IAS 2 (inventories) set out the accounting treatment for inventories, including the determination of cost, the subsequent recognition of the expense and any write-down to Net Realizable Value (NRV)
So what is the inventory?
Inventory according to IAS 2 are assets that are :
- Held for sale in the ordinary course of business
- are in the process of production for such sale; or
- In the form of material or supplies to be consumed in the production process or in the rendering of services.
Inventories, as stipulated in IAS 2, consist of:
- production supplies
- work in progress
- finished goods
In general IAS 2 applies to all inventories except:
- Work in progress on construction and service contracts which are dealt with IAS 11 (construction contracts)
- Financial instruments which are dealt with IFRS 9 (financial instruments)
- Biological assets arising from the agricultural activity which are dealt with IAS 41 (agriculture)
In the case of the service provider, inventories include the cost of service for which the entity has not yet recognized the related revenues. These costs consist primarily of the labor and other costs of personnel directly engaged in providing the service, including supervisory personnel and attributable personnel.
Labor and other costs relating to sales and general administrative personnel are not included but are recognized as expenses in the period in which they are incurred.
How is the figure included in the financial statement determined? (the measurement of inventory value)
Inventories are measured at the lower of cost or Net Realizable Value (NRV).
Cost of inventory comprises all costs used to purchase inventory, cost of conversion and other costs incurred in bringing the inventories to their present location and condition.
- Cost of purchase consist of the purchase price, import duties, and other taxes and transport, handling costs and other costs directly attributable to the acquisition of finished goods, materials and services; less discounts, rebates, and other similar items
- Cost of conversion includes cost which are directly related to units of production (for example direct labor, direct expenses and subcontracted work) and a systematic allocation of fixed and variable production overhead incurred in converting materials into finished goods.
- Other costs can be included in the cost of inventories to the extent incurred in bringing the inventories to their present location and condition for example non production cost of designing a product for the specific customer
The cost of inventories of items that are ordinarily interchangeable and have not been produced and segregated for a specific project is determined by using first-in, first-out (FIFO) or weighted average cost formula. The same cost formula must be adopted for all inventories having a similar nature and use to the entity.
The use of last-in, first-out (LIFO) is not permitted under IAS 2:
Net Realizable Value is the estimated selling price less the estimated cost of completion and the estimated cost necessary to the sale such as marketing, selling and distribution costs.
Estimates of Net Realizable Value are based on the most reliable evidence available at the time the estimates are made of the amount the inventories are expected to realize.
The principle situation in which net realizable value is likely to be less than cost is where there has been;
- an increase in loss or fall in selling price
- physical deterioration of inventories
- obsolescence of products
- a decision as part of a company’s marketing strategy to manufacture and sell products at loss
- errors in production or purchasing
How are inventories recognized in the financial statements?
When inventories are sold, the carrying amount of those inventories should be recognized as an expense in the period in which the related revenue is recognized.
Any losses of inventories and the amount of any write-down to net realizable value should be recognized as an expense in the period in which write down or loss has occurred.
Any reversal of any write-down of inventories that resulted from an increase of net realizable value should be recognized as a reduction in inventory expense in the period in which reversal occurred
According to IAS 2, the following should be disclosed in the financial statements:
- The accounting policies adopted in measuring inventories, including the cost formula used
- The total carrying amount of inventories and the carrying amount in the classifications appropriate to the entity
- The carrying amount of inventories carried at fair value less cost to sell
- The amount of inventories recognized as an expense during the period
- The amount of any write-down of inventories recognized as an expense in the period
- The amount of any reversal of any write-down that is recognized as a reduction in amount of inventories recognized as an expense
- The circumstance or events that led to the reversal of write down of inventories
- The carrying amount of inventories pledged as security for liabilities