SBR Notes IAS 2

IAS 2 — Inventories

Objective of IAS 2: The objective of IAS 2 is to prescribe the accounting treatment for inventories. It provides guidance for determining the cost of inventories and for subsequently recognising an expense, including any write-down to net realisable value. It also provides guidance on the cost formulas that are used to assign costs to inventories.

Definition of inventory: Inventories are:

• Assets held for sale in the ordinary course of business (finished goods). For a retailer, these are items that the business sells – its stock-in trade. For a manufacturer, assets held for sale are usually referred to as ‘finished goods’.

• Assets in the production process for sale in the ordinary course of business (work in process). E.g. Work-in-progress’ for a manufacturer.

• Assets in the form of materials or supplies to be used in the production process (raw materials). E.g. raw materials in the case of a manufacturer.

Scope: However, IAS 2 excludes certain inventories from its scope:

• Work in process arising under construction contracts

• Financial instruments

• Biological assets related to agricultural activity and agricultural produce at the point of harvest (IAS 41 Agriculture).

Also, while the following are within the scope of the standard, IAS 2 does not apply to the measurement of inventories held by:

• Producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realisable value (above or below cost) in accordance with well-established practices in those industries. When such inventories are measured at net realisable value, changes in that value are recognised in profit or loss in the period of the change

• Commodity brokers and dealers who measure their inventories at fair value less costs to sell. When such inventories are measured at fair value less costs to sell, changes in fair value less costs to sell are recognised in profit or loss in the period of the change.

Entries for purchase of stock:

Dr. Purchase

Cr. Cash/Payable

Entries for recording the value of closing stock:

Dr. Closing Stock

Credit: There are three possible variations in the account to be credited for recording the value of stock:

1. Trading a/c

2. Cost of Goods Sold a/c

3. Purchase a/c

Fundamental principle of IAS 2: Inventories are required to be stated at the lower of cost and net realisable value (NRV).

Measurement of inventories: Cost should include all:

• Costs of purchase (including taxes, freight, insurance, import duties, taxes, transport, and handling) net of trade discounts/less any trade discounts received and other directly attributable cost, irrecoverable taxes and letter of credit charges if related to inventory.

• Costs of conversion (including fixed and variable manufacturing overheads) are the ‘internal costs’ incurred in getting the inventory into its current state, such as the internal costs incurred in producing finished goods. They include both direct costs (such as labour and expenses) and a share of production overheads, where production overhead absorption rates are based on normal levels of activity.

• Other costs incurred in bringing the inventories to their present location and condition e.g. delivery cost, borrowing cost and non-production overheads.

IAS 23 Borrowing Costs identifies some limited circumstances where borrowing costs (interest) can be included in cost of inventories that meet the definition of a qualifying asset.

Inventory cost should not include:

• Abnormal waste

• Storage costs

• Administrative and general overheads unrelated to production

• Selling costs

• Foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency

• Interest cost when inventories are purchased with deferred settlement terms.

Techniques for measurement of cost: The standard cost and retail methods may be used for the measurement of cost, provided that the results approximate actual cost.

Standard cost	Retail Method
-Standards must be regularly reviewed and revised. -Takes in to account normal level of material, labour, capacity and efficiency.	- Reduces sales value by appropriate percentage gross margin. -For inventories of large number of rapidly changing items with similar margins.

For inventory items that are not interchangeable, specific costs are attributed to the specific individual items of inventory.

For items that are interchangeable, IAS 2 allows the FIFO or weighted average cost formulas. The LIFO formula, which had been allowed prior to the 2003 revision of IAS 2, is no longer allowed.

The same cost formula should be used for all inventories with similar characteristics as to their nature and use to the entity. For groups of inventories that have different characteristics, different cost formulas may be justified.

IAS 2 Inventories allows three methods of arriving at cost:

• Actual unit cost

• First-in, first-out (FIFO)

• Weighted average cost (AVCO).

Actual unit cost must be used where items of inventory are not ordinarily interchangeable. Actual cost is used where items can be individually traced. This is usual for high value items. For example, cars for sale in a car dealer’s showroom will normally be valued at actual cost in the financial statements of the car dealer.

