IAS 2 Inventories

1 Introduction

Inventories are assets held for sale in the ordinary course of business (finished goods), assets in the production process for such sale (work in progress), and materials and supplies to be consumed in production (raw materials). IAS 2 Inventories sets out how to measure them at the end of the reporting period.

The measurement matters twice over. Closing inventory sits in current assets on the statement of financial position, and the same figure is credited to cost of sales in the statement of profit or loss — it becomes next year's opening inventory. Value the inventory too high and this year's profit is overstated; too low and it is understated. Chapter 5 prepares both statements; this chapter decides the figure that goes into them.

This is prudence at work: inventory is normally carried at what it cost, but the moment its value falls below that cost, the fall is recognised immediately rather than waiting for the sale.

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2 Cost of inventories

Cost is every cost incurred in bringing the inventory to its present location and condition. IAS 2 breaks this into three parts:

• Costs of purchase – the purchase price, plus import duties and other irrecoverable taxes, plus transport and handling costs directly attributable to the acquisition, less trade discounts and rebates. If a sales tax can be recovered from the tax authority it is not a cost; if it cannot be recovered, it is.

• Costs of conversion – for a manufacturer, the direct costs of turning raw materials into finished goods: direct labour, plus a systematic allocation of production overheads.

• Other costs – any other cost incurred in bringing the inventory to its present location and condition, for example the cost of designing a product for a specific customer.

2.1 Production overheads and normal capacity

Fixed production overheads (factory rent, depreciation of plant, factory management salaries) are allocated to units using the normal capacity of the production facilities — the output expected on average over a number of periods, allowing for planned maintenance.

Fixed overhead per unit = Budgeted fixed production overheads ÷ Normal output (units)

If actual production is abnormally low — a strike, a machine breakdown — the overhead rate is not recalculated using the lower actual output. Doing so would load the cost of idle capacity into the inventory value. The unallocated overhead is instead expensed in the period it is incurred. (In a period of abnormally high production the rate is reduced, so that inventory is not measured above cost.)

2.2 Costs excluded from inventory

Some costs are never inventory costs. They are recognised as expenses in the period in which they are incurred:

3 Cost formulas

Where items are interchangeable — one bag of flour is much like another — an entity does not track the actual cost of each unit sold. IAS 2 permits two cost formulas:

• FIFO (first in, first out) – the units sold are assumed to be the oldest ones, so closing inventory carries the most recent purchase costs.

• Weighted average cost (AVCO) – a fresh average cost per unit is calculated after each purchase (or periodically), and closing inventory is measured at that average.

LIFO (last in, first out) is prohibited by IAS 2. In times of rising prices it would leave closing inventory at stale, old costs and understate the asset.

Items that are not interchangeable — a car dealer's individual vehicles, goods made for a specific project — are measured by specific identification of their individual costs. Whichever formula is chosen must be applied consistently to all inventories of a similar nature.

4 Net realisable value (NRV)

Net realisable value is what the entity actually expects to make from selling the inventory:

NRV = Estimated selling price − Costs to complete − Costs to sell

Costs to complete are any further work needed to get the goods into a saleable state — repackaging goods whose boxes were damaged, or finishing off work in progress. Costs to sell are the direct costs of making the sale, such as sales commission.

NRV normally sits comfortably above cost — that margin is why the business exists. It falls below cost when something has gone wrong:

• Physical damage or deterioration

• Obsolescence – last season's fashion lines marked down to clear, or a smartphone model superseded by its replacement

• A general fall in selling prices

• A marketing decision to sell below cost as a loss leader

• An increase in the estimated costs to complete or to sell

Evidence of net realisable value often arrives after the year end. Inventory sold below cost in the new year is evidence of what it was worth at the reporting date, so it is an adjusting event under IAS 10 (Chapter 9) and the write-down belongs in the year just ended.

5 Recognising inventory as an expense

When inventory is sold, its carrying amount is recognised as an expense (cost of sales) in the period the related revenue is recognised.

Any write-down to NRV is an expense in the period of the write-down. If, in a later period, the circumstances that caused the write-down reverse — the selling price recovers before the goods are sold — the write-down is reversed (up to the original cost, never above it), reducing that later period's expense.

6 Disclosure

The financial statements disclose the accounting policy and cost formula used, the total carrying amount of inventories broken down into the entity's classifications (raw materials, work in progress, finished goods), the amount recognised as an expense in the period, and the amount of any write-downs to NRV (and reversals).

7 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.