Inventories: International Accounting Standard (IAS) 2 Overview

The revised IAS 2 inventories or International Accounting Standard 2 Inventories has replaced IAS 2 inventories in 1993. These standards were applied annually from January 1, 2005. It superseded the earlier SIC-1 Consistency-Different Cost Formulas for Inventories.

The International Accounting Standards Board (IASB) revised IAS 2 to improve the International Accounting Standards. The IASB launched the project following questions and doubts about the Standards from regulators of securities, professional accountants and other concerned quarters. The aim was to reduce and remove options, delays and clashes between the norms of the Standards and also to manage few inter-related matters.

The Board's main objective was to introduce a limited revision to reduce the options for the measurement of inventories. But the Board refrained from reconsidering the basic method of accounting regarding the inventories in IAS 2.

Aims

The aim of this Accounting Standard was to streamline the accounting method for inventories.
The foremost concern in Inventory Accounting is that the cost would be considered as asset which gets carried further until the other relevant revenues are recorded. This provides guidance for determining the cost and its consecutive records as expense. It includes all written down to the net value which is realizable. Added to this it provides guidelines on cost formulas employed to depute costs for inventories.

Range of coverage

The IAS 2 is applicable to all the inventories, excepting for construction contracts including contracts that are in progress and also includes directly related service contracts and financial instruments. In addition, it also includes biological wealth connected to agriculture at the time of harvesting.

The Standard is not applicable to the inventories measurement with the makers of products related to forest and agriculture, after harvest and minerals products. These are measured at the net realizable value according to established practices. When such measurements are undertaken, changes in value are recorded in profit or loss during the period. When inventories are measured so, changes in fair value are recognized in profit and loss during change.

Paragraph 3(a) contains the inventories that are calculated at regular interval during production or you can say when production has accomplished certain stage. You can take example of agriculture, there will be so many calculations done from the sowing to harvesting like, to see whether sales will happen for the crops which have been harvested, is there any kind of assurance from government regarding the price of the crop, when will be the market active enough to ensure sales and reduce the risk of getting failed in selling. However, the actions that should be implemented are not mentioned in these inventories.

There are people who are not direct buyers or sellers, they just act as a mediator and buy or sell the products in their name, they are known as broker traders. If you go through the inventories mentioned in paragraph 3(b), then you will find that it has future plans for the sellers to make profits by narrowing the margin of broker-traders.

Definitions

Inventories are the assets produced or consumer goods in the production process. Net realisable value is the projected selling price minus the estimated cost of production. Fair value is the price of the asset or payment of debt.

Net realisable value is the amount expected to be realised from the sale of inventory. Fair value refers to the price of the inventory in the market. Net realisable value is an entity specific value but the fair value is not. Net realisable value might not be equal fair value minus cost to sell.

Inventories cover merchandise purchased and kept for resale inclusive of goods purchased by the retailer or any land and other property. These inventories also include the list or mass of the final output of the production by any organization and raw materials needed to be used in the production. Paragraph 19 covers the cost incurred in service, which is not mentioned by the organization.

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.”

Cost of Inventories

Costs of acquisition, manufacture, exchange and other expenses are included in the inventories that have made it possible for the inventories as they are in current position and stipulation. When purchase word in mentioned in inventories, it consists of the expenses that are made for purchase, transport, import duties, handling taxes and other expenses that are responsible or have direct impact on the procurement of finished production. There are several other aspects which contribute in the reduction of the price like rebates in taxes, discounts in trading, etc.

The cost of conversions or purchase is also affected by the overheads which are calculated by looking at the facilities at the production level. Normal ability is the expected amount of production on an average over certain span of time or season, taking into consideration of the failure in the production capacity due to planned maintenance.

A process of production may bring in several products: a main product and a by-product. As the cost of production is calculated as a whole and not by separate products, they are divided in a balanced way. The price of each product either at the production stage or after the final production may be considered for this purpose.

