CHAPTER 8: IAS 2 INVENTORY

8.1. INVENTORY
1.1 Inventory Overview
1.1.1 Inventory Classification
Inventory is the term used to describe the goods, materials and supplies held at the
accounting period end that have been purchased by a business and are either ready
for sale or used in the production of completed products for sale. Common
classifications of inventories include:
 Goods purchased for resale (For example, by a wholesaler or retailer)
 Raw materials and components purchased for manufacturing into goods for
sale
 Products and services in intermediate stages of completion (Work-in
progress)
 Finished goods
1.1.2 Accruals Accounting
Accruals accounting requires that business expenses be matched to the related
business income. This means that the statement of profit or loss needs to ensure that
the sales income generated in the year matches the trading costs associated with those
sales.
Inventory purchases not sold during the year make up part of the closing inventory at
the financial year-end. Furthermore, sales generated during the year may be for items
purchased in the previous year that are held as opening inventory.
The Statement of Profit or Loss needs to be adjusted to apply accruals accounting. To
correctly account for inventory according to the accruals concept, the Statement of
Profit or Loss records the cost of goods sold instead of items purchased.
1.2 Accounting for Inventories
Businesses will purchase raw materials and goods for resale throughout an accounting
period. These purchases are recorded in the Purchases account (expense) at the point
of the purchase.
At year-end, the total purchases appear in the Statement of Profit or Loss under the
heading Cost of sales (or cost of goods sold). To determine the final Cost of sales
figure, the business must adjust for opening and closing inventory.
The Cost of sales is the cost of the inventory sold during the accounting period.

Key Point

Cost of Sales = Opening inventory + Cost of goods purchased −

Closing inventory
Opening inventory = value of inventory held at the start of the accounting period.
Closing inventory = value of inventory held at the accounting period’s end.
Cost of goods purchased = Purchase cost of the goods for resale or all the direct costs
such as materials, supplies and wages needed to make the goods.

1.2.1 Inventory Journals

The record of inventory and cost of goods sold are made at the end of the year using
journals. The objective of the double entries is to:
 Ensurethe Inventory account reflects the closing inventory valuation
 Cost of
goods sold account is created and reflects the correct amount
To achieve these objectives, there are three double-entry steps to make:
1. Remove the Opening Inventory
Opening inventories are removed and transferred to the Cost of goods sold account.
This entry is necessary because the opening inventories are now used to generate
sales in the current accounting period.

General Ledger Category Explanation

Account

DR Cost of goods sold Expense Opening inventory cost now included as

expenses

CR Inventory Asset Inventory (asset) decreased

The cost of opening inventories is reflected as a current-year expense in the Statement
of Profit or Loss.
2. Close off the Purchases Account
A business makes purchases for inventory for resale. The cost is debited to the
Purchases account and credited to cash/payables at the point of purchase. At year-end,
the amount in the Purchases account is closed off and transferred to the Cost of Goods
Sold.

General Ledger Category Explanation

Account

DR Cost of goods sold Expense Purchases (expense) is transferred to

COGS

CR Purchases Expense Purchases (expense) is closed off

3. Post the Closing Inventory
The balance in the inventory account at year-end should reflect the value of closing
inventory. The closing balance is presented in the statement of financial position as a
current asset.
Since closing inventories are items purchased that are not sold in the accounting period,
their cost should not be reflected as an expense in the Cost of goods sold account
(SPL). Therefore, the value of closing inventory is transferred out of expenses and
reflected as Closing inventory in the Statement of Financial Position.

Individual Account Category Explanation

DR Inventory Asset Inventory (asset) increased

CR Cost of goods sold Expense Costs (expense) decreased

The value of closing inventory will be next year’s opening inventory value.

1.3 Inventory Quantity

Businesses need to know the inventory volume/quantity to attribute a value to the
opening and closing inventory. This allows the business to calculate the cost of sales,
which will be included in their statement of profit or loss.
Inventory management is also crucial for businesses to track their inventory levels at
different time stages. This allows a smooth process of purchasing further inventory to
meet sales.

