IAS 2 - Inventories (detailed review)
This Standard deals with the accounting treatment of Inventories. The main issues are the determination of the cost of inventory and Net Realizable Value, its subsequent accounting treatment, and the guidance on the cost formulas for the valuation of inventories.
The requirements of this standard are applicable for the accounting treatment of inventories. However this standard does not deal with the following
(a) The work in progress related to construction contracts, which are covered under IAS 11
(b) The agricultural and forest products after the harvest related to the agricultural activity, and mineral products at initial recognition which are covered under other applicable standards
(c) The stock brokers or traders who regularly buy and sell commodities for others or on their own account for the purpose of short term profit taking or margin
These are the assets which include
(a) Raw material held for use in the process of production or for rendering of services
(b) Work in process for the purpose of sale in the normal course of business
(c) Finished goods (produced or purchased) which are held for sale in the normal course of business.
Net Realizable Value:
It is determined as the estimated selling price less estimated cost to complete and less the estimated selling expenses. It is the net amount that an entity expects to realize from the sale of inventory in the normal course of business.
Measurement of Inventories
The entity will measure the inventory at reporting date at the lower off
(a) Cost of the inventory and
(b) Its Net Realizable Value
This is in accordance with the prudence concept.
Cost of Inventory
The cost of inventory includes its original purchase price any cost of conversion and any other directly related cost incurred in bringing the inventory to its present condition and location. It will be determined as
- Basic List Price
- Less any Trade Discount or Rebate,
- Plus any directly related cost which includes: Transportation cost, Sales tax and Import duties (if non-refundable), any legal charges, handling costs, any other cost incurred for the acquisition of finished goods or raw material
- Conversion cost i.e. (Direct labor and Production Overheads)
- Any other cost which is necessary to bring the inventory into its present condition and location such as designing cost or storage cost if essential before use in production process.
- Conversion cost is the cost of converting the raw material into finished goods and it encompasses (Direct labor cost and Production Overheads)
- Production overheads include fixed and variable overheads
- Fixed production overheads are those which remain fixed, irrespective of the level of production and these are allocated on the basis of normal or average capacity.
- The normal capacity should take into account the production loss due to planned repair and maintenance.
- If the actual production is lower than budgeted, then unallocated overheads will be charged to statement of profit or loss as expense.
- If the actual production is higher than the budgeted, then fixed overhead allocated to each unit should be decreased, on the basis of actual production
- Variables production overheads are those which vary with the level of production and are allocated on the basis of use of such facility.
(a) Following are the costs which will not be recorded as part of cost of inventory and will be charged to the statement of profit or loss as expense which includes:
- Any amount of abnormal loss due to wasted material or labor.
- Storage cost if it is not necessary before a production process
- Any administrative and selling overheads.
(b) If production of inventory is financed through a loan and inventory takes a substantial time period to get ready for sale or intended use, then any related interest cost will become the part of cost of inventory as per IAS 23.
(c) If the inventory is purchased on extended credit period or on deferred installment basis, then the cost of such inventory will be its Cash Price Equivalent any excess paid over the cash price will be treated as Interest expense which will be recognized over the period of credit.
Cost of Inventory of a Service Provider:
The cost of inventories of a service provider includes the cost of direct labor or personnel who are engaged in rendering the services and other directly attributable costs. However, it should not include any administrative and selling overheads, and profit margins.
Cost Measurement Techniques
The entity can use the following cost measurement techniques to determine the cost of inventory which includes:
a) Standard Unit Cost Method
Under this method, the cost of inventory is determined by taking into account normal direct material cost, labor cost and directly attributable overheads.
b) Retail Price Method
This method is normally used by the entities engaged in the retail business with large number of items in inventory having similar margins. The cost of inventory will be determined by deducting the margin from the selling price of such inventory items.
Cost Measurement Formulas
- The cost of items of inventory that are not ordinarily interchangeable or different in nature and the goods which are produced for a specified project will be determined by specific identification of their individual cost incurred on such items.
- The cost of items of inventory that are ordinarily interchangeable or similar in nature can be determined by using first-in, first-out (FIFO) method or weighted average cost method.
- Under FIFO method the units of inventory which are purchased or produced first are deemed to be sold first and the units remaining in the inventory will be with the most recent prices.
- Under weighted average cost method, a weighted average cost per unit is calculated by taking into account the cost of the units at the start of the period and the cost of the units which are purchased or produced during the year on periodic basis or when new shipment is received.
- This Standard requires that the entity should use the same formula for all the inventories in different segments of the business but have same nature and use.
Net Realizable Value
- If the cost of inventory exceeds the value which is expected to be received from its ultimate sale, then the inventory will be written down to its net realizable value.
- The net realizable value of inventory may fall down because of increase in cost, fall in selling price, physical damage or obsolescence.
- It should be the reliable estimate on the date of measurement considering all the relevant factors.
- If the cost of inventory falls lower than NRV, then each item of inventory should be written down to its NRV on individual basis. However, this may be applicable upon group of items in inventory if they are similar in nature or ultimate purpose.
- The entity should consider the purpose of the inventory in determination of its NRV such as, whether it is held for sale under a firm contract or for general sale purpose.
- The raw material which is held by the entity for use in production of finished goods needs not to be written down below its cost, if the finished goods in which such material will be used are expected to be sold at above its cost. However, if the finished goods in which such material will be used are expected to be sold at less than its cost, then the cost of such raw material will be written down to its NRV.
- If the same existing inventory is held at a subsequent reporting date, the NRV of the inventory will be re-measured at each subsequent reporting date. If subsequent circumstances indicates that NRV of inventory has increased, for which a write down has been recorded in the previous period, the reversal of write down will be made up to the extent of original write down made in the previous period.
Recognition as an Expense
- The carrying value of inventory will be recorded as expense in the period in which such inventory is sold. However, if the inventory is used in the construction of another asset then the cost of such inventory will become the part of cost of other asset.
- Any losses related to the inventory and write down of inventory to its NRV will be recorded as expense in the relevant period in which loss or write down arises.
- The reversal of write down related to inventory will be recorded as reduction in expense in the period in which reversal of write down arises.
The Standard requires the entity to disclose the following:
- The cost valuation method adopted by the entity.
- The carrying value of inventory at the end of reporting period.
- Any amount of write down in the value of inventory
- The value of inventory recognized in statement of profit or loss as expense.
- Any amount of reversal in the write down of inventory and such circumstances which reflect the reversal of write down.
- Any amount of inventory which is subject to a pledge arrangement.
- The carrying amount of inventory as per each classification of inventories such as raw material, work in process, and finished goods.