In this study, IAS 2 Inventories standard is examined and the real-world

accounting applications related to inventories are presented.IAS 2 Inventories is an

accounting standard, which is part of the International Financial Accounting
Standards (IFRS). It is the framework for the accounting treatment of inventories.
Inventory makes up substantial part of the total asset value. Therefore, value
determination and presentation of inventories is a fundamental part of
accounting.The contribution of this work is highlighting the components which
make up the value of inventories and the importance of choosing the inventory
valuation method in managerial decision making. Moreover, accounts are
suggested for journal entries to record inventory related costs.
1. INTRODUCTION
IAS 2 Inventories is an International Financial Reporting Standard (IFRS), which
regulates the accounting treatment of inventories. The main focus of this standard
is to find the value of inventory and how it is shown in the financial statements.
This standard applies to all inventories, except financial instruments and
agricultural products before they are harvested. All finished products that are
produced or bought, work in progress goods, raw materials and supplies needed for
production or rendering a service are considered inventories by this standard. The
cost of a service is accumulated in an inventory account until its related revenue is
recognized (Greuning, Scott and Terblanche, 2013, p. 183). The costs incurred by
the ongoing services, like the work in progress for auditors, are recorded as
inventories. The cost of a service includes labor expenses and other costs of
employees, who are directly related in rendering the service and overhead costs
associated with them, but it does not include expenses that are not related to the
production of these services (Gökçen, Ataman Akgül and Çakıcı, 2006, p. 58). Net
realizable value is the selling price, where the costs of completion and costs related
to making the sale are deducted. Fair value is the sales price, which is negotiated
between the related parties.

2. THE VALUE OF INVENTORIES

According to the conservatism principle of accounting, inventories cannot be
recorded in the financial statements at a higher price than expected to be obtained
as a result of their use or sale . The Standard is in compliance with the
conservatism principle. It states that the value of an inventory should be recorded
with the lower of cost or net realizable value (IASB 2003, AIS 2: 9). Therefore, an
inventory should be recorded with its acquisition (cost) value or with the selling
price, where the costs of completion and costs related to making the sale are
deducted (net realizable value), whichever one is lower.
The following example clarifies whether the cost value or the net realizable value
is recorded as the inventory value at the valuation date. The inventory is recorded
at its cost value, TL 60,000 at its acquisition date. At the end of the accounting
period, which is also the valuation date, the estimated selling price of the inventory
is TL 50,000. Moreover, the estimated expenses to sell the inventory are TL 4,000.
As seen, its net realizable value (TL 46,000) is less than its cost (TL 60,000).
Hence, the difference, TL 14,000, is written out as an expense of the period,
leaving the books to show TL 46,000 as the value of the inventory. If the net
realizable value were TL 65,000 at the valuation date, the cost value of TL 60,000
would have remained unchanged in the books.
3. COST OF INVENTORIES
Cost of an inventory includes all expenses related to purchasing, conversion and
bringing the inventory to its present condition and location .
3.1.Determining the Cost of Inventories
The fundamental characteristics that comprise the cost of an inventory are as
follows:
• Purchasing costs are included. These costs are related to the acquisition of
finished goods, materials and services. The following costs are included in the
purchasing cost:
• The purchase price
• Import duties
• Other taxes, except the ones which are recoverable from the taxing
authorities o Transportation costs
• Handling costs
• Other costs related to the acquisition of the inventory.
• Discounts and rebates are deducted from the purchasing costs.
• Costs of conversion are included. These costs are related to production.
Following principles are valid when calculating the costs of conversion:
o Direct costs of production, e.g. direct labor, are included.
o Allocated portion of the general production expenses to the finished goods
inventory is included. These are indirect costs. Some examples of these costs are as
follows: indirect materials, indirect labor, general production expenses like
depreciation of assets related to production site, maintenance of factory buildings,
cost of factory management and administration.
• Indirect fixed costs are allocated as if the production site is working at
normal capacity. If the actual production is lower than the normal capacity,
the increased overhead cost per unit is not allocated to the inventory. It is
recognized as the period’s expense. If the production is much higher than the
normal, the overhead cost per unit of production is lower than normal
periods. The allocated overhead cost is calculated using the actual costs.