The cost of inventories also includes excess wasted materials, labor, etc, storage costs, administrative overheads and selling costs. The assets, cost incurred for the harvested crop and cost of service provider are also included.

Measurement of Inventories

The inventories are should be measured at the “lower of cost and net realizable value”. Cost of inventories includes the purchase costs, conversion costs, and other costs incurred to bring the inventories to their present condition and location. Net realizable value (NRV) is the estimated selling price during the normal course of business less the estimated costs to make a sale and estimated costs to completion.

The cost of purchase includes the purchase price, import duties and taxes, transportation costs, and handling costs associated with the acquisition of goods. Trade discounts and rebates are excluded from the cost of purchase.

Cost of conversion of inventories includes the costs that can be directly attributed to the units of production. Direct labor costs are example of such costs. Variable and fixed manufacturing overheads incurred in converting the raw material to the finished goods can also be included in the conversion costs.

Other costs include all of the costs that are incurred for bringing the inventories to their present condition and location. A common example of such “other costs” is cost of designing products for specific customer needs.

Certain costs are NOT included in the valuation of inventories. These costs are recognized as expense when they occur. Following are some of the common examples of these costs:

• Abnormal wastage of materials, labor and other production costs
• Storage costs if they are not essential for the production process
• Selling and distribution costs
• Administrative costs that are not involved in bringing the inventory to its present condition and location

When inventories are purchased on deferred settlement terms, these arrangements contain a financing element. The portion of the price that can be attributed to the extended settlement terms is recognized as interest expense over the period of the financing arrangement. This portion is the difference between the purchase price for normal credit terms and the amount actually paid.

The inventories of service provider are measured at the cost of production. The cost of production primarily comprises cost of labor and other personnel directly involved in providing the services. The costs of supervisory staff and attributable overheads are also part of the cost of production. The profit margins and non-attributable overheads (that are usually used in the prices quoted to the customers) should not be included in the cost of production.

Case Study

ABC Trading Company purchases motorbikes from several countries and sells them to European countries. During the current year, this company has incurred following expenses:

1. Trade discounts on purchase

2. Handling costs relating to imports

3. Salaries of accounting department

4. Sales commission paid to sales agents

5. After sales warranty costs

6. Import duties

7. Costs of purchases (based on supplier’s invoices)

8. Freight expense

9. Insurance of purchases

10. Brokerage commission paid to indenting agents

Requirement: ABC Trading Company seeks your advice on which costs are allowed by IAS 2 for inclusion in the cost of inventory.

Solution: Items 1, 2, 6, 7, 8, 9, 10 are allowed by IAS 2 for the calculation of cost of inventories. Salaries of accounts department, sales commission, and after sale warranty costs are not considered to be the cost of inventory therefore they are not allowed by IAS 2 for inclusion in cost of inventory.

Techniques of Measurement of Costs

If the actual costs more or less equal the results of other techniques of measurement of cost, these techniques can be used. Standard cost method and retail method are two examples of allowed measurement techniques.

Cost Formulas

Costs should be using the specific identification of their individual costs if inventories are not normal interchangeable and if goods or services are produced and segregated for specific projects.

In all other cases the cost of inventories should be measured using either the

• FIFO method (First-in, First-out method)
• Weighted-average cost (WAC) method

FIFO method assumes the inventories that are purchased first are sold first. This implies that the ending or remaining inventory is valued at the most recent prices. The WAC method determines the weighted-average cost of similar items at the start of a period and the cost of goods or services purchased or produced during the period.

An entity should value the inventories by using same formula if the items are or similar nature and use. Different cost methods can be used if the inventories are not similar in nature and use.

Case Study

XYZ Company imports good from China and sells them in the local market. It uses FIFO method to value its goods. Following are the purchases and sales made by the company during the current year.

Purchases:

January: 20,000 units @ $25 each

March: 25,000 units @ $ 30 each

July: 30,000 units @ $35 each

Sales:

May: 25,000 units

November: 30,000 units

Requirement: Based on the FIFO method, calculate the value of inventory at the end of May and November and December.

Solution: