SESSION 07 – IAS 2 INVENTORIES

OVERVIEW
Objective

¾ To prescribe the accounting treatment for inventories under the historical cost system.

¾ To provide practical guidance on:

‰ determination of cost;
‰ expense recognition;
‰ cost formulas.

¾ Scope
IAS 2 ¾ Inventories
¾ Net realisable value

¾ Cost
MEASUREMENT ¾ Cost formulas
¾ Net realisable value

¾ Recognition as an expense
RECOGNITION ¾ Disclosure
AND DISCLOSURE

0701
SESSION 07 – IAS 2 INVENTORIES

1 IAS 2
1.1 Scope

¾ All inventories except:

‰ contract work in progress;
‰ financial instruments;
‰ biological assets related to agricultural activity and agricultural produce at the
point of harvest .

Commentary

These inventories are entirely outside the scope of IAS 2 and the more specific IASs
that deal with them are outside the scope of the F3 syllabus.

¾ The measurement provisions of IAS 2 do not apply to inventories held by:

‰ producers of agricultural and mineral products to the extent that they are measured
at net realisable value ;
‰ commodity broker-traders who measure their inventories at fair value less costs to
sell.

Commentary

That is, in addition to some inventories being entirely outside the scope of IAS 2, some
are within its scope but excluded from the measurement rules.

1.2 Inventories

Definition

Inventories are assets:

¾ held for resale in the ordinary course of business (e.g. merchandise

purchased by retailer); or

¾ in the process of production for resale (e.g. finished goods, work in

progress, raw materials); or

¾ in the form of materials or supplies to be consumed in the production

process or rendering of services.

1.3 Net realisable value

Definition

The estimated selling price in ordinary course of business less the estimated
cost of completion, and estimated costs necessary to make the sale.

0702
 SESSION 07 – IAS 2 INVENTORIES

2 MEASUREMENT

Key point

³ Inventories should be measured at the lower of cost and net realisable value.

2.1 Cost

Definition

All costs of purchase, costs of conversion and other costs involved in bringing the
inventories to their present location and condition.

2.1.1 Components

Purchase costs Conversion costs Other costs

¾ purchase price; ¾ direct production costs; ¾ only if incurred in bringing

inventories to present location
¾ import duties/non- ¾ production overheads; † and condition (e.g. non-
refundable taxes ; production overheads such as
storage in whiskey distillers
and specific design costs);

¾ transport/handling; fixed variable

e.g. factory e.g. indirect
depreciation materials

¾ deduct trade ¾ joint product costs ¾ borrowing costs in limited

discounts/rebates. (deduct NRV of by- circumstances.
products).
Commentary

† Production overheads are absorbed based on normal capacity (i.e. expected, on

average, under normal circumstances).

703
SESSION 07 – IAS 2 INVENTORIES

¾ The following expenditures are excluded:

‰ abnormal amounts of wasted materials, labour and other production costs;

‰ storage costs unless necessary to the production process;
‰ administrative overheads; and
‰ selling costs.

Commentary

For service providers the cost of inventories consists primarily of labour including
supervisory personnel and attributable overheads.

2.1.2 Techniques for measurement of cost

¾ Two costing methods can be used for convenience if results approximate actual cost.

Standard cost Retail method

‰ Takes into account normal levels of ‰ For inventories of large numbers of

materials, labour, efficiency and rapidly changing items with similar
capacity utilisation margins

‰ Must be regularly reviewed and ‰ Reduces sales value by appropriate

revised as necessary percentage gross margin

‰ A management tool which may ‰ This is a practical means of

need to be adapted to conform to measurement for financial reporting
IAS 2. purposes.

Commentary

Note that methods which exclude fixed overheads are inappropriate for IAS.

Illustration 1— J Sainsbury plc (2005)

1 Accounting policies

Stocks
Stocks are valued at the lower of cost and net realisable value. Stocks at
warehouses are valued on a first in first out basis. Those at retail outlets
are valued at calculated average cost prices.

0704
 SESSION 07 – IAS 2 INVENTORIES

2.2 Cost formulas

2.2.1 Specific identification of individual costs

¾ Specific identification of individual costs is required for

‰ items not ordinarily interchangeable; and

‰ goods/services produced and segregated for specific projects.

2.2.2 Formulae

¾ Formulae are permitted where specific identification of individual costs to individual

items is not practicable.

¾ Formulae permitted are:

‰ First-in, first-out (FIFO)

‰ Weighted average.