FIFO Formulae	Weighted Average Formulae
It assumes inventory which purchased first is sold first. Therefore the inventory which is unsold at period end is the latest one.	Determined from weighted average cost of: Items at beginning of period And cost of similar items purchased/ produced during the period -It may be calculated on periodic basis or on each additional shipment

Where it is not possible to identify actual cost, a choice is allowed between FIFO or AVCO. The chosen

EXAMPLE: MOIZ: Moiz sets up in business on 1^st November by buying and selling toys. These were purchased during the month:

On 25^th November, Moiz sold consignment of 250 toys for $ 50,000

Calculate gross profit and value of closing inventory using

1) FIFO

2) Weighted average

Solution:

FIFO	Weighted Average
Sale: 50000 Cost(w) ( 39250) = 10750	Sale: 50000 Cost(w) (40000) = 10000
Working: 200 units x 150s.p = $30000 50Units x 185s.p = $9250                                 = 39250	Working: 200units x 150 u.p= 30000 80units x 185 u.p=14800                                = 44800

Closing Inventory

FIFO 30 x 185= $5550

Weighted average = 30 x 160= 4800

Write-down to net realisable value: NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale.  Replacement cost cannot be used as NRV. Any write-down to NRV should be recognised as an expense in the period in which the write-down occurs. Any reversal should be recognised in the income statement in the period in which the reversal occurs. Cost of inventories may not be recoverable due to

• Damage

• Obsolescence

• An increase in estimation cost to be incurred in completion

• Decline in selling price

Estimations of net realisable value take into account due to:

• The purpose for which inventory is held

• Fluctuations of price or cost relating to events after the period end.

The inventory valuation should be assessed in every accounting period and should be updated in financial statements.

Example: Cheeema is trying to calculate year end inventories figure for inclusion in his accounts. Details of his three stock lines are as follows:

Product	Cost	Realisable Value	Selling exp
A	$100	$120	$25
B	$50	$60	$5
C	$75	$85	$15

Calculate the value of closing inventories which Cheema should use for his accounts.

Solution:

A. 120-25 =	95
B. Cost	50
C. 85-15=	70
	215

Expense recognition: IAS 18 Revenue addresses revenue recognition for the sale of goods. When inventories are sold and revenue is recognised, the carrying amount of those inventories is recognised as an expense (often called cost-of-goods-sold).

Disclosure: Required disclosures:

• Accounting policy for inventories

• Carrying amount, generally classified as merchandise, supplies, materials, work in progress, and finished goods. The classifications depend on what is appropriate for the entity

• Carrying amount of any inventories carried at fair value less costs to sell

• Amount of any write-down of inventories recognised as an expense in the period

• Amount of any reversal of a write-down to NRV and the circumstances that led to such reversal

• Carrying amount of inventories pledged as security for liabilities

• Cost of inventories recognised as expense (cost of goods sold).

IAS 2 acknowledges that some enterprises classify income statement expenses by nature (materials, labour, and so on) rather than by function (cost of goods sold, selling expense, and so on). Accordingly, as an alternative to disclosing cost of goods sold expense, IAS 2 allows an entity to disclose operating costs recognised during the period by nature of the cost (raw materials and consumables, labour costs, other operating costs) and the amount of the net change in inventories for the period). This is consistent with IAS 1 Presentation of Financial Statements, which allows presentation of expenses by function or nature.

Illustration – Valuation of inventories: An entity has the following items of inventory.

(a) Materials costing $12,000 bought for processing and assembly for a profitable special order. Since buying these items, the cost price has fallen to $10,000.

(b) Equipment constructed for a customer for an agreed price of $18,000. This has recently been completed at a cost of $16,800. It has now been discovered that, in order to meet certain regulations, conversion with an extra cost of $4,200 will be required. The customer has accepted partial responsibility and agreed to meet half the extra cost.

Required: In accordance with IAS 2 Inventories, at what amount should the above items be valued?

Solution: (a) Inventory is valued at the lower of cost or net realisable value, not the lower of cost or replacement cost. Since the materials will be processed before sale there is no reason to believe that net realisable value will be below cost. Therefore the inventory should be valued at its cost of $12,000.

(b) The net realisable value is $15,900 (contract price $18,000 – Constructor’s share of modification cost $2,100). The net realisable value is below the cost price. Therefore the inventory should be held at $15,900.