a manufacturer).

Net Realizable Value (NRV): is the estimated selling price in the normal course of business less
estimated cost to complete and cost to make the sale.

Fair Value: the price received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date.

Wait! Dont get it twisted

If you still remember your manufacturing account, inventories to a manufacturer is more than
that of a trader, thats why the standard gave a full definition of inventories so as to cover both
businesses.
Raw Materials: A manufacturer buys goods for the purpose of production. Those goods
are in form of materials (raw materials) or supplies to be used in the production process.
They are current assets (inventories) to the manufacturer.
Work-in-progress: The manufacturer tries to convert some of those goods to finished
products by incurring conversion cost (direct labor and overhead) on them. Some of these
goods are left unfinished by the end of the year. They are referred to as work-in-progress
i.e. goods in the process of production for sale. At the end of the period, they are treated
as current assets (inventories).
Finished goods: some of the completed goods are available for sale at the end of the year.
They are held for sale. Thus, treated as current assets (inventories).

RECORDING INVENTORIES

There are two main methods of recording inventory so as to enable the calculation of cost of
sales:
Periodic inventory system (period-end system)
Perpetual inventory system

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Periodic inventory system

This is simply the financial accounting way of stock-taking and determining cost of sales in line
with the periodicity concept. The opening inventory is added to purchases in order to derive the
cost of goods available for sale, and where there are closing inventories (inventories unsold),
these are subtracted from the cost of goods available for sale so as to arrive at the cost of sales.
There is almost no need of everyday counting of stock as the opening and closing inventories tell
what was issued to production and what was left in the warehouse. Here, all records of
inventories are recorded in the purchases account.

Perpetual inventory method

This system is mostly used in cost accounting where inventory records are continuously updated
so that inventory values are always available. A single account is used to record all inventory
movements. The account is used to record all issues out of inventory. These issues constitute the
cost of sales. When the perpetual inventory method is used, a record is kept of all receipts of
items into inventory (at cost) and all issues of inventory to cost of sales. Hence, the existence of
a separate account referred to as inventory account.

Hey! Lets take a break

Just for laughs

An accountant is having difficulty sleeping and goes to see his doctor.
Accountant: Doctor, I just cant get to sleep at night.
Doctor: Have you tried counting sheep?
Accountant: Thats the problem I make a mistake and then spend three hours trying
to find it.
______________________________________________________________________________
A 54-year-old accountant left a letter for his wife one evening which read: Dear Wife,
I am 54 years old, and by the time you get this letter I will be at the Grand Hotel with
my beautiful and sexy 18-year-old secretary.
When he arrived at the hotel, there was a letter waiting for him that read, Dear
Husband, I too am 54 years old, and by the time you receive this letter I will be at the
Savoy Hotel with my 18-year-old boyfriend. Because you are an accountant, you will
surely appreciate that 18 goes into 54 many more times than 54 goes into 18.

___________________________________________________
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Hey! Welcome back

MEASUREMENT OF INVENTORIES

Inventories are measured at the lower of cost and net realizable value

NB: this is an implicit impairment test, thus inventories are excluded from the scope of IAS 36
impairment of assets.

Wait! Dont get it twisted

You might want to question that statementlower of cost and net realizable value. The IASB
just displayed the Use of English here. You might have as well thought that it should have been
lower of cost or net realizable value.
Nope, the use of and displays the presence of two or more factors in one entity at the same
time, while or depicts the presence of either i.e. not appearing together.
Since it is certain that at every point in time, an item of inventory has the cost associated with
it and at the same time the amount to be realized assuming the organization decides to sell it at
the moment i.e., the net realizable value. Hence, it is obvious that the IASB thought it out well
to have declared that statement above.
Also, note that the idea of measuring inventories at the lower of cost and net realizable value
is in tandem with the prudence concept. Closing inventories should not be overstated in the SOFP
as prices might change in the future. It is better to have valued it lower and watch prices fluctuate
than to value it higher and make a loss as a result of fall in prices of our inventories.