1.3.1 The Continuous Approach

In this approach, each product sold by a business has its inventory record, either on a
manual card or a computer record.
The card records quantities of purchases and sales of that product. It is set up to keep a
running total of the amount of inventory as each new transaction (either sales or
purchases) takes place. The record identifies how much inventory the business holds at
any time.
This system uses the following principle: Opening Inventory + Purchases − Sales =
Closing Inventory

1.3.2 The Periodic Approach

In this approach, there are no record cards. Inventory is physically counted at the end of
the year (inventory count), and their quantities are recorded in a list.
The inventory count is usually performed on the last day of the accounting period when
the business is closed with no inventory movements occurring.
Keeping continuous records can be time-consuming for businesses with multiple lines of
products to sell, even if they are computerised. A business typically performs an
inventory count at year-end, even when continuous records are kept. It may also carry
out inventory counts on specific items during the year to keep a check on the card
records.
Where year-end inventory is based on the valuation of balances extracted from
continuous inventory records, the recorded quantities must be shown to be accurate
and up to date. Businesses may require an inventory-management system, which
includes:
 A test-counting program designed to cover all product/line items at least once
a year.
 The investigation and correction of differences between the ledger and
physical quantities.
Key Point

If the stock-checking system is ineffective, a complete physical

count may be required for financial reporting.

8.2 INVENTORY VALUATION

2.1 IAS 2 Inventories
Under IAS 2 Inventories, inventories are valued at the lower of cost or net realisable
value (NRV).

2.1.1 Cost
The cost of inventory includes the cost of bringing the inventories to their current
location and condition. The below flowchart illustrates the components that make up the
cost of inventories.
If the business manufactures the goods, the inventory cost includes raw materials
purchases plus the cost of converting the material into the finished product (for
example, wages and overheads).
IAS 2 stipulates several costs that are excluded in calculating the cost of inventory, as
illustrated in the diagram below:

The cost is determined using applicable pricing valuation methods (FIFO, continuous
weighted average or periodic weighted average).
2.1.2 Net Realisable Value (NRV)
The net realisable value (NRV) of an item of inventory is its selling price after all further
costs to complete and sell the item have been considered.
Selling expenses include expenses in getting the inventories from the business
premises to the customer, including delivery costs that the business will incur.
NRV = Estimated selling price − Estimated future costs of completion − Estimated future
selling expenses (if inventory is still in production)

2.2 Pricing Valuation Methods

The cost price of each item is called the unit cost. If this stays the same throughout the
accounting period, then it is simple to determine the price per item in the inventory.
However, inventory prices may rise or fall over the accounting period. Therefore, the
order of sold inventory needs to be established to determine the value of closing
inventory.
There are two methods of calculating the cost of inventory:
 First In-First Out (FIFO)
This method assumes that inventories that are purchased first are sold first.
 Average Cost (AVCO)
The average cost (AVCO) is calculated by determining the average cost for
items held in the opening inventory and purchased during the period. There
are two main methods of calculating average cost.
o The first is where the calculation is done on a periodic (such
as monthly) basis, known as the periodic weighted average.
o The other method is where an average value for inventory is
calculated before every issue from inventory and is known as
the cumulative weighted average.
FIFO and AVCO calculate the cost of inventory, which is then compared to the net
realisable value to determine which is lower and should be presented as the inventory
value in the statement of profit or loss.
After obtaining the opening and closing value, the cost of sales is calculated and
recorded in the statement of profit or loss.
Cost of sales = Opening inventory + Cost of goods − Closing inventory

2.2.1 First In-First Out (FIFO)

FIFO assumes that inventory leaves the warehouse in the same order as its receipt.
Therefore, the inventories remaining in the warehouse at the end of the accounting
period are the most recently purchased and should be valued at the most recent
purchase price.

2.2.2 Periodic Weighted Average

With this inventory valuation method, the business totals the value of purchases of raw
materials at the end of the reporting period. Then it divides the value by the number of
units acquired.
This provides an average cost used to value the cost of goods sold and the inventory at
the period end.

2.2.3 Cumulative Weighted Average

With this inventory valuation method, calculate the average unit price of the inventory
after each purchase. The average is therefore adjusted throughout the period.

2.2.4 Impact of Pricing Methods on Profit and Assets

The different methods of valuing inventory affect the profit and asset amount reported in
the financial statements.
The closing inventory is reported as the inventory asset amount in the statement of
financial position. At the same time, the cost of goods sold is an expense which reduces
the profit figure in the statement of profit or loss.

