The aim of this accounting standard is to prescribe the accounting treatment of inventories. It provides guidance with regards to determining the cost of inventories as well as subsequent recognition as expenditure, including any write-down to net realizable value (NRV). In addition, it also provides guidance regarding the use of cost formulas for assigning costs to different inventory items.
Scope (IAS 2)
This standard is applicable to all inventories, apart from the following:
- Financial instruments (IAS 32 Financial Instruments: Presentation and IFRS 9 Financial Instruments)
- Biological assets that are related to agricultural activity and agriculture products at the point of harvest (IAS 41 Agriculture)
This standard is not applicable to the measurement of inventory items that are held by:
- Commodity traders/ brokers who measure their inventories at fair value less costs to sell.
- Producers of agricultural, forest, and mineral products, that are measured at NRV in accordance with the practices established in those industries.
Any change in the value of the above-mentioned inventories will be recognized in the statement of profit or loss in the financial period in which the change has taken place.
Definitions of Important Terms
Inventories are current assets that are:
- held by an entity for selling purposes in the normal course of its business operations;
- in the production process for such sale; or
- in the form of raw materials or other supplies that are to be utilized during the production/ manufacturing process or rendering of services.
Inventories may include:
- Items purchased and held for resale such as merchandize by a retailer or land and similar property held for the purpose of resale.
- Raw materials and other supplies that are to be used during the process of production.
- Products either at work in the process stage or in the form of finished goods.
Net Realizable Value
Net realizable value (NRV) can be defined as the amount which an entity expects to receive from the sale of an asset in its normal course of business operations less the total estimated costs (including repair/ completion costs) that are needed to be incurred to ensure the sale of that asset takes place.
It is the price that an entity would receive for selling an asset or pay to settle a liability in an orderly transaction among market participants at the measurement date.
Inventories should be measured/ valued at lower of cost and NRV.
The cost of an inventory item should comprise all costs incurred (including purchase and conversion costs) for bringing that inventory item to its current condition and location.
The purchase cost of an inventory item includes the purchase price (net off trade discount, rebates, and similar deductions), import duties, taxes (non-recoverable), freight, handling, loading, and all other costs incurred for bringing the finished product to its intended location.
Conversion costs can be defined as costs that are incurred for converting materials into finished goods. The conversion costs include costs that are directly attributable to the number of units produced/ manufactured like direct labor. These costs also include variable and fixed production overheads that are incurred by an entity when converting raw materials and other supplies into finished products. Fixed production overheads are indirect production costs that remain the same irrespective of the number of units produced/ manufactured by the entity. Variable production overheads are indirect production costs that are directly proportional to the production volume like indirect labor and indirect materials.
Other costs are those costs that are necessary to bring the inventory to its intended condition and location.
The cost of an inventory item should not include the following:
- Abnormal losses caused due to fire, theft, labor negligence, wastage, etc.
- Storage cost unless necessary for the production of an inventory item.
- Administrative costs that play no role in bringing the inventory item to its intended condition and location
- Selling and distribution expenses.
IAS 23 provides information regarding certain circumstances where the cost of borrowings (Interest) can be made part of the inventory cost if it meets the criterion specified for a qualifying asset.
Techniques for Cost Measurement
Standard cost and retail methods are the techniques that can be used for measuring inventories if the results are close to the actual costs.
For inventory items that are not interchangeable and are produced for specific projects or on orders, specific costs are attributed to specific individual items of inventory by using the specific identification method of inventory costing.
For inventory items that are interchangeable, the specific identification method of inventory costing is not cost effective and therefore not required. In such situations, the standard recommends the following two methods for measuring inventory:
- First in, first-out method
- Weighted average method
First in, First out Method (FIFO)
In the FIFO method, it is assumed that inventories that are produced or procured first are sold to customers first and similarly the items that do not get sold at a period end are the ones that have been recently produced or purchased.
Weighted Average Method
In the weighted average method, the cost of an inventory item is determined by taking the weighted average of the cost of all similar items produced or purchased at the start of a financial period and the cost of all similar items produced or purchased during a financial period.
Net Realizable Value (NRV)
The cost of an inventory item may be irrecoverable if that inventory item has been damaged, if it has become obsolete or if its selling price has declined. The cost of an inventory item may also be irrecoverable if expected completion costs or expected costs that are necessary to be incurred for the sale have increased. The practice of writing down inventories to their NRV is consistent with the idea that assets should be carried at amounts that are expected to be realized from their use or sale.
Materials and supplies that are to be used in the process of producing/ manufacturing inventories, should not be written down to their NRV if the finished goods in which they will ultimately be used are expected to be sold either at cost or above.
The net realizable value (NRV) of each inventory item should be assessed in each subsequent period. When conditions and circumstances that led to the write-down of inventories below their cost in previous years no longer exist or there is evidence supporting an increase in NRV of certain inventory items because of change in economic conditions, the amount of the write-down should be reversed to the extent of the original amount of the write-down.
Recognition as Expenditure
When Inventory items are sold, the carrying value of those inventory items should be recorded as expenditure in the financial period in which the related revenue is recognized. Any expense with respect to the write down of inventories to NRV should be recorded in the financial period in which it occurs. Similarly, any reversal of previously recorded write down should be recognized in an entity’s statement of profit or loss, as a reduction in the amount of inventories recorded as an expense in the period in which the reversal occurs.
An entity is required to disclose the following as per the requirements of IAS 2:
- the policies that have been adopted by an entity for measuring the cost of inventories, including the cost formula(s) used;
- the total carrying value of all the inventory items held by an entity during a financial period and the carrying value in classifications appropriate to the entity;
- the carrying value of inventories carried at fair value less selling expenses;
- the amount of inventories recognised as expenditure during the year;
- the amount of any write-down to NRV recognised as expenditure in the financial period in which it occurs;
- the amount of any reversal of a write-down to NRV that is recognised as a reduction in the amount of inventories recorded as expenditure in the financial period in which the reversal occurs;
- the circumstances or events that led to the reversal of a write-down of inventories;
- the carrying amount of inventories pledged as security for liabilities.