Okay! So how do we measure the COST and the NET REALIZABLE VALUE?

COST OF INVENTORIES
IAS2 states that the cost of inventories shall comprise all:
Purchase costs, such as the purchase price, import charges, non-recoverable taxes, and other
directly attributable transport and handling costs;
Note that the purchase cost should be net of volume rebates i.e. trade discounts.

Costs of conversion; direct labor; and production overheads, including variable overheads
and fixed overheads allocated at normal production capacity; and

Other costs, such as design and borrowing costs.

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NB: the following costs are excluded from the cost of inventories.
Abnormal waste
Storage costs (unless necessary for the production process)
Admin overheads not related to production
Selling costs
Discount received
Interest cost (where settlement is deferred)

- IAS 23 Borrowing Costs identifies rare circumstances where borrowing costs can be included.

Lets test your understanding

Brilliant Trading Inc. purchases motorcycles from European countries and sells them to African
countries. During the current year, the company has incurred the following expenses:

(a) Cost of purchases (based on vendors invoices)

(b) Trade discounts on purchases
(c) Import duties
(d) Freight and insurance on purchases
(e) Other handling costs relating to imports
(f) Salaries of accounting department
(g) Brokerage commission payable to indenting agents for arranging imports
(h) Sales commission payable to sales agents
(i) After-sales warranty costs Trade discount on purchase

Required: Brilliant trading Inc. seeks your advice on which costs are allowed by IAS 2 for
inclusion in the cost of inventory.
Wiley

Wait! Dont get it twisted

Items (a), (b), (c), (d), (e), and (g) are permitted to be included in cost of inventory under IAS 2.
Salaries of accounting department, sales commission, and after-sales warranty costs are not
considered cost of inventory under IAS 2 and thus are not allowed to be included in cost of
inventory. The reason is simple, they dont form part of the cost attributable to our inventories.

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Okay, try this also

The following information applies to the Grady Company for the current year:
$
Purchases of merchandise for resale 300,000
Merchandise returned to vendor 3,000
Interest on notes payable to vendors 6,000
Freight-in on merchandise 7,500
Gradys inventory costs for the year would be?

Hennie Van Greuning

Wait! Dont get it twisted

The only costs allowed here are: $
Purchases of merchandise for resale 300,000
Freight-in on merchandise 7,500
Merchandise returned to vendor (3,000)
304,500

Note that Interest costs on financing are not part of inventory cost.

NET REALIZABLE VALUE (NRV)

This 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 i.e.

NRV = Selling price (Cost to complete + Cost to sell)

Sometimes, the selling price can be the fair value/market price.

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Okay, lets try our hands on the principle of measuring inventories.

Note that while measuring inventories in accordance with the principle of lower of cost and
net realizable value. Note that the cost and net realizable value should be compared for each
separately identifiable item of inventory, or group of similar inventories, rather than for
inventory in total.

Moonstruck Enterprises Inc. is a retailer of Italian furniture and has 5 major lines: sofas, dining
tables, beds, closets and lounge chairs.

Product line quantity cost per unit ($) NRV per unit ($)
Sofas 100 1000 1020
Dining tables 200 500 450
Beds 300 1500 1600
Closets 400 750 770
Lounge chairs 500 250 200

Required
Compute the valuation of the inventory of Moonstruck Enterprises at December 31, 200X, under
IAS 2 using the lower of cost and NRV principle.
Wiley

Wait! Dont get it twisted

Product line quantity cost/unit NRV/unit ($) lower of Cost and Value
($) ($) NRV ($) ($)
Sofas 100 1000 1020 1000 100,000
Dining tables 200 500 450 450 90,000
Beds 300 1500 1600 1500 450,000
Closets 400 750 770 750 300,000
Lounge chairs 500 250 200 200 100,000
1,040,000
Note that the value is derived by multiplying the lower of cost and NRV by the quantity.

