IAS 2 Inventories

IAS 2 Inventories contains accounting rules and principles that need to be followed with respect to inventories when financial statements of a company are being prepared according to IFRS. The major requirements of IAS 2 are regarding the determination of cost on initial recognition, the subsequent measurement and the disclosures that need to be given in the financial statements.

Scope

IAS 2 is applicable to all inventories other than the following:

  • Financial instruments (these are treated as per IAS 32 and IFRS 9)
  • Biological assets from agricultural activity and agricultural produce at the time of harvest (these are treated as per IAS 41)

In addition to above exceptions, the standard also excludes the following, only from its measurement requirements. These entities adopt industry best practices for measurement:

  • Producers of agricultural/mineral products
  • Commodity brokers

Therefore, the above two are exempt from annual NRV valuation. However the other requirements of IAS 2 still apply.

Definitions

Inventories are assets:

  • that are held for sale in the ordinary course of business i.e. merchandise or finished goods which are usually sold by a given type of business. For example, shoes are finished goods (and thus inventory) for a shoe manufacturer.
  • that are work-in-process or raw material which is held with the aim to produce the above finished goods. For example, unfinished shoes and leather form part of inventory of a shoe manufacturer.

Net Realizable Value (NRV) is the expected selling price in the ordinary course of business less the total estimated total cost (including completion/repair cost) that needs to be incurred to make that sale. NRV is entity specific and may be different from fair value.

Initial Measurement at Cost

The cost of inventories includes all of the following:

  • Purchase costs
  • Conversion costs
  • Other costs (such as some administrative costs)

Purchase costs include price paid including all non-refundable duties and taxes and other costs incurred that are directly attributable to acquisition of the inventory. Discounts obtained are subtracted when determining the cost of acquisition.

Conversion costs are costs such as direct labor and overheads that are incurred in converting inventory in the form of raw material to finish goods. These form part of the cost of inventory subject to rules given below.

Variable overheads are allocated on the basis of actual usage of production facilities.

Fixed cost is allocated to units of production depending on whether or not there has been abnormal production as explained below:

  • If the production is below expected level, it means that the production facility has not been fully utilized and there has been loss of fixed overheads. Therefore, fixed overheads should only be capitalized in inventory to the extent of actual production as a proportion of normal production. The remaining fixed overhead needs to be expensed in the income statement. For example, for fixed overhead costs of $160,000, if normal capacity is 100,000 units and only 40,000 units are produced due to abnormal shutdowns, only $64,000 [=$160,000*40,000/100,000] of fixed costs should be capitalized in inventory. The remaining $96,000 should be expensed in income statement. The unit fixed cost in this case should be actual fixed cost divided by normal production units.
  • If the production is above expected level, the total fixed cost actually incurred should be capitalized. The unit fixed cost in this case should be actual fixed cost divided by actual units produced.

Other costs that may form part of inventory costs are those that are incurred in bringing inventories to their present location and condition. For example, certain non-production overheads if only incurred due to specific orders, certain borrowing costs if they meet the criteria given in IAS 23 for capitalization in inventory cost.

Costs that do not form part of cost of inventories include abnormal wastage (material, labor or overhead), storage costs (unless necessary part of production process), indirect administrative expenses and selling costs.

Techniques of measurement of cost such as standard costing and retail method of cost estimated may be used for convenience provided that the result obtained approximates the actual cost.

Subsequent Measurement

Subsequently, inventories must be measured at lower of cost and NRV. If an item needs to be written-down, the related expense is charged to the profit and loss for the year.

In case of sale during the year, the value of inventory in the books is charged to profit and loss in the period in which the related revenue is recognized.

Cost Formulas / Methods

For items of inventory which are not interchangeable, and for inventory related to specific orders or projects, the cost must be allocated to specific items. This is also called specific identification method of inventory costing. However if the items are ordinarily interchangeable, the specific identification method is not cost effective and therefore not required.

In such cases, the standard allows the following two methods:

An entity may use different methods from the above for different classes of inventories. However, the entity must use the same method for an entire class of inventory.

NRV

NRV is measured and inventories are written down, usually on an item by item basis. But in some cases where items of inventory are of similar nature, NRV may be determined for the whole lot of similar items.

Materials and supplies are not written down below cost if the finished goods in which they are planned to be used are expected to sell for above cost.

NRV assessment is revised each year. Therefore circumstances may arise where an item which was written down in prior year, now has NRV above the book value. In such cases, the write down is reversed in the current period by valuing the inventory item upwards in the books. However the value of the asset cannot be increased above the original cost even if the NRV is higher than that.

Disclosures

IAS 2 requires disclosures about accounting policies, cost formulas used, total carrying amount (including by class) and of those at fair value less cost to sell, inventories expensed, inventories written-down, reversals of write-downs and the circumstances that lead to such reversals, inventories pledged as security.

by Irfanullah Jan, ACCA and last modified on

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