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IAS 2 – Inventories

Part 1: Introduction + Executive Summary

Part 2: Inventory, Measurement of Inventory

Part 3: Cost formulas, Net realisable value

Part 4: Disclosures required in the financial statements

Read IAS 2 Summary Online IAS 2 Test

1 Inventory
1.1 Introduction

One of the key assets that business holds is inventory which is also named as stock or
goods. Inventories can simply be defined as such assets that business bought and hold with
an intention to sell further in the ordinary course of business which simply means that it is
the business of the entity to sell such assets on regular basis.

Inventory is treated as current assets of the entity

IAS 2 deals with the accounting treatments of inventories at different stages starting from
recognition and after recognition and lastly when they are sold. Overall IAS 2 touches the
following topics:

1. Cost of inventory to be recognized

2. Cost formula to be used for inventory valuation

3. Adjustments in the carrying value of inventory for write-downs

4. Subsequent recognition as an expense when the goods are sold

1.2 What is inventory?

According to IAS 2 Inventories are assets:

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1. held for sale in the ordinary course of business;

2. in the process of production for such sale; or

3. in the form of materials or supplies to be consumed in the production process or in the

rendering of services.

2 Measurement of Inventory
Inventories shall be measured at the lower of cost and net realisable value.

2.1 What is Cost of inventory?

Costs to be included

The cost of inventories shall comprise:

1. all costs of purchase;

2. costs of conversion; and

3. other costs incurred in bringing the inventories to their present location and condition.

Costs to be Excluded

Examples of costs excluded from the cost of inventories and recognised as expenses in the
period in which they are incurred are:

1. abnormal amounts of wasted materials, labour or other production costs;

2. storage costs, unless those costs are necessary in the production process before a
further production stage;

3. administrative overheads that do not contribute to bringing inventories to their present

location and condition; and

4. selling costs.

2.1.1 Cost of Purchase

The costs of purchase of inventories comprise:

1. the purchase price,

2. import duties

3. irrecoverable taxes

4. transportation costs; e.g. carriage inwards, freight etc

5. handling costs e.g. insurance cost

6. any other cost that is directly attributable to the acquisition of finished goods, materials
and services.

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Following are deducted while determining cost of purchase:

1. Trade discounts,

2. Rebates, recoverable taxes

3. other similar items; e.g. grants

2.1.2 Cost of conversion

Cost of conversion includes direct labour cost. It also includes fixed and variable overheads
which are incurred in converting raw materials to finished goods.

Fixed production overheads are fixed as they do not change with the change in the activity
level i.e. these costs are independent of production level. Examples include factory rent,
depreciation of asset if it is on straight line basis.

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Variable production overheads are variable costs because they change with the change in
the activity level. For example; indirect material and indirect labour.

Fixed production overheads are allocated using normal capacity. Normal capacity means the
production capacity that is attainable under normal conditions and circumstances. Actual
capacity may also be used for allocation purposes if it approximates normal capacity.
However, such fixed production overheads which cannot be allocated to a particular cost
object then they will charged as an expense in profit and loss account.

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Variable production overheads are included in the production cost of each unit on basis of
the basis of actual use.

If a conversion process renders more than one product and conversion costs is not
separately identifiable for each product then conversion cost can be divided on some
rational basis. However, such allocation basis should be used consistently over the period of
time. Methods of allocation include:

1. Sale price at split off point

2. Sale price after further processing (at completion)

Usually if output contains main-products and by-products then the value of by-products is
immaterial compared to the value of main-product. Therefore, by-product is valued at its
NRV which is then deducted from the cost of the main-products.

2.1.3 Other Costs

Other costs include all such costs that are incurred specifically for the inventory to bring
them in present location or condition. For example, while preparing an order of a particular
customer who demands special kind of packing then the additional cost of packing will be
added in the cost of inventory.

2.2 Other Techniques for the measurement of cost of inventory

IAS 2 allows the use of standard cost and retail method if the cost determined under such
method is approximately the same as cost measured under the provisions described above.

Under standard costing management of the entity determines the different costs related to
production in advance on the basis of normal conditions and circumstances and such costs
are then kept fairly constant. However, if circumstances and conditions change management
should review its standards and must make amendments accordingly to reflect the changes.

Retail method of costing the inventory is used in such industries where there is large
number of inventories that change rapidly i.e. there is a rapid flow of inventories. In such
situations if inventories have similar profit margin then cost of the inventory is determined
by deducting profit margin from the selling price. This method makes costing much easier
as with large amount of inventories it is impracticable to use other costing methods.
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However, care should be taken while determining the margin to be deducted as margin is
usually determined in relation to price which can change.

2.3 Special Cases

Borrowing Costs

Borrowing costs can be included in the inventory if inventory fulfills the definition of
qualifying asset which means an asset that takes substantial time to complete.

However, inventories that are produced in a short period of time are not qualifying asset.
For example, inventory held by usual producers other than building contractors.

Also, the items that were ready to be used or sold at the time of acquisition are also not
qualifying assets. For example, inventory held by retailers.

Deferred Payment Terms

An entity may purchase inventories on deferred settlement terms. When the arrangement
effectively contains a financing element, that element, for example a difference between the
purchase price for normal credit terms and the amount paid, is recognised as interest
expense over the period of the financing.

2.4 Cost of inventory for service providers

To the extent that service providers have inventories, they measure them at the costs of
their production. These costs consist primarily of the labour and other costs of personnel
directly engaged in providing the service, including supervisory personnel, and attributable
overheads.

Labour and other costs relating to sales and general administrative personnel are not
included but are recognised as expenses in the period in which they are incurred.

The cost of inventories of a service provider does not include profit margins or non-
attributable overheads that are often factored into prices charged by service providers.

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