IAS 2 - INVENTORIES

Definitions
Inventories are assets:
(a) held for sale in the ordinary course of business; (e.g. Finished Goods)
(b) in the process of production for such sale; or (e.g. Work in Process)
(c) in the form of materials or supplies to be consumed in the production process or in the
rendering of services. (e.g. Raw Materials)

Net realisable value

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.

The cost of inventories may not be recoverable if those inventories are damaged, if they have
become wholly or partially obsolete, or if their selling prices have declined.

Estimates of net realisable value also take into consideration the purpose for which the inventory
is held. For example, the net realisable value of the quantity of inventory held to satisfy firm sales
or service contracts is based on the contract price.

IAS 2 explains that materials and other supplies held for use in the production of inventories are
not written down below cost if the final product in which they are to be used is expected to be
sold at or above cost. This is the case even if these materials in their present condition have a net
realisable value that is below cost and would therefore otherwise require write down.

Thus, a sugar manufacturer would not write down an inventory of sugar cane because of a fall in
the sugar cane price, as long as it is expected to sell the sugar at a price which is sufficient to
recover the cost. If a decline in the price of material indicate that the cost of final product will
exceed net realisable value, then a write down is necessary and the replacement cost of those
material may be the best measure of their net realisable value.

MEASUREMENT OF INVENTORIES
Inventories shall be measured at the lower of cost and net realisable value.
COST OF INVENTORIES
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
The costs of purchase of inventories comprise the purchase price, import duties and other taxes
(other than those subsequently recoverable by the entity from the taxing authorities), and
transport, handling and other costs directly attributable to the acquisition of goods. Trade
discounts, rebates and other similar items are deducted in determining the costs of purchase.

Case Study 1 – Costs

A company purchases motorcycles from various countries and exports them to Europe. The
company incurred these expenses in 2009.

1. Cost of purchase (based on vendor's invoice)

2. Trade discounts on purchases
3. Import duties
4. Freight and insurance on purchase
5. Other handling costs relating to imports
6. Salaries of the accounting department
7. Brokerage commission payable to indenting agents for arranging imports
8. Sales commission payable to sales agent
9. After-sales warranty cost

Required
The Company is seeking your advice on which costs are permitted under IAS 2 to be included in
the cost of inventory.

Solution
Items 1,2,3,4,5 & 7 are permitted to be included in the cost of inventory under IAS 2. Salaries of
accounting department, sales commission and after sales warranty cost are not considered cost
of inventory under IAS 2 and thus are not allowed to be included.

Costs of conversion
The costs of conversion of inventories include costs directly related to the units of production,
such as direct labour.

They also include a systematic allocation of Overheads i.e. fixed and variable production
overheads that are incurred in converting materials into finished goods. Other overheads e.g.
administration should not be included.
Fixed production overheads are those indirect costs of production that remain relatively constant
regardless of the volume of production, such as depreciation and maintenance of factory
buildings etc. used in the production process, and the cost of factory management and
administration.
Variable production overheads are those indirect costs of production that vary directly, or nearly
directly, with the volume of production, such as indirect materials and indirect labour.
- Indirect materials are goods that, while part of the overall manufacturing process, are not
integrated into the final product.
For example, disposable gloves, personal protective equipment etc., may be essential to a
production line, but they are not part of the actual product created on that line.
- Indirect labor is the cost of any labor that supports the production process, but which is not
directly involved in the active conversion of materials into finished products. (i.e. they cannot be
directly traceable to a particular item of inventory)
Examples of indirect labor positions are the production supervisor, materials handling staff and
quality control staff.
Case Study - 2

Overhead Allocation

Cost of Item Rs. 2 per unit

Direct Labour Rs. 3 per unit
Fixed Production Overhead 40,000
Variable Production Overhead 60,000
Administrative overhead of the company 80,000
Total production during the year 20,000 units
Special packing Rs. 1 per unit

Required:
Calculate total cost of item as per IAS 2.

