Inventory – IAS 2

Definition of Inventory

Inventory refers to assets held for sale in the ordinary course of business, in the process of production for sale, or in the form of materials to be consumed in the production process or in rendering services. The classification of an asset as inventory depends on its intended use by the entity.

• Examples: Raw materials, work in progress, finished goods, and consumables.

• Key Point: Only items held for sale or for use in production are classified as inventory; other assets (e.g., vehicles used for distribution) are not inventory.

Example: Newspapers held by a seller are inventory, but the vehicle used for distribution is an asset, not inventory.

Measurement of Inventories

Inventories are measured at the lower of cost and net realisable value (NRV), as required by IAS 2.9. This ensures that inventory is not overstated in the financial statements.

• Standard Cost and Retail Methods: May be used when they approximate actual cost (IAS 2.21, 2.22).

Cost of Inventories

The cost of inventory includes:

• Purchase Costs: Purchase price, import duties, transport, handling, and other directly attributable costs, less trade discounts and rebates.

• Conversion Costs: Costs incurred in converting raw materials to finished goods, including direct labour and production overheads (variable and fixed).

• Other Costs: Only those necessary to bring inventory to its present location and condition (e.g., design costs, capitalised borrowing costs).

Excluded Costs: Abnormal wastage, administrative expenses not related to production, selling expenses, and storage costs (unless necessary in production).

Example: Calculation of Inventory Cost

Consider a company purchasing goods with the following costs:

• Purchase price (after trade discount)

• Freight, insurance, cartage, customs duty, non-refundable deposit

• Less: Cost of goods written off due to damage

Formula:

Joint Costs, Main and By-Products

When a process yields multiple products, joint costs are allocated using rational and consistent methods:

• Physical quantity method

• Sales value at split-off point

• Further processing cost method

• Net realisable value method

By-products are measured at NRV and deducted from the cost of main products.

Other Techniques for Measurement of Costs

• Standard Cost: Estimated cost based on normal levels of input and efficiency; regularly reviewed and adjusted.

• Retail Method: Cost is determined by reducing sales price by average profit margin; used when detailed records are unavailable.

Cost Formulas

IAS 2 allows the following cost formulas for inventory valuation:

• First-In, First-Out (FIFO): Oldest costs assigned to units sold first; ending inventory valued at most recent costs.

• Weighted Average: Average cost of all units available during the period is used for both cost of goods sold and ending inventory.

• Specific Identification: Used for items not ordinarily interchangeable or segregated for specific projects.

Example: Calculating ending inventory using FIFO and weighted average methods based on purchase and sales data.

Determining Net Realisable Value (NRV) and Recognition at Lower of Cost and NRV

NRV is the estimated selling price in the ordinary course of business, less costs to complete and sell (e.g., advertising, sales commission, packaging, transport). Inventory is written down to NRV if cost exceeds NRV, and the loss is recognised immediately in profit or loss.

• Write-downs are usually item-by-item but may be grouped for similar items.

• NRV is reassessed at each reporting date.

Formula:

Recognition of Expense

When inventory is sold, its carrying amount is recognised as an expense (cost of sales) in the period when the related revenue is recognised. Write-downs to NRV and inventory losses are also recognised as expenses.

• Perpetual Inventory System: Updates inventory and cost of sales continuously.

• Periodic Inventory System: Updates inventory and cost of sales at period end.

Disclosure Requirements

Financial statements must disclose:

• Accounting policies for inventory measurement and cost formula

• Total carrying amount of inventories by classification

• Amount of inventories carried at fair value less costs to sell

• Amount recognised as cost of sales

• Amount of write-downs and reversals

• Inventories pledged as security

Differences between Full IFRS, IFRS for SMEs, and GRAP

• IFRS for SMEs: Uses "estimated selling price less costs to complete and sell" instead of "NRV"; allows "most recent purchase price" as a measurement technique.

• GRAP: Applies to public sector; includes additional categories (e.g., spare parts, strategic stockpiles); allows measurement at current replacement cost for inventories distributed at no or nominal charge.

Summary Table: Key Differences between Full IFRS, IFRS for SMEs, and GRAP

Practice Examples

• Calculation of inventory value at lower of cost and NRV for various inventory types (raw materials, work in progress, finished goods).

• Allocation of joint costs using different methods (physical quantity, sales value at split-off, further processing costs, NRV).

• Disclosure of inventory in financial statements and recognition of write-downs.

Additional info: These notes are based on IAS 2 and related standards, with examples and applications relevant for Financial Accounting students. They cover all major aspects of inventory accounting, including measurement, recognition, disclosure, and differences between major reporting frameworks.