IAS 2 sets out the accounting treatment for inventories. For many entities, closing inventory can be a highly significant figure and is used in the calculation of profit and also shown as a current asset in the Statement of Financial Position.
Thus, the main issue addressed in IAS 2 is the establishing of the amount of cost that should be recognised in the accounts.
The standard applies to all inventories with the exception of:
- Work in progress arising under construction contracts
- Financial instruments
- Biological Assets related to agricultural activity
Inventories are assets:
- Held for sale in the ordinary course of business; or
- In the process of production for such sale; or
- In the form of materials or supplies to be consumed in the production process or in the rendering of services.
Inventories should be measured at the lower of cost and net realisable value.
Cost should comprise:
Costs of purchase
+ Costs of conversion
+ Other costs incurred in bringing the inventories to their present location and condition
Net Realisable Value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
The costs of purchase include the purchase price, import duties (and other taxes not recoverable by the entity), transport and handling costs and any other directly attributable costs. However, note that trade discounts, rebates and other similar items must be deducted.
The costs of conversion include costs that are directly related to the units of production e.g. direct labour, direct expenses, work subcontracted to third parties. They also include a systematic allocation of fixed and variable overheads. When allocating such overheads, the overheads must be based on normal level of activity.
The other costs mentioned above are any other costs incurred in bringing the inventory to its present condition and location.
The standard mentions other costs which must be excluded from the cost of inventories. These are:
- Abnormal amounts of wasted materials, labour and other production costs
- Storage costs (unless necessary in the production process before a further production stage)
- Administration overheads which do not contribute to bringing inventories to their present condition and location
- Selling costs
Instead, these costs are to be charged as expenses in the period they are incurred.
In relation to Net Realisable Value, the standard makes the following points:
- Inventories may have to be written down below cost to NRV if the item becomes damaged, obsolete or if the selling price has declined
- Inventories are normally written down to NRV, in such circumstances, on an item-by-item basis, although it may be appropriate to group similar or related items, in some cases
- Estimates of the NRV are based on the most reliable estimate, at the time estimates are made, of the amount the inventory is expected to realise
- A new assessment of NRV is made in each subsequent period
If the circumstances which caused inventories to be written down below cost no longer apply, the amount of the write-down is reversed.
IAS 2 states that the cost of inventories should be arrived at using:
- First In First Out (FIFO); or
- Weighted Average Cost
The same cost formula should be used for all inventories having a similar nature and use.
If the inventories are not interchangeable, they should be valued using specific identification of their individual costs.
The following should be disclosed:
- The accounting policy
- The total carrying amount of inventories, classified as appropriate
- Carrying amount of inventories carried at fair value less costs to sell
- Amount of any write-downs
- Amount of any write-down reversals
- Details of the reasons why the reversal occurred
- Carrying amount of any inventories pledged as security for liabilities