Cost of Purchase 2
Conversion Costs
Direct Labour 3
Fixed Production Overhead 2
Variable Production Overhead 3
Other Cost
Special Packing 1

Total Cost/Unit 11
Other costs
Other costs are included in the cost of inventories only to the extent that they are incurred in
bringing the inventories to their present location and condition. For example, while preparing an
order of a particular customer who demands special kind of packing then the additional cost of
packing will be added in the cost of inventory.
Examples of costs excluded from the cost of inventories and recognised as expenses in the period
in which they are incurred are:
(a) abnormal amounts of wasted materials, labour or other production costs; (it means normal
wastage will become part of the cost)
(b) storage costs, unless those costs are necessary in the production process before a further
production stage;
(c) administrative overheads that do not contribute to bringing inventories to their present
location and condition (i.e. salary of CFO, CEO etc.); and
(d) selling costs.
NOTE
Value of inventory which is still in the company at the end of an accounting period (i.e. closing
inventory) directly effect the gross profit figure.
Example: Sales for the period Rs. 1,000
Purchases for the period Rs. Rs. 800
Closing Inventory Rs. 50
GP ?
Case Study

Particulars Year 1 Year 2

Sales 2,000 3,000
Opening Inventory 800 950
Purchases 1,600 2,100
Less Closing Inventory (950) (1,150)
Gross Profit 550 1,100
After the end of year 2, it was discovered that an error was made in the inventory valuation at
the end of year 1, so the figure of Rs. 950 was revised to Rs. 850.
Required: Recalculate the profit and comment on the impacts on the profit in these two years.
COST FORMULAS
Why we Need Cost Formulas?
Consider the following transactions:
Purchases January 10 units @25
February 15 units @ 30
April 20 units @ 35
Sales March 15 units @ 50
May 18 units @ 60
It is clear that the total purchase figure is Rs. 1,400 and total sales figure is Rs. 1,830 but how do
we calculate closing inventory, COGS, and gross profit for the period. There are several ways of
doing this, based on different assumptions as to which unit has been sold or which unit is deemed
to have been sold. (i.e. Specific Identification Method, FIFO, LIFO).
Note: LIFO is not allowed in IAS 2.
Specific Identification Method
The cost of inventories of items that are not ordinarily interchangeable (i.e. every item is unique)
and goods produced and segregated for specific projects shall be assigned by using specific
identification of their individual costs.
In practice this is an unusual method of valuation, as the clerical effort requires does not make it
feasible unless there are relatively high value items being bought or produced. Consequently, it
would normally be used where the inventory comprised items such as antiques, jewellary and
automobiles in the hands of dealers.
Here we identify the actual physical units of production that have moved in or out. In order to
use this method, each unit must be individually distinguishable e.g. through serial number. In
these circumstance we simply add the cost of items that has been sold to give COGS and those
units that are left in the company to give closing inventory.
The cost of inventories, other than those for which specific identification method is used, shall
be assigned by using the first-in, first-out (FIFO) or weighted average cost formula.
First In First Out
The FIFO formula assumes that the items of inventory that were purchased or produced first are
sold first, and consequently the items remaining in inventory at the end of the period are those
that are most recently purchased or produced.
E.g. A business which deals in perishable goods will sale the goods which is received first.
Weighted Average
Under the weighted average cost formula, the cost of each item is determined from the weighted
average of the cost of similar items at the beginning of a period and the cost of similar items
purchased or produced during the period.
Last In First Out
LIFO is the opposite of FIFO and assumes that most recent purchase or production are used first.
In certain cases, this could represent the physical flow of inventory (e.g. if a store is filled and
emptied from the top).
IAS 2 prohibits the use of LIFO method.
Case Study
Purchases January 10 units @ 25
February 15 units @ 30
April 20 units @ 35
Sales March 15 units @ 50
May 18 units @ 60
Required
Calculate COGS, gross profit and value of closing inventory using FIFO & weighted average
method. (For solution refer case study - 3).
Recognition as an Expense
When inventories are sold, the carrying amount of those inventories shall be recognised as an
expense in the period in which the related revenue is recognised.
The amount of any write-down of inventories to net realisable value and all losses of inventories
shall be recognised 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 net
realisable value, shall be recognised as a reduction in the amount of inventories recognized as an
expense in the period in which the reversal occurs.