International Accounting Standard 2 (IAS 2) defines inventories as the “assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.
Inventories are those assets of an entity which are sold in the normal course of business. These are the finished goods which are ready for being sold. Assets which are held for sale but are not traded in the normal course of business cannot be classified as inventories.
Apart from the finished goods that are ready for sale the goods in the process of production are also classified as inventories. The goods which have undergone some production process but are not in the intended selling condition are termed as work in progress or work in process. Work in progress is also part of the inventories.
The raw materials used for the production of goods are also classified as inventories. All the raw materials that are available in the store waiting for being used in the production of goods are included in inventories.
The inventories are usually measured at the “lower of cost and net realizable value”. The cost of inventories comprises the costs of purchase, the cost of conversion and any other cost incurred to bring the inventories to their present location and condition. The net realizable value is the estimated selling price in the ordinary course of business less the estimated cost to completion and estimated costs make a sale.
The logic behind measuring the inventories at “lower of cost and net realizable value” is that the assets should not be carried in excess of amounts likely to be realized from selling or using them. The inventories might need to be written down to net realizable value if inventories are damaged, obsolete, or their selling price has declined.
The costs of inventories should be measured using either the FIFO (first in, first out) method or the weighted-average cost method. If the inventories are not interchangeable and are being produced and segregated for specific projects, the costs should be measured by using specific identification of their individual costs.