2.3 Inventory Disclosures

2.3.1 Disclosure Requirements
For businesses that manufacture goods, the disclosure should include the accounting
policy for inventory and a breakdown of inventory into appropriate classifications such
as materials, work-in-progress and finished goods.
The business is also required to disclose the following in the financial statements:
 The valuation method it has used in valuing its inventories
 How the business has applied those methods to calculate the inventory value.
CHAPTER 10: IAS 38 INTANGIBLE ASSETS
10.1. IAS 38 INTANGIBLE ASSETS
1.1 Introduction to Intangible Assets
Definition

An intangible asset is a non-current asset that is identifiable and

without physical substance.
An intangible asset is identifiable when it:
 is separable (it can be sold, transferred, licensed or exchanged) or
 arises from contractual or other legal rights
A non-current asset is a resource controlled due to past events, from which future
economic benefits are expected to flow and is owned for more than a year.
Intangible assets that have been purchased can be capitalised and included in the
statement of financial position as non-current assets. However, intangible assets
internally generated by the business cannot be capitalised. Typically, this includes
goodwill and brands.
Once an intangible asset is capitalised, it must be amortised. The amortisation of an
intangible asset is the same as the depreciation of a tangible non-current
asset. Amortisation charge measures the consumption, or usage, of the intangible
asset.

1.1.2 Examples of Intangible Assets

Examples of intangible assets include:
 Computer software
 Patents and licences (exclusive rights to use a process, product or name)
 Copyright (legal right belonging to the originator of a material which cannot be
reproduced or copied)
 Trademarks (a legally registered or established symbol or word that is used to
represent a company or product)
 Brands (a symbol or wording identifying a product)
 Intellectual property (technical knowledge obtained from a development
activity)
 Goodwill (value of business above the value shown in the financial statement,
coming from the strength of a brand and reputation)
 Development cost (as described later in this chapter)
1.2 Amortisation
The amortizable (depreciable) amount should be allocated systematically over the best
estimate of useful life. The amortisation period:
 commences when the asset is available for use
 ceases when the asset is derecognised (if it is sold)
The carrying amount (intangible asset cost − accumulated amortisation) is reduced to
reflect the consumption of economic benefits over time. The following factors should be
considered:
 expected usage of the asset
 typical product life cycles for the asset
 technical obsolescence, etc
 stability of industry and market demand
 expected competition
 maintenance required
 period of control (e.g. the legal limit on a lease)
 dependency on the useful lives of other assets

1.2.1 Amortisation Method

The amortisation method should reflect the consumption pattern (for example, the unit
of the production method). The straight-line method should be used if a pattern cannot
be determined reliably.
The amortisation charge is recognised as an expense unless included in the carrying
amount of another asset.
Amortisation methods should be reviewed at least annually at each financial year-end.
The amortisation charge for current and future periods should be adjusted for any
changes in the:
 period (if the expected useful life is significantly different)
 method (to reflect a changed pattern).

1.2.2 Residual Value

The residual value is assumed to be zero unless there exists:
 a commitment by a third party to purchase the asset at the end of its useful
life; or
 an active market exists for the asset.

1.3 Double Entries for Intangible Assets

Capitalising an intangible asset means that it can be accounted for and included on the
statement of financial position.
The double entry to record the purchase of an intangible asset is:

Individual Account Category Explanation

DR Intangible asset – cost Asset Intangible asset (asset) is

(SFP) recognised

CR Bank/cash (SFP) Asset Bank (asset) has decreased

Amortisation is the systematic allocation of the depreciable amount of an intangible
asset (its cost minus residual value) over the period expected to benefit from its use.
The double entry to record the amortisation of an intangible asset is:

Individual Account Category Explanation

DR Amortisation (SPL) Expense Amortisation (expense)