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COST FORMULAS USED FOR MEASURING COST

On the BlogSpot, we did an introduction to the problems arising in the course of determining the
value to be attached to inventories when issues are made to production. Especially where the
organization buys in batches at different prices, what then will be the price used for valuation?

IAS 2 provides a very good solution to this issues on a principles-based stance.

For non-interchangeable items:

- Specific identification

Wait! Dont get it twisted

Where a commodity is non-interchangeable i.e. the customer specifically requested for it

and the cost of production differs from other items. The cost here can simply be specifically
identified without stress.
The idea is simple, when goods or services are produced and segregated for specific
projects or where the products are exclusive and unique, such costs should be attributed to
individual items of inventory when they are segregated for a specific project.

For interchangeable items:

- First In, First Out (FIFO)
- Weighted average cost.
NB: Last In, First Out (LIFO) formula is NO longer allowed.

Wait! Dont get it twisted

Where a commodity is interchangeable i.e. the inventories can be issued to production
(manufacturer) or sold (retailer) without preference to the choice of the inventories (especially
where the inventories are available in large volumes), the question of what price to be used arises
where the same sort of inventories have different prices attached to them.
IAS 2 permits the use of FIFO (selling/issuing inventories in the order in which they are
produced/purchased). This means the most recent products/purchases are left in the warehouse.
Rather, IAS 2 also permits the use of weighted average cost of inventories at the most
recent weighted average price. This is measured by multiplying the total units purchased/issued
by the price then divided by the total balance of the units.
Im sure you want to question the IASB for rejecting the use of LIFO. The reason is that
the LIFO method reflects old prices as closing inventory in the SOFP. This is because the new
purchase prices are issued first over and over again. Note that accounting prefers that the current
economic reality of transactions are reflected in the financial statements. LIFO method does not.

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TECHNIQUES USED FOR MEASUREMENT OF COSTS

Other techniques used by organization in setting cost of inventories include:

Standard cost: This takes into account normal levels of materials and supplies, labor,
efficiency and capacity utilization.
They are regularly reviewed and, if necessary, revised in the light of current conditions.

Retail method: This 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.

RECOGNITION

The following treatment is required when inventories are sold.

The carrying amount is recognized as an expense in the period in which the related
revenue is recognized.
The amount of any write-down of inventories to NRV and all losses of inventories are
recognized as an expense in the period the write-down or loss occurs.
The amount of any reversal of any write-down of inventories, arising from an increase
in NRV, is recognized as a reduction in the amount of inventories recognized as an
expense in the period in which the reversal occurs.

CONSISTENCY DIFFERENT COST FORMULAS FOR INVENTORIES

IAS 2 allows two cost formulas (FIFO or weighted average cost) for inventories that are
ordinarily interchangeable or are not produced and segregated for specific projects. Whatever
method an organization adopts, IAS 2 provides that an entity should use the same cost formula
for all inventories having similar nature and use to the entity. And such formula should be
consistently applied over the years of operation of the entity.

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DISCLOSURE REQUIREMENTS

IAS 2 requires the following disclosures in the notes to the financial statements.
The accounting policy adopted for measuring inventories, including the cost
measurement method used.

The total carrying amount of inventories, classified appropriately. (For a manufacturer,

appropriate classifications will be raw materials, work-in-progress and finished goods.)
The amount of inventories carried at net realizable value or NRV.
The amount of inventories written down in value, and so recognized as an expense
during the period.
Details of any circumstances that have led to the write-down of inventories to NRV.
The amount of any reversal of any write-down that is recognized as a reduction in the
amount of inventories recognized as expense in the period.
The circumstances or events that led to the reversal of a write-down of inventories.

I hope this material threw more light on IAS 2 Inventories. Watch out for the Questions and
Solutions edition. It promises to have numerous practical questions to your advantage. Stay
tuned.
You can get more topics on Financial Reporting on adedamolaotun.blogspot.com.
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Regards,
Adedamola Otun
tnadedamola@gmail.com

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