• Variable indirect costs are allocated with respect to the actual usage of the
production site. o If more than one product is being produced, the allocation
of general production expenses should be done on “a rational and consistent
basis” (IASB, 2003, AIS 2: 14).
• Sometimes the production process yields by-products. They are usually
immaterial and are measured by net realizable value. Net realizable value is
the selling price, where the costs of completion and costs related to making
the sale are deducted. This value is deducted from the cost of the main
product.
• Costs to bring the inventory to its present location and condition are included.
Costs incurred to change the design of a product that is specific to a customer are
included to the cost of the inventory. Indirect costs that are not related to the
production are not part of the cost of the inventory.
• Agricultural products are considered as inventories after harvesting them. The
initial recognition value of such inventories is equal to their fair value minus the
selling costs. The following costs are not included into the cost of an inventory:
• The costs related to wasted amounts: Costs due to the abnormal usage of
materials, labor or other production costs are not included in the cost of the
inventory.
• Storage costs: Costs related to storing the inventory should not be included.
However, the storage costs necessary for the production process, such as storing
materials or work in progress goods before a production stage, are included in the
cost of the inventory.
• Administrative costs: If an administrative cost, which is not related to bringing
inventories to their present location and condition, should not be included into the
cost of the inventory.
• Sales costs: Costs related to the sale of the inventory are not included into the
cost of the inventory.
• Financial costs: Interest expenses related to a purchase are not included in the
purchasing costs . If an inventory is purchased on credit, the difference between the
purchasing price and the amount that is paid is considered as an interest expense.
This amount is not included in the cost of the inventory. However, an asset that
requires a significant time for its production, namely a qualifying asset, is an
exemption to this rule (IASB, 2007, AIS 23: 5). IAS 23 Borrowing Costs standard
states that financial costs related to the acquisition, construction or production of a
qualifying asset are included in the cost of the inventory. The financial expenses,
which are not excluded from the cost of the inventory, are considered improper
accounting application
3.2. Techniques to Measure the Cost of Inventories
The following methods can be used to measure the cost of inventories (IASB,
2003, AIS 2: 21, 22):
• Standard cost method
• Retail method The standard cost method is a costing system that traces direct
costs to the inventory by multiplying the standard prices by the standard quantities
and allocates overhead costs using the standard overhead-cost rates multiplied by
the standard quantities of the allocation bases . The word standard here means
planned or estimated. The standard quantities of materials, supplies and labor are
what the entity estimates to use at its normal level of capacity utilization.
Reducing the sales value of an inventory by a margin to find its cost is called the
retail method. The same percentage is used on homogenous items. This method is
applicable when prices of inventory change with similar margins.
 3.3. Assigning Costs to Inventories
Inventory value is material to the total asset value of the entity. Therefore, utmost
care should be shown for accurate valuation. The valuation methods are used to
find the cost of inventory. Specific identification, First-in, First-out (FIFO), Last-
in, First-out (LIFO) and weighted average are methods to calculate the cost of
inventories. The entity has to choose one of these methods and has to be consistent
within the accounting year and the years to come for the comparability of its
financial statements. Last-in, First-out (LIFO) method states that inventory which
is acquired last should be sold first. LIFO method usually causes highest value of
cost of goods sold and the lowest profit. The International Accounting Standards
Board does not allow the use of LIFO method on the basis that the value of the
inventory is not presented fairly when the entity uses this method for calculating
the cost of the inventory..
Specific identification method can be used for identifiable costs related to an
inventory, which cannot be substituted with one another, or cost of goods that are
produced or sold for special projects are assigned to that inventory. For this to
happen, the product or service has to have unique features and the costs can be
attributed as the costs the inventory in question. This treatment of costs is valid for
both bought and produced inventories.
It is not likely to assign costs to inventory when the inventory consists of large
number of interchangeable items. The costs need to be calculated for this type of
inventory. Two methods are allowed by the Standard, namely the first-in first-out
(FIFO) method and weighted average method.