increased

CR Intangible asset – accumulated Asset Accumulated amortisation

amortisation (SFP) reduces the value of IA

10.2. RECOGNITION OF INTANGIBLE ASSETS

2.1 Research and Development
2.1.1 Introduction of Research and Development
It may be challenging for businesses to determine a value of an internally generated
intangible asset. Specifically, it is often difficult to determine whether:
 there is an identifiable asset
 future economic benefits are probable
 cost can be measured reliably.
It isn’t easy to distinguish the cost of generating a brand, for example, from the cost of
developing the business as a whole, maintaining goodwill, or operating on a day-to-day
basis.
Therefore, internally generated intangible assets such as brands, publishing titles,
customer lists and items similar in substance cannot be capitalised and recognised as
intangible assets in the Statement of Financial Position.
The only exception is research and development costs.
Research: Research is an original and planned investigationundertaken to gain new
scientific or technical knowledge and understanding.
Development: Development is the application of research findings or other
knowledge to a plan or design for the production of new or substantially improved
materials, devices, products, processes, systems or services before the
commencement of commercial production or use.
Research is gathering new knowledge, and development is the application of the
knowledge gained before the business can use it commercially.
For example, a company that makes medicines carries out research into the use of
herbs to cure headaches. This research results in the company finding one herb with
unique properties for curing headaches. The company then uses this research and
develops a headache pill using this herb, which is tested and then made ready to sell to
the public.

Examples of research expenditure

Aiming to obtain new knowledge.

Seeking applications of research findings.

Seeking and evaluating product or process alternatives.

Formulating and designing possible new or improved product or

process alternatives.

Examples of development expenditure

Design, construction and testing of pre-production prototypes and

models and chosen alternative materials, processes, etc.

Designing tools, etc., involving new technology.

Design, construction and operation of a pilot plant (not of a scale

 economically feasible for commercial production).

Related to, but neither research nor development

Engineering follow-through in an early phase of commercial

production.

Quality control during commercial production, including routine

product testing.

Troubleshooting commercial production breakdowns.

Routine refining or otherwise improving existing products.

Adapting an existing capability (for example, to a particular

customer's requirement)

Seasonal/periodic design changes to existing products.

Routine design of tools, etc.

2.2 Accounting for Research and Development

Research and development expenditure includes all costs incurred directly from
carrying out the R&D or can be allocated reasonably.
Costs that may be included as a result of the research and development activities are:
 Salaries and Wages – Any employment-related costs for staff carrying out the
research and development activities can be included. For example, salaries,
wages, payroll taxes, pension contributions
 Materials and Services – Any materials or services used in the research and
development activity can be included. For example, product development
materials and external market research experts.
 Overhead Costs – Any overhead costs (excluding general overheads) related
to the research and development activity can be included. For example,
energy and security costs.

2.2.1 Recognition of Research

Research costs are always treated as expenses and cannot be capitalised as
intangible assets because it is uncertain whether the research will generate future
economic benefits.
The double entry to account for research expenditure is:

General Ledger Account Category Explanation

DR Research (SPL) Expense Research (expense) has increased

 CR Bank/cash (SFP) Asset Bank (asset) has decreased

2.2.2 Recognition of Development

Development cost can only be capitalised as an intangible asset if it meets all the
following criteria below:
 Technical feasibility of completing the development of the intangible asset
 Intention to complete the development of the intangible asset
 Ability to use or sell the intangible asset
 The intangible asset will generate future economic benefits
 Sufficient resources exist to complete the intangible asset
 Cost can be measured reliably
 General Ledger Category Explanation
Account

DR Intangible asset (SFP) Asset Intangible asset (asset) is recognised

CR Bank/cash (SFP) Asset Bank (asset) decreased to pay for

development cost
The capitalised development cost will be amortised over its useful life and charged to
the Statement of Profit or Loss. Development expenditure has no residual value since
no active market exists (each development will be unique).
If any of the above criteria is not met, the development cost cannot be capitalised and
must be treated as an expense in the Statement of Profit or Loss.

General Ledger Account Category Explanation

DR Development (SPL) Expense Development (expense) has increased

CR Bank/cash (SFP) Asset Bank (asset) has decreased

2.3 Intangible Assets Disclosures
2.3.1 Disclosure Requirements
IAS 38 Intangible Assets include very detailed requirements about what should be
disclosed concerning non-current assets in a set of financial statements. These
disclosures will typically be included in the notes to the financial statements.
The standard requires a reconciliation between the opening and closing carrying
amounts of the non-current assets prepared and disclosed.
The financial statements should disclose each class of intangible assets:
 Useful lives or amortisation rates used.
 Amortisation methods used.
 Gross carrying amount and accumulated amortisation.
 A reconciliation of the carrying amount at the beginning and the end of the
period showing additions, disposals, amortisation, etc.
The aggregate amount of R&D expenditure recognised as an expense during the
period.