Financial Reporting (F7/FR)

IAS 2 Inventory
1. Inventories are assets:
• Held for sale in the ordinary course of business;
• In the process of production for such sale; or
• In the form of materials or supplies to be consumed in the production process or in the
rendering of services.
2. 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.
(IAS 2: para. 6)
3. 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.

Measurement of inventories
The standard states that 'Inventories should be measured at the lower of cost and net realizable
value.

Cost of inventories
The cost of inventories will consist of all costs of:

1. Purchase
2. Costs of conversion
3. Other costs incurred in bringing the inventories to their present location and condition

Costs of purchase
The standard lists the following as comprising the costs of purchase of inventories.

1. Purchase price PLUS

2. Import duties and other taxes PLUS
3. Transport, handling and any other cost directly attributable to the acquisition of finished
goods, services and materials LESS
4. Trade discounts, rebates and other similar amounts

Costs of conversion
Costs of conversion of inventories consist of two main parts.

(a) Costs directly related to the units of production, eg direct materials, direct labour

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(b) (b) Fixed and variable production overheads that are incurred in converting materials
into finished goods, allocated on a systematic basis.

The standard emphasises that fixed production overheads must be allocated to items of
inventory on the basis of the normal capacity of the production facilities. This is an important
point.

(a) Normal capacity is the expected achievable production based on the average over several
periods/seasons, under normal circumstances.

(b) The above figure should take account of the capacity lost through planned maintenance.

(c) If it approximates to the normal level of activity then the actual level of production can be
used.

(d) Low production or idle plant will not result in a higher fixed overhead allocation to each unit.

(e) Unallocated overheads must be recognised as an expense in the period in which they were
incurred.

(f) When production is abnormally high, the fixed production overhead allocated to each unit
will be reduced, so avoiding inventories being stated at more than cost.

(g) The allocation of variable production overheads to each unit is based on the actual use of
production facilities.

Other costs
Any other costs should only be recognised if they are incurred in bringing the inventories to their
present location and condition. (IAS 2: para. 15)

The standard lists types of cost which would not be included in cost of inventories. Instead, they
should be recognised as an expense in the period they are incurred.

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

(b) Storage costs (except costs which are necessary in the production process before a further
production stage)

(c) Administrative overheads not incurred to bring inventories to their present location and
conditions

(d) Selling costs

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Techniques for the measurement of cost
Two techniques are mentioned by the standard, both of which produce results which
approximate to cost, and so both of which may be used for convenience. (IAS 2: para. 21)

(a) Standard costs are set up to take account of normal production values: amount of raw
materials used, labour time etc. They are reviewed and revised on a regular basis.

(b) Retail method: this is often used in the retail industry where there is a large turnover of
inventory items, which nevertheless have similar profit margins. The only practical method of
inventory valuation may be to take the total selling price of inventories and deduct an overall
average profit margin, thus reducing the value to an approximation of cost. The percentage will
take account of reduced price lines. Sometimes different percentages are applied on a
department basis.

Cost formulae
Cost of inventories should be assigned by specific identification of their individual costs for:

(a) Items that are not ordinarily interchangeable

(b) Goods or services produced and segregated for specific projects (IAS 2: para. 23)

Specific costs should be attributed to individual items of inventory when they are segregated for
a specific project, but not where inventories consist of a large number of interchangeable (ie
identical or very similar) items. In the latter case the rule is as specified below.

Interchangeable items
The cost of inventories should be assigned by using the first-in, first-out (FIFO) or weighted
average cost formulas. The LIFO formula (last in, first out) is not permitted by IAS 2.

Net realisable value (NRV)

As a general rule assets should not be carried at amounts greater than those expected to be
realised from their sale or use. In the case of inventories this amount could fall below cost when
items are damaged or become obsolete, or where the costs to completion have increased in
order to make the sale.

(IAS 2: para. 28)

In fact we can identify the principal situations in which NRV is likely to be less than cost, ie
where there has been:

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(a) An increase in costs or a fall in selling price

(b) A physical deterioration in the condition of inventory

(c) Obsolescence of products

(d) A decision as part of the company's marketing strategy to manufacture and sell products at
a loss

(e) Errors in production or purchasing

A write down of inventories would normally take place on an item by item basis, but similar or
related items may be grouped together. This grouping together is acceptable for, say, items in
the same product line, but it is not acceptable to write down inventories based on a whole
classification (eg finished goods) or a whole business. (IAS 2: para. 29)

The assessment of NRV should take place at the same time as estimates are made of selling
price, using the most reliable information available. Fluctuations of price or cost should be taken
into account if they relate directly to events after the reporting period, which confirm conditions
existing at the end of the period. (IAS 2: para. 30)

The reasons why inventory is held must also be taken into account. Some inventory, for
example, may be held to satisfy a firm contract and its NRV will therefore be the contract price.
Any additional inventory of the same type held at the period end will, in contrast, be assessed
according to general sales prices when NRV is estimated. (IAS 2: para. 31)

Net realisable value must be reassessed at the end of each period and compared again with
cost. If the NRV has risen for inventories held over the end of more than one period, then the
previous write down must be reversed to the extent that the inventory is then valued at the
lower of cost and the new NRV.

This may be possible when selling prices have fallen in the past and then risen again.