In First-in, First-out (FIFO) method, the value of the inventory is based on the cost
of items bought earliest in the accounting period. FIFO method presumably
calculates lower inventory values. Therefore, if the entity is using the FIFO
method, it is expected that it will have lower cost of goods sold and higher profit
values.
In the weighted average method, the value of the inventory is based on the
weighted average cost of the items. This method is a good representation of value
if the purchase prices of the items do not change much over the accounting period.
The choice of the costing method is a strategic decision making tool. As it is seen,
the cost of the inventory directly affects the cost of goods sold value, and hence,
the profit of the period. High profits are desirable, but they lead to paying higher
taxes. The entity may choose a method which would enable to show the net profit
higher or lower.
4. LOSS IN THE VALUE OF INVENTORIES
The values of inventories may decrease after their initial recognition. The reasons
for the loss in value can be listed as follows:
• Damages
• Becoming obsolete
• Declined selling price
• Increased costs of completion and sales
Inventories should not be presented in the financial statements of the entity above
their net realizable value. At the end of each accounting period, the impairment of
inventories has to be assessed. It is considered a financial statements fraud not to
take the impairment of inventories into account.
Industry factors may also cause material misstatements in inventory. Improper
valuation and obsolescence of inventory due to technology changes are the major
industry risk factors.
The principals in setting the net realizable value of an inventory are as follows: •
Net realizable value is an estimate. This estimate should base on the most reliable
evidence at the time of estimation.
• The reason to have that inventory should be taken into consideration.
If there is a change in the circumstances and the new assessment of net realizable
value increases, the amount of write-down is reversed up to the original amount .
5. RECOGNITION AS AN EXPENSE
When an inventory is sold, its value is deducted from inventories and it becomes
an expense of the period.
In case of any write-downs from the net realizable value, the amount is recognized
as an expense of the period and this amount is deducted from the value of
inventories.
6. ACCOUNTING APPLICATIONS
Some accounting applications for this standard are given below. The account
codes and names of the Turkish Uniform Chat of Accounts are used in journal
entries.
Application 1:
ABC Corporation buys trade goods with a list price of TL 10,000 (18% VAT not
included). The value added tax (VAT) of the merchandise is TL 1,800. The goods
are sent by cargo for TL 200, and insured for TL 100. The shipment costs are paid
by the company. The company rents a storage room to put the merchandise, and
pays TL 500 until the end of the current accounting year. The general
administrative expenses for which the period the merchandise is owned by the
company is TL 5,000.
The cost of the inventory is calculated as follows:
List price TL 10,000
Transportation cost TL 300 (cargo TL 200 + insurance TL 100)
Total cost TL 10,300
The rent and the administrative expenses are not related to the acquisition of the
inventory. Therefore, they are not included in the cost. The value added tax on the
merchandise will be deducted eventually. Hence, it is not included in the cost as
well
7. CONCLUSION
IAS 2 Inventories is an accounting standard, which is part of the International
Financial Reporting Standards (IFRS). This standard regulates the accounting
treatment of inventories. It sets the framework to determine the value of
inventories and its presentation in the financial statements. Products that are
produced and bought, raw materials, work in progress and services in progress are
considered inventories. Financial instruments and agricultural products before
harvesting are taken into account in different standards; hence, they are not
included in IAS 2 Inventories standard. Inventory is a major part of the total asset
value. Therefore, value determination and presentation of inventories is an integral
part of accounting. IAS 2 Inventories standard defines the components of the
inventory value and gives options of valuation methods. According to the standard,
the value of the inventory is the cost value or the net realizable value, whichever
one is lower. The cost includes purchasing costs, conversion costs and other costs
related to bring the inventory to its present location and condition. Net realizable
value is the selling price from which the costs of completion and costs related to
making the sale are deducted. The costs are assigned to inventory by using one of
the three methods, namely, specific identification, first-in first-out and weighted
average. The cost calculation slightly differs from one method to another one.
Since inventory is part of the total asset value and it is written off as the cost of
goods sold after its sale, the value of the inventory has an effect on the total asset
value and the profit of the period. Therefore, the choice of the valuation method is
related to the strategic managerial decisions.