2.2.3 Inventories ordinarily interchangeable

FIFO formula or Weighted average formula

¾ Assumes that items purchased ¾ Determined from weighted

(or manufactured) first are sold average cost of:
first.
‰ items at beginning of period;
¾ Therefore inventory at period and
end is most recently purchased
‰ cost of similar items
or produced.
purchased/ produced during
the period.
¾ Used, for example, for: ¾ May be calculated on a periodic
basis or on each additional
‰ cars on a production line;
shipment.
‰ Retail produce with a “sell
by” or “best before” date).
¾ Used for like items used in
production/sold without regard
to when received.

Commentary

In practice these formulas are likely to produce similar results when price changes
small and infrequent and there is a fairly rapid turnover of inventories.

705
SESSION 07 – IAS 2 INVENTORIES

Illustration 2

Accounting policies (extract)

Inventories
In accordance with IAS 2 (Inventories), inventories encompass assets (finished goods and
goods purchased for resale) held for sale in the ordinary course of business, in the
process of production for such sale (work in process) or in the form of materials or
supplies to be consumed in the production process or in the rendering of services (raw
materials and supplies). Inventories are usually valued by the weighted-average method
and recognized at the lower of cost or fair value less costs to sell, which is the estimated
normal selling price less the estimated production costs and selling expenses.

The cost of acquisition comprises all costs incurred to bring inventories to their present
location in their present condition. The costs of production comprises the direct cost of
materials, direct manufacturing expenses and appropriate allocations of fixed and variable
material and manufacturing overheads, where these are attributable to production.

Notes to Consolidated Financial Statements of the Bayer Group 2005

Example 1

XYZ sells telephones and is valuing its inventory at FIFO cost price at 31
December. A record of the transactions is shown below:

Bought Sold
2003 $ 2003 $

January 10 @ $20 each 200

April 10 @ $24 each 240 May 8 @ $45 each 360

October 20 @ $30 each 600 November 20 @ $60 each 1,200

___ _______ _______

40 1,040 1,560
___ _______ ________

Required:

Calculate the value of closing inventory at 31 December.

Solution

¾ Items remaining @ 31 December:

¾ Most recently purchased:

¾ Closing value:

0706
 SESSION 07 – IAS 2 INVENTORIES

Example 2

Freya sets up in business on 1 September buying and selling CD players.

These were purchased during the month as follows.

Quantity Price per unit

5 September 200 $150
16 September 80 $185

On 24 September Freya sold a consignment of 250 CD players for $50,000.

Required:

Calculate (a) gross profit and (b) total value of closing inventory using each of
the following inventory valuation methods:

(i) FIFO
(ii) weighted average cost.

Solution

(a) Gross profit

(i) (ii)
FIFO Wav cost
$ $
Proceeds 50,000 50,000

Less Cost
______ ______
Gross profit
______ ______

(b) Closing inventory

(i) FIFO

(ii) Wav

707
SESSION 07 – IAS 2 INVENTORIES

2.3 Net realisable value

2.3.1 Need for

¾ Costs of inventories may not be recoverable due to:

‰ damage;
‰ obsolescence;
‰ decline in selling price;
‰ an increase in estimated costs to completion/to be incurred.

¾ Inventories must not be carried in excess of amounts expected to be realised from their
sale or use.

Commentary

An application of the prudence concept.

¾ Any write down to NRV is usually on an item by item basis (though items may be grouped
in some circumstances).

Commentary

This applies the principle of offset.

2.3.2 Considerations

¾ Estimates of NRV take into consideration:

‰ fluctuations of price or cost relating to events after the period end; and
‰ the purpose for which inventory is held.

2.3.3 Materials

¾ Materials for use in production are not written down to below cost unless the cost of
finished products would exceed NRV.

2.3.4 Timing

¾ A new assessment is made of NRV in each subsequent period. When circumstances

causing write-down no longer exist, write-down is reversed.

Commentary

Reversals are generally rare.

0708
 SESSION 07 – IAS 2 INVENTORIES

Example 3

Barnes is trying to calculate the year-end inventories figure for inclusion in his
accounts. Details of his three stock lines are as follows:

Product Cost Realisable Selling

value expenses
$ $ $
Alpha 100 120 25
Beta 50 60 5
Omega 75 85 15

Required:

Calculate the value of closing inventory which Barnes should use for his
accounts.

Solution

$
Alpha

Beta

Omega

____

____

709
SESSION 07 – IAS 2 INVENTORIES

3 RECOGNITION AND DISCLOSURE

3.1 Recognition as an expense

¾ The amount of inventories recognised as an expense during the period is often referred
to as “cost of sales”.

