ACCT 111 FINANCIAL ACCOUNTING IA

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Accounting for Inventories (IAS 2)

Objective of IAS 2
The objective of the standard is to prescribe the accounting treatment for inventories. A primary issue in accounting
for inventories is the amount of cost to be recognised as an asset and carried forward until the related revenues are
recognised.
Thus the standard provides guidance on the determination of cost and its subsequent recognition as 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.

Measurement of inventories
 Inventories shall be measured at the lower of cost and net realisable value.
 The cost of inventories shall comprise costs of purchase, cost of conversion and other costs incurred in
bringing the inventories to their present location and condition.
 Cost of purchase of inventories comprise of:
 Purchase
 Price
 Import duties – manica, expedisis , condep
 Other taxes
 Transport
 Handling and other costs

Methods of valuating stock

 FIFO

 AVCO

Stock valuation and the calculation of profits

Example
Assume that a business had just completed its first financial year and is about to value stock at cost price. It has dealt
in only one type of goods. A record of the transaction is now shown below:

Bought Sold
2016 $ 2016 $
January 10 @ 300 each 3 000 May 8@500 each 4 000
April 10 @340 each 3 400 November 24 @ 600 each 14 400
October 20 @400 each 8 000

Using the figures in the records of the stock transaction,

1. value the stock using 2 methods FIFO and AVCO and

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2. Prepare the trading account for the business.

First in First Out Method (FIFO)

This method assumes that the first units purchased are the first units to be sold. In practise, however, it is difficult to
follow such an order especially with homogeneous items.

Average Cost Method (AVCO)

This involves valuing stocks at an average price. i.e. using the AVCO method with each receipt of goods the average
cost for each item of stock is recalculated. Further uses of goods are then at that figure until another receipt of goods
means that another recalculation is needed.

As you can see different methods of stock valuation, result in different profits. It is therefore important that the
method chosen is the one that is closest in its assumption to the nature of the business.

Reduction to net realisable value

 Having selected the most appropriate method to apply when determining the cost of closing stock, you next
need to consider whether that value is realistic i.e. whether it is what the stock is actually worthy at the end
of the period. This is an example of the application of the prudence concept (accountants should always
exercise caution when dealing with uncertainty, while at the same time ensuring that the financial
statements are neutral- that gains and losses are neither overstated nor understated.
 Following the prudence concept, stock should never be overvalued or undervalued.
 To check that stock is not overvalued accountants calculate its net realisable value. This is done according
to the formulae:
Saleable value (i.e. what it can be sold for)- expenses needed before completion of sale (such as
costs of delivering to the seller’s shop)= Net Realisable Value
 If the net realisable value of the stock is less than the cost of the stock, then the figures to be used in the
financial statement is net realisable value not cost.

Net realisable value

Net realisable value is the amount that can be obtained from disposing of the inventory in normal course of business,
less any further costs that will be incurred in getting it ready for sale or disposal.
 Net realisable value is usually higher than cost. Inventory is therefore usually valued at cost.
 However, when inventory loses value, perhaps because it has been damaged or is now obsolete, net
realisable value will be lower than cost.

The cost and net realisable value should be compared for each separately-identifiable item of inventory, or group of
similar inventories, rather than for inventory in total.

Note: IAS2 uses the term ‘measurement’ of inventory. You may prefer to think of this as a ‘valuation’ of inventory.
‘Measurement’ here means expressing inventory as a monetary amount.

Example
In year 2016 a business has four items of inventory. A count of the inventory has established that the amounts of
inventory currently held, at cost, are as follows:
$
Inventory item A1 8 000
Inventory item A2 14 000
Inventory item B1 16 000
Inventory item C1 6 000

Required: What should be the value for inventory in the statement of financial position?

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Lower of cost and NRV: events after the end of the accounting period

Inventory must be valued at the lower of cost and net realisable value, but it might not become apparent that NRV is
less than cost until after the end of the financial period.

For example, suppose that a company has 100units of an item at the end of the accounting period on 31 December
2016, and these units have a cost of $20 each or $2 000 in total. The units might be sold in January 2017, but only
for $15 each net of selling expenses. if the company has not yet published its financial statements for 2016, it should
amend the value of the inventory value as at 31 December. Since the units were sold for only $15 in January, it is
clear that their net realisable value at 31 December was only $15, even though this only became apparent later.

The inventory at 31 December 2016 should therefore be stated at net realisable value, $1 500, and the write-off of
$500 should be included as an expense in profit and loss for 2016.

Cost of inventories

IAS 2 states that ‘the cost of inventories shall comprise all cost purchase, cost of conversion and other costs incurred
in bringing the inventories to their present location and condition.

Purchase cost

The purchase cost of inventory will consist of:

 The purchase price
 Plus import duties and other non-recoverable taxes (but excluding recoverable sales tax)
 Plus transport, handling and other costs directly attributable to the purchase (carriage inwards), if these
costs are additional to the purchase price.

The purchase price excludes any trade discounts, and is the cosr after deduction of trade discounts.

Conversion costs

When materials purchased from suppliers are converted into another product in a manufacturing or assembly
operation, there are also conversion costs to add to the purchase costs of the materials. Conversion costs must be
included in the cost of finished goods and unfinished work in progress.

Conversion costs consist of:

 Costs directly related to units of production, such as costs of direct labour (i.e. the cost of the labour
employed to perform the conversion work)
 Fixed and variable production overheads, which must be located to costs of items produced and closing
inventories. (fixed production overheads must be allocated to costs of finished output and closing
inventories on the basis of the normal production capacity in the period)
 Other costs incurred in bringing the inventories to their present location and condition.
Production overheads also known as factory overheads include:
 Costs of indirect labour, including the salaries of the factory manager and factory supervisors
 Depreciation costs of non-current assets used in production
 Costs of carriage inwards, if these are not included in the purchase costs of thr materials.

Other costs
Other costs can be included in the cost of inventories only to the extent that they are incurred in bringing the
inventory to its present location and condition. Costs that should not be included in the costs of inventories include:

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  Abnormal amounts of wasted materials
 Storage costs
 Administrative overheads
 Costs of selling the inventory

Only production overheads are included in costs of finished goods inventories and work-in-progress. Administrative
costs and selling and distribution costs must not be included in the cost of inventory.

Carriage inwards and carriage outwards

Two expenses that you might come across are carriage inwards and carriage outwards. Even though they are
both expenses they are reportedly differently in the income statement.

Carriage inwards
This is the cost a business might incur in getting its purchases delivered to its business premises. Sometimes the
supplier may pay any delivery costs but if the business has to pay its own delivery cists it records these costs as
carriage inwards. The double entry is:

Debit Carriage inwards

Credit Bank

Cost of carriage inwards is part of the costs of bringing the inventory to its current location and condition. The cost
is usually added to the purchase cost of the goods and so this cost included in the cost of sales and the calculation of
gross profit.

Carriage inwards

Carriage inwards is the cost of delivering goods to customers. This is a normal selling expense, which is treated as
an expense in the income statement. The cost of carriage outwards is not included in the cost of inventory or cost of
sales and so does not affect gross profit (only net profit)