Recognition as an expense
The following treatment is required when inventories are sold.

(a) The carrying amount is recognised as an expense in the period in which the related revenue
is recognised.

(b) 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.

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(c) The amount of any reversal of any write-down of inventories, arising from an increase in
NRV, is recognised as a reduction in the amount of inventories recognised 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. The issue is
whether an entity may use different cost formulas for different types of inventories.

IAS 2 provides that an entity should use the same cost formula for all inventories having similar
nature and use to the entity. For inventories with different nature or use (for example, certain
commodities used in one business segment and the same type of commodities used in another
business segment), different cost formulas may be justified. A difference in geographical
location of inventories (and in the respective tax rules), by itself, is not sufficient to justify the
use of different cost formulas.

Disclosure requirements for inventory

IAS 2 requires the following disclosures in notes to the financial statements.

1. The accounting policy adopted for measuring inventories, including the cost valuation
method used.
2. The total carrying amount of inventories, classified appropriately. (For a manufacturer,
appropriate classifications will be raw materials, work-inprogress and finished goods).
3. The amount of inventories carried at fair value minus costs to sell.
4. The amount of inventories recognised as an expense during the period.
5. The amount of any write-down of inventories recognised as an expense in the period.
6. The amount of any reversal of any write-down that is recognised as a reduction in the
amount of inventories recognised as expense in the period.
7. Details of any circumstances or events that have led to the reversal of a writedown of
inventories.
8. The carrying amount of inventories pledged as security for liabilities.

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Chapter end exercise

Q1 According to IAS 2 Inventories, which of the following costs should be included in valuing
the inventories of a manufacturing company?

(1) Carriage inwards (2) Carriage outwards

(3) Depreciation of factory plant (4) General administrative overheads

A 1 and 3 B 1, 2 and 4

C 2 and 3 only D 2, 3 and 4

Q2 IAS 2 Inventories defines the extent to which overheads are included in the cost of
inventories of finished goods. Which of the following statements about the IAS 2
requirements relating to overheads are true?

(1) Finished goods inventories may be valued on the basis of labour and materials cost only,
without including overheads.

(2) Factory management costs should be included in fixed overheads allocated to inventories of
finished goods.

A 1 only B 2 only

C Both 1 and 2 D Neither 1 nor 2

Q3 Which of the following are correct?

(1) The carrying amount of inventory should be as close as possible to net realizable value

(2) The valuation of finished goods inventory must include production overheads

(3) Production overheads included in valuing inventory should be calculated by reference to the
company’s normal level of production during the period

(4) In assessing net realisable value, inventory items must be considered separately, or in groups
of similar items, not by taking the inventory value as a whole

A 1 and 2 B 1 and 3

C 2, 3 and 4 D 3 and 4 only

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Q4 The net realisable value of inventory is defined as the actual or estimated selling price
less all costs to be incurred in marketing, selling and distribution.

Which of all the following additional items should be deducted in calculating the net realisable
value of inventory?

Trade discounts Settlement discounts Costs to completion

A No Yes Yes

B Yes No Yes

C Yes Yes No

D Yes Yes Yes

Q5 Which of the following items should be included in the cost of inventory of a service
provider?

(1) Salary of staff engaged in the service contract

(2) Profit margin factored into the contract price

(3) Depreciation of office computer used by staff engaged on contract

(4) Salary of sales staff who negotiated the service contract

A 1 and 2 B 1 and 3

C 2 and 4 D 3 and 4

Q6 First-in first-out is one method allowed by IAS 2 Inventories for determining the purchase
price or cost of production of finished goods inventory.

Which of the following valuation methods is also allowed by IAS 2?

A Both last-in first-out and weighted average

B Only last-in first-out

C Only weighted average

D Neither last-in first-out nor weighted average

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Q7 During the year ended 31 December 20X6 Grasmere purchased the following items for
resale:

Date Number of items Cost price per item

March 20 $11

June 20 $13

This was a new product line and by 31 December 20X6 twenty items were left unsold. At that
date they were being sold at $12 an item and it would have cost Grasmere $10 an item to buy
further supplies. Grasmere determines cost of inventory under the first-in first-out method.

At what amount should finished goods inventory be shown in the statement of financial position
as at 31 December 20X6?

A $200 B $220

C $240 D $260

Q8 Toulouse makes three different products. The following table shows the inventory
valuation for each of the products under different bases:

FIFO LIFO Net realisable value

$ $ $

Product I 10 11 12

Product II 13 15 14

Product III 9 5 7

—— —— ——

32 31 33

—— —— ——

At what amount should Toulouse’s inventory be stated in accordance with IAS 2 Inventories?

A $28 B $30

C $31 D $32

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Q9 On 30 September 20X4, Razor’s closing inventory was counted and valued at its cost of
$1 million. Some items of inventory which had cost $210,000 had been damaged in a
flood (on 15 September 20X4) and are not expected to achieve their normal selling price
which is calculated to achieve a gross profit margin of 30%. The sale of these goods will
be handled by an agent who sells them at 80% of the normal selling price and charges
Razor a commission of 25%.

At what amount will the closing inventory of Razor be reported in its statement of financial
position as at 30 September 20X4?

A $1 million B $790,000

C $180,000 D $970,000

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