¾ When inventories are sold, their carrying amount should be recognised as an expense in
the period in which related revenue is recognised.

Commentary

Under the accruals concept costs and revenue are matched.

¾ Any write-down to NRV and all losses should be recognised in the period the write-
down/loss occurs.

¾ Any reversal of any write-down should be recognised as a reduction in expense in the

period the reversal occurs.

Commentary

This is a change in accounting estimate (see IAS 8).

¾ Inventories allocated to asset accounts (e.g. self-constructed property plant or

equipment) are recognised as an expense during the useful life of an asset (as the asset is
depreciated).

3.2 Disclosure

3.2.1 Accounting policies

¾ Accounting policies adopted in measuring inventories including cost formula used

3.2.2 Carrying amounts

¾ Total carrying amount – in appropriate classifications (e.g. merchandise, raw materials,

work in progress, finished goods);

¾ Carrying amount at fair value less costs to sell;

¾ Carrying amount of inventories pledged as security for liabilities.

0710
 SESSION 07 – IAS 2 INVENTORIES

Illustration 3

10. Inventories
In millions of CHF 2005 2004

Raw materials, work in progress and sundry supplies 3 187 2 719

Finished goods 5 193 4 474
Allowance for white-off at net realisable value (218) (168)
8 162 7 025

Inventories amounting to CHF 112 million (2004: CHF 92 million) are pledged as security for
financial liabilities.
Nestlé Consolidated accounts 2005

3.2.3 Expense in the period

¾ The amount of inventories recognised as an expense;

¾ The amount of any write-down;

¾ Any reversal of write-down recognised as income;

¾ Circumstances or events that led to reversal of a write-down.

¾ A write-down to net realisable value may be of such size, incidence or nature as to

require separate disclosure.

711
SESSION 07 – IAS 2 INVENTORIES

Key points

³ Value at lower of cost and net realisable value (NRV).

³ NRV is selling price less cost to complete and sell.
³ Cost includes all costs to bring inventories to their present condition and
location.

³ If specific cost is not determinable, use FIFO or weighted average.

³ Cost of inventory is recognised as an expense in the period in which the
related revenue is recognised.

³ Any write-down is charged to expense. Any reversal in a later period is

credited to income by reducing that period’s cost of goods sold.

³ Required disclosures include:

‰ accounting policy;
‰ carrying amount;
‰ amount of any reversal of a write-down;
‰ cost charged to expense for the period.)

FOCUS
You should now be able to:

¾ identify the alternative methods of valuing inventory;

¾ understand and apply the IASB requirements for valuing inventories (i.e. IAS 2);

¾ recognise which costs should be included in valuing inventories;

¾ calculate the value of closing inventory using FIFO (first in, first out) and AVCO
(average cost);

¾ understand the impact of accounting concepts on the valuation of inventory; and

¾ identify the impact of inventory valuation methods on profit and on assets.

0712
 SESSION 07 – IAS 2 INVENTORIES

EXAMPLE SOLUTION
Solution 1 — FIFO (“Long-hand”)
Inventory after
Received Issued transaction

January 10 @ $20 each 10 @ $20 200

_____

April 10 @ $24 each 10 @ $20 200

10 @ $24 240
___ _____
20 440
___ _____

May 8 @ $20 2 @ $20 40

10 @ $24 240
___ _____
12 280
___ _____

October 20 @ $30 2 @ $20 40

10 @ $24 240

20 @ $30 600
___ _____
32 880
___ _____

November 2 @ $20 12 @ $30 360

10 @ $24

8 @ $30
___ ___
40 28
___ ___

Value of inventory FIFO 31 December $360

______

713
SESSION 07 – IAS 2 INVENTORIES

Solution 2 — Freya

(a) Gross profit

WORKING

No Unit No Unit
units price $ units price $
FIFO 200 × 150 30,000 Wav 200 × 150 30,000
50 × 185 9,250 80 × 185 14,800
______ ___ ______
39,250 280 44,800
______ ___ ______
Therefore 1 160
Therefore 250 40,000

(i) (ii)
FIFO Wav cost
$ $
Proceeds 50,000 50,000
Less Cost (W) (39,250) (40,000)
______ ______
Gross profit 10,750 10,000
______ ______

(b) Closing inventory value

(i) FIFO 30 × 185 = $5,550

(ii) Wav 30 × 160 = $4,800

Solution 3 — NRV

$
Alpha NRV 120 – 25 = 95
Beta Cost 50
Omega NRV 85 – 15 = 70
____

215
____

0714